Fm - Marriott[1]

8/3/2019 Fm - Marriott[1]

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Marriott Corporation: Cost of

Capital


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Marriott Corporation: The Cost of Capital

Learning Outcomes Calculate betas based on comparable companies and

lever betas to adjust for capital structure Determine appropriate risk less rate and market risk

premium

Choice of time period to estimate expected returns

Assignment Computing cost of capital of firm and each division Examining the central role that the hurdle rate plays in

financial strategy


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Dated:April 1988

By: Dan Cohrs, Vice president of project finance

Situation:Annual recommendation for the hurdlerates at each of the firms three division

Investment projects: discounting the cash flowsusing appropriate hurdle rate for each division


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Discussion Question

Investors look at the company as a whole

Company as a whole has one cost of capital

Then why divisional cost of capital is computed?


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Marriott Corporation

Began in 1927 By: J. Willard Marriotts root beer stand After 60 yearsOne of the leading lodging and food service companies in US

Major lines of business Lodging 361 hotels More than 100,000 rooms in total Range: full-services, high-quality Marriott hotels, and moderately priced fairfield inn

Contract services Food and services management to health care and educational institutions and

corporations Airline catering and airline services Marriotts in-flite services and host internationaloperations

Restaurants Includes Bobs Big Boy, Roy Rogers, Hot Shoppes


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Product Line

Proportion of

Sales 1987

Proportion of

Profit 1987

Lodging 41% 51%

Contract Services 46% 33%

Restaurants 13% 16%


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Marriotts Performance

In 1987 Sales grew by 24% Return on equity is 22% Profits: $223 million

Sales: $6.5 million Sales and EPS have doubled over the 4 previous years Reprurchased 13.6 million shares of its common stock for $429 million

As per 1987 annual report Remain premier growth company Aggressively developing appropriate opportunities within chosen lines of

business

To be the.. Preferred employer Preferred provider Most profitable company

Operating strategy: continuing this trend


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Marriotts Cost of Capital

Mr. Cohrss opinion

Divisional hurdle rates have significant effect onthe firms financial and operating strategies

Increasing hurdle rate decreases the NPV of theprojects and investments

Decreasing hurdle rates would accelerate thefirms growth


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Discussion Question

How does Marriott uses its estimate of its cost ofcapital? Does this make sense?


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How does Marriott uses its estimate

of its cost of capital?Using WACC

Determine incentive compensation (30% to 50% of base pay) Bonus awards is based on

Specific job responsibilities Earnings level Ability of managers to meet budgets Overall corporate performance

Proposed use.. Basing the incentive compensation on..

Comparison of divisional return on net assets Market based divisional hurdle rates

Compensation plan would then reflect hurdle rates, making managersmore sensitive to Firms financial strategy and capital market conditions


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Errors in the hurdle rate can lead to incorrect decisions about the type and amount

of investment, trigger or fail to trigger repurchases, and affect incentive compensation


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1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

Sales 1 174.1 0 1 426.00 1 633.90 1 905.70 2458.90 2950.50 3524.90 4241 .70 5266.50 6522.20

EBIT 107.10 133.50 150.30 173.30 205.50 247.90 297.70 371.30 420.50 489.40

Interest expenses 23.70 27.80 46.80 52.00 71.80 62.80 61.60 75.60 60.30 90.50

Income before income taxes 83.40 105.70 103.50 121.30 133.70 185.10 236.10 295.70 360.20 398.90

Income taxes 35.40 43.80 40.60 45.20 50.20 76.70 100.80 128.30 168.50 175.90Income from continuing operations 48.00 61.90 62.90 76.10 83.50 108.40 135.30 167.40 191.70 223.00

Net income 54.30 71.00 72.00 86.10 94.30 115.20 139.80 167.40 191.70 223.00

Funds from continuing operations 101.20 117.50 125.80 160.80 203.60 272.70 322.50 372.30 430.30 472.80

