Case Cover Page
Title of Case: Marriott Corporation: Cost of Capital
Submission date: 5/10/2016
CERTIFICATION OF AUTHORSHIP: I certify that I am the author of this report and that
any assistance I received in its preparation is fully acknowledged and disclosed in the
paper. I have also cited any sources from which I used data, ideas or words; either
quoted directly or paraphrased I also certify that this paper was prepared by me (my
team) specifically for this course.
Team member
Last name, First name/ ID/ Sign
Team member 1
Bui, Thao / 009969505 /
Team member 2
Bakhtiari, Nima / 008487921 /
Team member 3
Catig, Justin / 008460569 /
Team member 4
Hiep, Sorony / 009754277 /
Team member 5
Vo, Huynh / 009535240 /
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Table of Contents
Executive Summary
3
What is the weighted average cost of capital for Marriott
Corporation?
6
What type of investments would you value using Marriott’s
WACC?
8
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 time?
9
What is the cost of capital for the lodging and restaurant
divisions of Marriott?
10
What is the cost of capital for Marriott’s contract services
division? How can you estimate its equity costs without
publicly traded comparable companies?
15
2
Dan Cohrs, Vice-President of Marriott Corporation's project finance prepares the
annual provisions for hurdle rates at each of the three key operations for the firm.
Founder Willard Marriott started Marriott Corp in the late 1920s with stand alone root
beer stand, expanding it over time into a biggest leader in providing lodging, contract
services and food service with sales of over $6 billion by the late 1980s. In 1987, sales
grew by 24% and return on equity remained at 22%. In addition, sales and earnings per
share has doubled over the past few years, Marriott’s operating strategy was to sustain
this direction. Marriott’s 1987 annual report stated:
“We intend to remain a premier growth company. This means aggressively developing
appropriate opportunities within our chosen lines of business—lodging, contract
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.
According to Harvard Business School, Marriott had three main lines of
business: lodging, contract services and restaurants. Each line of business is calculated
as an independent company due to the different risk and business operations across
the three divisions. The first key operation lodging generating close to 51% of
company’s profits and 41% of company sales. Second key line of business contract
service generating close to 33% of company profit and 46% of company sales.Third key
operation of the company provided by restaurants adds 16% of company profits and
13% of sales.
The four key elements of Marriott’s financial strategy were managing hotel assets
as opposed to owning, goal of increasing shareholders’ value from investing in projects,
optimizing the use of debt in capital structures, and repurchasing undervalued shares.
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The first financial strategy was managing hotel assets as opposed to owning. Marriott
developed over $1 billion worth of hotel properties. After development, Marriott sold the
hotel assets to limited partners while retaining operating control. In 1987, Marriott and
Courtyard hotels were syndicated for $890 million, Marriott operated over $70 billion
worth of syndicated hotels. The second financial strategy was investing in projects that
increase shareholder value. Discounted cash flow methods were used to assess
potential investments. According to a Marriott Executive, ”Our projects are like a lot of
similar little boxes...managers still have discretion over unit-specific assumptions, but
they must conform to the corporate templates.” The third strategy was optimizing the
use of debt in capital structure. Marriott used an interest coverage target instead of a
target debt-to-equity ratio, 59% of total capital. The final strategy was repurchasing
undervalued shares. Marriott was focused on repurchasing stocks that fell under their
“warranted equity value.” The company repurchased 13.6 million shares of common
stock for $429 million.
Marriott Corporation relied on measuring the opportunity cost of capital for
investments by utilizing the concept of Weighted Average Cost of Capital (WACC). In
April 1988, VP of project finance, Dan Cohrs suggested that the divisional hurdle rates
at the company would have a key impact on their future financial and operating
strategies. Marriott intended to continue its growth at a fast pace by relying on the best
opportunities arising from their lodging, contract services and restaurants lines of
businesses. To make the company managers more involved in its financial strategies,
Marriott also considered using the hurdle rates for determining the incentive
compensations.
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1. What is the weighted average cost of capital for Marriott Corporation?
Marriott uses the Weighted Average Cost of Capital (WACC) as a metric for cost of
capital. The formula for calculation below:
WACC = (1 - T) * rd(D/V) + re * (E/V)
Where:
T
Corporate tax
rd
Cost of debt
D
Market value of debt
V
Firm’s Enterprise Value (Market Value of Debt + Market Value of Equity)
re
Cost of equity
E
Market value of equity
Calculations for Marriott Corporation:
Value:
Source:
T
34.00%
Provided
rd
10.25%
*See Calculations on p. 7
D
60%
Given target debt ratio
V
100%
40.00%+60.00%=100%
re
20.72%
*See Calculations on p. 16
E
40%
100%-60%=40%
WACC = (1-.34)(.1025)(.60) + (.2072)(.40) = .12347 ≈ 12.35%
a) What risk-free rate and risk premium did you use to calculate the cost
of equity?
