1. How does Marriott use its estimate of its cost of capital? Does this make sense?
Marriott has defined a clear financial strategy containing four elements. To determine the cost of capital, which also acted as hurdle rate for investment decision, cost of capital estimates were generated from each of the three business divisions; lodging, contract services and restaurants. Each division estimates its cost of capital based on: Debt Capacity
Cost of Debt
Cost of Equity
All of the above are calculated individually for each of the three divisions, and this is a critical aspect due to the varying cost of debt in particular for each division. Marriott then calculate company wide cost of capital using weighted average of the individual divisions cost of capital. This is a very clever approach, particularly as we see that for example the lodging unit, has a 74% debt percentage in the capital structure, and the fact that Marriott use long term cost of debt for lodging (which in this case is close to Government debt 110 bps margin) demonstrates the low risk investors perceive this side of the business to have
We believe this approach is sound due to the difference in the cost of capital between the divisions being a function of the risk associated with the investments considered so this approach incorporates the fact that risk between the divisions varies.
Given this we believe the method chosen by Marriott is compliant with the “Marriott Financial Strategy” as the capital costing approach is due diligent and reflect the single entity risk (bottom-up) rather than an estimated top-down. We believe this approach enables Marriott to optimize the financial performance and in turn increase the shareholder value.
2. If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time?
Marriott's three divisions are very different in terms of business area, business risk and capital structure (debt capacity). The result is varying capital costs between the divisions. For instance Lodging has a significant lower cost of capital (WACC) than the Restaurant and even than the company as a whole. Using a single company-wide hurdle rate would create an uneven process in assessing investment opportunities across the divisions. In practical terms the accept/reject decision would not reflect the inherent business risk of the division, which could lead to investments being accepted, while they should have been rejected.
Given the WACC calculations in the following questions, we see there is a significant difference in the cost of capital between the different divisions varying from 8.85% (Lodging) to 12.11% (Restaurants)
Therefore, if we were to use one single corporate hurdle rate, we would assume in this instance that we would use the Marriott WACC of 10.01%, then we may reject an investment in ‘Lodging’ which would yield a positive NPV and vice versa, we may accept an investment opportunities in ‘Restaurants’ which potentially would yield a negative NPV.
Going back to the brief, we know that typically an increase in hurdle rate of 1% will decrease present value of project inflows by 1%.
If we were to then use one hurdle rate (10.01%) and take the lodging hurdle rate (8.85%) this would be an increase in WACC of 13.10% (lodging) and would therefore decrease PV of project inflows by the same 13.10% - so the effect of using a single rate is compounded, firstly it impacts the decision, and the PV due to the discount impact.
Over time a single hurdle rate (if consistently higher than the existing approach) would significantly hurt the performance of company as the approach could lead Marriott to reject (or accept) investment opportunities which should have been accepted (or rejected). This would destroy shareholder value.
3. What is Marriott’s Weighted Average Cost of Capital? What types of investments would you...
Please join StudyMode to read the full document