EXECUTIVE SUMMARY
The purpose of this report is to examine the effectiveness of using divisional hurdle rates to evaluate projects with different risk profiles. The benefits of using risk specific hurdle rates are that projects will be evaluated using their appropriate risk and return payoffs. This is essential because each division in Marriott has a different risk structure and needs to be evaluated accordingly. Accurate hurdle rate implementation will help Marriott achieve its four financial strategies;
1) Manage Rather than own Assets – cost of capital would be used to determine if owning hotel assets is value added or not, this requires the lodging divisions hurdle rate.
2) Invest in Projects that Increase Shareholder Wealth – accurate division specific hurdle rates apposed to a firm wide rate is required to make sure optimal value added decisions are made with regard to project selection.
3) Optimize Use of Debt in Capital Structure – Marriott currently use an interest coverage ratio. But a cost of capital approach using the firm wide hurdle rate could be used to evaluate the effects of changing the interest coverage ratio on firm value.
4) Repurchase Undervalued Shares – The firms cost of capital is required to calculate the warranted share value to determine if the share value is currently under valued, triggering a stock buy back.
Calculating the weighted average cost of capital requires evaluating each division as a separate entity to determine the cost of debt, cost of equity and the debt capacity. In the calculations for the cost of debt, a corporate tax rate of 34%, various risk free rates depending on asset life and differing debt premium based on riskiness were used. The cost of equity involved using the CAPM model and manipulations of the betas. A market risk premium of 5% was calculated using historical data. Marriott’s beta was given in the data, with lodgings and restaurants using comparable firm’s data, then contract services were backed out using the fact that Marriott’s beta is the weighted average of all three division’s betas. These betas were then unleveraged at their current debt to equity ratios and re-leveraged at their target debt to equity estimates. The cost of debt and the cost of equity is then combined at the target ratios to give the weighted average cost of capital for Marriott and its three divisions.
1.0 INTRODUCTION
This reports purpose is to assist Marriott with their annual re-evaluation of hurdle rates. Marriott Corporation requires four hurdle rates to be estimated, a firm wide rate and three divisional rates as divisions within the company face different risk exposures. The advantage of calculating and implementing correct hurdle rates is that value destroying decisions will be avoided. All steps in calculations are explained and justified to show how accurate estimates have been achieved. The hurdle rates will help Marriott achieve its four financial strategies and growth objective.
Marriott Corporation is a hospitality company that operated from 1927. Marriott has three major lines of business, which are lodging, contract service and restaurant. Lodging operations mainly include hotels; it has both full-service, high quality accommodation and high turnover budget quality. Lodging was the most profitable business line in 1987. Contract services provide food and food service management to health-care and educational institutions and corporations. It also provides airline catering and airline services through its Marriott In-Flite Service and host international operations. In addition to providing accommodations and various contract services, Marriott also operate restaurants based in the fast food industry.
2.0 FINANCIAL STRATEGIES
Marriott Corporation has four finical strategies to help achieve its growth objective. The following discussions explain each of the financial strategies and how they achieved.
2.1 Key element 1: Manage rather than own hotel assets:
In 1987, Marriott developed more than $1 billion worth of hotel properties, making it one of the ten largest commercial real estate developers in the US. With a fully integrated development process, Marriott identified markets, created development plans, designed projects, and evaluated potential profitability. After development, hotel assets are sold to limited partners, while operating control is retained under long-term management contracts. Management fees typically equalled 3% of revenue plus 20% of the profit before tax and deprecation. This strategy would support Marriott’s holding of larger cash balances in hand. Marriott sells its hotels in order to use the cash to invest in other projects with higher returns rather than owning hotel assets. This strategy provides a higher level of growth in the lodging division.
2.2 Key element 2: Invest in projects that increase shareholder value:
The company uses market based discounted cash flow techniques to evaluate potential investments. Projects are only accepted that are expected to add value to the firm after being discounted at the appropriate hurdle rate. A hurdle rate is determined by using market interest rates, project risk and estimates of risk premiums. They then evaluate potential projects by using the discounted cash flow and only choose to invest in projects with positive NPV’s at the hurdle rate.
