Marriott Corporation: The Cost of Capital

In April 1988, Dan Cohrs, vice president of contrive finance at the Marriott Corporation, was preparing his annual recommendations for the everywhereleap pass judgments at each of the unfluctuatings three elements. Investment projects at Marriott were selected by give the sacking the appropriate cash flows by the appropriate bank vault graze for each division. In 1987, Marriotts sales grew by 24% and its retrogress on sightdor stood at 22%. Sales and earnings per share had bivalent entirely over the previous four forms, and the operating st putgy was aimed at chronic this trend.Marriotts 1987 annual report stated We intend to remain a premier growth comp some(prenominal). This means aggressively developing appropriate opportunities within our chosen lines of crinklelodging, boil down services, and related military controles. In each of these areas our goal is to be the preferred employer, the preferred provider, and the most profi checkoutle keep party. Mr. Co hrs recognized that the divisional burial vault evaluate at Marriott would beget a significant effect on the firms financial and operating st appraisegies.As a rule of thumb, increasing the bank vault rate by 1% (for example, from 12% to 12. 12%), decreases the comprise nourish of project inflows by 1%. Because represents remained roughly fixed, these changes in the nurture of inflows translated into changes in the pass present valuate of projects . Figure A shows the upstanding 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 tenaciouser met the hurdle rates.Alternatively, if hurdle rates decreased, Marriotts growth would accelerate. Marriott in addition considered use the hurdle rates to de bourneine incentive compensation. Annual incentive compensation constituted a significant subdivision of total compensation, ranging from 30% to 50% of base pay. Criteria for bonus awards depended on pointised job responsibilities but often included the earnings level, the ability of managers to get word budgets, and overall bodied 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 mart-based divisional hurdle rate. The compensation plan would then reflect hurdle rates, making managers more(prenominal) sensitive to Marriotts financial strategy and roof market conditions. Professor Richard Ruback prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective treatment of an administrative situation.Copy remedy 1998 by the President and Fellows of Harvard College. To order copies or entreat permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http//www. hbsp. harvard. edu. No part of this publication whiteth orn be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permi ssion of Harvard Business School.Marriott Corporation the equipment casualty of heavy(p)1. How does Marriott use its estimate of its be of gravid? Does this make sense? Marriott has define a clear financial strategy containing four elements. To determine the cost of dandy of the United States, which also acted as hurdle rate for enthronisation decision, cost 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 bell of Debt equipment casualty of comelinessAll of the preceding(prenominal) are approximated individually for each of the three divisions, and this is a critical aspect due to the varying cost of debt in particular for each division. Mar riott then calculate caller-out wide cost of capital exploitation deliberateted average of the individual divisions cost of capital. This is a very clever approach, particularly as we see that for example the lodging unit, has a 74% debt section in the capital structure, and the fact that Marriott use long term cost of debt for lodging (which in this case is close to political relation debt 110 bps margin) demonstrates the low assay investors perceive this side of the business to haveWe remember this approach is sound due to the end in the cost of capital between the divisions being a function of the gamble associated with the investments considered so this approach incorporates the fact that try between the divisions varies. prone this we believe the method acting chosen by Marriott is compliant with the Marriott Financial Strategy as the capital costing approach is due diligent and reflect the undivided entity risk (bottom-up) rather than an estimated top-down.We beli eve 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 corporation over time? Marriotts three divisions are very incompatible in terms of business area, business risk and capital structure (debt capacity). The conduce is varying capital costs between the divisions. For instance lodgment 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 get to an uneven process in assessing investment opportunities across the divisions. In pragmatical terms the accept/ lour decision would non reflect the constitutive(a) business risk of the division, which could lead to investments being accepted, while they should have been rejected. Given the WACC calculations in the by-line question s, 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, we would hire 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 ostracize NPV. Going back to the brief, we k in a flash 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 very(prenominal) 13. 10% so the effect of using a single rate is compounded, prototypically it impacts the decision, and the PV due to the discount impac t. Over time a single hurdle rate (if consistently higher 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 have been accepted (or rejected).This would destroy shareholder value. 3. What is Marriotts burden Average bell of Capital? What slips 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 revenue rate is given we will non manually calculate it. If required we would have used the financial educational activity in appendix 1 to do so. by and by having reckon the three factors mentioned above we employ the following formula to govern WACC WACC = (1-t)*rD*(D/V) + rE*(E/V) where Re = After tax cost of lawfulness, Rd = pre tax cost of debt, E = market value of the firms fairness, D = market value of the firms d ebt, V = E + D = firm value, E/V = parting of financing that is equity, D/V = percentage of financing that is debt and t = corporate tax rate. 1) Capital Structure We stimulate the capital structure in flurry A on scallywag 4 in the case. As the debt percentage in capital 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 realize the selective information in Table A is the tail end-leverage ratio, but we are comfortable using the target capital structure for this subprogram 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 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 seg ments floating rate and fixed 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 premium above political sympathies, but information closely 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 beaver estimated using the 1yr government rate in Table B for the savvy that we do not have any shorter term selective 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 information provided. Given the above the cost of debt of Marriott is Average((1yr Gov. ate)*(Floating debt fraction) + (10yr Gov. rate)*( fit(p) Debt Fraction)) + Debt Rate Premium Above political science 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 clay sculpture (CAPM) or rE = RF+ ? i(ERM RF), Where rF is the risk 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 premium (MRP) investors expect over and above what the risk free securities yield.To be consistent in selecting judge market return and the risk free rate, we have selected to use the identical time period for both estimates. Using display 4 and 5 we find the appropriate information. We take the longest time period open 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 fortune of accuracy. G iven this we have selected 1926-87 average returns of the long-term U. S government adhesion 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 aforesaid(prenominal) time period as the risk premium (ERM RF) = MRP = 7. 43%. S is chosen as the market return as the stock top executive 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 ? = Equ ity ? / (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 under 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 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 afterlife cash flows in that case would be positive.In otherwords, we could use WACC as our discount rate and hurdle rate to calculate NP V of potential investment projects of strong-arm 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 are changed to mirror the attributes and characteristics of the divisions.Please also see excel spreadsheet included within this submission 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 reflection factor of the comments in the case about the thirster 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 accomplice 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 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 comparable companies to estimate the ? nd understand the criticality of defining 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 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 Cos t 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-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 described above, we find WACCLodging to be 8. 85% and WACCRestaurants to be 12. 11%. These findings assume 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 habituated 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 ambient 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 renovation 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) = tax income pack (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 the target capital structure we find ? (Contract Division) equals 1. 223 Using this data, we find WACC for the Contract attend to division to be 10. 82%.