Marriott Corporation free essay sample

The four components of its financial strategy are steady with this growth objective. Its growth objective is to remain a leading growth company and developing appropriate investment opportunities in its different business sections. In 1987, Marriott’s sales grew more than 20% and its return on equity was at 22% that shows the sales and earnings per share have doubled over the previous year. The company’s lodging divisions generated 41% of sales and 51% of profits, contract services generated 46% of sales and 33% of profits and restaurants division earned 13% of sales and 16% of profits in 1987 correspondingly. The four key elements of the reasons and motives are listed below; †¢Manage, rather than own, hotel assets. The Marriott Corporation sold its hotel assets to limited partners to reduce assets and in this manner the return on assets it is increased which results in increased profitability. Invest in projects that increase shareholders’ value. The discou nted cash flow, net present value, and internal rate of return calculations to appraise potential investments permit the corporation to invest just in profitable projects. Investment projects at Marriott were selected by discounting the appropriate cash flows by the appropriate hurdle rate for each division. Therefore, the profitable projects are desirable but projects with a negative returns are rejected and fundamental selection of its cash flow can be carried that it can gain and maximize shareholders’ profits. Optimize the use of debt in the capital structure. The main objective of all business is to have a lower percentage of debt relative to higher percentage of equity which results in the higher value overall for the businesses. The Marriott Corporation uses this strategy in order to increase its value and in so doing it used interest-coverage ratio to make sure that debt can be covered. The company used an interest coverage target ratio (more traditional than debt / equity ratio) which may exclude the company from financing a new project if net income falls and results in lower interest coverage ratio. Repurchasing of undervalued shares increased the earnings on the spread between the warranted equity value and the market value . The company’s warranted equity was calculated by discount equity cash flows, by its equity cost of capital . To make sure that the common shares are undervalued the price/earnings ratio was used across comparable companies and valuing each business line under its ownership structure. The company believed that the better use of its cash flows and debt size is repurchase of undervalued shares than acquisitions or owning real estate. The repurchase of 13. 5 million shares in 1987 spending $429 million proves the company approach towards increase shareholders wealth. Repurchase of undervalued shares increased shareholders wealth and employee compensation. The Company should use hurdle rates based on each project, not an overall corporate rate. Only this approach is appropriate for estimate its cost of capital. The Marriott Corporation evaluates its potential investments by discounting the appropriate cash flows by the appropriate hurdle rate for each division. The Marriott Corporation 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. The main goal is to determine the WACC for every division established on the information and the data that are provided. To begin with, the first step is determined the cost of debt, cost of equity and the capital structure for the whole company. After find out the results the next step will allow to compute for the taxes, and establish the WACC for the whole company. The discount rate represented by the weighted average cost of capital (WACC) has an important factor in deciding the net present value (NPV) of a project. Calculating the NPV is an important task since it allows the investors to make proper investment decisions. Given that the NPV of a project is positive, then the project is profitable and should be taken, but if the project has a negative NPV, then the project should be rejected. In the evaluations of a project the investors are making an investment decision with the objective of maximizing shareholders wealth. The next step is determined the Risk-free Rates, Risk Premiums and Betas for lodging and restaurant divisions in order to calculate the Cost of Equity for both divisions. After finding out the cost of debt and the debt for lodging and restaurant divisions, the cost of equity will follow. The WACC for the Marriot Corporation is calculated using the formula based on following data: This approach uses the primary assumption that the debt-equity ratio for the corporation remains constant. In Marriott’s case the corporation’s target leverage ratio based on interest coverage target is set at 60% as given from Table A. The main goal is to calculate the Weighted Average Cost of Capital (WACC) for Marriott as the whole and each of its three divisions which are Lodging, Contract Services, and Restaurants. The first step is calculated the two major components of WACC, cost of debt and return on equity. The WACC for the whole firm represents the average cost of capital of the corporation’s basic operating structure. To use this WACC approach it should be assumed that the cost of capital of the company’s individual business units and their share within Marriott’s operations remain constant. For the weights of debt and equity (We and Wd), the 1988 market value target leverage ratios of debt-to-assets and debt-to-equity were used as the only measures available in the case. The Cost of Debt The formula to calculate cost of funds would result in; Interest rate x (Debt rate premium + 100%) = Interest rate of debt The cost of debt is the rate on the company’s debt, which is provided in Table A and Table B. Under the assumption that Marriott’s credit rating remains at the same level (which is an A), the cost of debt has a debt rate premium of 1. 30% above the risk free rate. The risk free government interest rate with maturity of 30 years was at 8. 95% in April, 1988. Given that this concerns long-term debt the proper measure is using the 30 year risk free rate. Therefore the cost of debt equals to the risk free government interest rates plus debt premium of 1. 3% results into cost of funds for Marriott of 10. 