marriot - final 22.07.2012

Executive Summary

J. Willard Marriott started Marriott Corporation in 1927 with a root beer stand, expanding it into a

leading lodging and food service company with sales of over $6 billion by 1987. At the time, Marriott

had three main lines of business, lodging, contract services and

restaurants, with lodging generating about 51% of company’s

profits. The four key elements of Marriott’s financial strategy were

managing hotel assets rather than owning, investing in projects

with the goal of increasing shareholder value, optimizing the use of

debt, and repurchasing their undervalued shares. 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) Are the four components of Marriott’s financial strategy consistent with its growth objective?

a) Manage rather than own. Consistent with growth strategy. In this way, Marriot attracts

additional capital, which gives an opportunity to invest more in the future, share some risks

with limited partners. Partnership may be also a good way of saving on taxes.

b) Invest in projects that increase Shareholder value. Consistent with growth. Positive NPV

projects increase SH value.

c) Optimizing capital structure. Consistent with growth. Optimal capital structure generally

should lead to a higher shareholder value. It also gives a good way to control default risk by

aiming at certain coverage ratio.

d) Repurchase of undervalued assets. Hard to say – generally, NO! Generally, it can lead

to a lower growth, because company uses it’s free funds to buy back shares and

therefore will under invest in NPV positive projects (that leads to lower growth). We should

be very clear why shares are going down it may be a result of a very bad investment⎯

decisions that led to losses. In this case, buybacks will lead to overpricing of Marriot’s

shares. This strategy implies that Marriot is smarter than the market is. But that’s simply

impossible in the long run. Additional argument against from the position of shareholders

buybacks, if shares are temporary undervalued, than it might be a cheap way of paying⎯

dividends to shareholders.

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2) How does Marriott use its estimate of its cost of capital? Does this make sense?

We calculate the cost of capital by using the Weighted Cost of Capital (WACC). In the

particular case of Marriott, there is a need to adapt the calculations to the corporate tax rate

(t). The opportunity cost of capital is calculated for investments with comparable risk.

Therefore under the use of the following formula:

WACC = (1-t) rD (D/V) + rE (E/V)

Where D represents debt at market value and rD the pretax cost of debt; E represents the

market value of equity, and rE the after-tax cost of equity. In addition, V represents the

market value of the firm which equals the sum of the Market Equity and Book Value, where

V = E + D. Marriott Corporation uses this same approach for the purpose of calculating

WACC for the company as a whole as well as for each sub-division with WACC differing

across each division.

In order to measure WACC, it is necessary to first calculate the return of equity which

corresponds to:

rE = Risk Free Rate + Beta of Equity * (Market Premium)

The market premium is based on the Capital Asset Pricing Model (CAPM).

In addition, Marriott Corporation selects investment projects by exercising cash flow

discounts according to the suitable hurdle rates for every division; where the hurdle rate

represents the minimum return required from a company for any specific project. In this case,

hurdle rates are used to allow managers to monitor the company’s performance more

efficiently. Furthermore, the different projects applied correspond to a portfolio of

investments where risk is diversified across the company.

Finally, for simplicity purposes, the distinction between floating rate and fixed coupon rate

debts will be ignored.

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3) What is the weighted Average Cost of Capital for Marriot Corporation?

Marriott measured the opportunity cost of capital for investments of similar risk using the weighted average cost of capital (WACC).

WACC for Marriott Corp is 11.89 (Consists of 9.63 Lodging, 15.65 Restaurant, 16.39 Contract Services)

a) What risk-free rate and the risk premium did you use to calculate the cost of

equity? Why did you choose this number?

To be consistent with risk premium calculations we used the arithmetic average (best

estimator) of historic LT US Government Bonds (4.58%) for the longest period because of

the most precise estimate (unfortunately, ignoring possible structural change).

As a risk premium we used the 7.43% (Spread between S&P Index and LT US Govt. Bonds),

although it’s relatively high, my comparably low risk free rate will compensate for that.

Then to calculate the cost of equity we need beta. As there are no good comparables that

match the Marriot’s operational profile, we use historical beta with correction on target D/E

ratio and reaching 1 in the long run.

Beta = 1.64

ke=8.95%+1.64*7.43%=21.14%

b) How did you measure Marriott’s cost of debt?

We added the premium, according to the rating of the company, to the current 10-years US

government interest rate. We used this rate because it matches on average the company’s

profile.

kd = 1.3% + 8.95% = 10.25%

As the rating of the company is very high the probability of default is low and the difference

between this estimated cost of debt and the actual one is expected to be low.

So the WACC = (1-0.44) (.60) (10.25)+ (.40) (21.14) = 11.894%

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C) Did you use arithmetic or geometric averages to measure rates of return?

Why?

SBBI shows rate of return data based on both arithmetic and geometric means. The appraiser

must decide which mean to use. The arithmetic mean is a simple average of the rates of return

for each year. The geometric mean is based on compounding and is generally less than the

arithmetic mean. The authors recommend using the arithmetic mean because investors tend to

use arithmetic means in forming their expectations of future returns. Therefore we have

chosen to use the arithmetic average, but both are possible.

