Assignment:-2

2012

Marriott Corporation
Cost of Capital

Sumit Malhotra Section: D 2011PGP906 Finance 2

Executive Summary MARRIOTT Corporation, a leading lodging and food services company, is aggressively developing appropriate opportunities within chosen line of business lodging, restaurant and contract services. The Vice-president of Marriott Corporation was preparing his annual recommendation for the hurdle rates for each of his firms divisions. The divisional hurdle rates is expected to show a huge impact on the firms operational and financial strategies As they are also using hurdle rates for managers compensation estimation, so it becomes necessary to calculate in reasonable form. The key issue for us in this case was to calculate WACC for all three divisions. For this i needed cost of debt, cost of equity and debt capacity. In our analysis below we are going through 5 step process in order to formulate them. Without publicly traded comparable companies, it is usually difficult to estimate the equity costs. Hence we try to arrive at the desired value using the information that we have. Since we had the amount of unlevered beta for the hotel as a whole and for the lodging and restaurant divisions, i used this information to solve for the unlevel beta of the contract services division. I used identifiable assets to calculate the ratio for the weighting purpose because the company or the division normally uses cost of capital to purchase assets for the operation. Thus, assets should be the best item to weight the unlevel beta. The summarized view of WACC obtained through the analysis is as below: Marriott WACC= 8.152919719 Lodging 9.173324792 Contract 9.214883204 Restaurant 10.95875664

Marriotts divisional weighted average cost of capital gives us a better picture for investment decisions in respective divisions. The case was useful in understanding the concepts like a) How to calculate the cost of capital for the whole firm and as well for the individual divisions b) How to effectively evaluate the investment opportunity of a project belonging to one division and c) Effect of using the single hurdle rate to evaluate the investments across different divisions of a firm.

Company MARRIOTT INTERNATIONAL, INC. is a leading worldwide hospitality company, with operating units in the United States and 53 other countries and territories. It began in 1927 with J. Willard Sumit Malhotra Sec D Roll no: 2011PGP906 Page 2

Marriotts root beer stand. Over the years it has become a leading lodging and food service companies in US. It has three major lines of business: Lodging Contract services Restaurants

It is 6 billion dollar in sales and a growth oriented company. The vice president of project finance at Marriott Corporation prepares recommendations annually for the hurdle rates at each of the firms three divisions. In this reflective case, the companys policies and strategies related with hurdle rates and cost of capital are discussed. In the above context, the companys policy of repurchasing its shares is also reviewed; particularly, it focuses on the financial effects there may be if there is a 30% repurchase of the common stock. Objective is estimate hurdle rate for each division. Asset risk in each division is different from others. Cost of debt at each division is chosen according to the risk and period and hence different hurdle rates for each division. Hurdle rates are used to determine incentive compensation Managers would be more sensitive to financial strategy and capital market conditions. Hurdle rates would affect the firms financial and operating strategy The four key elements of financial strategy of Marriot Corporation were: 1. Manage rather than own hotel assets 2. Invest in projects rather than increase shareholder value 3. Optimize the use of debt in the capital structure 4. Repurchase undervalued shares Marriott measured the opportunity cost of capital for investments of similar risk using the weighted average cost of capital (WACC):

where D and E are the market value of the debt and equity, respective]y, debt,

is the pretax cost of is the

is the after-tax cost of equity, and V is the value of the firm. (V= D + E) and

corporate tax rate. Marriott used this approach to determine the cost of capital for the Sumit Malhotra Sec D Roll no: 2011PGP906 Page 3

corporation as a whole and for each division. To determine the opportunity cost of capitalMarriott required three inputs: debt capacity, debt cost, and equity cost consistent with the amount of debt Problem Statement Marriott currently uses a common hurdle rate to evaluate the investment decisions in all the three divisions. Using a single hurdle rate for the whole company would be too low for some divisions and too high for others. Hence there is a need of computation of hurdle rates for each division separately. Reason and Effects Since each of the lines of business has different risks attached to them, it would be incorrect to use a single hurdle rate for them. If the same were done, a lower discount rate might be used for lodging assets, which had long useful lives and consequently commanded a higher, longterm cost of debt for its cost-of-capital calculations; or higher discount rate might be used for its restaurant and contract services divisions which had shorter useful lives. This might result in some projects which ought to be rejected to be selected, and some projects which out to be selected to be rejected. When hurdle rate is too high, very few projects shall be considered for investments as the present values of the cash flows comes down with increase in hurdle rate. This results in slowing down the growth rate of Marriott. There would be problems if the hurdle rate used is too low for the portfolio also. In this case, projects that are not profitable will also be selected in some cases because of the reason that the cash flows are overvalued due to lower hurdle rate used for discounting them. Consequently, the companys growth would be hurt even in this also as such projects decrease the confidence of the investors in the firm. Hence, the calculation of costs of capital for use as hurdle rates is essential for managing the companys growth. Hence, either way the company is at a loss if it continues to use a single hurdle rate for all the divisions. The companys growth objective is to remain a premier growth company within its lines of business by aggressively developing appropriate opportunities. Strategy 2 conflicts with the companys objective because the company is using hurdle rate to discount cash flows and evaluate potential investments. If Re was higher, then WACC, which is the hurdle rate, would be higher as well. If this was the case, the companys growth would be reduced therefore failing the companys growth objective. Sumit Malhotra Sec D Roll no: 2011PGP906 Page 4

Solution: Step 1: Debt Percentage in Capital Marriott Lodging Contract Restaurants 60% 74% 40% 42%

The beta asset for each of the company can be arrived at using the following info 1. Beta Equity () 2. Market Leverage () The formula for calculating beta asset is ( )

Based on this beta asset values, industry weighted average for beta asset can be calculated using the revenues of particular companies. Using this approach we arrived at the average of 0.6894. Since Beta asset for contract services is not available we can use the company average for our calculations. The beta for each division was measured by calculating the lever beta using an average unlevel beta of the proxy firms. First, we chose the companies in the same line of business of each division (lodging and restaurant). Next, we used the equity beta of those firms to calculate unlevel beta. After that, we used total sales of those companies to calculate a weighted average unlevel beta of those proxy firms. Finally, we used the average unlevel beta to calculate the beta of each division from the formula: Lever beta (L) = x [1+(1-t) D/E]. The proportion of debt and equity was from the market value-target leverage ratios in above table.

