Marriott Corporation: Cost of Capital

Marriott Corporation: The Cost of Capital

Learning Outcomes
Calculate betas based on comparable companies and lever betas to adjust for capital structure Determine appropriate risk less rate and market risk premium Choice of time period to estimate expected returns

Assignment
Computing cost of capital of firm and each division Examining the central role that the hurdle rate plays in financial strategy

Marriott Corporation: The Cost of Capital Dated: April 1988 By: Dan Cohrs, Vice president of project finance Situation: Annual recommendation for the hurdle rates at each of the firms three division Investment projects: discounting the cash flows using appropriate hurdle rate for each division

Discussion Question
Investors look at the company as a whole Company as a whole has one cost of capital

Then why divisional cost of capital is computed?

Marriott Corporation
Began in 1927 By: J. Willard Marriotts root beer stand After 60 yearsOne of the leading lodging and food service companies in US Major lines of business
Lodging
361 hotels More than 100,000 rooms in total Range: full-services, high-quality Marriott hotels, and moderately priced fairfield inn

Contract services
Food and services management to health care and educational institutions and corporations Airline catering and airline services Marriotts in-flite services and host international operations

Restaurants
Includes Bobs Big Boy, Roy Rogers, Hot Shoppes

Product Line

Proportion of Proportion of Sales 1987 Profit 1987

Lodging Contract Services Restaurants

41% 46% 13%

51% 33% 16%

Marriotts Performance
In 1987
Sales grew by 24% Return on equity is 22% Profits: $223 million Sales: $6.5 million Sales and EPS have doubled over the 4 previous years Reprurchased 13.6 million shares of its common stock for $429 million

As per 1987 annual report

Remain premier growth company Aggressively developing appropriate opportunities within chosen lines of business To be the.. Preferred employer Preferred provider Most profitable company

Operating strategy: continuing this trend

Marriotts Cost of Capital

Mr. Cohrss opinion
Divisional hurdle rates have significant effect on the firms financial and operating strategies Increasing hurdle rate decreases the NPV of the projects and investments Decreasing hurdle rates would accelerate the firms growth

Discussion Question

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

How does Marriott uses its estimate of its cost of capital?

Using WACC
Determine incentive compensation (30% to 50% of base pay) Bonus awards is based on
Specific job responsibilities Earnings level Ability of managers to meet budgets Overall corporate performance

Proposed use..
Basing the incentive compensation on.. Comparison of divisional return on net assets Market based divisional hurdle rates Compensation plan would then reflect hurdle rates, making managers more sensitive to Firms financial strategy and capital market conditions

Errors in the hurdle rate can lead to incorrect decisions about the type and amount of investment, trigger or fail to trigger repurchases, and affect incentive compensation

Sales EBIT Interest expenses Income before income taxes Income taxes Income from continuing operations Net income Funds from continuing operations Total assets Total capital Long-term debt Shareholders' equity Long-term debt / total capital EPS - continuing operations Net income Cash dividends Shareholders' equity Market price (year-end) Shares outstanding (millions) Return on average shareholders' equity

1978 1174.10 107.10 23.70 83.40 35.40 48.00 54.30 101.20 1000.30 826.90 309.90 418.70 37.48%

1979 1426.00 133.50 27.80 105.70 43.80 61.90 71.00 117.50 1080.40 891.90 365.30 413.50 40.96%

1980 1633.90 150.30 46.80 103.50 40.60 62.90 72.00 125.80 1214.30 977.70 536.60 311.50 54.88%

1981 1905.70 173.30 52.00 121.30 45.20 76.10 86.10 160.80 1454.90 1167.50 607.70 421.70 52.05%

1982 2458.90 205.50 71.80 133.70 50.20 83.50 94.30 203.60 2062.60 1634.50 889.30 516.00 54.41%

1983 2950.50 247.90 62.80 185.10 76.70 108.40 115.20 272.70 2501.40 2007.50 1071.60 628.20 53.38%

1984 3524.90 297.70 61.60 236.10 100.80 135.30 139.80 322.50 2904.70 2330.70 1115.30 675.60 47.85%

1985 4241.70 371.30 75.60 295.70 128.30 167.40 167.40 372.30 3663.80 2861.40 1192.30 848.50 41.67%

1986 5266.50 420.50 60.30 360.20 168.50 191.70 191.70 430.30 4579.30 3561.80 1662.80 991.00 46.68%

1987 6522.20 489.40 90.50 398.90 175.90 223.00 223.00 472.80 5370.50 4247.80 2498.80 810.80 58.83%

