Case Study: Marriot Corporation : the Cost of Capital. Essay

Marriott Corporation began from root bear stand, and developed to be the leading supplier of food services and leading logging company in the U.S. The leading parts of the business were lodging, contract services, and restaurants. Their intentions regarding the business strategy was to focus on employees and customer satisfaction. In that way, they can remain the leading growth company. The financial strategies used were:

➢ Franchisees and Owners - “As Marriott pursues its growth plan and continues to expand; we want diverse partners and stakeholders to grow and prosper with us. (3)”

Pretax cost of debt= 5.88%, Tax Rate= 40%, Weight of equity = 77.8%, Cost of Equity= 10.95%, Weight of debt = 22.2%

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,

Marriott’s unsecured debt was A rated in 1988, and thus they could be expected to pay a spread above the current government bond rates. Each line of business had a different spread between the debt rate and the government bond rate due the varying differences in risk. Lodging was considered to have longer useful lives and thus Marriott would use long-term debt for their lodging cost of capital. Restaurant and contract services had shorter useful lives and therefore a shorter term debt was used to determine cost of debt.

If the company doesn’t take on any high risk projects or new divisions, the hurdle rate may remain constant or very close to the calculated number. The hurdle rate of 10.66% is a safe hurdle rate that will guide the company in making good

Step 2: Estimate the firm’s cost of equity based on the data. According to the capital asset pricing model (CAPM), we have:

Cost of Capital for Restaurant Division was calculated in the same manner. The 1-year T-bill was used as a usual shorter-term security to obtain the risk-free rate. The unleveraged Beta, used to obtain the leveraged Beta for the CAPM, was once again the weighed-average of the unleveraged B's of the restaurant industry representatives given in the case. However, the restaurants given for the calculation were mostly fast-food chains while Marriott operates rather middle-level restaurants. Today's WA Bu of the middle-class and upper-class restaurants appeared to be slightly higher indicating that the overall cost of capital for Marriott's restaurant division should be slightly higher. The cost of capital for the restaurant division is 14.85%.

Invest in projects that increase shareholder value: Marriott is focused on project, which will give a potential return. To invest in projects that increase shareholder value is good for growth. Marriott

3. Should Midland use a single corporate hurdle rate for evaluating investment opportunities in all of its divisions? Why of why not?

Dan Cohrs is preparing the annual hurdle rates for the three divisions of Marriot Corporation (Lodging, Contracts, and Restaurants) which will have a significant impact on the firm’s financial and operating strategies. Marriott’s has been truthful to its operating strategy to remain a premier growth company, Marriott’s sales and earnings per share have doubled over the last four years. In 1987 Marriot’s sales rose 24%, the return on equity was 22% and profits were $223 million. Lodging consisted of 51% of Marriott’s profits, while contracts services and restaurants amounted to 33% and 16% respectively. However, the sales mix is not proportionate to relative profits, where 41% of

The company has invested into many different industries and markets. Each industry’s risk is different and remaining diversified is crucial to obtaining a marginal rate of return. The company needs to use single corporate cost of capital hurdle rates in order to evaluate projects and in order to allocate costs. PPC has integrated so many different industries into their portfolio that it would be best for them to look at each division differently. Their oil division is going to have a higher risk compared to the plastics division. The divisions need to allocate costs according to the risk within that division. The multiple hurdle rates need to be determined to this risk.

Discount rate of 10-13%. 10% seems low given the corporate bond rates and the risk free rates given in Exhibit 14. We should also perform a Weighted Average Cost of Capital calculation based on the desired equity return of the investors and the potential Debt/Equity ratio. A preliminary estimate assuming a 60%/40% D/E ratio, a required equity return of 20%, a required debt return of 10% and a 41% tax rate would require a minimum discount rate of 11.5%.

I choose the Hospitality Industry in the line of Accommodation. As we all know, there are many rivals in this industry line, and many of them are the large companies that have many chains along the line. Therefore, I would like to focus on one big company, and categorize its chains in each competitive strategy, Marriott.

Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate).