Fm - Marriott

Marriott Corporation: Cost of Capital

Discussion Question

Investors look at the company as a wholeCompany as a whole has one cost of capital

Then why divisional cost of capital is computed?

Product Line

Proportion of

Sales 1987

Proportion of

Profit 1987

Lodging 41% 51%

Contract Services 46% 33%

Restaurants 13% 16%

Errors in the hurdle rate can lead to incorrect decisions about the type and amountof investment, trigger or fail to trigger repurchases, and affect incentive compensation

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987Sales 1174.10 1426.00 1633.90 1905.70 2458.90 2950.50 3524.90 4241.70 5266.50 6522.20EBIT 107.10 133.50 150.30 173.30 205.50 247.90 297.70 371.30 420.50 489.40Interest expenses 23.70 27.80 46.80 52.00 71.80 62.80 61.60 75.60 60.30 90.50Income before income taxes 83.40 105.70 103.50 121.30 133.70 185.10 236.10 295.70 360.20 398.90Income taxes 35.40 43.80 40.60 45.20 50.20 76.70 100.80 128.30 168.50 175.90Income from continuing operations 48.00 61.90 62.90 76.10 83.50 108.40 135.30 167.40 191.70 223.00Net income 54.30 71.00 72.00 86.10 94.30 115.20 139.80 167.40 191.70 223.00Funds from continuing operations 101.20 117.50 125.80 160.80 203.60 272.70 322.50 372.30 430.30 472.80

Total assets 1000.30 1080.40 1214.30 1454.90 2062.60 2501.40 2904.70 3663.80 4579.30 5370.50Total capital 826.90 891.90 977.70 1167.50 1634.50 2007.50 2330.70 2861.40 3561.80 4247.80Long-term debt 309.90 365.30 536.60 607.70 889.30 1071.60 1115.30 1192.30 1662.80 2498.80Shareholders' equity 418.70 413.50 311.50 421.70 516.00 628.20 675.60 848.50 991.00 810.80Long-term debt / total capital 37.48% 40.96% 54.88% 52.05% 54.41% 53.38% 47.85% 41.67% 46.68% 58.83%

EPS - continuing operations 0.25 0.34 0.45 0.57 0.61 0.78 1.00 1.24 1.40 1.67Net income 0.29 0.39 0.52 0.64 0.69 0.83 1.04 1.24 1.40 1.67Cash dividends 0.03 0.03 0.04 0.05 0.06 0.08 0.09 0.11 0.14 0.17Shareholders' equity 2.28 2.58 2.49 3.22 3.89 4.67 5.25 6.48 7.59 6.82Market price (year-end) 2.43 3.48 6.35 7.18 11.70 14.25 14.70 21.56 29.75 30.00Shares outstanding (millions) 183.60 160.50 125.30 130.80 132.80 134.40 128.80 131.00 130.60 118.80Return on average shareholders' equity 13.90% 17.00% 23.80% 23.40% 20.00% 20.00% 22.10% 22.10% 20.60% 22.20%The company 's theme park operations were discontinued in 1984

Funds from continuing operations consists of income from contnuing operations plus deprecaition, deffered incoem taxes, and other items not currently affecting working capital

Total capital represents total assets less current liabilities

1982 1983 1984 1985 1986 1987LodgingSales 1091.70 1320.50 1640.80 1898.40 2233.10 2673.30Operating profit 132.60 139.70 161.20 185.80 215.70 263.90Identifiable assets 909.70 1264.60 1786.30 2108.90 2236.70 2777.40Depreciation 22.70 27.40 31.30 32.40 37.10 43.90Capital expenditure 371.50 377.20 366.40 808.30 966.60 1241.90Contract servicesSales 819.80 950.60 1111.30 1586.30 2236.10 2969.00Operating profit 51.00 71.10 86.80 118.60 154.90 170.60Identifiable assets 373.30 391.60 403.90 624.40 1070.20 1237.70Depreciation 22.90 26.10 28.90 40.20 61.10 75.30Capital expenditure 127.70 43.80 55.60 125.90 448.70 112.70RestaurantsSales 547.40 679.40 707.00 757.00 797.30 879.90Operating profit 48.50 63.80 79.70 78.20 79.10 82.40Identifiable assets 452.20 483.00 496.70 582.60 562.30 567.60Depreciation 25.10 31.80 35.50 34.80 38.10 42.10Capital expenditure 199.60 65.00 72.30 128.40 64.00 79.60

1982 1983 1984 1985 1986 1987LodgingSales 100.00% 120.96% 150.30% 173.89% 204.55% 244.87%Operating profit 100.00% 105.35% 121.57% 140.12% 162.67% 199.02%Identifiable assets 100.00% 139.01% 196.36% 231.82% 245.87% 305.31%Depreciation 100.00% 120.70% 137.89% 142.73% 163.44% 193.39%Capital expenditure 100.00% 101.53% 98.63% 217.58% 260.19% 334.29%Contract servicesSales 100.00% 115.96% 135.56% 193.50% 272.76% 362.16%Operating profit 100.00% 139.41% 170.20% 232.55% 303.73% 334.51%Identifiable assets 100.00% 104.90% 108.20% 167.26% 286.69% 331.56%Depreciation 100.00% 113.97% 126.20% 175.55% 266.81% 328.82%Capital expenditure 100.00% 34.30% 43.54% 98.59% 351.37% 88.25%RestaurantsSales 100.00% 124.11% 129.16% 138.29% 145.65% 160.74%Operating profit 100.00% 131.55% 164.33% 161.24% 163.09% 169.90%Identifiable assets 100.00% 106.81% 109.84% 128.84% 124.35% 125.52%Depreciation 100.00% 126.69% 141.43% 138.65% 151.79% 167.73%Capital expenditure 100.00% 32.57% 36.22% 64.33% 32.06% 39.88%

