Marriott Corporation
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In early 1988, Marriott Corporation was in the growth stage, with sales and EPS doubling over the last four years. The company intends to continue this trend and has developed a new financial strategy in this regard. The various aspects of the strategy and their effectiveness are as under:
Manage rather than own hotel assets: By not owning the assets outright, the company manages to maintain a lean and flexible balance sheet with low assets. Hence, the return on assets would be considerably higher. Also, the company can use its capital for more profitable projects.
Invest in projects that increase shareholder value: The company already has in place unbiased methods of estimating the project cash flows and hurdle rates. By investing in projects with returns greater than the hurdle rate, the company would add value. This is an effective use of the capital and would increase EPS and ROIC in the long run.
Optimize the use of debt in the capital structure: By having optimal debt, the company can lower both its cost of equity and debt, and effectively the hurdle rate. This would let the company to undertake more value-adding projects, thereby improving the revenues and profitability. However, this strategy depends on the company effectively determining its optimal capital structure.
Repurchase undervalued shares: If the companys shares are truly undervalued, then this strategy is an effective use of the excess cash and would improve the EPS, ROE and effectively the share price. However, in case the shares are at fair value, then through share repurchases the company is diverting the cash from more profitable projects which would actually add value to the shareholders. Hence, this strategy is very sensitive to the companys perception of fair value.
Cost of Capital: The weighted average cost of capital (WACC) includes the cost of equity and the cost of debt. Capital Asset Pricing Model (CAPM) is used for determining the cost of equity: re = Risk Free Rate + β * Market Risk Premium.
Since, we assume the company to be a going concern and value the equity to eternity, the longest available Government bond rate is used as a proxy for risk free rate. In this case, it is the 30-year rate or 8.95% from Table B. Given the market conditions in late 1980s, a realistic estimate for the market risk premium is 7.00% (forward looking), which is very close to the historic spread of S&P500 return over Long term government debt for 1927-1987. The equity beta for Marriott is given as 0.97 based on the 1987 market leverage of 41% (Exhibit 3). We know from Table A that going forward the target leverage for the company is 60%. Hence, we need to calculate a new beta for the company based on the target D/E ratio. This is done by first unlevering the beta or essentially removing the financial risk arising from the capital structure and then relevering it using on target D/E. The average tax rate for the last five years (44%) is used in WACC.
The entire debt of Marriott is divided into floating and fixed components. The cost of debt is given as a spread of 1.30% over Government bonds. For the floating component the reference Government bond rate is taken as the 1-year rate, since the floating rates are reset for short periods of time. Since the overall assets of Marriott have a long life, the 30-year rate is taken as reference for the fixed component of the debt. The total cost debt is calculated as the weighted average of the floating and fixed parts. Theoretically, the returns on the debt are used in calculating the WACC. However, the debt of Marriott is A rated and the probability of default is negligible. Hence, the cost of debt is a realistic assumption. Given the costs of debt and equity, the WACC is calculated in Exhibit 1 as 10.35%.
Divisional Hurdle Rate: The operations of Marriott can be divided into Lodging, Contract Services and Restaurant businesses. The comparable companies are given for lodging and restaurant divisions. The betas of these companies are used to calculate the average unlevered betas of the two divisions. There are no comparable companies for the contract services. The unlevered beta is the beta if the company has no debt. In other words, it is the asset beta. Hence, given the unlevered betas of the other two divisions and the company as a whole, the unlevered beta of contract services division is estimated based on the asset weights. The betas are relevered based on target divisional D/E ratios and the cost of equity is computed using the CAPM. The cost of the floating component of debt is calculated as the respective spread over 1-yr rate. In the case of fixed component, the 10-yr rate is taken as reference for restaurant and contract services, since assets in these divisions have a shorter life. The detailed computations are given in Exhibit 2.
Division
Cost of Debt
Cost of Equity
Cost of Capital/Hurdle Rate
Lodging
9.03%
17.63%
8.32%
Restaurant
10.07%
15.27%
11.23%
Contract Services
9.39%
27.20%
18.42%
Marriott
9.43%
17.94%
10.35%
In case Marriott uses the same corporate rate to value all the projects, then it does not capture the actual riskiness of the project. The company may reject less risky value-adding projects, but on the other hand accept risky projects with a low rate of return. For instance, if Marriott uses the hurdle rate of 10.35%, it effectively