Total assets 1000.30 1080.40 1214.30 1454.90 2062.60 2501.40 2904.70 3663.80 4579.30 5370.50

Total capital 826.90 891 .90 977.70 1167.50 1634.50 2007.50 2330.70 2861 .40 3561 .80 4247.80Long-term debt 309.90 365.30 536.60 607.70 889.30 1071 .60 1115.30 1192.30 1662.80 2498.80

Shareholders' equity 418.70 413.50 311.50 421 .70 516.00 628.20 675.60 848.50 991 .00 810.80

Long-term debt / total capital 37.48% 40.96% 54.88% 52.05% 54.41% 53.38% 47.85% 41.67% 46.68% 58.83%

EPS - continuing operations 0.25 0.34 0.45 0.57 0.61 0.78 1.00 1.24 1.40 1.67

Net income 0.29 0.39 0.52 0.64 0.69 0.83 1.04 1.24 1.40 1.67

Cash dividends 0.03 0.03 0.04 0.05 0.06 0.08 0.09 0.11 0.14 0.17

Shareholders' equity 2.28 2.58 2.49 3.22 3.89 4.67 5.25 6.48 7.59 6.82

Market price (year-end) 2.43 3.48 6.35 7.18 11.70 14.25 14.70 21.56 29.75 30.00

Shares outstanding (millions) 183.60 160.50 125.30 130.80 132.80 134.40 128.80 131.00 130.60 118.80

Return on average shareholders' equity 13.90% 17.00% 23.80% 23.40% 20.00% 20.00% 22.10% 22.10% 20.60% 22.20%

The com pany 's theme park operat ions were discont inued in 1 984

Funds from con tinu ing operations consists of incom e from contnu ing operations plus deprecaition, deffered incoem ta xes, and other item s not curren tly a ffecting w orking

Total capital r epresents total assets less curren t liabilities


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1982 1983 1984 1985 1986 1987

Lodging

Sales 1091.70 1320.50 1640.80 1898.40 2233.10 2673.30

Operating profit 132.60 139.70 161.20 185.80 215.70 263.90Identifiable assets 909.70 1264.60 1786.30 2108.90 2236.70 2777.40

Depreciation 22.70 27.40 31.30 32.40 37.10 43.90

Capital expenditure 371.50 377.20 366.40 808.30 966.60 1241.90

Contract services

Sales 819.80 950.60 1111.30 1586.30 2236.10 2969.00Operating profit 51.00 71.10 86.80 118.60 154.90 170.60

Identifiable assets 373.30 391.60 403.90 624.40 1070.20 1237.70

Depreciation 22.90 26.10 28.90 40.20 61.10 75.30

Capital expenditure 127.70 43.80 55.60 1 25.90 448.70 1 12.70

RestaurantsSales 547.40 679.40 707.00 757.00 797.30 879.90

Operating profit 48.50 63.80 79.70 78.20 79.10 82.40

Identifiable assets 452.20 483.00 496.70 582.60 562.30 567.60

Depreciation 25.10 31.80 35.50 34.80 38.10 42.10

Capital expenditure 199.60 65.00 72.30 128.40 64.00 79.60


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1982 1983 1984 1985 1986 1987

LodgingSales 1 00.00% 1 20.96% 1 50.30% 1 73.89% 204.55% 244.87%

Operating profit 100.00% 105.35% 121.57% 140.12% 162.67% 199.02%Identifiable assets 100.00% 139.01% 196.36% 231.82% 245.87% 305.31%Depreciation 100.00% 120.70% 137.89% 142.73% 163.44% 193.39%Capital expenditure 100.00% 101.53% 98.63% 217.58% 260.19% 334.29%

Contract services

Sales 1 00.00% 11 5.96% 1 35.56% 1 93.50% 272.76% 362.1 6%Operating profit 100.00% 139.41% 1 70.20% 232.55% 303.73% 334.51%Identifiable assets 100.00% 104.90% 108.20% 167.26% 286.69% 331.56%Depreciation 100.00% 113.97% 126.20% 175.55% 266.81% 328.82%Capital expenditure 100.00% 34.30% 43.54% 98.59% 351.37% 88.25%

