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Marriot Corp: Cost Of Capital

Essay by 24  •  March 21, 2011  •  2,535 Words (11 Pages)  •  1,661 Views

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Introduction and background

We are conducting an analysis of Marriott Corporation for calculating the hurdle rates at each of the firm's three divisions--lodging division, restaurant division and contract service division. Marriott uses Weighted Average Cost of Capital (WACC) as the hurdle rate, and use it to discount the appropriate cash flows when evaluate an investment project. Our goal is to determine the WACC at every division base on the information that the case has provided. First of all, we will determine the cost of debt, cost of equity and the capital structure for the whole company. Then we will compute for the tax rate, and calculate the WACC for the whole company. After this, we will determine the Risk-free Rates, Risk Premiums and Betas for lodging and restaurant divisions in order to calculate the Cost of Equity for these two divisions. After finding out the cost of debt and the fraction of debt for lodging and restaurant divisions, we will be able to calculate the WACC at each of the two divisions. Using a mathematical method, we will then be able to find out the Beta and determine the cost of debt and the fraction of debt for this division. Finally, we will be able to calculate the WACC for contract service division.

Background

Marriott Corporation was started in 1972, and its founder is Marriott is J. Willard Marriott. The company became one of the leading lodging and food service companies in the U.S. in 60 years. Marriott had three major lines of business: lodging, contract services and restaurants. Lodging operations included 361 hotels, with more than 100,000 rooms in total. Hotels ranged from the full-service, high-quality Marriott hotels and suites to the moderately priced Fairfield Inn. Contract services provided food and services management to health care and educational institutions and corporations. It also provided airline catering and airline service through its Marriott In-Flite Service and Host International operations. Marriott's restaurants included Bob's Big Boy, Roy Rogers, and Hot Shoppes.

When the management of Marriott evaluated an investment project, they used an appropriate hurdle rate to discount the appropriate cash flows. Since the lodging assets had longer useful lives than contract service division and restaurant division, the cost of debt at each division are different. Also, the expected returns at each of the three divisions were different as well. Therefore, the Marriott's management decided to use different hurdle rate for each of the three divisions.

The divisional hurdle rate had a significant effect on the firm's financial and operating strategies. If hurdle rates were to increase, the present value of project inflows would be decreased, and the company's growth would be reduced. Marriott also considered using the hurdle rates to determine incentive compensation. Managers would be more sensitive to Marriott's financial strategy and capital market conditions, if the compensation plan could reflect hurdle rates.

In April 1988, Dan Cohrs, the company's vice president of project finance, was preparing his annual recommendations for the hurdle rates at each of the firm's three divisions. Since the hurdle rates would affect the firm's financial and operating strategy, he had to consider all the aspects that related to this analysis, and calculate the rates very carefully.

Assumptions

In order to present our evaluations and calculations of the hurdle rates, we had to make certain assumptions. These assumptions are described below.

Capital Structure

- The existing capital structure of Marriott was optimal.

Questions

1. Are the four components of Marriott's financial strategy consistent with its growth objectives?

The company's growth objective is to remain a premier growth company by aggressively developing appropriate opportunities within its lines of business. This indicates that its cost of equity might be higher because the company is using CAMP to measure Re, and investing in higher risk projects will yield higher returns. Strategy #2 conflicts with the company's objective because the company is using hurdle rate to discount cash flows and evaluate potential investments. If Re was higher, then WACC, which is the hurdle rate, would be higher as well. If this was the case, the company's growth would be reduced therefore failing the company's growth objective.

If the company's objective is to keep growing by aggressively developing appropriate opportunities, it is best if they do not use their funds to buy back stock shares, even though these shares were undervalued. So strategy #4, which is to repurchase undervalued shares, conflicts with the company's objective. When the company intends to remain a premier growth company, it must aggressively invest in different profitable projects to generate more profit. If Marriott used their funds to buy back stock shares, the available funds for investment would be reduced. This will have a negative effect on the company's growth objective.

2.How does Marriot use its estimate of its cost of capital? Does this make sense?

Marriot use cost of capital as the hurdle rate to discount future cash flows for the investment projects of the firm's three divisions. Hurdle rate is the minimum rate of return that is required in order for the company to accept the investment. Marriot use the hurdle rate to calculate the net present value and net present value over cost to decide for the profit rate. Since cost of the project stays constant, net present value and hurdle rate are used as variable to decide if they should accept the project. The higher the hurdle rate, the lower the net present value because future cash flows are discounting at a higher rate. This also means lower return on the project. However, WACC and net present value of the project should be considered and calculated separately for each division for different investments projects. Therefore figure A could be misleading because it does not separate hurdle rate into different division.

For example, NPV is equal to zero when hurdle rate equal to 10% according to figure A. But for a division with lower risk, it could have positive NPV when hurdle rate equal to 10%. Therefore, use a firm wide WACC, they might end up reject

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