1982 1983 1984 1985 1986 1987Sales / AssetsLoding 120.01% 104.42% 91.85% 90.02% 99.84% 96.25%Contarct Services 219.61% 242.75% 275.14% 254.05% 208.94% 239.88%Restaurants 121.05% 140.66% 142.34% 129.93% 141.79% 155.02%Operating Profit / SalesLoding 12.15% 10.58% 9.82% 9.79% 9.66% 9.87%Contarct Services 6.22% 7.48% 7.81% 7.48% 6.93% 5.75%Restaurants 8.86% 9.39% 11.27% 10.33% 9.92% 9.36%Operating Profit / AssetsLoding 14.58% 11.05% 9.02% 8.81% 9.64% 9.50%Contarct Services 13.66% 18.16% 21.49% 18.99% 14.47% 13.78%Restaurants 10.73% 13.21% 16.05% 13.42% 14.07% 14.52%Depreciation / SalesLoding 2.08% 2.07% 1.91% 1.71% 1.66% 1.64%Contarct Services 2.79% 2.75% 2.60% 2.53% 2.73% 2.54%Restaurants 4.59% 4.68% 5.02% 4.60% 4.78% 4.78%

Marriott’s Debt

Market Value-Target Leverage Ratios and Credit Spreads for

Marriott and its Division

Debt % in

Capital

Fraction of

Debt at Floating

Fraction of

Debt at Fixed

Debt Rate Premium

Above Govt.

Marriott 60% 40% 60% 1.30%

Lodging 74 50 50 1.10

Contract Services 40 40 60 1.40

Restaurants 42 25 75 1.80

Interest Rates

US Govt. Interest Rates, April 1988

Maturity Rate

30-year 8.95%

10-year 8.72

1-year 6.90

Leavered and Unleavered Beta

ED

* t)- 1(+1

β=β

]ED

* t)- 1(+1[β=β

LU

UL

Marriott’s WACC

Equity Beta D/V Revenue D/E Tax Rate Unlevered Beta Weighted Unlevered BetaLodgingHilton Hotels 0.88 14.00% 0.77 16.28% 40% 0.80 0.184Hoilday Corporation 1.46 79.00% 1.66 376.19% 40% 0.45 0.222Ramada Inns 0.95 65.00% 0.75 185.71% 40% 0.45 0.101La Quinta Motor Inns 0.38 69.00% 0.17 222.58% 40% 0.16 0.008Total …. …. 3.35 …. …. …. 0.515RestaurantsChurch’s Fried Chn. 0.75 4.00% 0.39 4.17% 40% 0.73 0.039Collin Foods 0.60 10.00% 0.57 11.11% 40% 0.56 0.044Frisch’s 0.13 6.00% 0.14 6.38% 40% 0.13 0.002Luby’s 0.64 1.00% 0.23 1.01% 40% 0.64 0.020McDonald’s 1.00 23.00% 4.89 29.87% 40% 0.85 0.570Wendy 1.08 21.00% 1.05 26.58% 40% 0.93 0.135Total …. …. 7.27 …. …. …. 0.811

Marriott’s WACCMarriott Lodging Restaurant Contract Services

US Governement Interest Rate - 30-Year 8.95% 8.95% …. …. Table BUS Governement Interest Rate - 10-Year …. …. 8.72% 8.72% Table BRiskless Rate 8.95% 8.95% 8.72% 8.72% Page 4Target D/ V 60% 74% 42% 40% Table ATarget D/ E 150% 285% 72% 67% Table AActual D/ E 70% …. …. …. Exhibit 1Levered Equity Beta 0.97 …. …. …. Page 5Unlevered Equity Beta 0.68 0.52 0.81 1.00 Estimated from comparable firmsRestimated Levered Equity Beta at Target Debt 1.30 1.39 1.16 1.40 EstiamtedRisk Premium 7.43% 7.43% 7.43% 7.43% (12.01%-4.58%) Exhibit 4, and Exhibit 4Cost of Equity 18.59% 19.31% 17.36% 19.13% EstimatedCost of Debt 10.25% 10.05% 10.52% 10.35% Table A and BTax Rate 40% 40% 40% 40% Estimated from exhibit 1WACC 11.13% 9.48% 12.72% 13.96% EstimatedIdentifiable Assets (1987) 4582.70 2777.40 567.60 1237.70Proportion of Identifiable Assets 100.00% 60.61% 12.39% 27.01%

Insight

Using single rate imposes a systematic bias on project selectionValuation error caused by using a single discount rate result in riskier, less profitable investment projects