Marriott Corporation: The Cost of Capital (Abridged)
Dan Cohrs, Vice President of Marriott Corporations project finance, prepared his annual recommendations for the hurdle rates. The year before, Marriott’s sales grew 24%, sales and earnings per share had doubled the last 4 years and the ROE stood at 22%.
The strategy of Marriott was to remain a growth company. The goal was to be one of most preferred employer, the most profitable company and a preferred provider.
The financial strategy of Marriott was about 4 criteria: 1. Manage rather than own Hotels assets 2. Invest in projects that increase shareholder value 3. Optimize the use of dept in the capital structure 4. Repurchase undervalued shares.
Manage rather than own hotels assets
Marriott became on of the largest commercial real estate developers in the US. Marriott sold hotels assets to limited partners but retained operating control as the general partner. 3% of revenue and 20% profit before depreciation typically equalled management fees. During 1987, 70 Courtyard hotels and 3 Marriott hotels were syndicated $890.000.000. The company operated about $7 billion worth oft he syndicated hotels in total.
Invest in projects that increase shareholder value
The company uses a discount cash flow technique and the hurdle rates to a specific project that was based on market interest rates, project risk and estimates of premium risk. They also used a cash flow forecast.
Optimize the use of debt in the capital structure
In 1987, 59% of the total capital of Marriott consists of $2.5 billion dept. Instead of using an target dept to equity ratio, Marriott used an interest coverage target.
Repurchase undervalued shares
Marriott calculated a ”warranted equity value”. They repurchased its stock whenever the market price fell below that value. This value was compared to other companies and was calculated by discounting the firm’s equity cash flow by its equity cost of capital. Marriott repurchased $13.6 Million of its common stock for $429 billion in 1987.
The cost of capital
Marriott usually measured the cost of capital for investments with the Weighted Cost of Capital (WACC). They used this formula to determine their cost of capital for the corporation in general and for each department. For determine the opportunity cost of capital, they needed the dept of capacity, the depft of costs and the equity costs. These inputs could vary for each department so they updated this annually.
Dept capacity and the cost of dept
The financing policy of Marriott applied to each division. Marriott determined the fraction of dept, which should be the floating rate dept. Mariott based this on the sensitivity Cash flow to interest rates. In 1988 Marriotts unsecured dept was A-rated. They used each division’s dept cost on an estimate of the division’s dept cost of an independent company. There were differences in risk so the spread between the dept rate and the governmental bond rate varied.
The cost of equity
The financial strategy of Marriott was to increase shareholders value. Therefore they had to use its shareholders measure of equity costs. For estimating the cost of equity, Marriott used the CAPM Model.
Expected return = r = riskless rate + beta * (risk premium)
The key here is to measure a fully diversified portfolio of risks asset. The shareholders could minimize their risk by holding assets in fully diversified portfolios. This method also has some problems. One problem is for example, that companies had multiple lines of businesses. The beta is an average of all the betas of the different businesses.
In Exhibit 3-5 you can see several betas, leverages, historical information and statistics.
In this certain case of Marriot it would be interesting what the WAAC is. It is also interesting to find out what the weighted average of the cost of capital for Marriot is.