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Cost Of Capital

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In April l988, Dan Cohrs, vice president of project finance at the Marriott Corporation was preparing his annual recommendations for the hurdle rates at each of the firm’s three divisions. Investment projects at Marriott were selected by discounting the appropriate cash flows by the appropriate hurdle rate for each division.

In 1987,Marriott's sales grew by 24% and its return on equity (ROE)Stood at 22% .Sales and earnings per share had doubled over the previous 4 years, and the operating strategy was aimed at continuing this trend. Marriott’s 1987 annual report stated:

We intend to remain a premier growth company-This means aggressively developing appropriate opportunities within our chosen lines of businessвЂ"lodgingпјЊcontract services, and related businesses. In each of these areas, our goal is to be the preferred employer-the preferred provider, and the most profitable company.

Cohrs recognized that the divisional hurdle rates at Marriott would have a significant impact on the firm's financial and operating strategies. As a rule of thumb, increasing the hurdle rate by 1%(for example, from 12% t0 12.12%) decreased the present value of project inflows by l%. Because costs remained roughly fixed, these changes in the value of inflows translated into changes in the net present value of projects. Figure A shows the substantial impact of hurdle rates on the anticipated net present value of projects. If hurdle rates increased, Marriott's growth would be reduce, as once profitable projects would no longer meet the hurdle rates. Conversely, if hurdle rates decreased, Marriott's growth would accelerate.

Marriott also considered using the hurdle rates to determine incentive compensation. Annual incentive compensation constituted a significant portion of total compensation, ranging from 30% to 50%of base pay. Criteria for bonus awards depended on specific job responsibi1ities but often included the earnings level, the ability of managers to meet budgets, and overall corporate performance. There was some interest,

however,in basing the incentive compensation ,in part, on a comparison of the divisional return on net assets and the market-based divisional hurdle rate, making managers more sensitive to Marriott’s financial strategy and capital market conditions.

Company Background

Marriott Corporation began in 1927with J. WillardMarriott's root beer stand. Over the next 6O years, the business grew into one of the leading lodging and food service companies in the United States. Marriott's l987 profits were $223million on sales of 56.5binion.See Exhibit l for a summary of Marriott's financial history.

Marriott had three major lines of business: lodging, contract services, and restaurants. Exhibit 2 summarizes its line-of-business data. Lodging operations included 361 hotels, with more than l 00,000 rooms in total. Hotels ranged from the fun-service, high-quality Marriott hotels and suites to the moderately priced Fairfield Inn. Lodging generated 41 % of l987 sales and 5l% of profits.

Contract services provided food and services management to health-care and educational institutions and corporations. It also provided airline catering and airline services through its Marriott In-Flite Services and Host International operations. Contract services generated 46% of 1987sales and 33% of profits.

Marriott’s restaurants included Bob’s Big Boy, Roy Rogers, and Hot Shoppe. Restaurants provided 13% of l987 sales and l6% of profits.

Financial Strategy

The four key elements of Marriott' financial strategy were :

* 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

Manage Rather Than Own Hotel Assets

In 1987, Marriott developed more than $1 billion worth of hotel properties, making it one of the ten largest commercial real estate developers in the United States. With a fully integrated development process, Marriott identified markets, created development plans, designed projects, and evaluated potential profitability.

After development, the company sold the hotel assets to limited partners, while retaining operating control as the general partner under a long-term management contract. Management fees typically equaled 3% of revenues plus 20% of the profits before depreciation and debt service. The 3% of revenues usually covered the overhead cost of managing the hotel. Marriott's 20% of profits before depreciation and debt service often required it to stand aside until investors earned a prespecified return. Marriott also guaranteed a portion of the partnership’s debt. During l987.3 Marriott hotels and 70 Courtyard hotels were syndicated for $890 million. In total, the company operated about $7 billion worth of syndicated hotels.

Invest in Projects That Increase Shareholder Value

The company used discounted cash flow techniques to evaluate potential investments.

The hurdle rate assigned to a specific project was based on market interest rates, project risk, and estimates of risk premiums. Cash flow forecasts incorporated standard companywide assumptions that instilled some consistency across projects. As one Marriott executive put it:

Our projects are like a lot of similar little boxes. This Similarity disciplines the pro forma analysis. There are corporate macro data on inflation, margins, project lives, terminal values, percent of sales required to remodel, and so on. Projects are audited throughout their lives to check and update these standard pro forma template assumptions. Divisional managers still have discretion over unit-specific assumptions, but they must conform to the corporate templates.

Optimize the Use of Debt in the Capital Structure

Marriott determined the amount of debt in its capital structure by focusing on its ability to service its debt. It used an interest-coverage target instead of a target debt-to-equity ratio. In 1987, Marriott had about $2.5 billion of debt, 59% of its total capital.

Repurchase

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