Case Study: Marriott Corporation

The Cost of Capital

A Brief about Marriott

The four components of Marriotts financial strategy are to manage rather than own hotel assets, to
invest in projects that increase shareholder value, to optimize the use of debt in the capital structure,
and to repurchase undervalued shares when necessary.

Marriotts growth objective is to become the preferred employer and provider in lodging, contract
services (such as catering), and restaurants, and to be the most profitable company in their industry.

By choosing to manage hotel properties instead of owning them Marriott lowers their accounting
assets on the books, therefore increasing their return on assets as compared to owning the properties
outright. This strategy also effectively shares the risk that comes from the properties, and lets Marriott
operate with more liquidity, offering them the opportunity to relocate their hotel or restaurant
operations without the need to sell properties, for instance.

Marriott can analyze potential projects and discount the future cash flows to determine which projects
will have a higher net present value, and ultimately which will be most profitable to Marriott at the
present time, therefore increasing shareholder wealth.

Balance sheets reflect all company debt, so by reducing debt Marriott can decrease their Debt to
Equity ratio, becoming more attractive to new and existing shareholders. Marriotts plan to repurchase
shares when they are undervalued can positively affect share price and therefore shareholder value,
but it is not directly in line with their project-based growth objective.

By repurchasing shares, they are removing shares from the market. As they continue to make a profit,
the profit per share is now higher due to the buyback, theoretically causing the demand for shares to
increase and the price to increase accordingly.

This process does not guarantee increasing shareholder wealth in the long-run, especially compared
to their competitors or the market. Often, institutional investors consider a stock buyback a sign that
the company has found no opportunities for growth projects that will provide an adequate net present
value.









Marriott should only consider this strategy when there are no projects in the foreseeable
future that will provide a positive net present value, and when they have enough cash to
both buyback shares and adequately fund future projects that meet their hurdle rates. In
other words, having excess cash on hand is sometimes a value in itself.

Marriott should consider how they will become the preferred employer, as this will
positively affect the experience of guests in lodging and restaurants, and ultimately affect
their profit. They should examine their hiring procedures, acquisition of talent, and
corporate culture, and pay extra attention to their guests experience as it relates to their
employees ability to provide excellent customer satisfaction.

Overall, Marriotts financial strategy aligns with their growth objective, although planning
to buy back shares when they are undervalued may not be a good long-term plan.
Additionally, their financial strategy does not address their interest in becoming a
preferred employer.


Estimation and Calculation of its cost of capital


Marriott used the Weighted Average Cost of Capital calculation to measure the opportunity
costs for company investments that have similar risk.

WACC = (1 t) r
d
(D / V) + r
E
(E/V)

T = corporate tax rate
rD = Cost of debt before tax rE = Cost of equity after tax D = Market value of Debt
E = Market value of Equity V = Firm Value (D + E)


Marriott calculated the WACC for each of the three divisions (lodging, restaurants, and
contractor services) as well as for the company as a whole. They updated their cost of capital
annually.

Marriotts WACC equation does make sense as it uses several variables in an effort to weight
each division appropriately against the firm value (V) and the corporate tax rate (T). Furthermore, the
divisions cost of debt before tax (rD), cost of equity after tax (rE), market value of debt (D) and the
market value of equity (E) give Marriotts WACC equation appropriate weight per division and tie the
cost of debt and equity to the market values.

The WACC was integral in setting hurdle rates for each of Marriotts divisions. Hurdle rates are
a prerequisite return any project for any division must provide in order to be approved. In this capacity,
Marriott can ensure they invest only in projects that have an adequate net present value to increase
shareholder wealth.

Once all variables are identified, WACC can be solved (Appendix I shows the calculations to
determine each variable):

WACC = (1 - .44) (.1010) (.60) + (.1017) (.40) =.0746

Marriotts WACC = 7.46%



What risk-free rate and risk premium is used to calculate the cost of equity?

The risk-free rate of 8.95% and calculated risk premium of .95% were used to calculate the
cost of equity.

The risk-free rate was chosen as it is the highest rate offered on the government fixed rates
found within Table B. Since it is a government fixed rate, it is the longest risk-free term rate available.
Similarly, the geometric average expected market return for Standard & Poors 500 Composite Stock
Index Returns found on Exhibit 4 was used for finding the market risk premium (MRP = Rm - Rf = 9.90
8.95 = .95). It was chosen over S&P 500 Composite and Long-term U. S. Government Bond Returns
geometric average of 5.63% to allow for the Risk Premium to be at a positive, moderate risk level.

