Marriott Corporation:The Cost of Capital

Introduction

• Cost of capital is important in determining to accept or reject projects (investments)

• Also, it is important in determining capital structure

• Important in the regulation of electric, gas, and telephone companies

WACC

• Investors: stockholders (common and preferred stocks) and debtors

• Depends on capital structure• Components:– Cost of debt– Cost of preferred stock– Cost of common stock

Cost of Debt & Preferred Stocks

• New (marginal) rate versus historical (embedded) rate

• For the firm: Use the after-tax cost of debt: Kd(1-T)

• Cost of Preferred Stock Component: cost of preferred stock = preferred dividends/net issuing price

Cost of Common Stock

• New shares versus retained earnings• Determined by using:– CAPM Approach– Bond-yield-plus-risk-premium approach– dividend-yield-plus-growth-rate or Discounted

cash flow (DCF) approach

Company Background

• Began with J. Willard Marriott’s root beer stand

• Grew into one of the leading lodging and food service companies

• Lines of business:

Lodging Contract services Restaurants

Company Goals

• Intend to remain premier growth company:

Aggressively developing appropriate opportunities within existing line of business

To become preferred employer, preferred provider and the most profitable company in existing lines of business

Financial Strategy

• Selection of investment project by discounting expected cash flow at hurdle rate for each divisions.– Hurdle rate is the minimum rate of return that must be met for a

company to undertake a particular project.

For example,

Elements of Financial Strategy

I. Manage rather than own hotel assets

II. Invest in projects that increase shareholder value

III. Optimize the use of debt in the capital structure

IV. Repurchase undervalued share

Cost of Capital and the Company

• Company measures opportunity cost of capital for investment with similar risk using the Weighted Average Cost of Capital.

• WACC= (1-t)*rD*D/V + rE*E/V

Where, t= corporate tax rate

rD= cost of debt

D/V= % of debt financing

rE= cost of equity

E/V= % of equity financing

Key Isues

1. Are the four components of Marriott’s financial strategy consistent with its growth objective?

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

3. Compute the WACC of Marriott Corporation:• What risk-free rate and the risk premium did

you use to calculate the cost of equity?• How did you measure Marriott’s cost of debt?

Key Isues (Con’t)

4. Calculate the hurdle rate for the lodging division.

5. Comment on the firm’s use of hurdle rates

Are the four components of Marriott’s financial strategy consistent with its growth objective?

• Manage rather than own hotel assets.Exhibit 1 Financial History of Marriott Corporation

(dollars in millions, except per share amounts)MORE > > > > > >

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987Summary of Operations

Sales 1.174,1 1.426,0 1.633,9 1.905,7 2.458,9 2.950,5 3.524,9 4.241,7 5.266,5 6.522,2Earnings before interest expense and income taxes 107,1 133,5 150,3 173,3 205,5 247,9 297,7 371,3 420,5 489,4Interest Expense 23,7 27,8 46,8 52,0 71,8 62,8 61,6 75,6 60,3 90,5Income before income taxes 83,5 105,6 103,5 121,3 133,7 185,1 236,1 295,7 360,2 398,9Income taxes 35,4 43,8 40,6 45,2 50,2 76,7 100,8 128,3 168,5 175,9Income from continuing operations 48,1 61,8 92,9 76,1 83,5 108,4 135,3 167,4 191,7 223,0Net Income 54,3 71,0 72,0 86,1 94,3 115,2 139,8 167,4 191,7 223,0Funds provided from cont. operations(b) 101,2 117,5 125,8 160,8 203,6 272,7 322,5 372,3 430,3 472,8

Capitalization and Returns

Total Assets 1.000,3 1.080,4 1.214,3 1.454,9 2.062,6 2.501,4 2.904,7 3.663,8 4.579,3 5.370,5Total capital(c) 826,9 891,9 977,7 1.167,5 1.634,5 2.007,5 2.330,7 2.861,4 3.561,8 4.247,8Long-term debt 309,9 365,3 536,6 607,7 889,3 1.071,6 1.115,3 1.192,3 1.662,8 2.498,8 Percent to total capital 37,5% 41,0% 54,9% 52,1% 54,4% 53,4% 47,9% 41,7% 46,7% 58,8%Sharholders' equity 418,7 413,5 311,5 421,7 516,0 628,2 675,6 848,5 991,0 810,8

