Summary Determining the appropriate cost of capital for new investment projects for a diversified company like the Marriott Corporation is not an easy endeavor. However, it is an Important exercise because the more effective the process, the better it can help to support the company’s growth objective with Its financial strategy. The four components of the financial strategy are: manage rather than own hotel assets invest in projects that increase shareholder value optimize the use of debt in the capital structure repurchase undervalued shares
Each of these aspects of the financial strategy support Amorist’s growth objective, except for the repurchasing of undervalued shares, which Is not based on feeling of significant undervaluing of the stock by the market, but based on an Internally generated intrinsic value of the company. Amorist’s cost of capital estimation process involves consideration of debt capacity, cost of debt and cost of equity. This data, plus consideration of capital structure and effective tax rate, is then applied to the Capital Asset Pricing Model, using the U.
S. Government 10-year bond as the risk-free rate and the spread between the S 500 impose and the U. S. Government 10-year bond rate. Beta Is based on the last five years of monthly return data. The resulting corporate WAC Is 10. 22%. However, new investments in the different divisions requires the application of a hurdle rate that reflects the business risk of that particular unit, rather than the overall corporate hurdle rate, which is primarily applicable to corporate capital expenditures, such as headquarters and IT support systems.
The table below summarizes the WAC for each Marriott division based on Its mix fixed and floating rate debt, capital structure, ND applicable unleavened beta for Its Industry. Lodging 8. 72% Restaurant Services Marriott Corporation Target DON 74. 0% 42. 0% 40. 0% 60. 0% Actual DON 55. 8% 1. 110 0. 554 0. 929 0. 616 Relived PL 1 . 441 1 . 308 0. 839 1. 135 Risk Premium 7. 92% Cost of Debt 8. 91% 10. 07% 9. 39% 9. 29% Cost of Equity 20. 13% 19. 08% 1 5. 36% 17. 71% Estimated Tax Rate 43. 7% WAC 8. 95% 13. 45% 10. 2% Risk-Free Rate (US GOB 10-yr) Introduction Marriott Corporation is diversified company in the lodging, restaurant and contract services. Its lodging business unit consisted of managing the operation of 361 hotels f a variety of star ratings. Its restaurant business unit ran and owned a handful of fast food and diner chains. One of the perennial challenges that Marriott management faced was the close integration of its financial strategy, growth objectives, determining the appropriate hurdle rate for investments, and how to add a capital cost component to incentive compensation plans.
Amorist’s Financial Strategy The overall objective for Amorist’s vice president of project finance, Dan Coors, was to support the company’s growth objective in being the most profitable company in its nines of business. To support this growth objective, Marriott developed a financial strategy that consisted of four tactics – manage rather than own hotel assets, invest in projects that increase shareholder value, optimize the use of debt in the capital structure, and repurchase undervalued shares. Manage Rather than Own Hotel Assets Marriott would develop hotel properties and then sell them off to investment partnerships.
Its typical deal would consist of it being granted a long-term contract to operate and manage the property on behalf of the owner, where it receives 3% of venues as compensation and 20% of profit over and above a specified return for the owner. If you wanted to maximize growth and shareholder value, this was a more prudent approach to being in the lodging business because the company wouldn’t be held down by large amount of debt associated with these properties and it eliminated a portion of debt that it guaranteed instead of the entire amount.
Therefore, this tactic supported the company’s growth objective because it did not tie up huge amounts of investment capital in fixed assets and allowed it to focus on activities and projects hat could generate significant revenue growth. If Marriott could make a hotel very busy, it only had to make small increases in staff to accommodate large increases in business. Plus, its profitability would accelerate once it was able to clear its property owner’s return requirement. By being service oriented, Marriott greatly reduced the capital intensity of its lodging business unit.
Invest in Projects That Increase Shareholder Value Technically speaking, this is a tactic espoused by every company. Marriott purposed to only invest in NP positive projects based on the hurdle rate appropriate for the hype of investment. The pro formal cash flows for investment opportunities were developed at the division level using corporate templates. This provided consistency in methodology while allowing for variation in unit specific assumptions. This will also support the company’s growth objective because it promotes Marriott getting the best results for its investment funds to maximize the value created by the projects it invests in.
It also means that projects in riskier areas have to be that much profitable to generate the NP to make an investment competitive versus alternative investments in less risky units. Optimize the Use of Debt in the Capital Structure Marriott used a targeted interest coverage ratio to determine its optimal use of debt instead of a debt-to-equity ratio. Because this approach bases debt capacity primarily on financial operations instead of market capitalization, it is supportive of growth by limiting debt based on near term financial performance rather than the ups and downs of the capital markets.
Repurchase Undervalued Shares Marriott calculated its own valuation of its stock called its warranted equity value. Whenever its stock price went below the warranted value, Marriott would buy back stock. This tactic does not support growth because Marriott is using an intrinsic value of its stock to supersede the market value of the stock, which is the best indicator of the value of a publicly traded company. The company also assumed that this was the best use of cash and debt than investments.
Although companies have used debt to repurchase stock, it is usually to try to “game” the system and improve the profitability related financial ratios by reducing the amount of total equity and the number of shares outstanding. Three more legitimate reasons for Marriott to buy back its stock would be mitigate the impact of stock dilution due to the exercise of stock options used as incentive compensation; to disburse excess funds to shareholders without the tax penalty associated with dividends; or to cheaply remove stock when the market it trading it at a steep discount to historical trends when the company is performing well.
Buying back stock when it falls a small amount below an intrinsic value does not contribute to growth and those funds could have probably been used in a profitable, value- increasing project. Marriott uses the weighted average cost of capital (WAC) to determine its corporate hurdle rate, as well as estimate the hurdle rates for its different divisions. The process begins with the company determining its debt capacity, cost of debt and its cost of equity, also being a function of the amount of debt.
After determining the corporate level cost of debt, it allocated a portion of that debt to each of the business units to facilitate their unit hurdle rates. Each unit had a different debt weighting and cost of debt. Marriott annually updated its cost of capital for making investments. It does make sense for Marriott to determine a hurdle rate for its different business units because it is a diversified company, even if it is related diversification. Its business units carry the business risk of the industries they inhabit, regardless of the corporate make up of Marriott.
To make the best use of Marriott funds and maximize value, Marriott has to take into account the risk associated with each unit’s projects. Having a hurdle rate for each business unit eliminates bias in project selection that would occur if it used the corporate hurdle rate. Amorist’s Corporate Weighted Average Cost of Capital In its use of the weighted average cost of capital (WAC) formula below, Marriott uses its long-term debt to total capital ratio (total capital = total assets – current liabilities) for its debt weighting.
To determine the cost of equity, Marriott used the Capital Asset Pricing Model (CAMP), which relates the returns for a single stock against the excess returns for the market over the risk-free rate. Marriott has a target debt percentage in capital of 60% for the company. Its 1987 debt percentage is 58. 8% for which a beta of 1. 11 was calculated based on the past five years of monthly returns. The average corporate tax rate for the past five years is 43. 7%. The target debt percentage in capital is 60% and is treated as the debt-to-value ratio.
