Marriott Corporation The Cost of Capital.pptx

The Cost of Capital

1. Marriott Corporation began in 1927. Over the next 60 years, become one of the leading lodging and food service providing companies in the United States. 03 major line of business (data based on 1987): Marriott Corporation: Brief Overview Marriott Corporation 24% of Sales Increased & 22% ROE (Y-1987) Marriott Lodging – 361 Hotels – 41% of Sales ($2673 mn ) & 51% of Profit ($263.9 mn ) Restaurants – Bob's Big Boy, Roy Rogers, and Hot Shoppes – 13% of Sales ($879.9 mn ) & 16% of Profit ($82.4 mn ) Contract Services – Catering to Airlines & Service Management to Health & Educational institutes – 46% of Sales ($2969 mn ) & 33% of Profit ($170.6 mn ) Debt: 42% (Short Term) Debt: 40% (Short Term) Debt: 74% (Long Term)

2. Key Contents of Case Presentation 04 Financial Strategies Capital Assets Pricing Model (CAPM) To determine Cost of Equity using Beta considering Systematic Risks. To determine each divisional Project-specific Discount Rate/Hurdle Rate/WACC

3. Financial Strategies consistent with growth objectives? FS-1: Manage Rather than Own Hotel Assets. FS-2: Invest in projects that increase shareholder wealth. FS-3: Optimize the use of debt in the capital structure. FS-4: Repurchase undervalued shares. Growth Objectives aligned with each Line of Business/Division: To make each Line of Business profitable, aggregately Profitable Company. To be the best preferred employer with the best Compensation Plan comparing with each Divisional Return of Capital based on Hurdle Rate .

4. FS-1: Manage Rather than Own Hotel Assets Objectives: To get back invested capital for investing in new projects. To have Managing Control over the project. To share risk with Limited Partners. Strategies: Develop Hotel properties & sell off to LIMITED PARTNERS. To retain control as GENERAL PARTNERS. Management Fees – 3% of Revenues + 20% of the profits before Depreciation and Debt Service.

5. FS-2: Invest in projects that increase shareholder wealth Objectives: To increase shareholders value/wealth maximization. Strategies: Uses Discounted Cash Flow techniques to determine projects with positive NPV. Determine WACC/Hurdle Rate for every investment considering Interest Rates, Project Risk, and estimates of Risk Premiums based on PROXY COMPANIES.

6. FS-3: Optimize the use of debt in the capital structure Objectives: To determine optimum CAPITAL STRUCTURE to reduce Default Risk. Strategies: Not to have fixed Debt-Equity Ratio. To ensure continuous monitoring on Interest Coverage Ratio for each Line of business/Division. Interest Coverage Ratio: EBIT/Interest Expense Marriott Corporation Calculation (Exhibit-1)

7. FS-4: Repurchase undervalued shares Objectives: To adjust undervalued shares/wait for market rectification. To increase investors holdings/Rate of Return in the company. To reduce unutilized capital due to non-availability of prospective investments. Strategies: Regularly calculate “Reasonable Equity Value” / “Warranted Value” of each share. 03 methods were applied: a) Discounting the equity cash flows of the firm using the equity cost of capital. Value of Equity = Value of Firm/Assets – Value of Debt Net Asset Value per Share = Value of Equity / Outstanding Shares

8. FS-4: Repurchase undervalued shares (Conti…..) Strategies: b) Comparing P/E Ratio with similar companies. Strategies: c) Leveraged Buyout – restructuring of Capital Structure, DEBT increases, WACC reduced Company-A Per Share Price = BDT 100 EPS = BDT 10 P/E Ratio = 100/10 = BDT 10 Company-B Per Share Price = BDT 100 EPS = BDT 20 P/E Ratio = 100/20 = BDT 5