0.25 0.34 0.45 0.57 0.61 0.78 1.00 1.24 1.40 1.67 0.29 0.39 0.52 0.64 0.69 0.83 1.04 1.24 1.40 1.67 0.03 0.03 0.04 0.05 0.06 0.08 0.09 0.11 0.14 0.17 2.28 2.58 2.49 3.22 3.89 4.67 5.25 6.48 7.59 6.82 2.43 3.48 6.35 7.18 11.70 14.25 14.70 21.56 29.75 30.00 183.60 160.50 125.30 130.80 132.80 134.40 128.80 131.00 130.60 118.80 13.90% 17.00% 23.80% 23.40% 20.00% 20.00% 22.10% 22.10% 20.60% 22.20%

Th e com pa n y 's them e par k opera tion s w er e discon tinu ed in 1 9 8 4 Fun ds fr om con tinu in g opera tion s con sists of in com e from con tn u ing opera tion s plu s deprecaition , deffered in coem ta xes, a n d oth er item s n ot cu rr en tly a ffectin g w orkin g Tota l capital represen ts tota l a ssets less cu r ren t lia bilities

1982 Lodging Sales Operating profit Identifiable assets Depreciation Capital expenditure Contract services Sales Operating profit Identifiable assets Depreciation Capital expenditure Restaurants Sales Operating profit Identifiable assets Depreciation Capital expenditure

1983

1984

1985

1986

1987

1091.70 1320.50 1640.80 1898.40 2233.10 2673.30 132.60 139.70 161.20 185.80 215.70 263.90 909.70 1264.60 1786.30 2108.90 2236.70 2777.40 22.70 27.40 31.30 32.40 37.10 43.90 371.50 377.20 366.40 808.30 966.60 1241.90 819.80 51.00 373.30 22.90 127.70 547.40 48.50 452.20 25.10 199.60 950.60 1111.30 1586.30 2236.10 2969.00 71.10 86.80 118.60 154.90 170.60 391.60 403.90 624.40 1070.20 1237.70 26.10 28.90 40.20 61.10 75.30 43.80 55.60 125.90 448.70 112.70 679.40 63.80 483.00 31.80 65.00 707.00 79.70 496.70 35.50 72.30 757.00 78.20 582.60 34.80 128.40 797.30 79.10 562.30 38.10 64.00 879.90 82.40 567.60 42.10 79.60

1982 Lodging Sales Operating profit Identifiable assets Depreciation Capital expenditure Contract services Sales Operating profit Identifiable assets Depreciation Capital expenditure Restaurants Sales Operating profit Identifiable assets Depreciation Capital expenditure 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

1983 120.96% 105.35% 139.01% 120.70% 101.53% 115.96% 139.41% 104.90% 113.97% 34.30% 124.11% 131.55% 106.81% 126.69% 32.57%

1984 150.30% 121.57% 196.36% 137.89% 98.63% 135.56% 170.20% 108.20% 126.20% 43.54% 129.16% 164.33% 109.84% 141.43% 36.22%

1985 173.89% 140.12% 231.82% 142.73% 217.58% 193.50% 232.55% 167.26% 175.55% 98.59% 138.29% 161.24% 128.84% 138.65% 64.33%

1986 204.55% 162.67% 245.87% 163.44% 260.19% 272.76% 303.73% 286.69% 266.81% 351.37% 145.65% 163.09% 124.35% 151.79% 32.06%

1987 244.87% 199.02% 305.31% 193.39% 334.29% 362.16% 334.51% 331.56% 328.82% 88.25% 160.74% 169.90% 125.52% 167.73% 39.88%

1982

1983

1984

1985

1986

1987

Sales / Assets Loding 120.01% 104.42% 91.85% 90.02% 99.84% 96.25% Contarct Services 219.61% 242.75% 275.14% 254.05% 208.94% 239.88% Restaurants 121.05% 140.66% 142.34% 129.93% 141.79% 155.02% Operating Profit / Sales Loding 12.15% 10.58% 9.82% 9.79% 9.66% 9.87% Contarct Services 6.22% 7.48% 7.81% 7.48% 6.93% 5.75% Restaurants 8.86% 9.39% 11.27% 10.33% 9.92% 9.36% Operating Profit / Assets Loding 14.58% 11.05% 9.02% 8.81% 9.64% 9.50% Contarct Services 13.66% 18.16% 21.49% 18.99% 14.47% 13.78% Restaurants 10.73% 13.21% 16.05% 13.42% 14.07% 14.52% Depreciation / Sales Loding 2.08% 2.07% 1.91% 1.71% 1.66% 1.64% Contarct Services 2.79% 2.75% 2.60% 2.53% 2.73% 2.54% Restaurants 4.59% 4.68% 5.02% 4.60% 4.78% 4.78%

Marriotts Financial Strategy

Manage rather than own hotel assets
In 1987: developed more than $1 billion worth of hotel properties 10th largest commercial real estate developers in US Integrated development process Identified markets Created development plans Designed projects Evaluated potential profitability Company sold hotel assets to limited partners, retaining operating control as general partner under long term management contract

