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Marriott: Cost of Capital

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Marriott Case

Marriott Corporation, an American firm, has 3 major lines of business: lodging, contract service and restaurants. Its growth objective is to remain a premier growth company. The four components of its financial strategy are consistent with this growth objective for the reasons:

Manage rather than own hotel assets: Marriott sold its hotel assets to limited partners to reduce assets and thus, it can increase ROA and thereby increase potential profitability.

Invest in projects that increase shareholders’ value: the discounted cash flow techniques to evaluate potential investments allow the company to invest only in profitable projects. Therefore, it can maximize the use of its cash flow to gain profits.

Optimize the use of debt in the capital structure: because firms with lower percentage of debt have higher value, Marriott uses this strategy to increase its value and thereby increase it profitability.

Repurchase undervalued shares: By buying back its undervalued shares, Marriott can increase PE ration when needed and can make its investors’ holdings more valuable because share prices will increase (increase in ROE). It also can appease investors and avoid pressure to increase dividend, thereby it can use its retained earnings to invest more in profitable projects. This strategy means that Marriott are confident in its future performance.

Marriott use the Weighted-Average-Cost-of Capital (WACC) method to measure the opportunity cost for investments.

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

where D and E are the market values of the debt and equity respectively; rD is the pre-tax cost of debt; rE is the after-tax cost of equity; V is the firm value (V=E+D); and t is the corporate tax. This method is applied for Marriott as the whole corporation and for each of its three lines of business.гЂЂWACC is calculated based on its financial data of 1987 provided in the case.

1. Calculate the debt cost rD

- According to the summary of operation (exhibit 1) t = income taxes/income before income taxes = 175.9/398.9 = 44%

- According to Table A, D/V = 60%. Therefore, E/V = 40%

- Because Marriot is a high-quality rate company and it could pay a spread above the current government bond rates:

rD = S fraction of debt at floating for each line x US government interest rate + S fraction of debt at floating for each line x debt rate premium above government for each line

rD = [0.5x8.72 + 0.4x6.9 + 0.25x6.9] + [0.5x1.1 + 0.4x1.4 + 0.25x1.8] = 0.1041

Because lodging had long useful life, the long term interest rate for lodging line should be the interest rate of 10-year maturity bonds (8.72%). Meanwhile, restaurants and contract services are short term investment so the interest rate for these lines should be the interest rate of 1-year maturity bond (6.9%). гЂЂгЂЂ

2. Calculate the riskless

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