RestaurantsSales 1 00.00% 1 24.11% 1 29.1 6% 138.29% 1 45.65% 160.74%Operating profit 100.00% 131.55% 1 64.33% 1 61.24% 163.09% 169.90%Identifiable assets 100.00% 106.81% 109.84% 128.84% 124.35% 125.52%Depreciation 100.00% 126.69% 141.43% 138.65% 151.79% 167.73%Capital expenditure 100.00% 32.57% 36.22% 64.33% 32.06% 39.88%


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1982 1983 1984 1985 1986 1987

Sales / Assets

Loding 120.01% 104.42% 91.85% 90.02% 99.84% 96.25%

Contarct Services 219.61% 242.75% 275.14% 254.05% 208.94% 239.88%Restaurants 121.05% 140.66% 142.34% 129.93% 141.79% 155.02%

Operating Profit / Sales

Loding 12.15% 10.58% 9.82% 9.79% 9.66% 9.87%


Operating Profit / Assets

Loding 14.58% 11.05% 9.02% 8.81% 9.64% 9.50%


Depreciation / Sales

Loding 2.08% 2.07% 1.91% 1.71% 1.66% 1.64%

Contarct Services 2.79% 2.75% 2.60% 2.53% 2.73% 2.54%

Restaurants 4.59% 4.68% 5.02% 4.60% 4.78% 4.78%


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Marriotts Financial Strategy

Manage rather than own hotel assets In 1987: developed more than $1 billion worth of hotel properties

10th

largest commercial real estate developers in US Integrated development process

Identified markets

Created development plans

Designed projects

Evaluated potential profitability

Company sold hotel assets to limited partners, retaining operatingcontrol as general partner under long term management contract


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Manage rather than own hotel assets Management fee = 3% of revenues plus 20% of the profits before

depreciation and debt service

3% of revenues usually covered the overhead cost of managing thehotel

20% of the profits before depreciation and debt service required tostand aside until investors earned a prespecified return

Guaranteed a portion of partnership debt in 1987: three hotels and70 courtyard hotels were syndicated for $890 million

The firm in whole operated about $7 billion worth of syndicatedhotels


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Marriotts Syndication

Syndication Key control device for capital budgeting system

Invests $1 billion in assets each year, and sells off about $1 billion in assets

each year in syndications

Projects face a quicker market test than in the typical industrial firm

Since process turns over quickly, valuation errors appear quickly

Partnership syndication market is the important capital market for Marriott

Projects with zero NPV just break even at syndication great confidence in

cash flow and discount rate system


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Syndication Syndication market

Private market Less efficient than a public equity market

Limited information and marketability

High transaction costs

Syndication market test may be a poor test of the market

value of hotels As long as developed properties are sold in syndication

market, can capture some of the benefits of anymispricing that occurs


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Syndication Mispricing may benefit share holders but mislead the

Marriot about the reliability of its capital budgeting system Inefficiencies and instability in the syndication market can

have a large impact on Marriott


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Invest in projects that increase shareholder value Based on discounted cash flow model

Hurdle rate for specific project was based on Market interest rates

Project risk

Estimates of risk premiums

Cash flow forecasts were based on standard company wide

assumptions that limited discretion in cash flow estimates andinstilled consistency across projects


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Invest in projects that increase shareholder value Projects are similar little boxes

Similarity disciplines the pro forma analysis Corporate macro data on - inflation, margins, project lives,

terminal values, percent of sales required to remodel

Projects are audited throughout their lives to check and updatethese standard pro forma template assumptions

Divisional managers have discretion over unit-specificassumptions, but they must confirm to corporate templates


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Optimize the use of debt in the capital structure Determining the amount of debt based onability to service debt