Marriotts Financial Strategy

Manage rather than own hotel assets
Management fee = 3% of revenues plus 20% of the profits before depreciation and debt service 3% of revenues usually covered the overhead cost of managing the hotel 20% of the profits before depreciation and debt service required to stand aside until investors earned a prespecified return Guaranteed a portion of partnership debt in 1987: three hotels and 70 courtyard hotels were syndicated for $890 million The firm in whole operated about $7 billion worth of syndicated hotels

Marriotts Syndication
Syndication
Key control device for capital budgeting system Invests $1 billion in assets each year, and sells off about $1 billion in assets each year in syndications Projects face a quicker market test than in the typical industrial firm Since process turns over quickly, valuation errors appear quickly Partnership syndication market is the important capital market for Marriott Projects with zero NPV just break even at syndication great confidence in cash flow and discount rate system

Marriotts Syndication
Syndication
Syndication market
Private market Less efficient than a public equity market Limited information and marketability High transaction costs

Syndication market test may be a poor test of the market value of hotels As long as developed properties are sold in syndication market, can capture some of the benefits of any mispricing that occurs

Marriotts Syndication
Syndication
Mispricing may benefit share holders but mislead the Marriot about the reliability of its capital budgeting system Inefficiencies and instability in the syndication market can have a large impact on Marriott

Marriotts Financial Strategy

Invest in projects that increase shareholder value
Based on discounted cash flow model Hurdle rate for specific project was based on Market interest rates Project risk Estimates of risk premiums Cash flow forecasts were based on standard company wide assumptions that limited discretion in cash flow estimates and instilled consistency across projects

Marriotts Financial Strategy

Invest in projects that increase shareholder value
Projects are similar little boxes Similarity disciplines the pro forma analysis Corporate macro data on - inflation, margins, project lives, terminal values, percent of sales required to remodel Projects are audited throughout their lives to check and update these standard pro forma template assumptions Divisional managers have discretion over unit-specific assumptions, but they must confirm to corporate templates

Marriotts Financial Strategy

Optimize the use of debt in the capital structure
Determining the amount of debt based onability to service debt Uses an interest coverage target instead of target debt-to-equity ratio In 1987.. Debt: $2.5 billion (59% of its total capital)

Marriotts Financial Strategy

Repurchase undervalued shares
Regularly calculated a warranted equity value Repurchasing stocks whenever its market price fell substantially below that value Checking stock price by comparing them with comparable companies using P/E ratios for each business and by valuing each business under alternative ownership structures, such as leveraged buyout More confidence in its measure of warranted value than in the day-to-day market price of stocks

Marriotts Financial Strategy

Repurchase undervalued shares
Gap between warranted value and market price, triggered repurchases Believes that repurchases of shares below warranted equity value were a better use of its cash flows and debt capacity than acquisitions or owning real estate

Discussion Question

Are the four components of Marriotts financial strategy consistent with its growth objective?

Marriott Corporation: The Cost of Capital

Marriotts financial strategy

Is consistent and can be pursued coherently

Marriotts WACC
Computation of cost of capital (WACC)
Used for corporation as a whole and for each division Inputs: debt capacity, debt cost, equity cost consistent with the amount of debt WACC varied across divisions WACC for each division was updated annually

Debt Capacity
Debt capacity and cost of debt
Applied coverage-based financing policy to each division Fraction of debt floats based on sensitivity of the divisions cash flows to interest rate changes Interest rate on floating-rate debt changed as interest rates changed Cash flows increased as the interest rate increased, using floating-rate debt expanded debt capacity

Debt Capacity
Debt capacity and cost of debt
In 1987
Unsecured debt was A-rated, high-quality corporate risk

Pays spread above the current govt. bond rates Debt cost is independent for each division as independent company Spread between debt rate and govt. bond rate varied by division because of difference in risk Cost of debt
Lodging assets: cost of long-term debt Restaurant and contract services: cost of shorterterm debt

Marriotts Debt

Market Value-Target Leverage Ratios and Credit Spreads for Marriott and its Division Debt % in Capital Marriott Lodging Contract Services Restaurants 60% 74 40 42 Fraction of Fraction of Debt at Floating Debt at Fixed 40% 50 40 25 60% 50 60 75 Debt Rate Premium Above Govt. 1.30% 1.10 1.40 1.80

Interest Rates
US Govt. Interest Rates, April 1988 Maturity 30-year 10-year 1-year Rate 8.95% 8.72 6.90

Cost of Equity
Uses CAPM model Beta estimated from daily historical return using simple linear regression analysis Using 1986 and 1987 daily stock return beta is 1.11 Limitations on using historical data for estimating beta
Multiple lines of businessestimated beta is weighted beta Leverage affected beta

Historical beta has to be interpreted and adjusted before using it for projects HPR is the returns realized by security holder including cash payment, capital gain or loss

Discussion Questions

What is the WACC for Marriott Corporation? What risk-free rate and risk premium did you use to calculate the cost of equity? How did you measure Marriotts cost of debt?

