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Assignment
Computing cost of capital of firm and each division Examining the central role that the hurdle rate plays in financial strategy
Marriott Corporation: The Cost of Capital Dated: April 1988 By: Dan Cohrs, Vice president of project finance Situation: Annual recommendation for the hurdle rates at each of the firms three division Investment projects: discounting the cash flows using appropriate hurdle rate for each division
Discussion Question
Investors look at the company as a whole Company as a whole has one cost of capital
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 international operations
Restaurants
Includes Bobs Big Boy, Roy Rogers, Hot Shoppes
Product Line
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
Discussion Question
How does Marriott uses its estimate of its cost of capital? Does this make sense?
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 managers more sensitive to Firms financial strategy and capital market conditions
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
Sales EBIT Interest expenses Income before income taxes Income taxes Income from continuing operations Net income Funds from continuing operations Total assets Total capital Long-term debt Shareholders' equity Long-term debt / total capital EPS - continuing operations Net income Cash dividends Shareholders' equity Market price (year-end) Shares outstanding (millions) Return on average shareholders' equity
1978 1174.10 107.10 23.70 83.40 35.40 48.00 54.30 101.20 1000.30 826.90 309.90 418.70 37.48%
1979 1426.00 133.50 27.80 105.70 43.80 61.90 71.00 117.50 1080.40 891.90 365.30 413.50 40.96%
1980 1633.90 150.30 46.80 103.50 40.60 62.90 72.00 125.80 1214.30 977.70 536.60 311.50 54.88%
1981 1905.70 173.30 52.00 121.30 45.20 76.10 86.10 160.80 1454.90 1167.50 607.70 421.70 52.05%
1982 2458.90 205.50 71.80 133.70 50.20 83.50 94.30 203.60 2062.60 1634.50 889.30 516.00 54.41%
1983 2950.50 247.90 62.80 185.10 76.70 108.40 115.20 272.70 2501.40 2007.50 1071.60 628.20 53.38%
1984 3524.90 297.70 61.60 236.10 100.80 135.30 139.80 322.50 2904.70 2330.70 1115.30 675.60 47.85%
1985 4241.70 371.30 75.60 295.70 128.30 167.40 167.40 372.30 3663.80 2861.40 1192.30 848.50 41.67%
1986 5266.50 420.50 60.30 360.20 168.50 191.70 191.70 430.30 4579.30 3561.80 1662.80 991.00 46.68%
1987 6522.20 489.40 90.50 398.90 175.90 223.00 223.00 472.80 5370.50 4247.80 2498.80 810.80 58.83%
0.25 0.34 0.45 0.57 0.61 0.78 1.00 1.24 1.40 1.67 0.29 0.39 0.52 0.64 0.69 0.83 1.04 1.24 1.40 1.67 0.03 0.03 0.04 0.05 0.06 0.08 0.09 0.11 0.14 0.17 2.28 2.58 2.49 3.22 3.89 4.67 5.25 6.48 7.59 6.82 2.43 3.48 6.35 7.18 11.70 14.25 14.70 21.56 29.75 30.00 183.60 160.50 125.30 130.80 132.80 134.40 128.80 131.00 130.60 118.80 13.90% 17.00% 23.80% 23.40% 20.00% 20.00% 22.10% 22.10% 20.60% 22.20%
Th e com pa n y 's them e par k opera tion s w er e discon tinu ed in 1 9 8 4 Fun ds fr om con tinu in g opera tion s con sists of in com e from con tn u ing opera tion s plu s deprecaition , deffered in coem ta xes, a n d oth er item s n ot cu rr en tly a ffectin g w orkin g Tota l capital represen ts tota l a ssets less cu r ren t lia bilities
1982 Lodging Sales Operating profit Identifiable assets Depreciation Capital expenditure Contract services Sales Operating profit Identifiable assets Depreciation Capital expenditure Restaurants Sales Operating profit Identifiable assets Depreciation Capital expenditure
1983
1984
1985
1986
1987
1091.70 1320.50 1640.80 1898.40 2233.10 2673.30 132.60 139.70 161.20 185.80 215.70 263.90 909.70 1264.60 1786.30 2108.90 2236.70 2777.40 22.70 27.40 31.30 32.40 37.10 43.90 371.50 377.20 366.40 808.30 966.60 1241.90 819.80 51.00 373.30 22.90 127.70 547.40 48.50 452.20 25.10 199.60 950.60 1111.30 1586.30 2236.10 2969.00 71.10 86.80 118.60 154.90 170.60 391.60 403.90 624.40 1070.20 1237.70 26.10 28.90 40.20 61.10 75.30 43.80 55.60 125.90 448.70 112.70 679.40 63.80 483.00 31.80 65.00 707.00 79.70 496.70 35.50 72.30 757.00 78.20 582.60 34.80 128.40 797.30 79.10 562.30 38.10 64.00 879.90 82.40 567.60 42.10 79.60
1982 Lodging Sales Operating profit Identifiable assets Depreciation Capital expenditure Contract services Sales Operating profit Identifiable assets Depreciation Capital expenditure Restaurants Sales Operating profit Identifiable assets Depreciation Capital expenditure 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
1983 120.96% 105.35% 139.01% 120.70% 101.53% 115.96% 139.41% 104.90% 113.97% 34.30% 124.11% 131.55% 106.81% 126.69% 32.57%
1984 150.30% 121.57% 196.36% 137.89% 98.63% 135.56% 170.20% 108.20% 126.20% 43.54% 129.16% 164.33% 109.84% 141.43% 36.22%
1985 173.89% 140.12% 231.82% 142.73% 217.58% 193.50% 232.55% 167.26% 175.55% 98.59% 138.29% 161.24% 128.84% 138.65% 64.33%
1986 204.55% 162.67% 245.87% 163.44% 260.19% 272.76% 303.73% 286.69% 266.81% 351.37% 145.65% 163.09% 124.35% 151.79% 32.06%
1987 244.87% 199.02% 305.31% 193.39% 334.29% 362.16% 334.51% 331.56% 328.82% 88.25% 160.74% 169.90% 125.52% 167.73% 39.88%
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% Contarct Services 6.22% 7.48% 7.81% 7.48% 6.93% 5.75% Restaurants 8.86% 9.39% 11.27% 10.33% 9.92% 9.36% Operating Profit / Assets Loding 14.58% 11.05% 9.02% 8.81% 9.64% 9.50% Contarct Services 13.66% 18.16% 21.49% 18.99% 14.47% 13.78% Restaurants 10.73% 13.21% 16.05% 13.42% 14.07% 14.52% 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%
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
Marriotts Syndication
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 any mispricing that occurs
Marriotts Syndication
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
Discussion Question
Are the four components of Marriotts financial strategy consistent with its growth objective?