Uses an interest coverage target instead of target debt-to-equityratio

In 1987.. Debt: $2.5 billion (59% of its total capital)


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Repurchase undervalued shares Regularly calculated a warranted equity value

Repurchasing stocks whenever its market price fell substantiallybelow that value

Checking stock price by comparing them with comparablecompanies using P/E ratios for each business and by valuingeach business under alternative ownership structures, such asleveraged buyout

More confidence in its measure of warranted value than in theday-to-day market price of stocks


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Repurchase undervalued shares Gap between warranted value and market price, triggered

repurchases

Believes that repurchases of shares below warranted equityvalue were a better use of its cash flows and debt capacity thanacquisitions or owning real estate


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Discussion Question

Are the four components of Marriotts financialstrategy consistent with its growth objective?


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Marriotts financial strategy

Is consistent and can be pursued coherently


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Marriotts WACC

Computation of cost of capital (WACC) Used for corporation as a whole and for each division

Inputs: debt capacity, debt cost, equity cost consistentwith the amount of debt

WACC varied across divisions

WACC for each division was updated annually


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Debt Capacity

Debt capacity and cost of debt Applied coverage-based financing policy to each division

Fraction of debt floats based on sensitivity of thedivisions cash flows to interest rate changes

Interest rate on floating-rate debt changed as interestrates changed

Cash flows increased as the interest rate increased, usingfloating-rate debt expanded debt capacity


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Debt Capacity

Debt capacity and cost of debt In 1987

Unsecured debt was A-rated, high-quality corporate risk

Pays spread above the current govt. bond rates

Debt cost is independent for each division as independent company

Spread between debt rate and govt. bond rate varied by divisionbecause of difference in risk

Cost of debt Lodging assets: cost of long-term debt

Restaurant and contract services: cost of shorterterm debt


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Marriotts Debt

Market Value-Target Leverage Ratios and Credit Spreads for

Marriott and its Division

Debt % in

Capital

Fraction of

Debt at Floating

Fraction of

Debt at Fixed

Debt Rate Premium

Above Govt.

Marriott 60% 40% 60% 1.30%

Lodging 74 50 50 1.10

Contract Services 40 40 60 1.40

Restaurants 42 25 75 1.80


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Interest Rates

US Govt. Interest Rates, April 1988

Maturity Rate

30-year 8.95%

10-year 8.72

1-year 6.90


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Cost of Equity

Uses CAPM model

Beta estimated from daily historical return using simple linearregression analysis

Using 1986 and 1987 daily stock return beta is 1.11

Limitations on using historical data for estimating beta

Multiple lines of businessestimated beta is weighted beta

Leverage affected beta

Historical beta has to be interpreted and adjusted before using it for

projects

HPR is the returns realized by security holder including cash payment,capital gain or loss


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Discussion Questions

What is the WACC for Marriott Corporation?

What risk-free rate and risk premium did you use tocalculate the cost of equity?

How did you measure Marriotts cost of debt?


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Firm Level Cost of Capital

Firm level cost of capital

Inputs

Target capital structure: 60% debt

Debt costs: 10.25% Spread: 1.30% above long term US govt. bonds

30-year fixed US government rate: 8.95%

Levered beta: 1.11 (could be used if the target debt ratiomatches with the actual debt ratio)

Actual debt ratio: 41% [2498.8 / (2498.8 + (30*118.8))]


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Asset Beta

Adjusting asset beta.. Asset beta has to be adjusted for difference between the

actual and target debt ratio Computed by unlevering and levering back at target debt

ratio

Asset beta = (D/V)*FD + (E/V)*FE

Equity beta = (V/E)*FV


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Risk-Free Rate

Riskless Rate CAPM is a one-period model

CAPM holds in each period Theoretically CAPM has to be recomputed in each period

Instead of using a sequence of forward rates, the yield ona long-term riskless bond is used

