Marriott Corporation: the Cost of Capital Essay

Dan Cohrs of Marriott Corporation has the important task of determining correct hurdle rates for the entire corporation as well as each individual business segment. These rates are instrumental in determining which future projects to pursue and thus fundamentally important for Marriott’s growth trajectory. This case analysis seeks to examine Marriott’s financial strategy in comparison with its growth goals as well as evaluate a detailed breakdown of Marriott’s cost of capital – both divisionally and as a whole. Financial Strategy and Growth Marriot’s current financial strategy is in line with its overall goal of steady growth. By building and then promptly selling their hotels to limited partners, the company recoups its costs almost immediately. They then run the hotels, taking a 20% cut of the profits in addition to a 3% management fee. This results in fast, stable returns, which is good for continued growth. They may run into issues with overexpansion in the future, but for the time being, their strategy is sound. The other elements of Marriott’s financial strategy are also in line with their overall goals. By seeking projects that would increase shareholder value and repurchasing undervalued shares, they ensure that the value of their equity does not decrease. When coupled with the use of debt in the company’s capital structure, they are creating a good framework for future growth. Cost of Capital – Lodging and Restaurant Divisions We begin with an analysis of hurdle rates for the Lodging and Restaurant divisions, for which public comparable company figures are provided, to back into cost of capital for Contract Services in the next section, for which public comparables are not available. Restaurant D/V D/E ÃŽ ²lev ered ÃŽ ²unlev ered Church’s Chicken 4.0 % 0.04 0.75 0.73 Frisch’s 6.0 % 0.06 0.60 0.58 Collins Foods 10.0 % 0.11 0.13 0.12 Luby’s Cafeterias 1.0 % 0.01 0.64 0.64 McDonald’s 23.0 % 0.30 1.00 0.86 Wendy’s Int. 21.0 % 0.27 1.08 0.94 Rf 8.72 % Market Premium 7.92 % Median ÃŽ ²unlev ered 0.685 Target Debt % 42 % ÃŽ ²lev ered 0.962 Cost of Equity 16.57 % Cost of Debt 10.52 % WACC 12.08 % Lodging D/V D/E ÃŽ ²lev ered ÃŽ ²unlev ered Hilton 14.0 % 0.16 0.88 0.81 Holiday 79.0 % 3.76 1.46 0.47 La Quinta 69.0 % 2.23 0.38 0.17 Ramada 65.0 % 1.86 0.95 0.47 Rf 8.95 % Market Premium 7.92 % Median ÃŽ ²unlev ered 0.468 Target Debt % 74 % ÃŽ ²lev ered 1.213 Cost of Equity 18.56 % Cost of Debt 10.05 % WACC 8.98 % For these two divisions, we found the unlevered beta for each company in the division’s peer set, then relevered the median of this set with respect to Marriott’s target debt percentage of 74% and 42% for Lodging and Restaurant divisions, respectively, as a proxy for Marriott’s Lodging levered beta. The risk-free rates are based on U.S Treasury interest rates: we used the 30-year for Lodging and the 10-year for Restaurant due to the longevity of the assets in each respective division. Lodging assets consist mostly of real estate and have lives spanning decades, while restaurants are more likely to have a life cycle closer to 10 years. The geometric average in 1987 for the spread between the S&P 500 and U.S. Government Bonds at 7.92% is used as the market risk premium in all cases, and the cost of debt is calculated by adding the debt rate premium for each division to each division’s risk free rate. A tax rate of 44.1% is extrapolated by dividing income tax expense by EBT in the historical financials. With the entire infrastructure in place, we can calculate each division’s cost of equity through the CAPM model: Cost of Capital – Contract Services Division Comparable companies are not given for the Contract Services Division, but information about the division can be backsolved using some simple algebra as we are given Marriott’s balance sheet breakdown by segment in Exhibit 2: Since it is given that Marriott’s unlevered beta is .97, its tax rate is 44.1%, and has 60% debt in its capital structure, we can unlever to see that Marriott as an entire firm has an unlevered beta of .79. Assuming that Marriott’s unlevered beta can be calculated as a weighted average of its divisions’ betas based on identifiable assets, we can find Contract Services unlevered beta by solving: Using some algebra, this yields an unlevered beta of 1.55 for Contract Services. Relevering with the 2/3 desired debt-to-equity ratio yields a levered beta of 2.13. This time, we use the 1-day risk-free rate due to the even shorter lifespan of contracts. Cost of Capital – Marriott as a Whole There are several ways to approach Marriott’s cost of capital as an entire firm. One way is to use CAPM to find its cost of equity, long-term interest rates for the cost of debt, and weigh according to its capital structure to find WACC. Under this method, we lever the previously found firm-wide ÃŽ ²U of .79 to the desired 3/2 debt-to-equity ratio to find a cost of equity of 17.12%. Next, we apply the CAPM using the 10-year Treasury for 1987 Assets % of total ÃŽ ²unlev ered Lodging 2777.4 60.6 % 0.47 Contract Services 1237.7 27.0 % Restaurants 567.6 12.4 % 0.68 Total 4582.7 100.0 % Contract Services Rf 6.90 % Market Premium 7.92 % ÃŽ ²unlev ered 1.550 Target Debt % 40 % ÃŽ ²lev ered 2.131 Cost of Equity 23.78 % Cost of Debt 8.30 % WACC 16.12 % the risk-free rate and the one-year arithmetic return for 1987. We use the arithmetic rather than geometric since CAPM is a one-period model. For Marriott’s cost of debt, we add the credit spread of 1.3% to the ten-year Treasury yield of 8.72%. Plugging all these variables into CAPM, we arrive at a WACC of 10.53%. Another method to finding Marriott’s cost of capital is by taking a weighted average of its three segments. Since its three segments have different business models – it may be helpful to see the cost of capital as a mix of its three divisions rather than an aggregate Marriott unit. Weighing each division by the same weights in the Contract Services section, we calculate that WACC is 11.3% A couple of items to note on Marriott’s firm-wide cost of capital are noted here. Marriott’s WACC measures the cost of capital for the whole Marriott Corporation. Marriott has three lines of business –each line of service has its unique cost of deb t and beta, so when valuing investments in those three service lines, we would use their own WACC instead of using Marriott’s WACC. If the firm only uses one hurdle rate for evaluating investment opportunities in each line of business, it may accept or reject some investment project improperly. From the question below we already found that the WACC for lodging and restaurants is not the same. So for example, if just using one hurdle rate, like 10%, to evaluate the project among these two line of service, the lodging service may reject this project while the restaurant service may accept it. Appendix Below are the costs of equity, debt, and capital for all of Marriott as well as its three divisions. Weight WACC Lodging 0.60606 8.98 % Contract Services 0.27008 16.12 % Restaurants 0.12386 12.08 % 11.30 % Contract Marriott Lodging Restaurant Services Cost of Debt 10.02 % 10.05 % 10.52 % 8.30 % Cost of Equity 17.12 % 18.56 % 16.57 % 23.78 % Cost of Capital 10.53 % 8.98 % 12.08 % 16.12 %