Marriott Corporation: The Cost of Capital
April 2012
Executive Summary Determining the appropriate cost of capital for new investment projects for a diversified company like the Marriott Corporation is not an easy endeavor. However, it is an important exercise because the more effective the process, the better it can help to support the company’s growth objective with its financial strategy. The four components of the financial strategy are:
manage rather than own hotel assets invest in projects that increase shareholder value optimize the use of debt in the capital structure repurchase undervalued shares
Each of these aspects of the financial strategy support Marriott’s growth objective, except for the repurchasing of undervalued shares, which is not based on feeling of significant undervaluing of the stock by the market, but based on an internally generated intrinsic value of the company. Marriott’s cost of capital estimation process involves consideration of debt capacity, cost of debt and cost of equity. This data, plus consideration of capital structure and effective tax rate, is then applied to the Capital Asset Pricing Model, using the U.S. Government 10-year bond as the risk-free rate and the spread between the S&P 500 composite and the U.S. Government 10-year bond rate. Beta is based on the last five years of monthly return data. The resulting corporate WACC is 10.22%. However, new investments in the different divisions requires the application of a hurdle rate that reflects the business risk of that particular unit, rather than the overall corporate hurdle rate, which is primarily applicable to corporate capital expenditures, such as headquarters and IT support systems. The table below summarizes the WACC for each Marriott division based on its mix fixed and floating rate debt, capital structure, and applicable unlevered beta for its industry.
Lodging 8.72%
Restaurant 8.72%
Contract Services 8.72%
Marriott Corporation 8.72%
Target D/V
74.0%
42.0%
40.0%
60.0%
Actual D/V
-
-
-
55.8%
βL
-
-
-
1.110
βU
0.554
0.929
0.610
0.616
Relevered βL
1.441
1.308
0.839
1.135
Risk Premium
7.92%
7.92%
7.92%
7.92%
Cost of Debt
8.91%
10.07%
9.39%
9.29%
Cost of Equity
20.13%
19.08%
15.36%
17.71%
Estimated Tax Rate
43.7%
43.7%
43.7%
43.7%
WACC
8.95%
13.45%
11.33%
10.22%
Risk-Free Rate (US Gov 10-yr)
Introduction Marriott Corporation is diversified company in the lodging, restaurant and contract services. Its lodging business unit consisted of managing the operation of 361 hotels of a variety of star ratings. Its restaurant business unit ran and owned a handful of fast food and diner chains. One of the perennial challenges that Marriott management faced was the close integration of its financial strategy, growth objectives, determining the appropriate hurdle rate for investments, and how to add a capital cost component to incentive compensation plans. Marriott’s Financial Strategy The overall objective for Marriott’s vice president of project finance, Dan Cohrs, was to support the company’s growth objective in being the most profitable company in its lines of business. To support this growth objective, Marriott developed a financial strategy that consisted of four tactics – manage rather than own hotel assets, invest in projects that increase shareholder value, optimize the use of debt in the capital structure, and repurchase undervalued shares. Manage Rather than Own Hotel Assets Marriott would develop hotel properties and then sell them off to investment partnerships. Its typical deal would consist of it being granted a long-term contract to operate and manage the property on behalf of the owner, where it receives 3% of revenues as compensation and 20% of profit over and above a specified return for the owner. If you wanted to maximize growth and shareholder value, this was a more prudent approach to being in the lodging business because the company wouldn’t be held down by large amount of debt associated with these properties and it eliminated a lot of long-term market risk. If a hotel went under, Marriott’s risk was limited to the portion of debt that it guaranteed instead of the entire amount. Therefore, this tactic supported the company’s growth objective because it did not tie up huge amounts of investment capital in fixed assets and allowed it to focus on activities and projects that could generate significant revenue growth. If Marriott could make a hotel very busy, it only had to make small increases in staff to accommodate large increases in business. Plus, its profitability would accelerate once it was able to clear its property owner’s return requirement. By being service oriented, Marriott greatly reduced the capital intensity of its lodging business unit. Invest in Projects That Increase Shareholder Value Technically speaking, this is a tactic espoused by every company. Marriott purposed to only invest in NPV positive projects based on the hurdle rate appropriate for the type of investment. The pro forma cash flows for investment opportunities were developed at the division level using corporate templates. This provided consistency in methodology while allowing for variation in unit specific assumptions. This will also support the company’s growth objective because it promotes Marriott getting the best results for its investment funds to maximize the value created