2.3 Key element 3: Optimize the use of debt in the capital structure:
In 1987, Marriott had about $2.5 billion of debt, making up 59% of its total capital. The optimal level of debt can minimize Marriott Corporations overall WACC. Since Marriott’s EBIT is growing, it uses a target interest coverage ratio, targeting its optimal debt rating rather than minimizing WACC. Marriott’s history shows that it has been successful at this use of debt to grow, and it has maintained a bond rating of A. The firm has to be careful that its bond rating does not slip into speculative grade in a recession. It is possible Marriott may be able to exploit further tax advantages from the use of debt if they were to adopt a policy of minimizing WACC directly.
2.4 Key element 4: Repurchase undervalued shares:
Marriott regularly calculates a “warranted equity value” for its common shares. It is calculated by discounting the firm’s equity cash flows by its equity cost of capital. The firm is committed to repurchasing its stock when the stock price is under its warranted value. This acts like an insurance policy for the shareholders, as the stock prices won’t fall far below the warranted equity value. Consideration of the buyback should only arise from a lack of positive NPV projects. The company strongly believes that repurchasing undervalued shares is a better use of its cash flow and debt capacity.
3.0 THE IMPORTANCE OF HURDLE RATES
Hurdle rates are an integral part of most financial analysis within a firm; as such it is extremely important they are correct. Incorrect hurdle rates will potentially lead to miss leading analytical results, causing sub optimal decision making. It is helpful to understand the importance of correct hurdle rates before they are calculated and used. The correct hurdle rate must also be used in different settings; otherwise value destroying decisions may be made.
Imprecisely estimating hurdle rates will give inaccurate financial outputs. For example, if the hurdle rate was miscalculated by one percent; say 12.12% instead of 12%. The net present value of a projects cash flow will fall by approximately one percent as well. The above example shows only minor miss-estimation; a larger error could result in a positive net present value project appearing negative or visa versa.
Using the appropriate hurdle rate for a particular task is essential in obtaining accurate results. This is the basis behind Marriott’s calculations of separate firm wide and divisional hurdle rates. When using a hurdle rate to undertake financial analysis on an asset, the hurdle rate represents the expected compensation for the risk undertaken by holding the asset. Consequently assets with different risk levels must be valued using different hurdle rates. The firm wide hurdle rate represents the compensation for the average risk level of all divisions combined, divisions within Marriott have different risk profiles and hence we require separate divisional rates. Also worth noting is that projects under a divisions umbrella all face similar risks to that division, so can be valued at that divisions hurdle rate.
To represent the consequence of using a firm wide rate to evaluate divisional specific projects, consider the security market line; which gives a fair expected return on an asset given a specific non-diversifiable risk level[1]. Furthermore, consider a firm made up of only a risky division and a less risky division. The firm’s risk profile is a weighted average of the two divisions risk levels. If the less risky division is considering a project that has the divisions typical risk structure and an expected return above the security market line but bellow the firm wide hurdle rate, the project will be rejected. This is the wrong decision as accepting this project would have added value to the firm. Conversely a project in the riskier division, with a return above the firm wide hurdle rate but bellow the security market line will be accepted although it will destroy firm value as it does not make an adequate return given its risk level.
As illustrated, the result of using hurdle rate in the wrong situation will cause the firm to destroy value through incorrect project evaluations. Overtime if the firm uses it’s firm wide rate to evaluate all projects it will accept riskier projects, increasing its overall underlying risk structure. An appropriate hurdle rate for the risk of a project must be used, justifying calculating separate divisional and firm wide rates. To do this the risk level of individual divisions must be known, or estimated.
A project within a division involves the following risks: project specific, competitive, industry, international and market or macro factors. Since Marriott is a large publicly traded company its marginal investor is assumed to be well diversified. The investor will only be concerned with the market risk of any project, as they cannot diversify this away. Therefore the risk we are concerned with for each division is its exposure to market risk. Factors affecting the exposure include; the nature of the line of business the division operates in, its size, the stability of earnings and other typical factors. Marriott evaluates each division as if they were a separate entity to determine their cost of equity, cost of debt and debt capacity. Equity is analysed using the capital asset pricing model and debt using interest coverage based approaches.
