MARRIOT COPORATION THE COST OF

CAPITAL (ABRIDGED)
HARVARD BUSINESS SCHOOL
 Presented to
Respected Sir, Dr. Ahmed Faraz

 Presented by
 Anees ul hassan
 Shahid abbas
 Sharoon javed
 Syed Muhammad Junaid jaffery
Company Background

 Beginning of company in 1927.

 J.William Marriot starts a root beer stand.
 60 years of continuous growth resulting into one of the leading
lodging and food services in united states.
 In 1987, profits were $223M and sales were $6.5B, sales growth of
24% and Roe stands at 22%
 Continued

 Marriot has three divisions:

 Lodging
 Contract services
 Restaurants
 Lodging operations include 361 hotels with more than 100,000 rooms
 Lodging generated 41% of sales in year 1987 and 51% of profits
 Contract services provided food and services management to health care and educational
institutions and corporations
 It generated 46% of sales and 33% of profits in the same year.
Continued

 Marriot restaurants generated 13% of sales and 16% of profits in

the year 1987.
Introduction

 April 1988, Vice president Mr. Dan Cohrs

 Annual recommendations for hurdle rates for three divisions
 Marriot has a thumb rule that increasing 1% hurdle rate would
cause 1% change (decrease) in present value of projects (NPV).
 Marriot also uses hurdle rates for determination of incentive
compensation plan.
Key Questions of the Case Study

1. What is the weighted average cost of capital (WACC) for Marriott

Corporation?
 What risk-free rate and risk premium to use to calculate the cost
of equity?
 How to estimate Marriott’s cost of debt?
2. What are the financial strategies of Marriott corporation?
Financial Strategies

Four key strategies

1. Manage rather than own hotel assets.
2. Invest in projects that increase shareholder value.
3. Optimize the use of debt in the capital structure.
4. Repurchase undervalued shares.
Financial Strategies (Cont)

 Manage rather than own hotel assets

 Main strategy was to sell the company to limited partners while
retaining operating control as the general partner under a long
term management contract after development.
 Management fees were 3% of revenue plus 20% of the profits
before depreciation and debt services.
 1987, the company operated $7B of syndicated hotels.
Continued

 Invest in projects that increase shareholder value

 The company used discounted cashflow techniques to evaluate potential
investments.
 The hurdle rate was based on market interest rates, projects risks, and
estimates of risk premium.
Optimize rhe use of debt in capital structure
 It focuses on its ability to service its debt.
Repurchase undervalued shares
 Marriot calculated a warranted equity value for its common shares and was
committed to repurchasing its stock whenever its market price fell substantially
below that value.
Calculations and answers to the questions

 (a) Calculating the cost of equity

 The cost of equity can be calculated by using the Capital Asset Pricing model
 Cost of Equity =Rf + beta *Risk premium
 Where Rf is risk free rate and risk premium is expected return on market
portfolio
 We consider that Marriot assets have useful lives of thirty So, we used 30-
year Government Interest rates (the borrowing rate available to US
government) as risk free rate.
 Our calculation of risk premium is based on arithmetic average of spread
between S& P return and long term US Government Bond returns from 1926
to 1987.
 Continued

 The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio
 βL = βu (1+ ((1-t) D/E))
 Calculate the unlevered beta to remove the beneficial effect (Tax effect) gained by adding debt to capital structure.
 Unlevered Beta = levered Beta/ (1 + (1- tax rate) (Debt/Equity))
 Bu =1.11/ [1+(1-0.34) *0.41/0.59] = 0.76
 Adjusting Unlevered Beta for financial leverage: -Calculate the Levered beta to achieve target leverage ratio of 60
% for Marriott corporation
 Levered Beta = Unlevered Beta* (1 + (1- tax rate) (Debt/Equity))
 Bl =0.76 *(1+(1-0.34) *0.6/0.4)
 Bl = 1.51
 Cost of Equity =Rf + beta *Risk premium
 Re =8.94+1.51*7.43 = 20.20%
Continued

 (b) Calculating the Cost of Debt

 Marriott’s capital structure has different proportion of fixed and floating debt. It targets a
debt structure of 60% fixed debt and 40 % floating debt in near future. For fixed debt, we
can consider fixed rate us government securities rate with 30-year maturity.
 Marriot also pays a premium above Government bond rates because it issues A rated
unsecured debt.
 Cost of Debt =Government borrowing rate for thirty years +Debt premium (for corporate
borrowing)
 =8.95+1.3 =>10.25%
 WACC= (1-0.34) *10.25*0.6 +20.20*0.40 =>12.14
 Continued

 How does Marriott use its cost of capital in operating its businesses?
 Marriott uses the cost of capital structure to determine the hurdle rate for each project in lodging,
restaurant and contacts division where the hurdle rate represents the minimum return required from a
company for any specific project. It selects future projects across different business units by
employing cash flow discounts to an appropriate hurdle rate and evaluates the worthiness of project by
comparing with the opportunity cost of capital. This has a key impact on company’s financial and
operating strategies because each division has different capital structure, and Time Value of Money,
Risk and Return. It also uses hurdle rate to determine compensation plan.
 What risk-free rate and risk premium did you use while
calculating the cost of equity for each division?

 As Lodging assets, such as hotels have useful lives and are creditworthy, we use 30 year US
government interest rate 8.95 % as risk free rate. We also think that the Restaurant and contract services
have shorter useful lives thus it will be based on 1 year US Government interest rate. Therefore, we use
6.90 as risk free rate.
 To maintain the consistency between risk free rate and risk premium. We also use the risk premium
based on assets useful lives. We use 7.43% as risk premium (Spread between S&P Index and Long
Term US Govt. Bonds), which is being calculated as difference between average Long term US
Government bond returns and S & P 500 returns for period 1926-1987.
 For Restaurant and contract division, we used 8.47 %(Spread between S&P 500 returns and short term
treasury returns)
 Calculating beta for each division is important in estimating the value of equity,
which contributes to the cost of capital in case of levered firm. Before doing this, it
is very important to understand the structure of Marriott.

 WACC For Marriott Lodging Division =10.08%

 Continued

 WACC For Marriott Restaurant Division 13.64%

 Continued

 WACC for Marriott’s contract Services Division =8.61%

 We can estimate the equity cost of contact services division without any publicly traded companies
 because Bottom-up Unlevered beta of Marriott is equal to weighted average of the unlevered betas of
 the individual business unit as identified by assets. Unlevered beta can be levered further to achieve
 target leverage ratio for Marriott’s contract Services Division.
 βu[Marriott] = W[Lodging] * βu[Lodging] + W[Contract] *βu[Contract] + W[Restaurant] *
βu[Restaurant]
Continued
 THANK YOU

 Question and answer session.