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Marriott-Corporation-Cost-of-Capital-Case-Analysis.pdf

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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 Restaurant
Contract
Services
Marriott
Corporation
Risk-Free Rate (US Gov 10-yr) 8.72% 8.72% 8.72% 8.72%
Target D/V 74.0% 42.0% 40.0% 60.0%
Actual D/V - - - 55.8%
β
L
- - - 1.110
β
U
0.554 0.929 0.610 0.616
Relevered β
L
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%

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.

wACC = R
Ð
(1 -t
C
) _
Ð
I
] + R
L
_
E
I
]

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.

[
L
= [
0
|1 + (1 - t
C
) _
Ð
E
]

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%.

R
L
= R
P
+ [(HRP)

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 30-
year 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 Weight Rate Product
Fixed 60% 8.72% 5.23%
Floating 40% 6.90% 2.76%
Total 7.99%
Premium 1.30%
Cost of Debt 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 - u.4S7)(u.6) + 17.71%(u.4) = 1u.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 Weight Rate Product
Fixed 50% 8.72% 4.36%
Floating 50% 6.90% 3.45%
Total 7.81%
Premium 1.10%
Cost of Debt 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%

β
U-Peer Group
= 0.5538
D/V = 0.74
D/E = 2.846
t
C
= 43.7%
β
L
= 1.441
r
F
= 8.72%
MRP = 7.92%
r
E
= 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 Weight Rate Product
Fixed 75% 8.72% 6.54%
Floating 25% 6.90% 1.73%
Total 8.27%
Premium 1.80%
Cost of Debt 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%

β
U-Peer Group
= 0.9290
D/V = 0.42
D/E = 0.724
t
C
= 43.7%
β
L
= 1.308

r
F
= 8.72%
MRP = 7.92%
r
E
= 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 Weight Rate Product
Fixed 60% 8.72% 5.23%
Floating 40% 6.90% 2.76%
Total 7.99%
Premium 1.40 %
Cost of Debt 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 β
C
will provide us with the last
piece of information needed to calculate its cost of capital.

[
Pì¡m
= w
L
[
L
+ w
R
[
R
+ w
C
ß
C


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.






'87
Assets

Unlevered
Division Identified Weight Beta
Lodging 2,777.4 0.6061 0.554
Restaurant 567.6 0.1239 0.929
Contract Services 1,237.7 0.2701 0.610

Total 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%.

β
U-Peer Group
= 0.9290
D/V = 0.42
D/E = 0.724
t
C
= 43.7%
β
L
= 1.308

r
F
= 8.72%
MRP = 7.92%
r
E
= 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%
βeta
L
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/1989-12-
19/business/fi-598_1_marriott-s-bob-s-big-boy

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