Firm Level Cost of Capital

Firm level cost of capital
Inputs
Target capital structure: 60% debt Debt costs: 10.25%
Spread: 1.30% above long term US govt. bonds 30-year fixed US government rate: 8.95%

Levered beta: 1.11 (could be used if the target debt ratio matches with the actual debt ratio) Actual debt ratio: 41% [2498.8 / (2498.8 + (30*118.8))]

Asset Beta
Adjusting asset beta..
Asset beta has to be adjusted for difference between the actual and target debt ratio Computed by unlevering and levering back at target debt ratio Asset beta = (D/V)*FD + (E/V)*FE Equity beta = (V/E)*FV

Risk-Free Rate
Riskless Rate
CAPM is a one-period model CAPM holds in each period Theoretically CAPM has to be recomputed in each period Instead of using a sequence of forward rates, the yield on a long-term riskless bond is used Assumes single expected equity return over the life of the project.beta and risk premium are stable over the life of the project

Risk Premium
Less risky securities have lower realized returns Characteristics of the securities change over time Spread between S&P composite returns and long-term US govt. bonds

Levered and Unlevered Beta

= =

D [1 + (1 - t) * ] E
L

D 1 + (1 - t) * E

Marriotts WACC
Equity Beta Lodging Hilton Hotels Hoilday Corporation Ramada Inns La Quinta Motor Inns Total Restaurants Churchs Fried Chn. Collin Foods Frischs Lubys McDonalds Wendy Total 0.88 1.46 0.95 0.38 . 0.75 0.60 0.13 0.64 1.00 1.08 . D/V 14.00% 79.00% 65.00% 69.00% . 4.00% 10.00% 6.00% 1.00% 23.00% 21.00% . Revenue 0.77 1.66 0.75 0.17 3.35 0.39 0.57 0.14 0.23 4.89 1.05 7.27 D/E 16.28% 376.19% 185.71% 222.58% . 4.17% 11.11% 6.38% 1.01% 29.87% 26.58% . Tax Rate Unlevered Beta Weighted Unlevered Beta 40% 40% 40% 40% . 40% 40% 40% 40% 40% 40% . 0.80 0.45 0.45 0.16 . 0.73 0.56 0.13 0.64 0.85 0.93 . 0.184 0.222 0.101 0.008 0.515 0.039 0.044 0.002 0.020 0.570 0.135 0.811

Marriotts WACC
US Governement Interest Rate - 30-Year US Governement Interest Rate - 10-Year Riskless Rate Target D/V Target D/E Actual D/E Levered Equity Beta Unlevered Equity Beta Restimated Levered Equity Beta at Target Debt Risk Premium Cost of Equity Cost of Debt Tax Rate WACC Identifiable Assets (1987) Proportion of Identifiable Assets Marriott Lodging Restaurant Contract Services 8.95% 8.95% . . . . 8.72% 8.72% 8.95% 8.95% 8.72% 8.72% 60% 74% 42% 40% 150% 285% 72% 67% 70% . . . 0.97 . . . 0.68 0.52 0.81 1.00 1.30 1.39 1.16 1.40 7.43% 7.43% 7.43% 7.43% 18.59% 19.31% 17.36% 19.13% 10.25% 10.05% 10.52% 10.35% 40% 40% 40% 40% 11.13% 9.48% 12.72% 13.96% 4582.70 2777.40 567.60 1237.70 100.00% 60.61% 12.39% 27.01%

Discussion Questions
What is the cost of capital for the lodging and restaurant divisions of Marriott? What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers? How did you measure the cost of debt for each division? Should the debt cost differ across divisions? Why? How did you measure the beta of each division?

Discussion Question

What is the cost of capital for Marriotts contract services division? How can you estimate its equity costs without publicly traded comparable companies?

Cost of Capital for Lodging and Restaurants

Cost of capital for lodging and restaurants
Converting levered betas of comparable firm to unlevered beta Weighted average of the unlevered beta (May also use Bayesian adjustment to beta to incorporate the observed tendency of equity betas to move toward 1 over time) Estimating levered equity beta

Cost of Capital of Contract Services

Cost of capital for contract services
No publicly traded comparable companies Residual approach can be used for computing beta Weights of beta can be based on identifiable assets

Discussion Question

What type of investments would you value using Marriotts WACC?

Discussion Question

If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time

Insight
Using single rate imposes a systematic bias on project selection Valuation error caused by using a single discount rate result in riskier, less profitable investment projects