by the projects it invests in. It also means that projects in riskier areas have to be that much profitable to generate the NPV to make an investment competitive versus alternative investments in less risky units. Optimize the Use of Debt in the Capital Structure Marriott used a targeted interest coverage ratio to determine its optimal use of debt instead of a debt-to-equity ratio. Because this approach bases debt capacity primarily on financial operations instead of market capitalization, it is supportive of growth by limiting debt based on near term financial performance rather than the ups and downs of the capital markets. Repurchase Undervalued Shares Marriott calculated its own valuation of its stock called its warranted equity value. Whenever its stock price went below the warranted value, Marriott would buy back stock. This tactic does not support growth because Marriott is using an intrinsic value of its stock to supersede the market value of the stock, which is the best indicator of the value of a publicly traded company. The company also assumed that this was the best use of cash and debt than investments. Although companies have used debt to repurchase stock, it is usually to try to “game” the system and improve the profitability related financial ratios by reducing the amount of total equity and the number of shares outstanding. Three more legitimate reasons for Marriott to buy back its stock would be mitigate the impact of stock dilution due to the exercise of stock options used as incentive compensation; to disburse excess funds to shareholders without the tax penalty associated with dividends; or to cheaply remove stock when the market it trading it at a steep discount to historical trends when the company is performing well. Buying back stock when it falls a small amount below an intrinsic value does not contribute to growth and those funds could have probably been used in a profitable, value-increasing project. Marriott’s Cost of Capital Estimation Process Marriott uses the weighted average cost of capital (WACC) to determine its corporate hurdle rate, as well as estimate the hurdle rates for its different divisions. The process begins with the company determining its debt capacity, cost of debt and its cost of equity, also being a function of the amount of debt. After determining the corporate level cost of debt, it allocated a portion of that debt to each of the business units to facilitate their unit hurdle rates. Each unit had a different debt weighting and cost of debt. Marriott annually updated its cost of capital for making investments. It does make sense for Marriott to determine a hurdle rate for its different business units because it is a diversified company, even if it is related diversification. Its business units carry the business risk of the industries they inhabit, regardless of the corporate make up of Marriott. To make the best use of Marriott funds and maximize value, Marriott has to take into account the risk associated with each unit’s projects. Having a hurdle rate for each business unit eliminates bias in project selection that would occur if it used the corporate hurdle rate.
Marriott’s Corporate Weighted Average Cost of Capital In its use of the weighted average cost of capital (WACC) formula below, Marriott uses its long-term debt to total capital ratio (total capital = total assets – current liabilities) for its debt weighting.
1
Cost of Equity To determine the cost of equity, Marriott used the Capital Asset Pricing Model (CAPM), which relates the returns for a single stock against the excess returns for the market over the risk-free rate. Marriott has a target debt percentage in capital of 60% for the company. Its 1987 debt percentage is 58.8% for which a beta of 1.11 was calculated based on the past five years of monthly returns. The average corporate tax rate for the past five years is 43.7%. The target debt percentage in capital is 60% and is treated as the debt-to-value ratio. For the target percentage the beta must be unlevered and then relevered based on the equation below.
1
1
This produces a relevered beta of 1.135. The market risk premium is based off of the spread between the S&P 500 composite returns and long-term U.S. government bond returns of 7.92%. The risk-free rate is 8.72% based on the 10-year U.S. government bond maturity rate. Using the CAPM equation below, this produces a cost of equity of 17.71%.