Per Share and Other Data

Earnings per share: Continuing operations (a) 0,25 0,34 0,45 0,57 0,61 0,78 1,00 1,24 1,40 1,67 Net income 0,29 0,39 0,52 0,64 0,69 0,83 1,04 1,24 1,40 1,67Cash Dividends 0,026 0,034 0,042 0,051 0,063 0,076 0,093 0,113 0,136 0,170Shareholders' equity 2,28 2,58 2,49 3,22 3,89 4,67 5,25 6,48 7,59 6,82Market price at year end 2,43 3,48 6,35 7,18 11,70 14,25 14,70 21,58 29,75 30,00Shares outstanding (in millions) 183,6 160,5 125,3 130,8 132,8 134,4 128,8 131,0 130,6 118,8Return on avg. shareholders' equity 13,9% 17,0% 23,8% 23,4% 20,0% 20,0% 22,1% 22,1% 20,6% 22,2%

Source: Company Reports(a) The Company's theme park operations were discontinued in 1984(b) Funds provided from continuing operations consist of income from continuing operations plus depreciation, deferred income taxes, and other items not currently affecting workign capital.(c) Total capital represents total assets less current liabilities

Con’t (1)• Invest in projects that increase shareholder value.

1. Net profit margin has been stable, ranged from 0.04 - 0.05 for the nine-year period before 1987. When the ratio diminished to 0.34 in 1987, it happened because in 1986 and 1987 Marriott develop many hotel properties, and it shows in the increase amount of Capital and Assets. And also subtracted by the increase of interest payment.

2. Share’s market price value in the year of 1978 to 1987 keep increasing significantly, except for 1987 the increasing was only $ 0,25, as an effect from repurchasing the shares in 1986.

Con’t (2)• Optimize the use of debt in the capital structure.

1. Table A shows that the company’s policy in capital structure is 60% debt and 40% equity. in Exhibit 1 found that in 1987 the proportion is nearly optimum (58,8%) followed by the increase of Capital or Assets.

2. Also showed in exhibit 1, debt ratio has constantly grown from 0.58 in 1978 to 0.85 in 1987, and debt-equity ratio has grown from 1.39 to 5.62 in the same period. Even when debt and debt-equity ratios has grown, the company still able to keep its interest coverage capability going from a 4.52 ratio in 1978 to 5.41 in 1987, means that the company’s liquidity still cover the debt.

3. An assumption about the cause of that high debt growth is that was a result of the company’s shares-repurchasing policy, because they had to raise funds by long-term debt in order to pay such repurchasement of shares

Con’t (3)• Repurchase undervalued share. This policy is not consistently support

the growth strategy.

1. Generally, it can lead to a lower growth, because company uses it’s free funds to buy back shares and therefore will underinvest in NPV-positive projects.

2. Some cause why shares’s price are going down, it may 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. Buybacks, if shares are temporary undervalued, then it might be a cheap way of paying dividends to shareholders . In the long run, this technique is simply impossible to do it continuously.

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

• Marriott measured the opportunity cost of capital for investments of similar risk using the weighted average cost of capital (WACC) approach to determine the cost of capital for the corporation as a whole and for each division:

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

Where:• t = corporate tax rate• rD= cost of debt (pre-tax)• D/V= % of debt financing• rE= cost of equity (after-tax)• D = the market values of the debt • E = the market values of the equity, • V = the value of the firm (V = D +E) • E/V= % of equity financing

Elements of WACC

• rE: cost of equity (CAPM)

• rE= Rf + Beta*(Risk premium)

where, Rf= risk free rate (generally, 3-month US treasury bill)

Beta= the sensitivity of the asset returns to market returns

Risk premium= rM-Rf

Elements of WACC

• rD: cost of debt

• rD= Government rate of borrowing + Premium above Government rate

• In this case we have Govt. rate is 8.95% (30- year maturity- for Marriott and lodging operations)

