Marriott Corporation: The Cost of Capital

In April 1988, Dan Cohrs, vice president of project finance at the Marriott Corpo ration, was preparing his annual recommendations for the hurdle rates at each of the firms one-third divisions. Investment projects at Marriott were selected by discounting the appropriate cash flows by the appropriate hurdle rate for each division. In 1987, Marriotts sales grew by 24% and its generate on righteousness stood at 22%. Sales and earnings per share had doubled oer the previous four years, and the operating strategy was aimed at continuing this trend.Marriotts 1987 annual report stated We intend to remain a premier growth company. This means aggressively developing appropriate opportunities within our chosen lines of condescension live, arrest services, and related businesses. In each of these areas our goal is to be the preferred employer, the preferred provider, and the most profitable company. Mr. Cohrs recognized that the divisional hurdle rates at Marriott would have a significan t tack together on the firms financial and operating strategies.As a rule of thumb, increasing the hurdle rate by 1% (for example, from 12% to 12. 12%), decreases the present cheer of project inflows by 1%. Because destinationss remained roughly fixed, these changes in the grade of inflows translated into changes in the net present regard as of projects . Figure A shows the substantial effect of hurdle rates on the anticipated net present value of projects. If hurdle rates were to increase, Marriotts growth would be reduced as once profitable projects no longer met the hurdle rates.Alternatively, if hurdle rates decreased, Marriotts growth would accelerate. Marriott also considered using the hurdle rates to twist back incentive compensation. Annual incentive compensation constituted a significant portion of total compensation, ranging from 30% to 50% of base pay. Criteria for bonus awards depended on specialised job responsibilities but often included the earnings level, th e ability of managers to meet budgets, and overall corporate performance.There was some interest, however, in basing the incentive compensation, in part, on a comparison of the divisional return on net assets and the trade-based divisional hurdle rate. The compensation plan would then reflect hurdle rates, making managers to a greater extent sensitive to Marriotts financial strategy and detonator market conditions. Professor Richard Ruback prepared this case as the basis for class discussion rather than to illustrate all effective or ineffective handling of an administrative situation.Copyright 1998 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, hold open Harvard Business School Publishing, Boston, MA 02163, or go to http//www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectro nic, mechanical, photocopying, recording, or otherwisewith knocked out(p) the permi ssion of Harvard Business School.Marriott Corporation the live of Capital1. How does Marriott use its estimate of its apostrophize of great(p)? Does this make sense? Marriott has defined a clear financial strategy containing four elements. To determine the terms of crown, which also acted as hurdle rate for investment decision, comprise of capital estimates were generated from each of the three business divisions lodging, contract services and restaurants. Each division estimates its cost of capital based on Debt Capacity address of Debt equal of EquityAll of the above are propose individually for each of the three divisions, and this is a critical edicttion due to the varying cost of debt in particular for each division. Marriott then calculate company huge cost of capital using weighted mediocre out of the individual divisions cost of capital. This is a very clever approach, particu larly as we see that for example the lodging unit, has a 74% debt percentage in the capital structure, and the fact that Marriott use long term cost of debt for lodging (which in this case is close to Government debt 110 bps margin) demonstrates the low respect investors behold this side of the business to haveWe believe this approach is sound due to the difference in the cost of capital between the divisions being a function of the risk associated with the investments considered so this approach incorporates the fact that risk between the divisions varies. Given this we believe the method chosen by Marriott is compliant with the Marriott Financial Strategy as the capital costing approach is due alert and reflect the mavin entity risk (bottom-up) rather than an estimated top-down.We believe this approach enables Marriott to optimize the financial performance and in turn increase the shareholder value. 2. If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over duration? Marriotts three divisions are very different in terms of business area, business risk and capital structure (debt capacity). The result is varying capital cost between the divisions. For instance Lodging has a significant lower cost of capital (WACC) than the Restaurant and even than the company as a whole.Using a single company-wide hurdle rate would create an uneven process in assessing investment opportunities across the divisions. In practical terms the play/reject decision would not reflect the inherent business risk of the division, which could lead to investments being accepted, season they should have been rejected. Given the WACC tallys in the following questions, we see there is a significant difference in the cost of capital between the different divisions varying from 8. 