Investment and Debt Capacity

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Stock Repurchase
Repurchase of stock can be viewed in each of the following way: investment, financing, shareholder distribution and control issue. Repurchase of stock can be a way to use firm’s excess debt capacity. By doing so, firm can lower the cost of equity financing. If debt financing is more flexible and cheap, replace equity financing with debt financing is a good way to lower the weighted cost of capital. In this sense, such action is a financing issue because it controls the cost of financing. On the other hand, repurchase of stock can adjust shareholder distribution. If shareholders consist of most individual investors, they may require more dividends or other forms of profit sharing. Firm can repurchase stocks from such investors so that they can adjust their dividend policy. If management holds few shares of the company, they may lose their control over operating and strategy decisions. By repurchasing stocks, management could regain majority control over the company on strategic decisions. Finally, repurchase of stock is also an investment issue because it enables the firm to increase its return on equity by eliminating dilution effect. Higher return on equity will attract more favorable investors as well as better vendors. It has the same outcome of investing in businesses, so it can be viewed as an investment. Debt Capacity for Stock Repurchase

From Exhibit 5, we get the total debt of Marriott at the end of 1979. We define total debt as sum of short-term loan, current portion of long-term debt, senior debt and capital leases. The average market price of Marriott in 1979 was $14.9, and interest rate for Baa corporate debt was 12%. We assume that Marriott would repurchase stocks at price of $15 using 12% debt financing. Marriott used Adjusted EBIT over net interest as a measure for debt capacity, so we use such measure as well.

The table above shows the main assumptions we make in the analysis. Before the stock repurchase, EBIT adjusted/Net interest rate was 6.64, above the 5 times threshold Marriott set for itself. Because the net interest before repurchase was $27.8 million, we conclude that adjusted EBIT was $184.59 million.

In 1979, additional debt from repurchase was $159 million, making the total debt $538.83 million. Net interest after repurchase is the original net interest plus the 12% interest from new debt. Based on such analysis, the new adjusted EBIT/Net interest ratio is 3.94, which is lower than 5. So we conclude Marriott may not have enough debt capacity to finance the stock repurchase. We further perform a scenario analysis. Suppose Marriott had just enough debt capacity, which means new adjusted EBIT/Net interest ratio equals 5. We find that repurchase price should be $7.17 so that Marriott could utilize its debt capacity fully.

We conclude that a repurchase price under $7.17 is in fact transferring value to remaining group because they can share more future profits resulting from the concentrated equity. Yet a repurchase of $15 is way above $7.17, which means selling shareholders have more value because they are compensated with higher return. Owned vs Managed

Marriot has two options about the operation of hotel chains. First, it can own the hotel and enjoy the profit margin. Second, it can sell the hotel but retain management contracts so it controls the operation of such units. Following is the detailed decomposition of costs associated with two options. According to Exhibit 9, in 1978 the typical cost for a hotel room consists of improvement cost, furniture, fixtures and equipment cost, land cost, pre-opening cost and operating cost. For an owned hotel, Marriot had to pay the total cost for running the property, but if it is managed, Marriot only had operating cost because the buyer was responsible for the maintenance. In an attempt to emphasize more on return on invested capital rather than margins, Marriot sold some of their existing hotels and retained management...
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