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Roll no: 2011PGP906

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Arithmetic Average Return

Geometri c Average Return

Equit y Beta

Market Leverag e

1987 Revenue s ($ billion)

Beta Asset s

MARRIOTT CORPORATION (Owns, operates, and manages hotels, restaurants, and airline and institutional food services.)

22.40%

21.40%

0.97

41%

6.52

0.57

Hotels:

HILTON HOTELS CORPORATION HOLIDAY CORPORATION LA QUINTA MOTOR INNS RAMANA INNS, INC.

13.3

12.9

0.88

14% 0.77 0.76

28.8

26.9

1.46

79% 1.66 0.31

-6.4

-8.6

0.38

69% 0.17 0.12

11.7

2.8

0.95

65% 0.75 0.33

Restaurants: CHURCH'S FRIED CHICKEN COLLINS FOODS INTERNATIONAL FRISCH'S RESTAURANTS LUBY'S CAFETERIAS 15.1 12.8 0.64 15% 0.23 Sumit Malhotra Sec D Roll no: 2011PGP906 0.54 Page 6 56.9 49.7 0.13 6% 0.14 0.12 20.3 17.7 0.60 10% 0.57 0.54 -3.2 -7.3 0.75 4% 0.39 0.72

Contract Services McDonalds 22.5 21.3 1.00 23% 4.89 WENDY'S INTERNATIONAL 4.6 -1.4 1.08 21% 1.05 0.85 0.77

Here we have calculated unlevered Asset Beta by going through following steps and then take the weighted mean and then calculate levered Asset Beta. Unlevered Asset Beta = Levered Equity Beta / (1- Actual Debt / Value) Based on above identified similar companies, we can calculate weighted average of unlevered beta assets for each subsidiary and then lever the beta by following formula Levered Asset Beta = Unlevered Equity Beta * (1- Actual Debt / Value) Here are the summarized results: Beta Asset for Marriott 0.57

Beta Equity for Marriott Beta Asset for Lodging Beta Asset for Restaurants Beta Asset for Contract Services Division Beta Equity for Lodging Division Beta Equity for Contract Services Division Beta Equity for Restaurant Division

0.97 0.52 0.55 0.78 1.98 0.95 1.31

Step2 : Calculation of Cost of Equity Cost Of Equity= Risk Free rate + Beta (Market Rate- Risk Free Rate) Marriott Risk Free Rate eta 4.58 0.97 Lodging 4.58 1.98 Contracts 3.54 0.95 Restaurants 3.54 1.31

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Roll no: 2011PGP906

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Market Rate- Risk Free Rate Cost Of Equity

7.43 11.7871

7.43 19.2914

8.47 11.5865

8.47 14.6357

Step3 : Calculation of Cost of Debt Marriotts cost of debt for each division was measured by using the U.S. Government interest rates plus debt rate premium above Government. Since the company expected that it would pay more than the government interest rate to lend money from investors. Including debt rate premium in the cost of debt would make the estimated interest rate as correct as the actual rate as possible. The debt cost should differ across divisions due to different risks in each division. Also the nature of business in each division is also different. These make the debt rate premium for the hotel (as a whole) and for each division differ, as can be seen from Table A from the case. The lodging division is a long-term investment while the restaurant division is a short-term investment. Thus, interest rates for these two divisions should be different. Marriotts Floating rate would be = 1.30 % + 6.9% = 8.2 % And Fixed rate would be = 1.3% + 8.95% = 10.25 Table B U.S. Government

Interest Rates in April 1988 Maturity 30-year 10-year 1-year Rate 8.95% 8.72% 6.90%

I am using 1- year US government interest rate for floating and 30 year US govt interest rate for fixed.Similariy it can be calculated for all three divisions as is shown in next table. Calculation of Cost of Debt

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Roll no: 2011PGP906

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Floating rD= Lodging Contracts Restaurants Step4 : Calculation of taxes Calculation of taxes Income Taxes EBT Taxes% (EBT/Income Taxes) 175.9 398.9 44.10% 8.2 8 8.3 8.7

Fixed 10.25 10.05 10.12 10.52

Aggregate 9.43 9.025 9.392 10.065

Step 5 : Calculation of WACC WACC = (1-t)*(D/V)*rd + (E/V)* re Where t = taxes D= debt V= debt + equity E= equity rd= Cost of debt re= Cost of Equity Marriott Taxes= Cost of Debt rD= Cost of Equity rE= D/V= E/V= 44.10% 10.25 11.7871 60% 40% 10.05 19.2914 74% 26% 10.12 11.5865 40% 60% 10.52 14.6357 42% 58% Lodging Contract Restaurant

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This weighted average cost of capital values can be used in evaluating the project investments. Investment decisions can be made better now than before. The future cash flows are discounted using the cost of capital value as the hurdle rate for each of the division. Hence, we can determine the profitability of the projects in each of the divisions, and hence invest in the right project in the right division in order to keep in line with the overall corporate financial strategy.

Sumit Malhotra Sec D

Roll no: 2011PGP906

Page 10