• Govt. rate is 6.90% ( 1-year maturity for restaurant and contract services)

Risk Premium for all the division was found to be from exhibit given in the case paper,Risk Premium(Restaurant & Contract services) = Market Return – Risk free rate = 0.0523 – 0.0546 = -0.0023Risk Premium( Marriot & Lodging)= Rm- Rf = 0.0523 – (-0.0269) = 0.0792

D/V E/V Beta Debt rate premium above Government

Marriott 0.60 0.40 1.11 1.30%

Lodging 0.74 0.26 1.09 1.10%

Contract Services

0.40 0.60 1.11 1.40%

Restaurants 0.42 0.58 1.082 1.80%

Compute the WACC of Marriott Corporation:

Calculate the hurdle rate for the lodging division.

• Because Lodging Division is a long term investments so the computing will use the Long-term, high-grade corporate bond rate of returns. With the Tax Rate 44% , then Lodging’s Cost of Debt is: :

• βl = βu [ 1 + ( 1- T) D/E ] = 1.09 [ 1 + (1- 0.44)*(0.74/0.26) ] = 2.83

• rE = rf + βl (rm - rf) = -0.0269 + ( 2.83 * 0.0792) = 19,72%

• rD = rf + Premium above Govt. Rate = 8.95% + 1.10% = 10.05%

• WACC= (1-t)*rD*D/V + rE*E/V = [(1- 0.44)*10.05%*(0.74)] + [19,72%*0.26] = 9.29%

In a same manner,WACC of Restaurant division and Contract services can be

found.

Contract Services Restaurants

WACC 4.93% 5.00%

Comment on the firm’s use of hurdle rates

• The hurdle rate for lodging division can be calculated in targeting the composition DV:EV = 60:40, according to corporate policy, so the rate would be:

• βl = βu [ 1 + ( 1- T) D/E ] = 1.09 [ 1 + (1- 0.44)*(0.60/0.40) ] = 2.01

• rE = rf + βl (rm - rf) = -0.0269 + ( 2.01 * 0.0792) = 13,23%

• rD = rf + Premium above Govt. Rate = 8.95% + 1.10% = 10.05%

• WACC= (1-t)*rD*D/V + rE*E/V = [(1- 0.44)*10.05%*(0.60)] + [13,23%*0.40] = 8,67%

Comment on the firm’s use of hurdle rates

• The hurdle rate should be 8,67%, if the debt composition not more than 60:40 (debt:equity). Since WACC Lodging is more than 8,67% it means that the Lodging Division has higher WACC, because of higher equity financing in some of its divisions and lower debt financing

• Higher WACC of lodging indicates that company should be careful enough in investing in lodging division as it demands for high required rate of return compared to those of restaurant and contract services.

• For hurdle rates calculation purposes, Marriott has determined a beta of 1.11 for the hole company. According to calculations shown in exhibit 4, pondering each division in accordance to its respective sales, Marriot should take in account each betas when evaluating each division’s projects, in addition to considering the global beta.

Comment on the firm’s use of hurdle rates

• The main use of the hurdle rates was the investment decision and this is reasonable. Using different rates for different division is also good. The idea of compensation based on hurdle rate is far from being just. And the rule of thumb may prove to be wrong in many cases, hope they don’t use it where it is crucial.

Analysis & Conclusion

• Marriott as a whole has WACC of 8.86%, which should be weighted avg of all of its divisions. Here, we found that WACC should be 6.42%.

• The higher WACC found above is because of higher equity financing in some of its divisions and lower debt financing vice versa.

• Higher WACC of lodging indicates that company should be careful enough in investing in lodging as it demands for high required rate of return compared to those of restaurant and contract services.

References

• Financial Theory and Corporate policy – by Copeland, Weston and Shastri

• Principles of Managerial Finance – by Lawrence Gitman

• Reference of Dr. Karen Denning

• Internet sources like www.marriott.com and www.investopedia.com