A recent annual report for Diageo PLC explains that its investments are expected to generate cash returns that exceed its

Diageo PLC explains that its investments are expected

COST OF CAPITAL 215 CHAPTER 8 Minicase  A recent annual report for Diageo PLC explains that its investments are expected

COST OF CAPITAL 215 CHAPTER 8 Minicase  ISBN: 0-536-42875-1

A recent annual report for Diageo PLC explains that its investments are expected to generate cash returns that exceed its “long-term cost of capital,” which Diageo estimated to be approximately 10%. Diageo has three main lines of business: food items, such as Haagen Dazs ice cream; alcoholic beverages, such as Seagrams; and restaurants, such as Burger King. Diageo did not report costs of capital separately for these three businesses. Information from the annual report is given here, followed by relevant market data. Financial information: Cash and marketable securities $1,498 million (approximates market value) Short-term debt $706 million (approximates market value) Long-term debt $8,509 million ($8,747 million market value) Common shares outstanding 788 million Year-end share price $55.875 Income tax rate 34% Market data: Diageo’s beta 1.00 Diageo’s long-term borrowing rate 6.75% Riskless returns: Short term 5.13% Intermediate term 5.50 Long term 6.00 Market risk premium: Short term 8.40% Intermediate term 7.40 Long term 7.00

The following table provides information concerning publicly traded restaurant firms. FIRMSTOCK LISTEDBETATOTAL DEBT ($ MILLIONS) PREFERRED STOCK ($ MILLIONS)COMMON SHARES (MILLIONS)CLOSING STOCK PRICE Applebee’sNASDAQ1.3028.5-31.0$22.750 Bob Evans FarmsNASDAQ0.9554.7-42.319.000 Brinker InternationalNYSE1.70104.7-72.115.125 CKE RestaurantsNYSE1.1586.7-18.416.000 McDonald’sNYSE1.004,820.1411.1694.045.125 NPC InternationalNASDAQ0.8081.4-24.57.250 Shoney’sNYSE0.90440.4-41.510.250 Wendy’s InternationalNYSE1.15147.0-103.421.250

QUESTIONS                                   

1. Diageo subtracts the value of its portfolio of short-term investments, which is held outside the United States and is not required to support day-to-day operations, from its total debt when calculating its “net debt ratio.” Use Diageo’s net debt ratio to calculate Diageo’s overall WACC.

2. Should Diageo use its overall cost of capital to evaluate its restaurant investments? Under what circumstances would it be correct to do so?

3. Estimate the cost of capital for Diageo’s restaurant businesses.

4. Explain why there is a difference between Diageo’s overall cost of capital and the cost of capital for its restaurant businesses.

SOLUTION PREVIEW

WACC = Wd x Kd (1 - t) + We x Ke
Common share outstanding =		788	million
Year-end share price=		$55.88
Value of equity=788*$55.875=		$44,029.50	million
Long term debt (market value) =		$8,747.00	million

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