The first financial strategy “Manage rather than own hotel assets” is consistent with growth objectives. The company sold out the hotel assets while keeping a long-term management contract. We calculated the Return on Assets (ROA) from 1978 to 1987, it increased a little in 1979 and kept decreasing to 1987(Exhibit 1). By managing rather than owning the hotel assets, Marriott is able to increase its ROA thereby increasing potential profitability and its financial position in the market. Marriott also improves its efficiency as the general partner under long-term management contract because it can decrease useless expenses and guarantee a part of the partnership’s debt.
The second financial strategy is investing in projects that increase shareholder value. Marriott uses the discounted cash-flow techniques to evaluate potential investments that falls in line with Marriott’s growth objectives. It is beneficial because it considers the present time value of investment. By comparing to its hurdle rates, Marriott concentrates on the projects which will bring potential return. The projects which increase shareholder value can result in profitable and competitive advantage.
The third financial strategy of optimizing the use of debt in the capital structure helps the company to maximize the revenues from its debt’s management. Marriott invests a large sum of money in long-term asset. It is essential to maximize and optimize its long-term debt to meet the need of investment. Generally, Marriott optimize the use of debt in its capital structure helps the company maximize revenues from its debt’s management.
The fourth financial strategy of repurchasing undervalued shares is also accordance with the growth objectives. Marriott calculates a “warranted equity value” and will repurchase its stocks if the price falls below the “warranted equity value”. By selling its undervalued common shares, Marriott is able to increase the profits. Also, the company uses the measure of warranted value instead of day-to-day market price of its stock. It allows Marriott not to depend on the market price.
Marriott measured the opportunity cost of capital for investments of similar risk using the weighted average cost of capital (WACC). It is an appropriate method to use for calculating cash flows with risk that leads to estimate the risk of investment projects. Meanwhile, the cost of capital will be calculated for each division – lodging, contract services and restaurants – as well as Marriott Corporation as a whole. It is also important to separate the calculation for each division because hurdles rates influence project investment and repurchase decisions for the firm.
According to the formula, WACC = (1-t)*rd*(D/V) + re(E/V). In order to get re, we need to use CAMP = Risk-free rate + βe*Risk premium rate. Thus, we have to figure out the tax rate, the cost of debt, the risk-free rate, βe as well as the risk premium rate for 3 divisions and the Marriott Corporation.
The Cost of Debt (rd)
The cost of debt is the yield-to-maturity on the company’s bonds, which we get from Table A and Table B (Exhibit 2) using the debt rate premium above government added to government interest rates. The debt rate premium is provided for the Marriott and each of its divisions. However, we need to calculate the Government Interest Rates for each category. In the case, it implied that the cost of long-term debt was suitable for Lodging division. So we assume the Lodging division in 30-year interest rate of 8.95%. It further indicated that the Contract Service and Restaurants run a shorter-term debt. For Contract Service, it is usually under 1-year contract and for Restaurants, it is generally under 10-year contract.
Therefore, we use the 1-year interest rate of 6.9% for Contract Service and the 10-year interest rate of 8.72% for Restaurants. For the Marriott Corporation, we make a weighted average of the two rates using the sales percentages because the cost of debt is the weighted average of the three divisions. It should be 8.95%*40.99% +6.9%*45.52%+8.72%*13.49% = 7.99%, in which 40.99%, 45.52% and 13.49% are separately the sales percentage in 1987 (Exhibit 3). Therefore, the cost of debt should be 9.29% (=7.99%+1.3%) for Marriott Corporation, 10.05% (=8.95%+1.1%) for Lodging Division, 8.30% (=6.9%+1.4%) for Contract Service and 10.52% (8.75%+1.8%) for Restaurants (Exhibit 2).
The Tax Rate
We can get the income before interest taxes and the income taxes from the case. To find the corporate interest tax rate, we should divide the income taxes by the before interest taxes. Thus, we calculate the tax rate from in 1987 in Exhibit 1, which is 44.10% as the tax rate for the cost of debt.
The Cost of Equity(re)
In order to get the Cost of Equity, we will use the CAMP, which is E(Ri) = Risk-free rate + βe*Risk premium rate. So we need to get the value of risk-free rate, risk premium rate as well as the Beta.
The risk-free rate is defined as the expected return on an investment that carries no risk. Using the S&P information, Marriott is under A-Grade which is not High-Grade Corporation. So we will use the Long-Term U.S. Government Bond Returns as the risk-free rate for Marriott Corporation and its Lodging Division which is 4.58%, while employing the Short-Term Treasury Bill Returns as the risk-free rate for Contract Service and Restaurants Devision which is 3.54% (Exhibit 2).
The risk premium rate can be defined as the Spreads between S&P 500 Composite Returns and Bond Rates from 1926 to 1987. The same as risk-free rate, we use the Spread between S&P 500 Composite Returns and Long-Term U.S. Government Bond Returns as the risk premium rate for Marriott Corporation and its 3 divisions, which is 7.43%. (Exhibit 2).
