Academic Case Studies: Marriott Corporation

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Academic Case Studies

THE BEST WAY TO LEARN ABOUT BUSINESS PRACTICE IS TO STUDY REAL-WORLD CASES. HERE YOU CAN FIND HELPFUL INFORMATION ABOUT TYPICAL CASE ANALYSIS FROM MY MBA PROGRAM IN JAPAN AND FROM MY BUSINESS EXPERIENCE.

THURSDAY, MARCH 23, 2006

Marriott Corporation
Net Present Value and Project Evaluation
IUJ, Spring 2006 Pham Thi Thuy Ha
BLOG ARCHIVE

Marriott Corporation, an American firm, has 3 major lines of business: lodging, contract service and restaurants. Its growth objective is to remain a premier growth company. The four components of its financial strategy are consistent with this growth objective for the reasons: Manage rather than own hotel assets: Marriott sold its hotel assets to limited partners to reduce assets and thus, it can increase ROA and thereby increase potential profitability. Invest in projects that increase shareholders value: the discounted cash flow techniques to evaluate potential investments allow the company to invest only in profitable projects. Therefore, it can maximize the use of its cash flow to gain profits. Optimize the use of debt in the capital structure: because firms with lower percentage of debt have higher value, Marriott uses this strategy to increase its value and thereby increase it profitability. Repurchase undervalued shares: By buying back its undervalued shares, Marriott can increase PE ration when needed and can make its investors holdings more valuable because share prices will increase (increase in ROE). It also can appease investors and avoid pressure to increase dividend, thereby it can use its retained earnings to invest more in profitable projects. This strategy means that Marriott are confident in its future performance. Marriott use the Weighted-Average-Cost-of Capital (WACC) method to measure the opportunity cost for investments. WACC = (1-t)rD(D/V) + rE(E/V) where D and E are the market values of the debt and equity respectively; rD is the pre-tax cost of debt; rE is the after-tax cost of equity; V is the firm value (V=E+D); and t is the corporate tax. This method is applied for Marriott as the whole corporation and for each of its three lines of business. WACC is calculated based on its financial data of 1987

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provided in the case. 1. Calculate the debt cost rD - According to the summary of operation (exhibit 1) t = income taxes/income before income taxes = 175.9/398.9 = 44% - According to Table A, D/V = 60%. Therefore, E/V = 40% - Because Marriot is a high-quality rate company and it could pay a spread above the current government bond rates: rD = S fraction of debt at floating for each line x US government interest rate + S fraction of debt at floating for each line x debt rate premium above government for each line rD = [0.5x8.72 + 0.4x6.9 + 0.25x6.9] + [0.5x1.1 + 0.4x1.4 + 0.25x1.8] = 0.1041 Because lodging had long useful life, the long term interest rate for lodging line should be the interest rate of 10-year maturity bonds (8.72%). Meanwhile, restaurants and contract services are short term investment so the interest rate for these lines should be the interest rate of 1-year maturity bond (6.9%). 2. Calculate the riskless rate - First, calculate the weighted average The weighted average of each business line is based on its profit contribution to Marriotts total profits. On page 2, the weighted average of lodging is 51%, that of contract services is 33% and that of restaurants is 16%. Marriotts lodging line is considered to be in the same market with Hilton, Holiday, La Quinta and Ramada. Similarly, its restaurants and contract services are in the same market as Church, Collins, Frisch, Luby, McDonald and Wendy. To be more conservative and accurate in the estimation of market volatility, Marriott should choose geometric average. - Second, calculate b To calculate b, assume that the project has the same risk and the same leverage as the firm overall. b = S weighted average x the average of equity Beta of firms in the same business lines = 0.51[(0.88+1.46+0.38+0.95)/4] + (0.33+0.16) [(0.75+0.6+0.13+0.64+1.00+1.08)/6] = 0.813 - Third, calculate Risk premium To better evaluate the market volatility Marriott should choose the time interval of 7 latest years, from 1981 to 1987. Then Risk premium = (Geometric average of long term US government bond return from 1981 to 1987 + Geometric average of long term high-grade corporate bond return from 1981 to 1987 + Geometric average of Standard & Poors 500 composite stock index return from 1981 to 1987)/3 = [(1.1682) 5x1.2444x0.9731]1/7 + [(1.1783)5x1.1985x0.9973]1/7 + [(1.1471) 5x1.1847x1.523]1/7 = 0.1412 - Forth, Expected return or cost of equity is 0.214 (Exhibit 3) - Fifth, calculate riskless rate (risk free rate) RF Expected return = RF + b[Risk premium] so RF = Expected return - b [Risk premium] RF = 0.214 - 0.813x0.1412 = 0.099 3. WACC WACC = (1-t)rD(D/V) + rE(E/V) = (1 0.44)x0.1041x0.6 + 0.214x0.4 = 0.121

ABOUT ME PH AM TH I TH UY H A

I am a kind of person who loves discovering the world around me, who always wants to make things happen, who are ready to take risk and enjoy ventures. I am full of energy, courage, bravery and confidence in every thing I do. To me, there is no border in the world. With the motto "you can win if you realy want", I believe that I can go to every corner of the world.
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PO ST E D B Y P HA M T HI T HUY H A AT 6 :3 4 AM

3 COMMENTS:

Portinho said... Good Job! Please let me know why you calculated rD using fraction of floating debt instead Debt percentage in capital(74%,40% and 42%). Thanks Jose Brazil
12:30 PM

Achal said... This post has been removed by the author.

9:12 AM

Katie said... To better evaluate the market volatility Marriott should choose the time interval of 7 latest years, from 1981 to 1987. Then Risk premium = (Geometric average of long term US government bond return from 1981 to 1987 + Geometric average of long term high-grade corporate bond return from 1981 to 1987 + Geometric average of Standard & Poors 500 composite stock index return from 1981 to 1987)/3 = [(1.1682)5x1.2444x0.9731] 1/7 + [(1.1783)5x1.1985x0.9973]1/7 + [(1.1471)5x1.1847x1.523] 1/7 = 0.1412 this equation doesn't calculate to the number you listed... can you elaborate what you did here?
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18-10-2011