The trade off model

Category: Money, Trade
Last Updated: 07 May 2020
Pages: 6 Views: 395

"If the Trade-Off Theory were true, then firms ought to have much higher debt levels than we observe in reality." -- Miller (in "Debt and Taxes" published in Journal of Finance, 1977) The simulation model does a good job of capturing some dynamic aspects of Diageo's capital structure problem. By using random variables to model for uncertainties, and generating 10,000 trials of 15 years each, a far range of outcomes can be quantified. The simulation includes many reactive variables, such as recalculation of the interest coverage ratio in each year and changes in the debt level to maintain a constant zero-cash balance. However, the model also uses many constant parameters for simplicity, and fails to capture some features of reality.

The greatest weakness of the model might be a lack of measures for preventing or responding to financial distress. The model is meant to evaluate the effectiveness of different interest coverage benchmarks, but it does not seem to allow for Diageo to take action to stick to each target benchmark. Only when the coverage is deemed too high, the company can issue a special dividend. But as the case describes, "there was no provision to pay down debt when coverage fell" to avoid potential distress. In fact, the coverage ratio and debt levels seemed to depend more on financing measures modeled to maintain constant year-end cash balances than on the target coverage ratio.

The model also lacks provisions for company reorganization in the face of financial distress. A 20% reduction in firm value occurs whenever the coverage falls below 1, but if the firm anticipated a fall in interest coverage due to low expected profitability, even if it cannot pay down debt at that point it can cut back on some major expense accounts such as its advertising budget, to leave some space for financing interest payments. Measures for preventing distress will decrease the likelihood of bankruptcy and may also decrease its cost.

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The cash assumptions and the definition of financial distress made by the model are also questionable. Interest payments are paid out of the cash account, not EBIT, so an interest coverage ratio below 1 does not mean that the company is insolvent and in distress. If it happens to be a bad season, then it is short term and if Diageo has a sufficient cash buffer then there is no real distress problem. Only when the coverage ratio continues to be below 1 does distress arise. This then leads to another modeling assumption that the year end cash balance is always zero and therefore no cash buffer exists to pay for interest in bad years.

This is a poor assumption since companies always maintain some minimum cash and liquid assets, and this minimum should grow as the size of the company grows. Assuming a zero year-end cash balance also forces Diageo to take out or repay additional debt when it may be better off not doing so. In some cases, Diageo may be too highly leveraged and will not even be able to take out additional debt but the model does not account for this possibility and does not allow the company to issue new equity in place of debt in any circumstance.

Further static assumptions of the model include a constant maturity mix of debt and presumably infinite refinancing at the range of rates given by a set of interest coverage ratios. Constant currency mix of debt is also assumed regardless of exchange rate dynamics and regional strategies. So management in effect has no control over the type of debt taken out and cannot choose less costly debt or debt that holds less exchange rate risk. If the model can capture this, the cost of holding debt should go down.

Finally, as the Treasurer Ian Cray describes, in the interest of Diageo, financial distress is not simply an inability to pay debt, it also should include an inability to meet the expectations of equity holders. Therefore even when interest coverage is above 1, the company could already be in a "distressed" situation and already have lost some of its firm value. At that point, the company can of course take action to reorganize, at some cost. Otherwise, there may be some chance of it suffering the full cost of financial distress. Since this is an important consideration to Diageo, the model can be enhanced to accommodate it. It will skew results to indicate a higher optimal coverage and less financial leverage.

More thoughts on Diageo's capital structure decision. There are other factors that we should take into account in choosing the optimal capital structure. Agency costs can be one factor. Agency costs involve conflict between the interest of the firm's management, its shareholders, and its debt holders. With respect to leverage policy, debt may have a disciplining effect on companies and causes underinvestment. If the leveraged firm undertakes a low-risk project with safe and consistent cash flows, most of the returns will be claimed by the debt-holders.

In response the equity holders will want the company to avoid those low-risk projects and only invest in those projects which are risky and can produce very high returns at the expense of the debt holders. Management acting in the interest of shareholders with therefore limit investment to high return projects and disregard other positive NPV projects which can increase firm value. The greater the firm's leverage, the more severe is the underinvestment problems. This is a cost of debt which the model has not accounted for.

From shareholders' perspective, they may or may not be satisfied with the debt to equity ratio suggested by the static trade-off theory. Shareholders have their own decisions on how much risk they can afford and how much return they are expecting. If the debt to equity ratio is way too high, the shareholders will be left in a highly risky position because in case the company encounters a financial distress the debt holders have priority in receiving protection. Since the management team is responsible to act in shareholders' interests, the CEO, CFO and other decision makers should pay attention to shareholders' tolerance of risk level while they adjust the company's capital structure.

In Diageo's case, the debt to equity ratio is about 1 to 3, while interest coverage ratio is 5 to 8 times. If the management decides to follow the trade-off model and target an interest coverage ratio of 3.9 to 4.5 times, the debt to equity ratio would increase (lower interest coverage ratio implies a higher debt level, assuming EBITDA remains the same). Then the management team should question themselves whether the shareholders would be satisfied with the higher debt level, or not.

Another way to think about the capital structure is to analyze the industry comparables. The major competitors, including Allied Domecq and Coca Cola, have higher interest coverage ratios than Diageo. Some competitors' interest coverage ratios have doubled or even tripled Diageo's. This implies that Diageo's debt level is a bit too high. If the management follows the competitors' choice on debt and equity ratio, they should rearrange the capital structure by reducing the debt level and increase equity level.

However, the industry comparable analysis may not suggest the right capital structure for Diageo because the competitors' financial condition and ability to generate earnings may differ from Diageo's. In fact, the decision on capital structure largely depends on Diageo's own positions in operation and financing as well as Diageo's management and shareholders' risk tolerance.

Last but not least, Diageo is currently allowed to take on a higher level of debt than other companies due to its relatively stable cash flows. It is questionable whether Diageo can maintain the cash flow stability. The cash flow stability can be affected by internal factors such as changes in investing activities and by external factors such as industry competition. In this sense, it is not guaranteed that Diageo can still enjoy a higher level of debt than other companies while maintaining A+ credit rating. Thus, the constraints on Diageo's debt level may vary over time.

Conclusion

The management's decision on Diageo's capital structure can be influenced by a variety of factors, which include the optimization of static trade off model, the maintenance of credit ratings, risk tolerance of shareholders and capital structures of comparable competitors, etc. It is important to acknowledge that these factors have set up constraints on the capital structure decision in very different directions. For instance, the optimal solution from the trade off model does not satisfy the requirements of credit ratings.

Surprisingly, the "real" trade off in Diageo's case is between all these factors. Thus, the amount of weights the management allocates to these factors becomes the key in making the capital structure decision. If the management put more weights on the maintenance of credit rating, the interest coverage ratio should be in the range of 5 to 8 and the debt level should be below 6.78 billion. If more weights are given to the trade off model, the interest coverage ratio should be around 4.2. The management may increase the debt level to 8.1 billion and risk a credit rating downgrade to BBB.

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The trade off model. (2018, Apr 24). Retrieved from https://phdessay.com/the-trade-off-model/

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