25 %. See attachment for the cost of debt for each division) The cost of long-term debt was most proper for the lodging division because of long live assets such as hotels, so the 30 year maturity rate of 8. 95 plus debt rate premium of 1. 1% results in cost of debt of 10. 05 % . For restaurants and contract service appropriate assumptions are to use short term to calculate the cost of debt because they have shorter useful life than lodging division. For these two divisions in table A and table B provide cost of debt calculations for restaurants ten year government interest rate(under assumption that has longer useful life than one year) of 8. 2% plus debt rate premium above government 1. 8% that equals 10. 52% of cost of debt. To the contract service appropriate hypothesis that has longer life than a year and applicable government interest rate of ten year maturity is 8. 72% plus debt rate premium of 1. 4% equals 10. 12% of total cost of debt. In the case study Marriott uses the capital asset pricing model (CAPM) in determining the cost of equity and the return from the company and each of its divisions. The formula for CAPM is; Cost of Equity = Risk-Free Rate + (Beta x Equity Premium) The cost of equity was calculated based on the CAPM formula. A 30 year Treasury bond was used as long-term risk-free security to get the risk-free rate, since Marriott used the cost of long-term debt for its lodging and restaurant cost of capital calculations. The market premium 7. 43 % was the arithmetic-average spread between the SP 500 returns and the long-term US Treasury bills in the time frame during 1926-1987. In order to calculate the beta for the contract service the lack of information provide an assumption from the data given in other two business lines. Therefore the evaluation can be determined based on unlevered asset beta that can be incorporated into formula. The equity beta of 1. 11 multiply one minus market leverage (1-. 41=. 59) equals average asset beta of . 65 and the rest data were given. The unlevered asset beta for Marriott was calculated; ?M=? L+? R+? CS .65= (. 42x. 61) + (. 96x. 12) +. 27x .65=. 256+. 115+. 27x X=? 1. 03 (See attachment Marriott. XLS) The next step is to calculate the equity beta that is consistent with Marriott as a whole target capital structure. The target equity ratio of 40% divided by the entire company structure (40/100=2. 5) to find an equity beta because target debt financing is 60%. Therefore ? 2. 5 times an asset beta equals an equity beta of 1. 625. Expected return is equal to 21. 02%, risk free rate of 8. 95% plus an equity beta of 1. 625 times risk premium of 7. 43%. See all data attached in excel under Marriott Case and its divisions. The beta value for the company overall was calculated in Exhibit 3 to be 1. 11 using monthly stock return during 1983-1987. It is also given market leverage and revenue to compare against. The result is in the market value leverage of the 41% leverage for Marriott. Weighed average cost of capital, rate on assets, is measured using the following equation: rate on assets = (1-t) (D/V) (rdebt) + (E/V) (requity) the portions (Debt/Value) and (Equity/Value) of the equation are the weighted averages of the returns on the securities. 5 billion of the debt, amounting to 59% of its total capital than calculate the remainder of its capital value, or 41% (100% 59%), to be in equity. To determine the beta values for the three divisions at Marriott from given information under an assumption that each division contributes to the overall company beta value somewhat in proportion to the amount of revenues the division produces. However, an overall company beta value for the Marriott Corporation, weights based on revenue for each of the three divisions, and a beta value for two of the three divisions, the last step is to calculate the last missing piece of data the beta for contract services by using return on equity calculations. The tax rate used of 32% was consistent with the calculations across company. The WACC and Debt-to-Equity Relationship Throughout calculations main conclusion from observation demonstrate that debt is cheaper than equity. For example in lodging segment cost of equity is 21% correlated to the debt cost of 10. 05% which more than double. In the order to lower the cost of equity it would be better off to consider more debt financing. In addition the ratio for debt should be increased contrast to the ratio for equity should be decreased to balance better and to increase WACC for the lodging (26% vs74%). To compare with restaurant segment where the cost of equity of 21. 50% and the cost of debt 10. 2% but the equity to debt ratio 58% vs. 42% results in WACC of 15. 18 %. There are two reasons for this evaluation; first, the pretax cost of debt is lower because it has a prior claim on the companys assets and second, it benefits the tax shield (i. e. it is a tax-deductible), which is why the balance sheet lacking of debt may be less advantageous. Because debt is cheap er, by swapping some equity for debt, the company may be able to reduce its WACC. Conclusion Marriott Corporation is determining the weighted average cost of capital (WACC) to use as the hurdle rates for future projects and compensation. In determining this, there is both a portfolio rate (which includes all divisions) and rates for each individual division. Since the company has three business divisions and the cost of capital in each division varies and differs from that of Marriott as a whole, each division needs to have its own hurdle rate. The reason behind this practice is the company’s strategy which focuses on growth. If using a single discount rate for the whole company would be too low for some divisions and too high for others. In the case when discount rate is too high, fewer projects would be considered rofitable and preset value of project inflows would be reduced. As a result, Marriott’s growth would be reduced too. These divisions are divided into different categories rather than using only a single rate for Marriott because the levels of risk vary from division to division. Although there is a determinable risk rate for Marriot as a whole, Marriott should use the separate divisional rat es when determining possible future projects and employee compensation. In evaluating Marriot and the market, the WACC for all four is as follows: Marriott as whole (not it’s components)12. 58%