Finally which rate to use?

The rate represents the overall return on the market. So we take it in exhibit 4. It is the

arithmetic average, since 1926, of the S&P 500 Composite returns, that is 12,01%

4) What type of investments would you value using Marriott’s WACC?

You would value investments that have similar characteristics as the divisions that were used to create the WACC.

Investments in Lodging, Contract services, or Restaurants would all use their own WACC measures and not that of the whole corporation.

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5) If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its line of business, what would happen to the company over time?

WACC for Marriott= 11.89%

WACC for lodging division = 9.63%

WACC for restaurant division = 15.65%

WACC for Marriott’s contract division = 16.39%

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 division is also good, but one has to be careful when

applying a single cost of capital across the various departments.

Based on the WACCs stated above for the company and its various departments it’s obvious that the

values are different. The cost of capital for lodging is lower than for the entire company, while that of

the other departments are higher. We can equate the cost of capital with risk, so 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 will be using the 11.89% rate which is for

the entire company. By Marriott using this rate, then any project that arises out of the lodging

division will be rejected since its cost of capital of 9.63% 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. 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. In summary, the risk that Marriott will be assuming will increase over time as it

continues to approve high risk projects.

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6) What is the cost of capital for the lodging and restaurant divisions of Marriott?

Lodging Cost of Capital

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LODGING

From Exhibit 3 Calculations

Revenues (in Billion)(b)

Market Leverage (c)Levered

Equity Beta (d)

Unlevered Asset Beta

(Book Value of Debt divided by book value of

the Debt + market value of equity)

= D* X (1-C*)

Hilton Hotels 0.77 0.14 0.76 0.65

Holiday Corp 1.66 0.79 1.15 0.28

LaQuinta Motor Inns 0.17 0.69 0.89 0.28

Ramada Inns 0.75 0.65 1.36 0.48

Average unlevered asset Beta: 0.42

• Step 2• Unlevered asset beta = 0.42• Target debt/value = .74 (from table A)• Levered Equity Beta:

• Be= (V/Et)*BA = (1/0.26)*0.42 = 3.85*0.42 = 1.6240

• Levered Equity Beta = βE = 1.62

• Step 3• KE = rF + βE x RPM

• KE = 8.95% + 1.62 * 7.43%

• KE = 21.02%

Average unlevered asset Beta:

S.No Description Value Reference

A Government Interest Rate 8.95% Table B

B Debt Premium 1.10% Table A

C Cost of Debt 10.05% A+B

D

E Risk Premium Equity 7.43% Exhibit 5

F Unlevered Asset Beta 0.42 Calculated Above

G Levered Equity Beta 1.62 ((1/0.26)*F)

H Cost of Equity 19.76% =A +E*G

I Target Debt Value 74%

J Target Equity Value 26%

K Tax Rate 44.00%

L WACC 9.63% =(1-T)*C*I + H*J

• WACC = (1 - T)(D/V)KD + (E/V)KE

• WACC = (1-.44)(.74)(10.05%) + (.26)(21.02%)• WACC = 4.16% + 5.14%• WACC = 9.63%

Restaurant Cost of Capital

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• Step 2 Lever Beta - Restaurant• Unlevered asset beta = 0.96• Target debt/value = .42 (from table A)• Levered Equity Beta:

• Be= (V/Et)*BA = (1/0.58)*0.96= 1.72*0.96= 1.6528


• Step 3 Equity Cost -Restaurant• KE = rF + βE x RPM

• KE = 8.72% + 1.65 * 8.47%(from Exhibit 5)• KE = 22.72%

Restaurant

From Exhibits 3

Sales (b)Market Value Levered Unlevered Leverage (1) Equity Beta Asset Beta (2)

Church's Fried Chicken 0.39 0.04 1.45 1.39Collins Foods 0.57 0.10 1.45 1.31Frisch's 0.14 0.06 0.57 0.54Luby's 0.23 0.01 0.76 0.75McDonald's 4.89 0.23 .94 0.72Wendys 1.05 0.21 1.32 1.04


• WACC = (1 - T)(D/V)KD + (E/V)KE

• WACC = (1-.44)(.42)(10.52%) + (.58)(17.58%)

• WACC = 15.65%

S.No Description Value Reference

A Government Interest Rate 8.72% Table B

B Debt Premium 1.80% Table A

C Cost of Debt 10.52% A+B

D

E Risk Premium Equity 8.47% Exhibit 5

F Unlevered Asset Beta 0.96 Calculated Above

G Levered Equity Beta 1.65 ((1/J)*F)

H Cost of Equity 17.58% =A +E*G

I Target Debt Value 42%

J Target Equity Value 58%

K Tax Rate 44.00%

L WACC 15.65% =(1-T)*C*I + H*J

a) What risk free rate and risk premium did you use in computing the cost of equity

for each division? Why did you choose these numbers?