Cost of Debt Marriott has fixed and floating debt. Its projected mix will be 60% fixed debt and 40% floating debt. Overall, Marriott has estimated that its debt risk premium is approximately 1.30% above U.S. government debt securities. Fixed rate corporate debt is going to be consistent with 10-year maturity U.S. government debt and the floating rate debt is going to be consistent with 1-year maturity U.S. government debt. The 30year debt is not applicable because Marriott manages rather than owns the hotel properties it manages. The resulting weighted cost of debt is 9.29%. Debt Type Fixed Floating Total Premium Cost of Debt
Weight 60% 40%
Rate 8.72% 6.90%
Product 5.23% 2.76% 7.99% 1.30% 9.29%
Corporate or Firm Level WACC By applying Marriott’s corporate cost of debt and cost of equity from the previous sections, we calculate a WACC of 10.22%. 9.29% 1
0.437 0.6
17.71% 0.4
10.22%
Which Investments Can the Corporate Hurdle Rate by Applied To? The corporate or firm level hurdle rate cannot be applied to all projects because of the bias it presents when business units have less or more risk than the company as a whole. However, there are investments to which the corporate hurdle rate would be applicable. That would involve any capital expenditures on behalf of the corporate parent, including buildings, as well as enterprise resource systems and any other support systems that serve all three business units. For example, the three business units should be using the same system to do financial reporting and accounting. If Marriott only used the corporate hurdle rate for all investments, in the long-run, it would do poorly because the rate would cause the company to invest in projects that are too risky and avoid projects that could increase company value. Basically, Marriott would be worth a lot less than it otherwise would have if it didn’t take a one-size-fits-all approach to its hurdle rate for different projects in the business units. Or worse, it could go out of business or be acquired by a competitor that had a more rational approach to its project selection process and was able to buy Marriott with the value it had created. Cost of Capital for Individual Divisions The process that Marriott employs to determine the corporate hurdle rate can also be applied to its different divisions. For the lodging and restaurant divisions, the cost of equity can be determined by using the weighted average unlevered beta for a group of peer companies and then relevering the beta for that division’s leverage circumstances. Contract services will require a residual approach for determining its cost of capital. Peer groups were used to calculate weighted average unlevered betas for the groups, using 46% as the highest marginal corporate tax rate for the fiscal year ended June 30, 1987. For the lodging and restaurant divisions, the same risk-free rate and market risk premium was used. Although both divisions own long-lived assets, they are closer to 10-year versus 30-year assets, other than any facilities owned. As for the lodging and restaurant properties, the bulk of the capital investment is made in renovation, updating or modernizing hotel properties and updating of the restaurants. For example, Marriott will periodically update the furniture, décor, color and amenities at the properties it manages to keep them competitive. This is a regular part of the business, so long-lived assets in those properties would be replaced anyway. This even occurs in restaurants, although less frequently. Contract services would also operate its long-lived assets in the same time frame.
Lodging Division Based on the projected mix of fixed and floating debt, the cost of debt for the lodging division is estimated at 8.91% Debt Type Fixed Floating Total Premium Cost of Debt
Weight 50% 50%
Rate 8.72% 6.90%
Product 4.36% 3.45% 7.81% 1.10% 8.91%
To determine the cost of equity for the lodging division, a group of peer companies were gathered and key data related to capital structure, revenue and beta was compiled to calculate a weighted average unlevered beta for the group. That beta was relevered based on the lodging divisions projected debt percentage in capital of 74% as the debt-to-value ratio for the operating unit, resulting in a cost of equity of 20.13% βU-Peer Group = D/V = D/E = tC = βL= rF = MRP = rE =
0.5538 0.74 2.846 43.7% 1.441 8.72% 7.92% 20.13%
With the cost of debt and cost of equity relative to its industry, the lodging division cost of capital is equal to 8.95%. Restaurant Division Based on the projected mix of fixed and floating debt, the cost of debt for the restaurant division is estimated at 10.07% Debt Type Fixed Floating Total Premium Cost of Debt
Weight 75% 25%
Rate 8.72% 6.90%
Product 6.54% 1.73% 8.27% 1.80% 10.07%
To determine the cost of equity for the restaurant division, a group of peer companies were gathered and key data related to capital structure, revenue and beta was compiled to calculate a weighted average unlevered beta for the group. That beta was relevered based on the lodging divisions projected debt percentage in capital of
42% as the debt-to-value ratio for the operating unit, resulting in a cost of equity of 19.08% βU-Peer Group = D/V = D/E = tC = βL=
0.9290 0.42 0.724 43.7% 1.308
rF = MRP = rE =
8.72% 7.92% 19.08%
With the cost of debt and cost of equity relative to its industry, the restaurant division cost of capital is equal to 13.45%. Contract Services Division To calculate the cost of capital for the contract services is more complex because there aren’t any publicly traded peer companies to compare against and privately held firms either do not report their results or do not report results compliant with the financial reporting requirements of publicly traded companies. Based on the projected mix of fixed and floating debt, the cost of debt for the contract services division is estimated at 10.07% Debt Type Fixed Floating Total Premium Cost of Debt
Weight 60% 40%
Rate 8.72% 6.90%
Product 5.23% 2.76% 7.99% 1.40 % 9.39%
A residual approach will be required to determine the cost of equity for the contract services division according to the formula below using the unlevered betas, weighted by identifiable assets. Solving the formula for βC will provide us with the last piece of information needed to calculate its cost of capital.