Calculating Cost of Equity:
Marriott Corp utilizes the Capital Asset Pricing Model (CAPM) to derive their cost of
equity:
re = Rf + Beta (Rm - Rf )
Market risk-premium is calculated by rm - rf . The spread between S&P 500 Composite
Returns and Long-Term U.S. Government bond returns for the year 1926-87 is 7.43%,
given by Exhibit 5.
Rf is constituted by the government bond rate of 8.95%. Using the highest and longest
as the risk free interest rate provided by the U.S government in April 1988, given by
Table B.
Value
Source
5
Equity Beta = 1.1
Asset Beta = .667
See Exhibit 3
D/E = .4/.6
βL = βu (1 + (1 – τ) (D/E))
= 1.1 (1 + (1 – .34) (.4/.6))
= 1.584
re = 8.95% + 1.584 (7.43%) = 20.72%
b) How did you measure Marriott’s cost of debt?
Calculating Cost of Debt:
Marriott risk free-rate is the government bond rate of 8.95%, obtained from Table B.
Marriott’s Debt Rate Premium is found as the credit spread on Table A, 1.30%.
Book definition: Cost of debt = Risk free rate +Spread
Thus,
Rd = government bond rate + credit spread= 8.95% + 1.30% = 10.25%
*Spread is based on riskiness of company
2. What type of investments would you value using Marriott’s WACC?
Since the WACC is 12.35%, any investments with a WACC equal or lower than
12.35% would be an investment to be considered of value by Marriott. The company will
continue to look at other investments that will lower their WACC. The type of investment
to be considered is issuing bonds to get the financing more cheaply. The firm is built
upon lodging, contract services and restaurants as the three key operations. By
continuing investments in their three key operations has created different WACC for
each operation versus the whole company.
Marriott can seek projects that will increase shareholders’ value by expanding its
investment interests. In 1976, Marriott attempted this by opening two theme parks. Long
term investments opportunities places Marriott in a predicament when attempting to
optimize their debt.
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3. 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 time?
Investopedia online defines a hurdle rate as the minimum rate of return on a project or
investment required by a manager or investor. In order to compensate for risk, the
riskier the project, the higher the hurdle rate. The main use of the hurdle rates is to
assess investment decision in order to determine if it’s reasonable. Using different rates
for different divisions can be advantageous as different projects amongst different
divisions might have different risk and reward. Companies should be careful when
applying a single cost of capital across various departments.
The numbers below were calculated for Marriott and its different divisions.
WACC for Marriott= 12.35%
WACC for lodging division = 10.37%
WACC for restaurant division =14.53%
WACC for Marriott’s contract division = 14.31%
Looking at the above WACC’s we can see that each division is different. The cost of
capital for lodging is lowest. It is even lower than the WACC for the entire company. The
cost of capital is often equated risk, therefore the risk in the lodging department is lower
when compared with other departments that have a higher WACC.
If Marriott was to use a single corporate hurdle rate then they would be using the
12.35% rate which is the WACC for the entire company. By breaking down WACC’s to
each respective division it will prevent Marriott from using this rate for every project.
This is beneficial or any project that arises out of the lodging division will be rejected
since its cost of capital of 9.25% is lower than the cost of capital for the company. Using
a higher rate will result in a negative NPV as well as a reduced cash flow.
What would happen is eventually projects from the restaurant and contract service
division will be approved since they are evaluated at a lower rate than the determined
cost of these various divisions. Over time, Marriott will be approving more high risk
project from the restaurant and contract service division by evaluating them at a lower
rate, while they will be rejecting lower risk projects from the lodging division because
they are using a higher rate. As this type of decision making continues Marriott will be
assuming higher risk as it to approve riskier projects.
