Founded in 1927, Marriott Corporation has become one of the leading food service companies in the United States. As of 1987, Marriott recorded a profit of $233 million on sales of $6.5 billion and retained a high sales growth rate of 24%. Marriott runs on three major lines of business lodging, contract services, and restaurants. Lodging division which includes 361 hotels generated 41% of 1987 sales and 51% profits. Contract services division which provides food and services management generated 46% of 1987 sales and 33% of profits. Lastly, the restaurant division generated 13% of 1987 sales and 16% of profits.
Marriott had been successful with its financial strategy which focused on the four key elements. First, Marriott managed the hotel assets rather than owning them. Marriott sold the hotel assets to limited partners while still retaining operating control under the long-term management contract. Second, Marriott invested in projects that increased shareholder value. The company used discount cash flow techniques to evaluate projects that could be profitable. Third, Marriott optimized the use of debt in the capital structure. The company determined the optimal amount of debt based on its ability to service the debt. As of 1987, Marriott had $2.5 billion debt which accounted for 59% of its capital. Lastly, Marriott repurchased undervalued shares. On regular bases, Marriott calculated a “warranted equity value” of its common shares and purchased the stocks that fell below the value. Marriott believed the repurchases of those shares were better uses of the company capital than acquisitions or owning real estate.
In April 1988, the vice president of project finance, Dan Cohrs, was preparing his annual recommendations for the discount rates of Marriott’s three divisions. The investment projects would be selected by discounting them with appropriate cash flows by the appropriate discount rates for each three division. The case study analyzed the WACC for the Marriott Corporation and the cost of capital for each division: lodging, contract services, and restaurants.
Weighted Average Cost of Capital
In order to calculate the Weighted Average Cost of Capital (WACC) of Marriott Corporation, we must use the formula: (D/D+E) (1-t) x Rd + (E/D+E) x Re. We will be using a tax rate of 44.1% which was based off the 1987 figures of income tax and income before income taxes as seen in Exhibit 1.Using the same table, we know that the total assets in 1987 was 5,370.5 million dollars and we also know from Table A that from this value, the percentage of debt that is equity is 60% while the percentage of debt that is debt is 40%. Before we can plug in the numbers we must first determine the cost of debt and the cost of equity:
Cost of Debt:
The formula for the cost of debt can be written as (Rf + credit risk rate)(1-t), where t is the corporate tax rate and Rf is the risk free rate. Plugging in the numbers we get:
Rd = 0.013+0.0895 = 0.1025
Where, 0.013 = Debt Rate Premium Above Government Interest Rate 0.0895 = 30 Year U.S. Government Interest Rate
Thus the cost of debt (Rd) is 0.1025
Cost of Equity:
In order to calculate the Cost of Equity, we must first un-lever the equity beta of Marriott Corporation in 1987.
Un-Levered Equity Beta = 0.97/(1+(1-0.441)*60/40) = 0.5276
Where, 0.97 = Marriott Corporation’s Equity Beta (Year 1986-1987) Thus the new un-levered equity beta is 0.5276
Re = -0.0269+0.5276(0.0792) = 0.0149
Where, -0.0269 = Long-Term U.S. Government Bond Return (Year 1987) 0.5276 = Un-Levered Equity Beta (Year 1987)
0.0792 = Spread between S&P 500 Composite Return and Long-Term U.S. Government Bond Return (Year 1987) Thus the cost of equity (Re) is 0.0149
We used the geometric averages to measure rates of return because the geometric...