85% (Lodging) to 12. 11% (Restaurants)Therefore, if we were to use one single corporate hurdle rate, w e would consider in this instance that we would use the Marriott WACC of 10. 01%, then we may reject an investment in Lodging which would yield a positive NPV and vice versa, we may accept an investment opportunities in Restaurants which potentially would yield a negative NPV. Going back to the brief, we know that typically an increase in hurdle rate of 1% will decrease present value of project inflows by 1%. If we were to then use one hurdle rate (10. 1%) and take the lodging hurdle rate (8. 85%) this would be an increase in WACC of 13. 10% (lodging) and would therefore decrease PV of project inflows by the same 13. 10% so the effect of using a single rate is compounded, firstly it impacts the decision, and the PV due to the discount impact. Over cartridge clip a single hurdle rate (if consistently high than the existing approach) would significantly hurt the performance of company as the approach could lead Marriott to reject (or accept) investment opportunities which should h ave been accepted (or rejected).This would destroy shareholder value. 3. What is Marriotts Weighted Average follow of Capital? What types of investments would you value using Marriotts WACC? To calculate Marriotts WACC, we need to assess three factors 1) Capital structure, 2) Cost of debt, 3) Cost of Equity. As the corporate tax rate is given we will not manually calculate it. If required we would have used the financial statement in appendix 1 to do so.After having calculated the three factors mentioned above we employ the following formula to incur WACC WACC = (1-t)*rD*(D/V) + rE*(E/V) where Re = After tax cost of equity, Rd = pre tax cost of debt, E = market value of the firms equity, D = market value of the firms debt, V = E + D = firm value, E/V = percentage of financing that is equity, D/V = percentage of financing that is debt and t = corporate tax rate. 1) Capital Structure We find the capital structure in get across A on page 4 in the case. As the debt percentage in capi tal D/V in the WACC formula is given we find the equity percentage in capital (E/V) as E/V= 1 D/V.Using this we see Marriott is funded using 60% debt and 40% equity. We do see to it the info in Table A is the target-leverage ratio, but we are comfortable using the target capital structure for this purpose instead of the reliable capital structure. 2) Cost of Debt The cost of debt is mathematically defined as Cost of Debt = (1-t) rD, where rD is the rate for pretax cost of debt and (1-t) represents the tax shield via the corporate tax rate. In the following rD is calculated, while the tax shield is not included until the final WACC calculation.Marriotts debt was divided into two different segments go rate and fixed rate. 40% of Marriotts debt was drift rate where the interest rate payment changes with changes in the market interest rates, while 60% was fixed rate. The case gives a debt rate premium above government, but information about term structure or other features of th e floating debt are limited. We believe the correct way to estimate the cost of debt is to estimate the cost per debt type/segment and then in a second step weigh the costs using the debt structure.To do this we estimate that the floating debt rate is best estimated using the 1yr government rate in Table B for the reason that we do not have any shorter term information or average, and this most closely would represent floating. While for the fixed debt portion we have selected the 10yr government rate. Again, this is due to a mix of long term and shorter term fixed debit. This is the best assumption we can take using the data provided. Given the above the cost of debt of Marriott is Average((1yr Gov. ate)*(Floating debt fraction) + (10yr Gov. rate)*(Fixed Debt Fraction)) + Debt Rate Premium Above Government Average((6. 90%)(40%) + (8. 72%)(60%)) +1. 30% = 9. 29% 3) Cost of Equity Cost of Equity is found using the Capital Asset Pricing Model (CAPM) or rE = RF+ ? i(ERM RF), Where r F is the risk easy rate we estimated earlier, ? is the systematic risk or the overall risk factor and (ERM RF) is the price of risk or market risk premium (MRP) investors expect over and above what the risk dethaw securities yield.To be consistent in selecting expected market return and the risk free rate, we have selected to use the same judgment of conviction period for both estimates. Using Exhibit 4 and 5 we find the appropriate data. We take the longest time period available as we believe this is the conservative method as outliers in the data is crowded out due to the law of large numbers, which increases the empirical probability of accuracy. Given this we have selected 1926-87 average returns of the long-term U. S government hold fast as the risk free rate (RF) thus RF is 4. 58%. (Exhibit 4).The MRP is estimated using Exhibit 5, where we use the S excess return over the long term U. S government bond over the same time period as the risk premium (ERM RF) = MRP = 7. 43% . S is chosen as the market return as the stock index represents a wide and diversified range of equity across different sectors and industries. Given this we believe it is fair to use the S excess return over the risk free rate as the market risk premium (MRP) To find the ? we need to adjust the equity ? given in Exhibit 3 as it reflects the current capital structure and not the target structure.To re-calculate in order for the ? to reflect the Marriott target capital structure, we first calculate the unleveraged ? and then re-leverage it with the target capital structure. The unleveraged ? is calculated using Unlevered ? = Equity ? / (1 + (1 t) x (Debt/Equity)). As all data is given in Exhibit 3, we find unleveraged ? = 0. 