We choose to use the arithmetic mean instead of the geometric mean because the quantity desired is the rate of return that inventors expect over the next year for the random annual rate of return on the market. The arithmetic mean is the unbiased measure of the expected value of repeated observations of a random variable. The geometric mean underestimates the expected annual rate of return.
Lastly, we need to define the Beta Value to get our final cost of equity. As it is said in the case, we already get the equity beta of Marriott as 0.97. But the leverage affects beta estimates. In order to eliminate the effect of leverage, we have to adjust the Equity Beta 0.97, which has been given out in the case for Marriott Corporation. To calculate the asset beta, we need the book value of debt value which is marked as the Market Leverage 41% in case. So the asset value=0.97*(1-41%)=0.57. Now we can re-calculate the effect of leverage in equity beta with the asset beta. We assume debt beta =0 thereby equity beta=asset Beta*(V/E)=0.57*1/(1-60%)=1.43(Exhibit 4). Since the risk of division in Marriott is different from the average risk, we should estimate the beta for each of the division.
However, the beta we can obtain in the case is from the other companies. Therefore, we need to get an average unleveraged one and then leverage it. We assume it is 100% equity financing. The average Equity Beta for Lodging is 0.92 and for Restaurants is 0.70. The same calculation process as the Marriott one and we can get the leveraged beta for Lodging and Restaurants are separately 1.53 and 1.08 (Exhibit 4). For Contract Services, we have neither the estimated beta nor the beta from other comparable firms. We assume the beta for Contract Services is weighted by Marriott beta*sales as well as the other 2 division beta*sales, which is 1.45= (1.43*$6,520 – 1.53*$2,673.3 – 1.08*$879.9)/$2,969 (Exhibit 4).
Using CAMP – E(Ri) = Risk-free rate + βe*Risk premium rate, we can get the Cost of Equity: 15.21% for Marriott, 15.95% for Lodging, 14.31% for Contract Services and 11.54% for Restaurants.
With all the numbers calculated above, we can use the WACC formula (WACC = (1-t)*rd*(D/V) + re(E/V)) and get the cost of capital for Marriott and its three divisions, which are 9.20% for Marriott, 8.30% for Lodging, 10.44% for Contract Services and 9.16% for Restaurants.
Ignoring the information from case, we download the current data for Marriott International, Inc. from Yahoo Finance and input in our Exhibit 5. Meanwhile, we use the data from US Treasury Bonds and Corporate Bonds at the time of 12:59AM Nov 30, 2011 and input in our Exhibit 6.
We get the market value of equity as 9.82 billion and total debt as 3.10 billion. Tax rate can be calculated by Income Tax Expense/Income before Tax=16.88%. Beta is estimated as 1.67 (Exhibit 5). We assume the Marriott is evaluating a 10-year project. In addition, Marriott now is a Baa2-Rated Company by Moody. So the risk-free rate is 1.99% and the corporate bond is 4.87%. We also assume the market risk premium is 5% for a 10-year project. We can calculate the cost of capital of Marriott today is 8.83% (Exhibit 6).
Compared with the data and WACC calculated in 1987, Marriott’s WACC decreases by 7.22%, which means the risk taken is reduced. By analyzing in detail, we can find that both the debt percentage in capital and tax rate declined by more than 60%. The cost of debt, in the same time, reduces by 47.58%. It indicates that Marriott decreases its long-term debt in a large amount. Consequently we assume the main driver of the difference between today’s cost of capital and the one in 1987 is because Marriott sold the hotel assets and retained operating control under a long-term management contract. Moreover, the optimization of the use of debt also plays an important role in reducing the cost of capital. It will apparently influence the cost of debt so as to decrease the value of capital of cost.
As for the cost of capital of the restaurant and lodging divisions, we need to find the Beta separately. However, we cannot find the data by division in Marriott Financial Statement and Statistics. We need to estimate their Betas from other companies in the same industry. For Lodging, we choose Morgans Hotel Group, Starwood Hotels & Resorts Worldwide and Wyndham Worldwide, whose beta is separately 2.67, 2.47 and 3.29.
We removed the leverage risk to get the asset beta as 2.03, 1.88 and 2.50. Finally, we get our equity beta by average asset beta times (D+E)/D which is 2.81. For Restaurant, we choose McDonald’s, Luby’s Inc. and The Wendy’s Company, whose beta is 0.34, 0.96 and 0.74 and using the same method we get the equity beta for Restaurants divion as 1.18 (Exhibit 6). All the data are from Yahoo Finance.
We assume that lodging and restaurants divisions have the same debt percentage in capital and the cost of debt as the Marriott Corporation. The cost of capital of Lodging and Restaurants can be calculated as 13.16% and 6.96% with WACC formula (Exhibit 6).