This results in an unlevered beta of 0.610. Based on the projected capital structure of the division, it levers to a beat of 0.839.
Division Lodging Restaurant Contract Services Total
'87 Assets Identified 2,777.4 567.6 1,237.7
Weight 0.6061 0.1239 0.2701
Unlevered Beta 0.554 0.929 0.610
4,582.7
1.0000
0.616
That beta was relevered based on the lodging divisions projected debt percentage in capital of 40% as the debt-to-value ratio for the operating unit, resulting in a cost of equity of 15.36%. βU-Peer Group = D/V = D/E = tC = βL= rF = MRP = rE =
0.9290 0.42 0.724 43.7% 1.308 8.72% 7.92% 19.08%
With the cost of debt and cost of equity applicable to this business unit, the contract services division cost of capital is equal to 11.33%. Conclusion There are already many assumptions made in a traditional cost of capital calculation for a single-industry company. When a company is diversified, like Marriott, it cannot use a single corporate cost of capital for making investment decisions. It must make decisions for each division according to the business risk faced by that business unit because the level of risk varies from industry and that must be accounted for. Otherwise, a firm will engage in biased decision-making, if they use discounted cash flow and net present value for making investment decisions because a single hurdle rate will inflate the value of some projects, while lowering the value of others. Epilogue To stay competitive and generate the most value that they can for shareholders, companies review and update their strategies. Marriott Corporation is no different. Not long after the time period associated with this case, Marriott began to take dramatic steps to maximize shareholder value. First, the company sold is restaurant operating division in 1990 (White, 1989). The competition from industry leaders was too intense and rapid expansion would have required a lot of additional capital. Subsequently, the company would go through multiple spinoffs. In 1993, the company spun off Marriott International, which managed and franchised hotels and
retirement communities (Marriott International, 2012). The remaining company changed its name to Host Marriott Corporation and owned many of the properties managed by Marriott International. In 1995, Host Marriott Corporation spun off some of the contract services business with the name Host Marriott Services. This allowed Host Marriott Corporation to focus on its real estate assets. In 1998, Marriott International spun off its management services business in a merger with Sodexho to create Sodexho Marriott Services. Later that year, Host Marriott Corporation spun off is senior retirement real estate business as Crestline Capital Corporation. At the end of 1998, Host Marriott Corporation converted into a real estate investment trust called Host Hotels & Resorts (Marriott International, 2012). The last spin off conducted by Marriott International occurred towards the end of 2011, where it spun off its time share operating segment as Marriott Vacations Worldwide Corporation (NYSE: VAC). Marriott International is only involved in lodging now and reorganized into four lodging divisions – North American Full-Service, North America limited-service, International Lodging and Luxury Lodging. In terms of the financial strategy outlined by the Marriott Corporation in 1987, that strategy continues in Marriott International. It doesn’t own the properties. It just manages and franchises them. At the end of fiscal year 2011, its debt-to-market value ratio is 0.1579. The company appears to be attempting to minimize the amount of debt it uses. The cost of debt is approximately 5.485% and the cost of equity is approximately 11.44%. Marriott International’s WACC, based on 2011 financial statements is 10.12%. Measure
Value
Risk-Free Rate (US Gov 10-yr)
1.98%
D/V
15.79%
βetaL
1.660
Risk Premium
5.70%
Cost of Debt
5.485%
Cost of Equity
11.44%
Estimated Tax Rate
44.38%
WACC
10.12%
References Marriott International (2012). 2011 Annual Report. Retrieved from http://investor.shareholder.com/mar/sec.cfm?DocType=&DocTypeExclude=&Sort Order=FilingDate%20Descending&Year=&Pagenum=4 Marriott International (2012). Frequently Asked Questions. Retrieved from http://investor.shareholder.com/mar/faq.cfm White, G. (1989, December 19). Marriott to Sell Its Restaurants, Focus on Hotels : Services. LA Times. Retrieved from http://articles.latimes.com/1989-1219/business/fi-598_1_marriott-s-bob-s-big-boy