When different hurdle rates are used will depend on the risk structure of the asset being evaluated. The firm wide rate should be employed when analysing assets with the overall firms risk profile, such as in the following cases; when collectively analysing all investments to determine if the company is making an adequate return on the whole, to find the optimal debt level and to value the firm currently. The divisional rate should be employed when calculating a division’s value, or when evaluating division specific projects with typical divisional risk exposures.
4.0 COST OF CAPITAL CALCULATIONS
4.1 COST OF DEBT
To calculate the cost of capital, the cost of debt, cost of equity and debt to equity weights are required. The risk free rate, corporate tax rate and debt premium are needed to determine the cost of debt for Marriott and its divisions.
4.1.1 Risk free rate
The risk-free rate is a theoretical return that is earned with perfect certainty. For an asset to be a risk-free investment there are two conditions that must to met, this is; no default risk and no reinvestment risk. For Marriott as a whole the 30 year Government bond rate of 8.95%[2] was selected as the risk-free proxy because the firm’s assets have a long life. The Lodging division has long term investments, so the same 30 year rate of 8.95% as above was used. Assets of the Restaurants and Contract Service divisions have shorter useful lives, so a middle term 10 year Government bond rate of 8.72% is used as the risk free rate.
4.1.2 Tax rate
The historical tax rate can be calculated as income tax divided by income before tax. Based on the EXHIBIT 1, the tax rate varied in the range of 34% to 46.5% over the last 10 years. The historical range is out of date as structural changes in the tax system occurred after the 1987 stock market crash. In this case, the most suitable tax rate is 34%, as this was the highest marginal corporate tax rate in U.S in 1988. This isn’t a perfect estimate as we don’t know if the industry specific rates vary from the standard rate.
4.1.3 After-tax Cost of debt
Marriott applied its interest coverage based financing policy to each of its divisions. It also determined for each division the fraction of debt that should be floating debt based on the sensitivity of the division’s cash flows to interest rates changes. The difference in Marriott’s cost of debt and the equivalent government risk free rate is known as the debt premium. To derive Marriott’s cost of debt, the dept premium of 1.3% is added to the risk free rate of 8.95% which gives a cost of debt of 10.25%[3]. Considering the tax benefit of debt, the after tax cost of debt is 6.765% for Marriott, 6.633% for Lodging, 6.942% for Restaurants and 6.679% for Contract Services3.
4.2 COST OF EQUITY
There are five major steps in calculating the cost of equity for Marriott Corporation. These are; working out the current leveraged betas for Marriot, as a whole, and its three divisions, finding each divisions asset weights, unleveraging these betas at their current debt to equity levels, leveraging these betas back up at their target debt to equity ratios, and finally finding the market risk premium to complete the cost of equity equation.
4.2.1 Marriott’s beta
To find Marriot’s beta for the whole company, there is data provided on the historical leveraged beta and also the current debt to asset ratio[4]. The debt to asset ratio is defined as the book value of debt divided by the sum of the book value of debt and the market value of equity. It is a simple step to convert this into a debt to equity ratio[5]. For all the calculations in this section the corporate tax rate will be 34%. Putting all of this information into the unleveraged beta formula[6] , Marriott Corp. comes up with an unleveraged beta of 0.76[7]. It is assumed that this unleveraged beta has been used in the past to evaluate all projects, regardless of the project’s risk profile or the division in which the project is to be implemented.
4.2.2 Comparable betas
Provided in the same table is a selection of comparable firms in both the lodging and restaurant industries. The information provided includes leveraged betas and debt to asset ratios for each of these comparable firms. Lodging operates both premium and budget quality services, both internationally and in the U.S. The mix of firms in the industry comparisons reflects this; Hilton Hotels Corp. is in the high price, low room turnover market and Ramada Inns, Inc. is in the low price, high room turnover market. This gives a good proxy to evaluate the lodging division in Marriot. Restaurants on the other hand, primarily operate in the fast food industry located in the U.S. The blend of firms given as comparisons reflects this; McDonalds, Wendy’s and Kentucky Fried Chicken are all in the high patronage, low price food market and reflect the industry that the restaurants division operates in. To figure out the two divisions’ leveraged betas and debt to asset ratios, an equally weighted average formula[8] is used. For the lodging division, the average industry beta is 1.09 and the average debt to asset ratio is 0.57[9]. For the restaurant division, the average beta is 1.08 with an average debt to asset ratio of 0.11[10]. For this information to be valid in calculating the unleveraged betas, the debt to asset ratios must be converted into debt to equity ratios. This means that the debt to equity ratio for lodgings is 1.31 and for restaurants is 0.12[11].