4. What is the cost of capital for the lodging and restaurant divisions of Marriott?
Lodging Division Cost of Capital
WACC = (1 - T) * rd(D/V) + re * (E/V)
T = 34%
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rd = 10.05%,
D/V = 74%,
See part a
Market-Value Target-Leverage Ratios and Credit Spreads for
Marriott and Its Divisions in Table A page 4
100%-D/V= 74%
E/V = 26%,
re = rf + Beta (RP)
rf = 8.95%
See part a
RP = 7.43%,
See part a
Beta = 1.623, See part c
re = .0895 + 1.623(.0743), re = .2101
WACC = (1-.34)*.1005(.74) + .2101*(.26)
WACC of Lodging Division = .1037, 10.37%
Restaurant Division Cost of Capital
WACC = (1 - T) * rd(D/V) + re * (E/V)
T = 34%
rd = 8.70%,
See part a
D/V= 42%,
Market-Value Target-Leverage Ratios and Credit Spreads for E/V=
Marriott and Its Divisions in Table A page 4
58%,
100%-D/V= 58%
re = rf + Beta (RP)
rf = 6.90%
See part a
RP= 8.47%,
See part a
Beta= 1.653,
See part c
re = .0690 + 1.653(.0847), re = .2090
WACC = (1-.34)*(.0870)(.42) + .2090*(.58)
WACC of Restaurant Division = .1453, 14.53%
a. What risk-free rate and risk premium did you use in calculating the cost of equity for
each division? Why did you choose these numbers?
The risk-free rate used for Marriott’s lodging division is 8.95%, which used a long-term
30 year risk-free rate. Marriott’s restaurant division has a 6.90% risk-free rate, which
used a short-term 1 year risk-free rate. The values for the risk-free rates are given in
Table B on page 4. The risk premium for the lodging division is 7.43%. The risk
premium for the restaurant division is 8.47%. We used the spread between using 19261987 periods as the market risk premium in Exhibit 5 page 10. Since the lodging
division is long term, we used the spread between S&P 500 Composite returns and
long-term U.S. government bond returns. Since the restaurant division is short term, we
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used the spread between S&P 500 Composite returns and short-term U.S. Treasury bill
returns.
b. How did you measure the cost of debt for each division? Should the debt cost differ
across divisions? Why?
To measure the cost of debt for each division we used, cost of debt r d = rf + spread. The
risk-free rates for the lodging and restaurant divisions are 8.95% and 6.90%
respectively. The risk-free rate is given in Table B page 4 based on the maturity of U.S
Government interest rates, 30-year and 1-year. The spread is the debt rate premium
above government in Table A page 4. The spread for the lodging and restaurant
divisions are 1.10% and 1.80% respectively. The pre-tax cost of debt for the lodging
division is 10.05%, 8.95%(risk-free) + 1.10(debt rate premium above government). The
pre-tax cost of debt for the restaurant division is 8.70%, 6.90%(risk-free) + 1.80%(debt
rate premium above government). The tax rate used is 34%, the highest corporate tax
between 1986-1992. The after-tax cost of debt is (1-t) x rd. The after-tax cost of debt for
the lodging division is 6.63%, (1-.34) x 10.05%. The after-tax cost of debt for the
restaurant division is 5.74%, (1-.34) x 8.70%.
The cost of debt should be different across each division because each division is
treated as an independent company. The maturity of U.S interest rates are different for
the two divisions because the lodging division uses long-term 30-year and the
restaurant division uses short-term 1-year. The spread between the debt rate and the
government bond rate varied by division because of differences in risk
c. How did you measure the beta of each division?
To measure the beta of each division you need to collect the raw equity(levered) beta
and D/E of other firms in the same industry. The equity(levered) beta and market
leverage of comparable firms is found on Exhibit 3 page 8. To the unlevered beta use
the following formula for each firm: B u= BL / (1+ (D/E) * (1-T)). To find the D/E, divide
market leverage by 1 minus market leverage, D/E = market leverage / (1-market
leverage). Once you have the D/E you can plug it into the unlevered beta formula. Once
you obtain the unlevered beta for each comparable firm, get the average. Next, re-lever
beta by plugging the unlevered average beta into the following formula:
BL = Bu(1+(D/E) * (1-T)). To find the D/E use the debt percentage in capital for the
division found in Table A page 4. To get D/E from debt percentage in capital use the
following formula: D/E= debt % / (1- debt %). Now the unlevered(asset) beta can be relevered(equity) beta using: B L = Bu(1+(D/E) * (1-T)). Note the tax rate is 0 since there is
no information of tax rates for other firms.
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Beta for Lodging Division
Step 1) Gather raw equity beta of other firms
Hilton
Hotels
Corporation
Hilton Hotels
Corporation
La Quinta
Motor Inns
Ramada
Inns, Inc.
Levered(equity)
beta
.76
1.35
.89
1.36
Market leverage
14%
79%
69%
65%
Step 2) Unlever the betas and convert Market leverage to D/E.
Tax = 0
Hilton Hotels
Corporation
Hilton Hotels
Corporation
La Quinta
Motor Inns
Ramada Inns,
Inc.
