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% Page | 4
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
Revenues (in Billion)(b)
LODGING
From Exhibit 3
Calculations
Market Leverage (c)
Unlevered Asset Beta
Levered Equity Beta (d)
(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:
• • • •
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
• • • •
• • •
0.42
Step 3 KE = rF + βE x RPM KE = 8.95% + 1.62 * 7.43%
• KE = 21.02%
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%
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%
F
Unlevered Asset Beta
0.42
Calculated Above
G
Levered Equity Beta
1.62
((1/0.26)*F)
H
Cost of Equity
I
Target Debt Value
74%
J
Target Equity Value
26%
K
Tax Rate
L
WACC
19.76%
Exhibit 5
=A +E*G
44.00% 9.63%
=(1-T)*C*I + H*J
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Restaurant Cost of Capital From Exhibits 3 Restaurant
Market Value
Levered
Unlevered
Sales (b)
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
1.31
Frisch'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
0.72
Wendys
1.05
0.21
1.32
1.04
Average unlevered asset Beta:
• 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
0.96
• Step 3 Equity Cost -Restaurant • • •
KE = rF + βE x RPM KE = 8.72% + 1.65 * 8.47%(from Exhibit 5) KE = 22.72%
• Levered Equity Beta = βE = 1.65
• •
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
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%
D
=(1-T)*C*I + H*J
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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
LODGING
Revenues (in Billion)(b)
From Exhibit 3
Calculations
Market Leverage (c)
Unlevered Asset Beta
(Book Value of Debt divided by book value of the Debt + market value of equity)
Levered Equity Beta (d)
= 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:
• • • •
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
0.42
Beta for Restaurant From Exhibits 3 Restaurant
Market Value
Levered
Unlevered
Sales (b)
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
1.31
Frisch'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
0.72
Wendys
1.05
0.21
1.32
1.04
Average unlevered asset Beta:
•
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
•
Levered Equity Beta = βE = 1.65
0.96
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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? Asset Beta for Contract Services
Lodging Restaurants Contract Services MARRIOTT
Identifiable Assets $ % 2777.4 60.6% 1237.7 27.0% 567.6 12.4% 4582.7 100.0%
Asset Beta 0.43 0.96 1.05 0.65
•
Step 2 Lever Beta - Restaurant
•
Step 3 Equity Cost -Restaurant
• • •
Unlevered asset beta = 1.05 Target debt/value = .40 (from table A) Levered Equity Beta:
• • •
KE = rF + βE x RPM KE = 8.72% + 1.75 * 8.47%(from Exhibit 5) KE = 23.54%
•
Be= (V/Et)*BA = (1/0.60)*0.1.05 = 1.67*1.05 = 1.75
•
Levered Equity Beta = βE = 1.75
• 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% Page | 11
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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