All of the necessary data has now been calculated to compute the unleveraged betas for both lodgings and restaurants. Again the 34% corporate tax rate is used. Substituting the data into the unleveraged beta formula[12], the unleveraged beta for lodgings is 0.58 and for restaurants it is 1.0[13].
4.2.3 Weightings
To find the unleveraged beta for contract services, the weights of each division within Marriott must be found. This can be computed using the identifiable assets in each division relative to the total identifiable assets in Marriot. Identifiable assets were used as the proxy for weightings because these are the assets that are solely used in each division and are not shared. Also, revenues or sales can distort the weightings data because if a division is small but has a huge profitability ratio, it will be biased upwards in the weightings. Marriot has supplied the data on identifiable assets[14] so weightings can be calculated easily[15]. Marriott’s unleveraged beta is the weighted sum of each division’s unleveraged beta[16]. As the weightings in all divisions and the unleveraged betas for Marriott, lodgings and restaurants are known, we can now back out the unleveraged beta for contract services. Making the unleveraged beta for contract services the subject of our weighted sum equation, contract services comes up with an unleveraged beta of 1.07[17].
4.2.4 Leveraged betas
For the betas to be used in the cost of capital equation they must be levered back up. Marriott has supplied their target debt to asset ratios and they are the ratios that will be used to lever up their betas[18]. The target debt to asset ratios are to be used because they are forward looking, long term goals of Marriott and any projects that are going to be evaluated, using the cost of capital, are going to be in the same time frame. Also the target levels are considered optimum given the risk structure of a division or the firm, so they best reflect the risk of the division or the firm. These target debt to asset ratios must be converted into debt to equity ratios. Again using a corporate tax rate of 34%, substituting the unleveraged betas and target debt to equity ratios into the leveraged beta formula, Marriot as a whole has a beta of 1.51, lodgings has 1.68, restaurants has 1.48 and contract services has 1.54[19].
Whole Firm
Divisions
Marriot
Lodging
Restaurants
Contract S.
D/ETarget
1.5
2.8462
0.7241
0.6667
βLeveraged
1.5144
1.6814
1.4800
1.5365
4.2.5 Risk Premium
To establish the cost of equity of each division and Marriott the only input in the capital asset pricing model left to calculate is the equity risk premium. The risk free rate used is the same as described in the cost of debt section, which depends on the asset life of each division. Marriott have been using historical observed risk premiums on the S&P500 to estimate the premium. To do this accurately there are three factors to consider; what time frame to measure over, which risk free rate to use and what averaging method to employ.
When increasing the timeframe in which the premium is measured over, there is a trade off between the number of observations and including structural changes in the market over the time period. The two best options with the available data are to measure the premium back to 1951 or back to 1976[20]. It is likely that too much structural change has occurred between 1951 and now (1988), distorting the underlying premium, as such measuring the premium back to 1976 is more appropriate. The effects of the 1987 stock market crash must also be taken into consideration as there was non-normal market conditions surrounding this event, for this reason 1987 and 1986 were omitted from premium calculations.
The premium should be measured as the returns on the S&P500 over the returns on long term government bonds. Long term government bonds are used as the risk free rate for reasons argued previously, that is because hurdle rates are used in long term evaluations and so a long term risk free rate is appropriate. To average the available data for the ten year period 1976 to 1985, a geometric average was used to avoid further upwards bias. This gave a risk premium of 4.97%[21], for simplicity 5% will be used. It is likely the premium would have changed after the 1987 stock market crash due to changes in investor risk aversion and the general risk level of the market, however this should revert over time.
4.2.6 Cost of Equity
Using the capital asset pricing model, the cost of equity for Marriott and all divisions can now be calculated[22]. Marriot has a cost of equity of 17.26%, lodging of 18.17%, Restaurants of 17.06% and Contract Services of 17.48%. The differences are a result of each division having varying exposures market risk as measured by beta.