D/E
.14/(1-.14)
= .163
.79/(1-.79)
= 3.762
.69/(1-.69)
= 2.226
.65/(1-.65)
= 1.857
Unlevere
d beta
formula
.76/(1+.163(
1-t))
= .653
1.35/(1+3.762
)
= .283
.89/(1+2.226)
= .276
1.36/(1+1.857)=
.476
Step 3) Compute the average of the asset betas
Unlevered(asset) beta
.653
Average
unlevered(asset) beta
(.653+.283+.276+.476) /
4
= .422
.283
.276
.476
Step 4) Re-lever the average asset beta
BL = Bu(1+ (D/E) * (1-t))
Debt % in capital for lodging division = 74%
D/E = debt % in capital / 1- debt % in capital = .74/(1-.74) = 2.846
BL = .422(1+2.846(1-0)) = .422(3.846) = 1.623
Re-levered(equity) beta of Marriott Lodging division = 1.623
Beta for Restaurant Division
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Step 1) Gather raw equity beta of other firms
Church’s
Fried
Chicken
Collins
Food Int.
Frisch’s
Rest.
Luby’s
Cafe.
McDonald’s
Wendy’s
Int.
Levered
(equity)
beta
1.45
1.45
.57
.76
.94
1.32
Market
Leverage
4%
10%
6%
1%
23%
21%
Step 2) Unlever the betas and convert Market leverage to D/E.
tax = 0
Church’s
Fried
Chicken
Collins
Food Int.
Frisch’s
Rest.
Luby’s
Cafe.
McDonald’s
Wendy’s
Int.
D/E
.04/(1-.04)=
.042
.10/(1.10)= .111
.06/(1.06)= .064
.01/(1.01)= .010
.23/(1-.23)
= .299
.21/(1-.21)
= .266
Unlever
ed beta
formula
1.45/(1+.04
2(1-t))
= 1.392
1.45/(1+.1
11)
= 1.305
.57/(1+.06
4)
= .536
.76/(1+.01
0)
= .752
.94/(1+.299) 1.32/(1+.2
= .724
66)
= 1.043
Step 3) Compute the average of the asset betas
Unlevered
(asset) beta
1.392
Average unlevered
(asset) beta
(1.392+1.305+.536+.752+.
724+1.043)/6
= .959
1.305
.536
.752
.724
1.043
Step 4) Re-lever the average asset beta
BL = Bu(1+ (D/E) * (1-T))
Debt % in capital for Restaurant division = 42%
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D/E = debt % in capital / 1- debt % in capital, .42/(1-.42) = .724
BL = .959(1+.724(1-0))= .959(1.724) = 1.653
Re-levered(equity) beta of Marriott Restaurant division = 1.653
5. What is the cost of capital for Marriott’s contract services division? How can you
estimate its equity costs without publicly traded comparable companies?
To calculate the cost of capital for the contract services is more complex because
there aren’t any publicly traded peer companies to compare against and privately held
firms either do not report their results or do not report results compliant with the financial
reporting requirements of publicly traded companies.
Based on the projected mix of fixed and floating debt, the cost of debt for the
contract services division is estimated at 10.07%
To calculate the cost of capital for the contract services is more complex because there
aren’t any publicly traded peer companies to compare against. Privately held companies
do not report their results because they do not have to be compliant with the financial
reporting requirements of publicly traded companies.
What is the WACC for Marriott’s contract services division?
βu for Marriott is the weighted average of the Divisional βu’s:
Identifiable
Assets
Ratio
Beta Unlevered
Lodging
$2,777.4
0.61
0.422
Restaurants
$567.60
0.12
0.959
Contract
Services
$1,237.70
0.27
Marriott
$4,582.70
1
0.667
.61(.422) + .12(.959) + .27(βu) = .667
βu = 1.0907
Cost of Debt
rd = government bond rate + credit spread
12
rd = 6.90% + 1.40%
= 8.30%
Cost of Equity for Contract Services:
Using the target debt ratio of 40%:
βcs = βu (1 + (1 – τ) (D/E))
= 1.0907 (1 + (1 – .34) (.4/.6))
= 1.571
Using CAPM:
re = rf + βTs (rm – rf )
= 6.9% + 1.571(8.47%)
= 20.20%
WACC = (1 - τ)rd(D/V) + re(E/V)
= (1 - .34)(.083)(.4) + (.2020)(.6)
= 14.31%
Reference:
Read more: Hurdle Rate Definition | Investopedia
http://www.investopedia.com/terms/h/hurdlerate.asp#ixzz487TKypm4
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