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 consistent with the amount of debt WACC varied across divisions WACC for each division was updated annually
Debt Capacity
Debt capacity and cost of debt
Applied coverage-based financing policy to each division Fraction of debt floats based on sensitivity of the divisions cash flows to interest rate changes Interest rate on floating-rate debt changed as interest rates changed Cash flows increased as the interest rate increased, using floating-rate debt expanded debt capacity
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 division because of difference in risk Cost of debt
Lodging assets: cost of long-term debt Restaurant and contract services: cost of shorterterm debt
Marriotts Debt
Market Value-Target Leverage Ratios and Credit Spreads for Marriott and its Division Debt % in Capital Marriott Lodging Contract Services Restaurants 60% 74 40 42 Fraction of Fraction of Debt at Floating Debt at Fixed 40% 50 40 25 60% 50 60 75 Debt Rate Premium Above Govt. 1.30% 1.10 1.40 1.80
Interest Rates
US Govt. Interest Rates, April 1988 Maturity 30-year 10-year 1-year Rate 8.95% 8.72 6.90
Cost of Equity
Uses CAPM model Beta estimated from daily historical return using simple linear regression 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
Discussion Questions
What is the WACC for Marriott Corporation? What risk-free rate and risk premium did you use to calculate the cost of equity? How did you measure Marriotts cost of debt?
Levered beta: 1.11 (could be used if the target debt ratio matches with the actual debt ratio) Actual debt ratio: 41% [2498.8 / (2498.8 + (30*118.8))]
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
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 on a long-term riskless bond is used Assumes single expected equity return over the life of the project.beta and risk premium are stable over the life of the project
Risk Premium
Less risky securities have lower realized returns Characteristics of the securities change over time Spread between S&P composite returns and long-term US govt. bonds
= =
D [1 + (1 - t) * ] E
L
D 1 + (1 - t) * E
Marriotts WACC
Equity Beta Lodging Hilton Hotels Hoilday Corporation Ramada Inns La Quinta Motor Inns Total Restaurants Churchs Fried Chn. Collin Foods Frischs Lubys McDonalds Wendy Total 0.88 1.46 0.95 0.38 . 0.75 0.60 0.13 0.64 1.00 1.08 . D/V 14.00% 79.00% 65.00% 69.00% . 4.00% 10.00% 6.00% 1.00% 23.00% 21.00% . Revenue 0.77 1.66 0.75 0.17 3.35 0.39 0.57 0.14 0.23 4.89 1.05 7.27 D/E 16.28% 376.19% 185.71% 222.58% . 4.17% 11.11% 6.38% 1.01% 29.87% 26.58% . Tax Rate Unlevered Beta Weighted Unlevered Beta 40% 40% 40% 40% . 40% 40% 40% 40% 40% 40% . 0.80 0.45 0.45 0.16 . 0.73 0.56 0.13 0.64 0.85 0.93 . 0.184 0.222 0.101 0.008 0.515 0.039 0.044 0.002 0.020 0.570 0.135 0.811
Marriotts WACC
US Governement Interest Rate - 30-Year US Governement Interest Rate - 10-Year Riskless Rate Target D/V Target D/E Actual D/E Levered Equity Beta Unlevered Equity Beta Restimated Levered Equity Beta at Target Debt Risk Premium Cost of Equity Cost of Debt Tax Rate WACC Identifiable Assets (1987) Proportion of Identifiable Assets Marriott Lodging Restaurant Contract Services 8.95% 8.95% . . . . 8.72% 8.72% 8.95% 8.95% 8.72% 8.72% 60% 74% 42% 40% 150% 285% 72% 67% 70% . . . 0.97 . . . 0.68 0.52 0.81 1.00 1.30 1.39 1.16 1.40 7.43% 7.43% 7.43% 7.43% 18.59% 19.31% 17.36% 19.13% 10.25% 10.05% 10.52% 10.35% 40% 40% 40% 40% 11.13% 9.48% 12.72% 13.96% 4582.70 2777.40 567.60 1237.70 100.00% 60.61% 12.39% 27.01%
Discussion Questions
What is the cost of capital for the lodging and restaurant divisions of Marriott? What risk-free rate and risk premium did you use in calculating the cost 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?
Discussion Question
What is the cost of capital for Marriotts contract services division? How can you estimate its equity costs without publicly traded comparable companies?
Discussion Question
Discussion Question
If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time
Insight
Using single rate imposes a systematic bias on project selection Valuation error caused by using a single discount rate result in riskier, less profitable investment projects