How did you measure Marriotts cost of debt?
The case study provides U.S. government fixed-rates for the current time period which shows
what Marriott would likely be paying on debt. Also, it is key to know that Marriott is comprised of three
primary divisions, and one (lodging) uses
long-term debt while the other two (restaurant and contract services) use short-term debt. To
determine the exact rate of debt it is necessary to calculate a weighted average amongst the potential
interest rates for debt. From Table B, 30-year (long-term) is 8.95% and 10-year (short -term) is at
8.72%.
Government Interest Paid =
8.95 + 8.72 + 8.72
= 8.80% 3
Full cost of debt is not just average government interest but also Marriotts debt rate premium
above the government average. As such:

rD = Government Interest Rate + Debt Rate Premium

Marriotts average debt rate premium is given on Table A as 1.30%

Therefore, rD = 8.80 + 1.30 = 10.10%




One of the objectives of Marriotts financial goals is to invest properly. Marriott would invest in
projects that will increase the shareholder wealth.

Derive WACC for Marriott
To determine WACC for Marriott has used the following formula:



WACC = (1 t) rd (D / V) + rE (E/V)

T = corporate tax rate
rD = Cost of debt before tax rE = Cost of equity after tax D = Market value of Debt E = Market value of
Equity V = Firm Value (D + E)

Each the above variables are determined as follows:

T, Tax Rate

Tax Rate is equal to ____Total Taxes Paid_____ = 175.9 = .44 = 44%
Total Income Before Taxes 398.9

These numbers are provided by the case study in Exhibit 1 in year 1987.

D, Market Value of Debt

D = .60; provided from Table A given as a target value for Debt per capital

E, Market Value of Equity

E = .40; ascertained from Table A as it is assumed that that since 60% of Marriotts target
leverage goes to debt the remaining portion of its capital must go to equity (as V = D+E, so E must
equal V-D)

V, Firm Value

V = .40 + .60 = 1

The remaining two components of WACC are the most major and influential. To solve for these
one must determine more key variables.
rD, Cost of debt


The case provides U.S. government fixed-rates for the current time period which shows what
Marriott would likely be paying on debt. Also, it is key to know that Marriott is comprised of three
primary divisions and one (lodging) uses long-term debt and the other two (restaurant and contract
services) use short-term debt. To determine the exact rate of debt it is necessary to calculate a
weighted average amongst the potential interest rates for debt. From Table B, 30-year (long-term) is
8.95% and 10-year (short-term) is at 8.72%.
Government Interest Paid =
8.95 + 8.72 + 8.72
= 8.80% 3
Full cost of debt is not just average government interest but also Marriotts debt rate premium
above the government average. As such:

rD = Government Interest Rate + Debt Rate Premium

Marriotts average debt rate is given on Table A as 1.30%

Therefore, rD =8.80 + 1.30 = 10.10%


rE, Cost of Equity

Of the three methods to find Cost of Equity, Marriott uses the Capital Asset Pricing Model
(CPAM). Within CAPM there are three main components to determine:

Rf = Risk-free Rate

Rf = 8.95%

This is the highest rate offered on the government fixed rates found on Table B. Since it is a
government and fixed market rate it comes as the longest risk-free term rate.

Rm = Expected Market Return

Rm = 9.90%

This rate is the geometric average (of all years from 1926 1987) for Standard & Poors 500
Composite Stock Index Returns found on Exhibit 4. It is an
Financial Management I
8 | P a g e B M E v e n i n g ( 2 0 1 3 - 1 6 )

ideal rate as it shows a comprehensive average of all stock returns since 1926. It was chosen over S&P
500 Composite and Long-term U. S. Government Bond Returns geometric average of 5.63% to allow for
the Market Risk Premium (MRP = Rm - Rf) to be at a positive moderate risk level.

= Beta of the Asset

The case provides equity beta as .97. However, this is a leveraged beta that will affect other beta
estimates. To avoid this influence, an asset beta must be calculated and then converted into an
unleveraged beta. From exhibit 3, equity beta (.97) and market leverage of 41% are provided. It should be
noted that market leverage is the book value of debt divided by the sum of the book value of debt plus the
market value of equity. Therefore, if E = V-D, which V=E+D=1, then E=1-.41=.59

L
=
u
[ 1+ (1-T) ] and
u
=

u
= = .6983

To be converted back to a firm leverage level, apply the market value of debt and equity for D and
E of the equations

L
= .6983 [1 + (1 - .44) ] = 1.2849

CAPM re = Rf + (Rm Rf)

= .0895 + (.990 - .0895) (1.2849) = .1017 = 10.17%

With all variables identified, WACC can be solved:

WACC = (1 - .44) (.1010) (.60) + (.1017) (.40) =.0746

Marriotts WACC = 7.46%