Marriot Corporation: The Cost of Capital

Sharad Mathur 033epgp2011

About Marriot Corporation

Began in 1927 by J. Willard Marriott Leading lodging and food services company of USA Three Lines of Business:
I. II. III.

In 1987, profits of $223 million on sales of $6.5 billion

Lodging : more than 361 hotels Contract Services : Food and services management Restaurants : Big Boy, Roy Rogers & Hot Shoppes

1987 Lines of Business: Profit and Sales share

Profits
16% 33% 51% Lodging Services

Contract Services
Restaurants

Sales
13% 46% Lodging Services 41% Contract Services Restaurants

Financial Strategy
Manage

rather than own hotels Invest in projects that increase shareholders value Optimize the use of debt in the capital structure Repurchase undervalued shares

Hurdle Rate

Followed different hurdle rate for each division Significant effect on firms financing and operating strategies 1% rise in hurdle rate would decrease NPV by roughly 1% Hurdle rates also determine annual incentive compensation Hurdle rate dependent on
I. II. III.

Market Interest Rates Project Risk Estimates of Risk Premium

Calculation of Cost of Capital

Updated
I. II. III.

Annually Requires three inputs

Debt Capacity Debt Cost Equity Cost based on amount of debt

WACC

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

i) Cost of Debt and Debt Capacity

Floating

rate or Fixed Rate : based on sensitivity of divisions cash flow to interest rate changes Estimated division debt cost as independent company
I. II. III. IV.

Rate of Debt, rD=Govt. Interest rate + Debt Premium Cost of long term debt for Lodging services => rD = 1.1+8.95 = 10.05% Cost of short term debt in Restaurant => rD=1.8+6.9 = 8.7% Cost of short term debt in Contract services => rD=1.4+6.9=8.3%

ii) Cost of Equity

Calculated by CAPM
I.
II.

rE= rRF + (rM-rRFD) : Measures systematic risks

Different for different Line of Business Affected by Leverage L= U(1+D/E)

Therefore, for Marriot with leverage of 41% , L = .97

U = .97(1+.41/.59) = 0.57 Therefore, at 60% Leverage, = .57(1+.6/.4) = 1.42

ii) Cost of Equity(contd.)

For

Lodging, from XLS, Restaurant, from Tab XLS

Unlevered Beta = 0.41

Unlevered Beta = 0.74

For

Now

we have market share of each division.

Therefore, (overall) =sum((division)*%Sale(division))
=> (CS) = (0.57-0.41*0.41-0.74*0.13)/0.45=0.68

WACC

From exhibit 5, risk premiums for period from 1981-86 has been quiet uneven. Therefore, for taking risk premium of Marriot and Lodging, premium over long term US Govt Bond for whole period 19261987 should be used. Similarly, for CS and Restaurants, premium over short term US bonds for whole period 1926-1987 has been used. Now that we have all the unknowns required for WACC, based on Table A, Exhibit 5, WACC can be calculated as follows :

Learning
Calculation

Beta Calculation of Cost of Equity Calculation of Cost of Debt Calculation of WACC Detailed calculation of Beta and WACC is provided below:

of Leveraged Unleveraged

Conclusions

Marriots Corporation use individual WACC for each department to select the favorability of projects. Based on each WACC, Lodging has lowest WACC because of highest leverage i.e. highest percentage of debt. Lower WACC implies that projects in lodging requires lower rate of return for approval than Contractual services, Restaurant. Marriot uses floating rate for part of debts based on sensitivity of cash flows to interest rates. Although higher leverage requires lower returns, but in turn it will reduce the debt raising ability.