Marriott Corp: the Cost of Capital

To : President, Marriott Corporation From : FLO299 Subject : Marriott Corporation – The Cost of Capital Date : April 6, 2010 The Importance of the Cost of Capital The cost of capital is important as it forms the basis for Marriott’s investing and financial decisions. By understanding and knowing the cost of capital, Marriott is able to select relevant investment projects for the company, determine incentive compensation, and repurchase undervalued shares when needed. The returns of a project were found by discounting the appropriate cash flows against the appropriate hurdle rates. Without knowing the cost of capital, Marriott would not be able to determine hurdle rates that would help Marriott’s growth. Also, knowing the cost of debt would allow Marriott to optimize the use of debt in the company’s capital structure. Knowing the hurdle rates on a divisional level would also enable Marriott to reward their managers using incentive compensation. By using hurdle rates, Marriott managers would be â€Å"more sensitive to Marriott’s financial strategy and capital market conditions† and would give the company a more accountable method of rewarding their employees. Lastly, Marriott’s method of calculating a â€Å"warranted equity value† for its common shares required knowing the company’s equity cost of capital. A share price that was below the â€Å"warranted equity value† signaled to Marriott when the company needed to step in to repurchase its stock as the company believed that repurchases of shares were a better use of Marriott’s cash flow and debt capacity than acquisitions or owning real estate. Computing Marriott’s WACC The cost-of-capital was computed both divisionally and overall for the company. It required using the formula WACC = (1-t_)RD(D/V) + RE(E/V). D and E are the market values of the debt and equity respectively and V (market value) = D+E. RD and RE are the pretax cost of debt and cost of equity respectively and t is the corporate tax rate. The Numbers Used in Marriott’s WACC A 34% tax rate rate will be assumed for simplicity's sake so more effort can be focused on other issues . The above WACC calculation uses market value of debt. Cost of debt can be observed directly by calculating the yield to maturity of outstanding bonds, but since the bond market is not very transparent and we know Marriott's unsecured debt is A-rated, the company can expect to pay a spread above some base rate. Which index to use should be determined by project life, and as lodging is based on a long term business model, a 30-year treasury bond is appropriate. In this case, the base is 8. 95% according to Tabe B and the spread for the overall company is 130 basis points according to Table A. Also found in Table A, Marriott set a target of the debt percentage in its capital structure to be 60% for the overall company. Because there is no way of directly observing the return that equity investors require, we rely on a couple of methods to estimate it. A dividend growth model can be used, and although simply to use, this approach assumes steady dividend growth. This approach also does not directly adjust for the riskiness of a project. An alternative approach is to use CAPM, which does not rely on dividend growth and does take both the market risk premium and systematic risk into consideration. Using CAPM to estimate the cost of equity we use the following formula: _E(R)=Rf+ {draw:frame} *MRP_. Rf is the same risk-free base rate used to calculate cost of debt, in this case, 8. 95% from Table A. The {draw:frame} is obtained from regression using market data and therefore is affected by leverage. To adjust for this, the B is unlevered and then relevered so that it is the B for business risk only, independent of capital structure. With due consideration given to each input, Appendix A is a computation of Marriott's WACC, 11. 87%, which is also the required rate of return for the company overall. The Use of Marriott’s WACC in Divisional Decisions Marriott can use the computed WACC to support its stock repurchasing decisions because it allows the equity cash flows to be discounted at a company level rate. But because each cost of capital input could differ amongst its divisions, the cost of capital varies across each. If Marriott used the above calculated WACC for all divisional decisions, it would cause the company to take on riskier projects, projects that once risk adjusted would likely cause the company to lose money in the long run. A better approach would be to use individual {draw:frame} for each project with CAPM to calculate the WACC for each project and compare it to IRR. Determining Divisional WACC To estimate the WACC for each division, we need their corresponding {draw:frame} . To do this we use comparable companies for each division; this is because we cannot run regressions at the divisional level as that information is not available. For the lodging division, we compare other hotel companies, for the restaurant division, we compare other restaurants, and for the contract services division we use the identity: {draw:frame} M=WL* {draw:frame} L+WR {draw:frame} R+WCS {draw:frame} CS. The identifiable assets in Exhibit 2 will be used to compute the weights of each division. Once again, because the information is actual market numbers, {draw:frame} E is affected by leverage and must be unlevered by multiplying it by 1 – market leverage. This results in {draw:frame} A which is business risk, independent of capital structure. Asset risk is the only thing that is comparable across firms. Within each divisional comparison to comparable companies, weighted average of {draw:frame} A is used as smaller companies have less impact on the overall segment. These numbers are shown in Exhibit 3. The WACC for each division is found in Appendix B to D. Differences in WACC Appendix A: Marriott’s Overall WACC Calculation Appendix B: Marriott’s WACC for Lodging Appendix C: Marriott’s WACC for Restaurants Appendix D: Marriott’s WACC for Contract Services Identifiable lodging assets = 2777. 4 WL = 60. 61% {draw:frame} L = . 57 Identifiable restaurant assets = 567. 6 WR = 12. 39% {draw:frame} R = . 75 Identifiable contract services assets = 1237. 7 WCS= 27. 00% {draw:frame} CS = solve for this below {draw:frame} M=WL* {draw:frame} L+WR {draw:frame} R+WCS {draw:frame} CS 0. 57 = . 6061*0. 42 + . 12390. 75 + . 2700 {draw:frame} CS {draw:frame} CS = 0. 57