7610. (See detailed calculations in excel sheet downstairs tab Exhibit 3). To re-leverage the data we re-write the formula Equity ? = Unlevered ? * (1 + (1 Tc) x (Debt/Equity)) = 0. 7610 *(1+(1-34%)*(60%/(1-60%)) = 1. 514.We now have all the data need to calc ulate the cost of equity rE = RF + ? (ERM RF ) 4. 58%+ 1. 514(7. 43) =15. 83%. Finally we find WACC by employing the formula WACC = E/V ? rE + D/V ? rD ? (1 t) 40%*15. 83% + 60% *(9. 29%(1-34%)) = 10. 01%. Please find all detailed calculations in the attracted excel sheet under tab Table A. We would value an investment of similar risk, which would offer us a return higher than the WACC of 10. 01%, as anything over and above this in terms of return would be adding value as the present value of the future cash flows in that case would be positive.In otherwords, we could use WACC as our discount rate and hurdle rate to calculate NPV of potential investment projects of physical asset, where it is expected the financing will be similar to the financing of the company conducting the investment. 4. What is the cost of capital for the lodging and restaurant divisions? The WACC calculation methodology is the same for the divisions as the calculations under question 3. However the inputs ar e changed to mirror the attributes and characteristics of the divisions.Please also see excel spreadsheet included within this submission for segmentation of the calculations. Lodging Cost of debt For the calculations of the fixed rate debt, we are using the 30 year government bond rate instead of the 10 year. This is a formulation of the comments in the case about the longer durability of the asset and longer financing. For the floating leg of the debt, we continue to use the 1 year government bond rate. rD = Average((1year US (Table B)*Fraction of Floating Debt + 30 Year US*Fraction of Fixed Debt) + 1. 10% rD = Average((6. 90%*50% + 8. 5%*50%) + 1. 10% = 9. 03% Cost of equity To be consistent we opt for the long-term securities and long-dated data just as we did when calculation the cost of equity in question 3. As for the ? we use the peer group as presented in Exhibit 3. Hence to find the unleveraged beta, we take the average of the equity ? s of the peer group the average deb t/equity ratio. After having calculated the unleveraged ? , we re-leverage using the target capital structure of the lodging division. We realize the limitations of using comparable companies to estimate the ? nd understand the criticalness of defining the right peer group of comparable companies. We could most likely have increased the accuracy of our calculations by being more due diligent in the selection to find companies that were a closer match to the Lodging (and restaurant) division. However, for the purpose of the calculations in this case, we use the peer group defined in the exhibit. Restaurants Cost of debt For the calculations of the fixed rate debt the 10 year government bond is used. rD = Average((1year US (Table B)*Fraction of Floating Debt + 10 Year US*Fraction of Fixed Debt) + 1. 10% D = Average((6. 90%*25% + 8. 72%*75%) + 1. 10% = 10. 07% Cost of equity To reflect the shorter nature of the assets in the restaurant business division, we use short securities to es timate the risk free rate and the risk premium. We use the same method for estimating ? as we did for the Lodging calculations. Using the data described above, we find WACCLodging to be 8. 85% and WACCRestaurants to be 12. 11%. These findings support the notion that incorporating debt will lower the cost of capital due to the tax shield. Lodging has a debt/equity ratio of 74/26 against the 42/58 in the restaurant division. See detailed calculations in the attached excel sheet) We would also like to point out that of the restaurants given in the brief, many of these would in essence not necessarily be our peer group per se and we would be more selective over the restaurants we would selected to more closely mirror Marriotts restaurants. With our aim to ensure we have the closest peer group possible for comparison. 5. What is the cost of capital for Marriotts contract services division? How can you estimate its equity cost without publicly traded comparable companies?We use the same f ramework as for the WACC calculations under Q3 and Q4. However, as we do not have a defined ? for the Contract Service division or an adequate peer group, we will estimate the ? using the existing data for Marriott and the two divisions. We know from the literature that a (holding) companys ? is the weighted ? s of the individual business divisions. We use the revenue as the catalyst for the deliberation of the ?. For the purpose of the calculations we use the unleveraged ? s. Mathematical this can be expressed as ?(Marriott) = Revenue Weight (Lodging)* ? Lodging) + Revenue Weight (Contract Division)* ? (Contract Division) + Revenue Weight (Restaurants)*? (Restaurants). To find the ? (Contract Division) we re-write the formula to ?(Contract Division) = ? (Marriott) Revenue Weight (Lodging)* ? (Lodging) Revenue Weight (Restaurants)*? (Restaurants)/ Revenue Weight (Contract Division) ?(Contract Division) = 0. 7610 40. 99%*0. 5841 13. 49%*1. 0014/45. 52% = 0. 8490 Adjusting for th e target capital structure we find ? (Contract Division) equals 1. 223 Using this data, we find WACC for the Contract Service division to be 10. 82%.