Assumes single expected equity return over the life of theproject.beta and risk premium are stable over the life ofthe project


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Risk Premium

Less risky securities have lower realized returns

Characteristics of the securities change over time

Spread between S&P composite returns and long-termUS govt. bonds


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Levered and Unlevered Beta

ED*t)-1(+1

=

]E

D*t)-1(+1[=

LU

UL


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Marriotts WACC

Equity Beta D/V Revenue D/E Tax Rate Unlevered Beta Weighted Unlevered Beta

Lodging

HiltonHotels 0.88 14.00% 0.77 16.28% 40% 0.80 0.184

Hoilday Corporation 1.46 79.00% 1 .66 376.19% 40% 0.45 0.222

Ramada Inns 0.95 65.00% 0.75 185.71% 40% 0.45 0.101

La Quinta Motor Inns 0.38 69.00% 0.17 222.58% 40% 0.16 0.008

Total . . 3.35 . . . 0.515

Restaurants

Churchs Fried Chn. 0.75 4.00% 0.39 4.17% 40% 0.73 0.039

Collin Foods 0.60 10.00% 0.57 11.11% 40% 0.56 0.044Frischs 0.13 6.00% 0.14 6.38% 40% 0.13 0.002

Lubys 0.64 1.00% 0.23 1.01% 40% 0.64 0.020

McDonalds 1.00 23.00% 4.89 29.87% 40% 0.85 0.570

Wendy 1.08 21.00% 1.05 26.58% 40% 0.93 0.135

Total . . 7.27 . . . 0.811


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Marriotts WACC

Marriott Lodging Restaurant Contract Services

US Governement Interest Rate - 30-Year 8.95% 8.95% . .

US Governement Interest Rate - 10-Year . . 8.72% 8.72%

Riskless Rate 8.95% 8.95% 8.72% 8.72%

Target D/V 60% 74% 42% 40%

Target D/E 150% 285% 72% 67% Actual D/E 70% . . .

Levered Equity Beta 0.97 . . .

Unlevered Equity Beta 0.68 0.52 0.81 1.00

Restimated Levered Equity Beta at Target Debt 1.30 1.39 1.16 1.40

Risk Premium 7.43% 7.43% 7.43% 7.43%

Cost of Equity 18.59% 19.31% 17.36% 19.13%

Cost of Debt 10.25% 10.05% 10.52% 10.35%

Tax Rate 40% 40% 40% 40%

WACC 11.13% 9.48% 12.72% 13.96%

Identifiable Assets (1987) 4582.70 2777.40 567.60 1237.70

Proportion of Identifiable Assets 100.00% 60.61% 12.39% 27.01%


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Discussion Questions

What is the cost of capital for the lodging and restaurant divisions ofMarriott?

What risk-free rate and risk premium did you use in calculating thecost of equity for each division? Why did you choose these

numbers?

How did you measure the cost of debt for each division? Should the

debt cost differ across divisions? Why?

How did you measure the beta of each division?


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Discussion Question

What is the cost of capital for Marriotts contractservices division? How can you estimate its

equity costs without publicly traded comparable

companies?


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Cost of Capital for Lodging and Restaurants

Cost of capital for lodging and restaurants Converting levered betas of comparable firm to unlevered

beta Weighted average of the unlevered beta (May also use

Bayesian adjustment to beta to incorporate the observedtendency of equity betas to move toward 1 over time)

Estimating levered equity beta


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Cost of Capital of Contract Services

Cost of capital for contract services No publicly traded comparable companies

Residual approach can be used for computing beta Weights of beta can be based on identifiable assets


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Discussion Question

What type of investments would you value usingMarriotts WACC?


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Discussion Question

If Marriott used a single corporate hurdle rate forevaluating investment opportunities in each of its

lines of business, what would happen to the

company over time


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Insight

Using single rate imposes a systematic bias onproject selection

Valuation error caused by using a singlediscount rate result in riskier, less profitableinvestment projects

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