9. Capital Assets Pricing Model (CAPM) To determine Cost of Equity using Beta considering Systematic Risks. To determine each divisional Project-specific Discount Rate/Hurdle Rate/WACC Project Risks (fully diversified portfolio): a) ‘Undiversifiable Risk’ or ‘Systematic Risk’ or ‘Market related Risk’– Can’t be eliminated. b) ‘Diversifiable Risk’, ‘Unsystematic Risk’, or ‘Specific Risk’ – Can be eliminated by portfolio diversification. CAPM address all Systematic Risks/Market Related Risks - Beta. Formula: E( ri ) = Rf + β i (E( rm ) – Rf ) E( ri ) = Return Required on Financial Asset  Rf = Risk-free rate of return β i = beta value for financial asset  E( rm ) = Average return on the capital market Equity Risk Premium = E( rm ) – Rf

10. Capital Assets Pricing Model (CAPM) (Conti…..) Assets Beta – No Debt, No Financial Risk Equity Beta – Debt, both Financial Risk + Business Risk

11. Capital Assets Pricing Model (CAPM) (Conti…..) Steps for CAPM calculation: Locate suitable proxy companies. (Exhibit -3) Determine the equity betas of the proxy companies, their gearings and tax rates. Ungear the proxy equity betas to obtain asset betas. Calculate an average asset beta. Regear the asset beta. Use the CAPM to calculate a project-specific cost of equity.

12. CAPM used for WACC calculation Marriott Corporation – Parent Company Marriott Lodging Contract Services Restaurants

13. What risk-free rate and risk premium did you use to calculate the cost of equity? Average   Marriot Lodging Contract Restaurant Kd (Cost of Debt) 10.02% 10.05% 8.30% 8.70% Wd (Weightage of Debt) 0.6 0.74 0.4 0.42 1-Tax 56% 56% 56% 56% Rf (Risk Free Rate) 8.72% 8.95% 6.90% 6.90% beta 1.28 1.24 1.58 0.87 Market Risk Premium 5.63% 5.63% 6.42% 6.42% Ws (Weightage of Equity) 0.4 0.26 0.6 0.58 Ks (Cost of Equity) 15.95% 15.93% 17.03% 12.47% WACC 9.75% 8.31% 12.08% 9.28%

14. How did you measure Marriott's cost of debt?   Marriot Lodging Contract Restaurant Debt Rate Premium above Government 1.30% 1.10% 1.40% 1.80% US Government Interest Rate 8.72% 8.95% 6.90% 6.90% Cost of Debt 10.02% 10.05% 8.30% 8.70%

15. Arithmetic or Geometric Averages to measure rates of return? Why? Arithmetic Average = (-37.5% + 60%)/2 = 22.5% Geometric Average = √(62.5)(1.60) - 1 = 0% Consideration: Geometric average considered volatility of return. (Exhibit-4) Geometric average is better to be used for historic data. Year-0 Year-1 Year-2 $80 $80 $50 R1 = (($50-$80)/$80)*100 = -37.5% R2 = (($80-$50)/$50)*100 = 60% R = (($80-$80)/$80)*100 = 0%

16. What type of investments would you value using Marriott's WACC? Geometric Average   Marriot Lodging Contract Restaurant Kd (Cost of Debt) 10.02% 10.05% 8.30% 8.70% Wd (Weightage of Debt) 0.6 0.74 0.4 0.42 1-Tax 56% 56% 56% 56% Rf (Risk Free Rate) 8.72% 8.95% 6.90% 6.90% beta 1.28 1.24 1.58 0.87 Market Risk Premium 5.63% 5.63% 6.42% 6.42% Ws (Weightage of Equity) 0.4 0.26 0.6 0.58 Ks (Cost of Equity) 15.95% 15.93% 17.03% 12.47% WACC 9.75% 8.31% 12.08% 9.28% Since WACC for Lodging is lower, its NPV will be HIGHER. So, comparing to other line of business, investment in Lodging is profitable. But, there is a possibility of reduction in portfolio diversification.

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