Marriott Corporation: the Cost of Capital (Abridged)

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Marriott Corporation: The Cost of Capital (Abridged)
Executive Summary: The case "Marriott Corporation: The Cost of Capital (Abridged)" focuses on an ideal opportunity to review the capital asset pricing model and the weighted average cost of capital through calculation of the cost of capital for Marriott as a whole. Dan Cohrs is faced with making recommendations for the hurdle rates at Marriott Corporation and its three divisions utilizing CAPM and WACC. This case illustrates how to calculate beta based on comparable companies and to lever betas to adjust for capital structure; the appropriate risk-less rate and market risk premium; the choice of time period to estimate expected returns and the difference between the geometric and the arithmetic average as a measure of expected returns. SYNOPSIS

Marriott Corporation began in 1927, and over the next 60 years, the company grew into one of the leading lodging and food service companies in the US. In 1987, the Marriott's annual report stated, "We intend to remain a premier growth company. Our goal is to be the preferred employer and provider, and the most profitable company". Marriott's profits were $223 million on sales of $6.5 billion. In April 1988, vice president of project finance at the Marriott Corporation, Dan Cohrs, must prepare annual recommendations for the hurdle rates at each of the firm's three divisions, including restaurant, lodging, and contract services, as well as Marriott Corporation as a whole. The company's restaurants, such as Roy Rogers and Hot Shoppes, provided 13 percent of 1987 sales and 16 percent of profits. Lodging operations included 361 hotels and more than 100,000 rooms, and generated 41 percent of 1987 sales and 51 percent of profits. Contract services provided food and services management to health-care and educational institutions and corporations, and accounted for 46 percent of 1987 sales and 33 percent of profits. It is important that Cohrs makes an appropriate recommendation for each division because hurdle rates influence project investment decisions. Cohrs is faced with 1) deciding which data he will use to calculate the rates and 2) calculating the weighted average cost of capital (WACC) with the little information given about the contract division and Marriott Corporation altogether. Cohrs recognized that the divisional hurdle rates at Marriott would have an impact on the company's financial and operating strategies. If hurdle rates decreased, Marriott's growth would hasten. The primary elements of Marriott's financial strategy were 1) managing rather than owning hotel assets, 2) investing in projects that increase shareholder value, 3) optimizing the use of debt in the capital structure, and 4) repurchasing undervalued shares. Managing hotel properties opposed to owning the properties creates greater value than property ownership. Investing in projects that increase shareholder value enhances the probability of growth in the market value of the firm. Optimizing the debt used in the firm's capital structure would typically result in a decrease in the firm's average cost of capital. Repurchasing the undervalue shares may result in a strong return on investment. The first step would be to determine the appropriate tax rate. The average of the tax rates for 1926 thru 1987 can be used as the tax rate for the corporation and its divisions. Each year's tax rate can be calculated using the tax amount divided by each year's income before tax. Note the following table in order to compute the Tax Rate calculations: Year Tax Rate (%) Year Tax Rate (%)

1978 42.39 1983 41.40
1979 41.47 1984 42.70
1980 39.22 1985 43.38
1981 37.26 1986 46.77
1982 37.54 1987 44.10
Average Tax Rate = 41.62%
In this case, use the effective tax rate in 1987 rather than the average tax rate in order to proxy for the tax rate, which is equal to income taxes in 1987 divided by taxable income in 1987, which is 175.9/398.9, or...
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