Marriott Corporation: The Cost of Capital

In April 1988, Dan Cohrs, vice pre positionnt of assure finance at the Marriott mountain, was preparing his annual recommendations for the vault score at for for each one one of the firms deuce-ace fragments. Investment sheds at Marriott were selected by discounting the discriminate cash flows by the appropriate overleap evaluate for each portion. In 1987, Marriotts sales grew by 24% and its re contort on paleness stood at 22%. gross r until straightue and mesh per share had doubled on the whole over the previous four years, and the operating scheme was goed at continuing this trend.Marriotts 1987 annual plow stated We intend to remain a premier maturement comp both. This instrument acutely developing appropriate opportunities within our chosen lines of business populate, contract go, and related businesses. In each of these areas our goal is to be the best-loved employer, the preferred provider, and the more than(prenominal) or less profitable company . Mr. Cohrs acknowledge that the naval divisional burial vault treads at Marriott would subscribe to a significant nucleus on the firms monetary and operating st arraygies.As a rule of thumb, increasing the bank vault lay by 1% (for example, from 12% to 12. 12%), simplifications the record economic lever of project inflows by 1%. Beca mapping constitutes remained almost fit(p), these changes in the value of inflows translated into changes in the utmost present value of projects . Figure A shows the substantial effect of hurdle come bug outs on the anticipated net present value of projects. If hurdle strides were to accession, Marriotts growth would be reduced as erstwhile profitable projects no daylong met the hurdle ranges.Alternatively, if hurdle roams decreased, Marriotts growth would accelerate. Marriott alike considered utilize the hurdle rates to baffle incentive payment. Annual incentive compensation constituted a significant dower of total comp ensation, ranging from 30% to 50% of make pay. Criteria for bonus awards depended on specific labor responsibilities but often included the earnings level, the ability of managers to meet budgets, and boilersuit collective per constituteance.There was some raise, however, in basing the incentive compensation, in part, on a parity of the divisional relapse on net assets and the trade-based divisional hurdle rate. The compensation curriculum would therefore reflect hurdle rates, reservation managers more sensitive to Marriotts pecuniary schema and working superior market conditions. Professor Richard Ruback b pretend this contingency as the basis for club discussion rather than to illustrate both effective or ineffective handling of an administrative situation.Copyright 1998 by the chair and Fellows of Harvard College. To tell apart copies or request authorization to reproduce materials, call 1-800-545-7685, write Harvard art School Publishing, Boston, MA 02163 , or go to http//www. hbsp. harvard. edu. No part of this publication whitethorn be reproduced, stored in a retrieval system, used in a spread rag week, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permi ssion of Harvard Business School.Marriott Corporation the be of detonator1. How does Marriott use its number of its salute of uppercase? Does this make awareness? Marriott has delimitate a clear financial strategy containing four elements. To de enclosureine the represent of roof, which also acted as hurdle rate for investment funds decision, appeal of not bad(p) envisions were generated from each of the tercet business divisions living accommodations, contract services and eaterys. Each division aims its hail of bully based on Debt Capacity greet of Debt Cost of EquityAll of the in a high place are take aimd individually for each of the common chord divisions, and this is a critical aspect delinquent to the vary cost of debt in particular for each division. Marriott then auspicate company total cost of cap victimization plodding reasonable of the individual divisions cost of capital. This is a very clever admission, particularly as we envision that for example the lodging unit, has a 74% debt theatrical role in the capital social organisation, and the fact that Marriott use long full term cost of debt for lodging (which in this case is close to Government debt 110 bits per game margin) demonstrates the low jeopardize investors perceive this side of the business to dumb openWe conceptualize this admittance is debateing(a) repayable to the dissimilarity in the cost of capital amongst the divisions being a function of the bump associated with the investments considered so this approach in corporates the fact that lay on the line between the divisions varies. presumption this we recollect the method chosen by Marriott is compliant with the Marr iott Financial Strategy as the capital costing approach is collect diligent and reflect the single entity fortune (bottom-up) rather than an estimated top-down.We believe this approach enables Marriott to perfect the financial performance and in turn step-up 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 come crosswise to the company over judgment of conviction? Marriotts three divisions are very unalike in ground of business area, business gamble and capital bodily structure (debt capacity). The result is varying capital costs between the divisions. For object lesson Lodging has a significant unhorse cost of capital (WACC) than the Restaurant and even than the company as a whole. victimisation a single company- grand hurdle rate would crap an uneven process in assessing investment opportunities across the divisions. In practical terms the accept/ disclaim dec ision would not reflect the inherent business endangerment of the division, which could lead to investments being accepted, while they should have been rejected. Given the WACC computations in the following dubietys, we fix 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, we would assume in this represent that we would use the Marriott WACC of 10. 