We used 8.95% risk free rate for lodging because it was the longest term division and we

assume they will get 30 years of usage out of this. It was stated that restaurant and contract

services had shorter useful lives. We assumed the restaurant & Contract Service division

would last at least 10 years so we used 8.72%.

We used 7.43% risk premium for lodging business since it have pretty long term rates, and

7.43% is the spread between S&P500 composite returns and Long-term government bond

returns.& 8.47% of Restaurant and Contract Service Business since they both have a pretty

short term rates.

b) How did you measure the cost of debt for each division? Should the debt costs

differ across division? Why?

For the lodging division the cost of debt was calculated as the 30 year risk free rate plus the

premium which was 8.95% + 1.10% or 10.05% before tax cost of debt. For the restaurant

division we used the 10 year risk free rate plus the premium which was 8.72% + 1.80% or

10.52%. We assumed that the lodging would have a useful life of 30 years and the restaurant

would have a useful life of 10 years, so they definitely need to have different debt costs

across the divisions because you have to compare them with the government rates that are

similar in duration/maturity to the division.

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c) How did you measure the beta for each division?

Beta for Lodging

Beta for Restaurant

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Restaurant

From Exhibits 3

Sales (b)Market Value Levered Unlevered Leverage (1) Equity Beta Asset Beta (2)

Church's Fried Chicken 0.39 0.04 1.45 1.39

Collins Foods 0.57 0.10 1.45 1.31Frisch's 0.14 0.06 0.57 0.54

Luby's 0.23 0.01 0.76 0.75

McDonald's 4.89 0.23 .94 0.72Wendys 1.05 0.21 1.32 1.04


LODGING

From Exhibit 3 Calculations

Revenues (in Billion)(b)

Market Leverage (c)Levered

Equity Beta (d)

Unlevered Asset Beta

(Book Value of Debt divided by book value of

the Debt + market value of equity)

= D* X (1-C*)

Hilton Hotels 0.77 0.14 0.76 0.65

Holiday Corp 1.66 0.79 1.15 0.28

LaQuinta Motor Inns 0.17 0.69 0.89 0.28

Ramada Inns 0.75 0.65 1.36 0.48


• Step 2• Unlevered asset beta = 0.42• Target debt/value = .74 (from table A)• Levered Equity Beta:

• Be= (V/Et)*BA = (1/0.26)*0.42 = 3.85*0.42 = 1.6240



• Be= (V/Et)*BA = (1/0.58)*0.96= 1.72*0.96= 1.6528


7) How did you estimate the cost of capital for Marriott’s contract services division? How can you estimate its cost of equity without publicly traded comparable companies?

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• Be= (V/Et)*BA = (1/0.60)*0.1.05= 1.67*1.05= 1.75


• Step 3 Equity Cost -Restaurant• KE = rF + βE x RPM

• KE = 8.72% + 1.75 * 8.47%(from Exhibit 5)• KE = 23.54%

Asset Beta for Contract Services

Asset$ % Beta

Lodging 2777.4 60.6% 0.43Restaurants 1237.7 27.0% 0.96Contract Services 567.6 12.4% 1.05MARRIOTT 4582.7 100.0% 0.65

Identifiable Assets

• WACC = (1 - T)(D/V)KD + (E/V)KE

• WACC = (1-.44)(.40)(10.12%) + .60)(23.54%)

• WACC = 2.266 + 10.362

• WACC = 16.39%

Conclusion

In analyzing hurdle rate when considering investing in order to optimize the outcomes, except

total WACC of Marriot Corporation, the company should consider WACC for each division

because varied conditions will affect and make a difference to the rates, and different rates in

each business line will help Marriott Corporation decide to invest in the right project more

profitably and accurately in order to increase profitability for its shareholders' value. There

are many concerns that are important to consider as significant factors in calculating the

hurdle rate for investing in projects.

The first significant consideration is different risk in each section of business line.

Due to having many types of risk to consider the hurdle rate, Marriott has to choose the

suitable risk for each investment. Period of investment will have effect on interest rates that

the company will pick such as investment as a long-term project or short-term investment.

Second, sometimes the firm cannot predict the exact value of the future rate which it

should apply to projects in order to achieve the expected return for investment that is why the

company has to use estimated value from the previous information such as interest rate or

average tax rates in the past.

Moreover, for estimating appropriate betas, there are many aspects that will help the

company pick the better beta for calculating WACC. To start with size of firms, some

evidence shows that smaller firms with higher beta value tend to have higher return than

larger firms. Next, due to relationship of Beta and financial risk, the firm which has higher

market leverage value than others with the same other conditions such as size of a company

will have possibility to be higher in Beta value because it obtains higher risk in its operations.

Finally, if the company succeeds in combining important perspectives appropriately

by using enough base information from the past, carefully analyzing the future trend in

financial rates, and deliberating separate financial factors in each business line for having

more visions to the firm in order to invest for optimization of return, the firm will get

important support information to decide appropriate investments in the projects which will

make significant return to the corporation.

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marriot - final 22.07.2012

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