Sean Park (260497399)
James Chan (260518302)
Rona Hunter (260518074)
Sean Stapley (260524697)
Fahad Syed (260528433)
Case Analysis: Marriott Corporation: The Cost of Capital (Abridged)
Marriott Corporation must determine the appropriate annual hurdle rates at each of the firm’s three divisions in order to accurately value and determine whether they should partake in an investment project.
Maintain the current capital structure
Change their current capital structure by implementing target debt and equity ratios
Marriott should apply the target capital structure in order to minimize costs and maximize profitability for their firm.
I) COMPANY BACKGROUND
Marriott Corporation started to operate in 1927 where it only had one line of business; a root beer stand. Over the next 60 years, J. Willard Marriott’s business was completely transformed and grew into one of the leading lodging and food services companies in the United States. In 1987, Marriott had three major lines of business: lodging, contract services, and restaurants.
Marriott follows a high growth strategy in which they are pursuing shareholder value-creating projects within their business divisions. In order to achieve their objective, the company designed its policies to aggressively develop appropriate opportunities for the expansion and growth of the different business divisions. Furthermore, to determine the attractiveness of investment projects, Marriott is currently discounting expected cash flows at a hurdle rate (minimum rate of return that must be met for the firm to proceed with a project) for each division.
II) PROBLEM ANALYSIS
Marriott’s Financial Strategy
We will first examine their current financial strategy to determine whether they are consistent with the firm’s growth objective:
A. Manage Rather Than Own Hotel Assets
This is an accounting maneuver which lowers their accounting assets on the books; increasing their profitability ratio such as return on assets. As a result, Marriott appears more attractive for investments.
B. Invest in Projects That Increase Shareholder Value
This ensures the company’s return on invested projects which as a result, leads to profitability for the firm.
C. Optimize the Use of Debt in the Capital Structure
By reducing debt, Marriott will be able to decrease their debt to equity ratio, making their firm more attractive to new and existing shareholders. Shareholders will generally prefer lower debt levels as this lowers the risks of financial distress costs.
D. Repurchase Undervalued Shares
They are profiting off undervalued shares and increasing earnings per share which may increase share price as a result of increase in demand. However, in the long run, this does not guarantee the increase of shareholder value. We have to consider that institutional investors may interpret the stock buyback as a sign that the company does not see any opportunities for growth; lowering shareholder value.
Conclusion: Marriott’s financial strategy aligns with their growth objective, however, share repurchase may not be in their best interest.
Overview of Weighted Average Cost of Capital (WACC)
Marriott is currently measuring its hurdle rates using the WACC. The accuracy of the hurdle rate is extremely important due to their substantial impact on the anticipated net present value of project. Currently, Marriott does not implement the optimal capital structure as suggested by their current policies for debt (interest-coverage ratio) and equity capacity (warranted equity value). Under WACC, Marriott must implement target equity and debt ratio in order to minimize costs; essentially optimizing the capital structure of the firm. We will be calculating the WACC for Marriott as a whole to determine the optimal capital structure, and for each division since the cost of capital varies among each division.
Assumptions for Marriott – (Appendix A)
Corporate Tax Rate (44%)