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C-11-1

Minicase 11 Divisional Cost of Capital

Diageo PLC (Diageo) operates three major lines of business: restaurants, alcoholic beverages, and food items. Its major restaurant chain is Burger King. Major food items include Haagen Dazs ice cream. Alcoholic beverages include the Segrams brands. Restaurants account for about 25% of sales and 10% of profits, alcoholic beverages contribute 50% of sales and 60% of profits, and food items account for 25% of sales and 30% of profits. The Restaurant Industry The U.S. restaurant industry is highly competitive with a large number of national chains competing with local restaurants. The national chains offer a menu of choices ranging from fast food (McDonald’s, Burger King, KFC Fried Chicken, Pizza Hut, Taco Bell (Mexican), CKE Restaurants’ Carl’s Jr., and Wendy’s) to casual family-style dining (TGI Friday’s, Applebee’s, and Bob Evans Farms), and full-service restaurants (Shoney’s).

The long-term outlook for the restaurant industry is favorable. The industry will continue to benefit from two-wage-earner families, who have larger disposable incomes but less time to prepare meals at home. Consequently, industry analysts expect that the trend toward eating away from home or bringing prepared meals home will continue into the foreseeable future, primarily benefiting the more efficient restaurant operators. Overview of Diageo Exhibit 11-1 furnishes income statements for Diageo and Exhibit 11-2 furnishes balance sheets. Diageo has book liabilities of $18.1 billion, and book value of stockholders’ equity of $7.3 billion. The market value of Diageo’s stockholders’ equity is much greater. With 788 million common

Diageo has established a long-term target range of 20%-25% for its market net debt ratio. which it believes will optimize its cost of capital. or roughly six times its book value. based on the year-end stock price) is the most appropriate measure of its financial leverage. Unlike historical cost measures. the market value of its stockholders’ equity is $44. Questions . Total debt includes the present value of operating lease commitments. Net debt reflects the pro forma remittance of the value of these portfolios (net of related taxes) as a reduction of total debt.C-11-2 shares outstanding and a share price of $55. It has not reported costs of capital separately for its three lines of business.S. Assume a 34% income tax rate and a target long-term debt rating of A-2. Diageo believes that market leverage (defined as net debt expressed as a percent of net debt plus the market value of equity. the market value of equity primarily reflects the estimated net present value of expected future cash flows that will both support debt and provide returns to shareholders. These portfolios are managed as part of Diageo’s overall financing strategy and are not required to support day-to-day operations. Financial Leverage Diageo measures financial leverage on both a market value and an historical cost basis. Then estimate a WACC for Diageo’s restaurant business using the information in Exhibit 11-5.875. Estimate Diageo’s WACC using the information furnished in this case and the market data in Exhibits 11-3 and 11-4.0 billion. This approach takes into account its large investment portfolios held outside the U. Diageo believes it appropriate to measure debt net of its available cash. Cost of Capital Diageo has reported its overall cost of capital to be approximately 10%.

Use Diageo’s net debt ratio to calculate Diageo’s overall WACC. from its total debt when calculating its “net debt ratio”. which is held outside the United States and is not required to support day-to-day operations. Should Diageo use its overall cost of capital to evaluate its restaurant investments? Under what circumstances would it be correct to do so? 3. Diageo subtracts the value of its portfolio of short-term investments. Explain why there is a difference between Diageo’s overall cost of capital and the cost of capital for its restaurant business. Estimate the cost of capital for Diageo’s restaurant business. 4.C-11-3 1. . 2.

434 2.432 826 $1. Annual Reports to Shareholders.114 2. ____________________________________________________________________________________________ Source: Diageo PLC.78 % 100 90 10 (2) 8 3 5 Net sales Costs and expenses Operating profit Interest expense Other income (expense) Pretax income Income taxes Effect of accounting changes Net income Earnings per share Dividends per share a Before cumulative effect of accounting changes.62 % 100 88 12 (2) 10 4 6 One Year Ago Amount $28.588 $1.423 835 $1. .70 % 100 89 11 (2) 9 3 6 Latest Year Amount $30.021 22.752 $2.22a $0.664 880 (32) $1.271 3.987 (682) 127 2.472 25.00 $0.606 $2.C-11-4 EXHIBIT 11-1 Diageo Income Statements (Dollars in millions) Two Years Ago Amount $25.201 (645) 108 2.907 (573) 89 2.96 $0.421 27.

546 1. Annual Reports to Shareholders.883 7.048 5.230 8.119 Approximates market value.452 678 3. 788 million shares in latest year) Total liabilities and stockholders’ equity 6.968 5.270 8.509 b 4.584 797 $25. plant.825 17. and equipment (net) Intangible assets (net) Other assets Total assets Liabilities and Stockholders’ Equity Accounts payable Short-term borrowings Other current liabilities Total current liabilities Long-term debt Other liabilities Total liabilities Stockholders’ equity (790 million shares outstanding one year ago.140 5. Market value equals $8.380 18.295 9.792 28 100 7. ____________________________________________________________________________________________ Source: Diageo PLC.584 5.747 million.870 7.841 3.842 700 $24.313 $25.635 9.116 a a Amount $331 1.856 $24.432 29 100 $1.556 706 a Latest Year % 1 5 14 20 5 40 32 3 100 Amount $382 1.432 6 3 12 21 33 17 71 2.C-11-5 EXHIBIT 11-2 Diageo Balance Sheets (Dollars in millions) One Year Ago Assets Cash and cash equivalents Short-term marketable securities (at cost) Other current assets Total current assets Investments in unconsolidated affiliates Property.072 1. a b .936 6 2 13 21 36 15 72 $1.792 % 2 4 16 22 6 39 30 3 100 4.157 3.

40% 7.00 Short-term Intermediate-term Long-term 8.C-11-6 EXHIBIT 11-3 Selected Market Data for Diageo Diageo’s beta Riskless returns: Short-term Intermediate-term Long-term 1.00 Market risk premium: 5.50 6.00 .40 7.13% 5.

03% 5.23 6.89 5.69 5.87 6.00% 5.58 5.17 6.75 A3 6.69 5.61 5.09 6.68 6.89 6. .92 5.06 6.95 6.89 5.71 A2 6.09 6.59 5.08 6.P.94 5.75 6.05% 5.80 5.79 5.60 5.37 6.60 5. L.73 5.81 Source: Bloomberg.84 6.C-11-7 EXHIBIT 11-4 Fair Market Yield Curves 3 MO 6 MO 1 YR 2 YR 3 YR 4 YR 5 YR 7 YR 10 YR 20 YR 30 YR A1 6.

L.P.15 1.250 10.C-11-8 EXHIBIT 11-5 Selected Data for Comparable Restaurant Companies PREFERRED STOCK FIRM Applebee’s International Bob Evans Farms Brinker International CKE Restaurants McDonald’s NPC International Shoney’s Wendy’s International LISTED NASDAQ NASDAQ NYSE NYSE NYSE NASDAQ NYSE NYSE BETA 1.70 1.250 Sources: Bloomberg.7 4.4 440.750 19.000 45.30 0. .80 0.00 0.95 1.3 72.1 18.820.0 STOCK ($ MILLIONS) $ 411.250 21.90 1.7 86.7 104.5 103.1 81.125 16.4 CLOSING STOCK PRICE ($) $ 22.125 7.5 41.0 42.5 54.15 TOTAL DEBT ($ MILLIONS) $ 28.4 147.4 694. and Value Line Investment Survey .0 24..000 15.1 - COMMON SHARES (MILLIONS) 31.