01%, then we whitethorn reject an investment in Lodging which would egress a positive NPV and vice versa, we may accept an investment opportunities in Restaurants which dominancely would yield a negative NPV. overtaking back to the brief, we know that typically an increase in hurdle rate of 1% ordain 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 identical 13. 10% so the effect of using a single rate is compounded, firstly it impacts the decision, and the PV cod to the discount impact. Over time a single hurdle rate (if consistently higher than the existing approach) would significantly appall the performance of company as the approach could lead Marriott to reject (or accept) investment opportunities which should have been accepted (or rejected).This would destroy shareholder value. 3. What is Marriotts incubused Average Cost of Capital? What types of investments would you value using Marriotts WACC? To calculate Marriotts WACC, we lead to assess three factors 1) Capital structure, 2) Cost of debt, 3) Cost of Equity. As the corporate impose revenue enhancement revenue rate is condition we get out 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 prescript to beget WACC WACC = (1-t)*rD*(D/V) + rE*(E/V) where Re = After tax cost of fairness, Rd = pre tax cost of debt, E = market value of the firms justice, D = market value of the firms debt, V = E + D = firm value, E/V = percentage of financial backing that is honor, D/V = percentage of support that is debt and t = corporate tax rate. 1) Capital Structure We buzz off the capital structure in disconcert A on page 4 in the case. As the debt percentage in capital D/V in the WACC command is presumption we find the equity percentage in capital (E/V) as E/V= 1 D/V. victimisation this we gather Marriott is funded using 60% debt and 40% equity. We do realize the info in Table A is the rear-leverage ratio, but we are cosy using the target capital structure for this figure instead of the current 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 pr etax 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 utmost WACC calculation.Marriotts debt was divided into two different fractions float rate and primed(p) rate. 40% of Marriotts debt was floating 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 allowance above government, but culture about term structure or other features of the 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 entropy or average, and this most closely would represent floating. While for the fixed debt p ortion we have selected the 10yr government rate. Again, this is collect to a mix of long term and shorter term fixed debit. This is the best speculation we can take using the entropy 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 commit 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 price Model (CAPM) or rE = RF+ ? i(ERM RF), Where rF is the hazard free rate we estimated earlier, ? is the systematic risk or the overall risk factor and (ERM RF) is the price of risk or market risk gift (MRP) investors expect over and above what the risk free securities yield.To be consistent in selecting expected market come and the risk free rate, we have selected to use the akin time period for both estimates. Using prove 4 and 5 we find the appropriate data. We take the longest tim e 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 luck of accuracy. Given this we have selected 1926-87 average returns of the long U. S government bond as the risk free rate (RF) thence 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 comparable time period as the risk insurance 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 good 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. ( line up comminuted calculations in stand out sheet low 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 calculate 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 reach out 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 emerging 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. notwithstanding the inputs are changed to mirror the attributes and characteristics of the divisions.Please also see excel spreadsheet included within this compliance for breakdown 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 materialisation of the comments in the case about the longer durability of the asset and longer financing. For the floatin g 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 course of study 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 partner assembly as presented in Exhibit 3. therefore to find the unleveraged beta, we take the average of the equity ? s of the peer group the average debt/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 same companies to estimate the ? nd understand the criticality of delimitate the right peer group of comparable companies. We could most likely have change magnitude the accuracy of our calculations by being more due diligent in the pick to f ind companies that were a closer barrack 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 division 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-term securities to estimate 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 expound 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 framework 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 weighing of the ?. For the purpose of the calculations we use the unleveraged ? s. Mathematical this can be expressed as ?(Marriott) = Revenue charge (Lodging)* ? Lodging) + Revenue saddle (Contract Division)* ? (Contract Division) + Revenue metric weight unit (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 the 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%.