Last Updated 20 May 2020

Marriott Case

Category Investment, Money
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Marriott Corporation: The Cost of Capital Executive Summary J. Willard Marriott started Marriott Corporation in 1927 with a root beer stand, expanding it into a leading lodging and food service company with sales of over $6 billion by 1987. At the time, Marriott had three main lines of business, lodging, contract services and restaurants, with lodging generating about 51% of company’s profits.

The four key elements of Marriott’s financial strategy were managing hotel assets rather than owning, investing in projects with the goal of increasing shareholder value, optimizing the use of debt, and repurchasing their undervalued shares.

Marriott Corporation relied on measuring the opportunity cost of capital for investments by utilizing the concept of Weighted Average Cost of Capital (WACC). In April 1988, VP of project finance, Dan Cohrs suggested that the divisional hurdle rates at the company would have a key impact on their future financial and operating strategies. Marriott intended to continue its growth at a fast pace by relying on the best opportunities arising from their lodging, contract services and restaurants lines of businesses.

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To make the company managers more involved in its financial strategies, Marriott also considered using the hurdle rates for determining the incentive compensations. What is the weighted average cost of capital (WACC) for Marriott Corporation?

WACC = (1 - ? )rD(D/V) + rE(E/V) D = market value of debt

E = market value of equity

V = value of the firm = D + E rD = pretax cost of debt rE = after tax cost of debt ? = tax rate = 175. 9/398. 9 = 44%

Cost of Equity Target debt ratio is 60%; actual is 41% [Exhibit 1] ?s = 1. 11 ?u = ? s / (1 + (1 – ? ) D/E) = 1. 11/(1 + (1 – . 44) (. 41)) = 0. 80

Using the target debt ratio of 60%: Ts = ? u (1 + (1 – ? ) D/E) = . 8(1 + (1 – . 44) (. 6/. 4)) ?Ts =1. 47

Using CAPM: rf = 8. 95% long-term rate on U. S. government bonds (rm – rf) = 7. 43% average 1926-1987 rE = rf + ? Ts (rm – rf) = 8. 95% + (1. 47)(7. 43%) = 19. 87%

Cost of Debt rD = government bond rate + credit spread = 8. 95% + 1. 30% = 10. 25%

WACC = (1 - ? )rD(D/V) + rE(1 - D/V) = (1 – . 44) (. 1025)(. 6) + (. 1987)(. 4) = 11. 39%

If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its line of business, what would happen to the company over time? WACC for Marriott= 11. 39%

WACC for lodging division = 9. 25% WACC for restaurant division = 13. 84% WACC for Marriott’s contract division = 23. 07%

The main use of the hurdle rates is to assess investment decision in order to determine if it’s reasonable. Using different rates for different division is also good, but one has to be careful when applying a single cost of capital across the various departments. Based on the WACCs stated above for the company and its various departments it’s obvious that the values are different. The cost of capital for lodging is lower than for the entire company, while that of the other departments are higher.

We can equate the cost of capital with risk, so therefore the risk in the lodging department is lower when compared with other departments that have a higher WACC. If Marriott was to use a single corporate hurdle rate then they will be using the 11. 39% rate which is for the entire company. By Marriott using this rate, then any project that arises out of the lodging division will be rejected since its cost of capital of 9. 25% is lower than the cost of capital for the company. Using a higher rate will result in a negative NPV as well as a reduced cash flow.

Projects from the restaurant and contract service division will be approved since they are evaluated at a lower rate than the determined cost of these various divisions. Over time, Marriott will be approving more high risk project from the restaurant and contract service division by evaluating them at a lower rate, while they will be rejecting lower risk projects from the lodging division because they are using a higher rate.

Marriott Case essay

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