4.3 COST OF CAPITAL
At this point we have all the inputs to calculate the firm wide and divisional costs of capital. Using the weighted average cost of capital the cost of capital for Marriot is 10.90%, for lodging it is 9.56%, Restaurants is 12.82% and Contract Services is 13.12[23].
5.0 CONCLUSION
It is hugely advantageous for Marriott Corp. to use precise hurdle rates to analyse both divisional and firm wide investments. Historically Marriott has used a single beta and debt to equity ratio to evaluate the profitability of each investment, regardless of that particular projects risk profile. There will be greater benefits to Marriott if they evaluate similar projects with a corresponding hurdle rate that reflects the risk and return profiles more accurately.
Using the correct hurdle rates will assist Marriott in achieving its four financial strategies:
1) Manage Rather than own Assets – cost of capital would be used to determine if owning hotel assets is value added or not, this requires the lodging divisions hurdle rate.
2) Invest in Projects that Increase Shareholder Wealth – accurate division specific hurdle rates apposed to a firm wide rate is required to make sure optimal value added decisions are made with regard to project selection.
3) Optimize Use of Debt in Capital Structure – Marriott currently use an interest coverage ratio. But a cost of capital approach using the firm wide hurdle rate could be used to evaluate the effects of changing the interest coverage ratio on firm value.
4) Repurchase Undervalued Shares – The firms cost of capital is required to calculate the warranted share value to determine if the share value is currently under valued, triggering a stock buy back.
There are three major steps in calculating the weighted average cost of capital for Marriott and its associated divisions, these are:
Cost of Debt
Cost of Equity
Cost of Capital
Using both the data that was supplied by Marriott and some extra market specific data, Marriott Corp. should use a WACC of 10.67%, lodgings should use 9.42%, restaurants should use 12.27% and contract services should use 11.36% to evaluate their specific investments.
6.0 RECOMMENDATIONS
Marriott Corporation will find it in their best interests to evaluate similar projects at a similar hurdle rate. Since within each division the investments have the same risk profile, separate hurdle rates should be used to evaluate projects in the separate divisions. This will increase the accuracy of Marriott’s analysis and will increase the profitability and efficiency of the whole corporation.
Reference
Retrieved January 5, 1999, from
www.shareholder.com/mar/downloads
www.nyse.com/about/listed/mar.
Internal Revenue Service. Corporation Income Tax Brackets and Rates,1909-2000
Received March 4, 2003
www.irs.gov/pub/irs-s01/02
W.Carl Kester, Richard S. Ruback and Peter Tufano: Case Problems in Finance, 12th edition, Irwin McGraw-Hill
Aswath Damodaran. (2001). Corporate Finance Theory(2nd edition).
Brealey, Myers and Marcus. (2004). Fundamentals of Corporate Finance (5th edition).
APPENDIX 1:
SECURITY MARKET LINE and FIRM and DIVISIONAL HURDLE RATES
Appendix 2
Pre-tax interest rate on borrowing for Marriott is 1.3% + 8.95% = 10.25%.
The tax rate is assumed at 34%.
After-tax Cost of debt = Pre-tax interest rate on borrowing * (1-tax rate)
= 10.25% * (1 – 34%)
= 6.765%
The debt premium for Marriott as a whole and three divisions was given by table A.
Result for the Marriott as a whole and three divisions
Marriott
Lodging
Restaurant
Contract services
Risk-free rate
8.95%
8.95%
8.72%
8.72%
Debt Premium
1.30%
1.10%
1.40%
1.80%
COD
6.765%
6.633%
6.942%
6.679%
Appendix 3
a) Debt / asset ratio Debt / equity ratio
Debt / asset = 41%
Debt / equity
b) Lodgings =
= 1.312
Restaurants =
= 0.1215
c) Weightings =
Marriott = 1
Lodgings =
= 0.6196
Restaurants =
= .1043
Contract Services =
` = .2761
Appendix 4
a)
b)
=0.7610
c) Lodgings =
= 0.5841
Restaurants =
= 1.001
d)
Marriot =
= 1.514
Lodgings =
= 1.681
Restaurants =
= 1.4710
Contract Services =
= 1.536
Appendix 5
a) Equally weighted average
b) Lodgings leveraged beta =
= 1.09
Lodgings comparable debt / asset ratio=
= 0.5675
c) Restaurants leveraged beta =
= 1.0816
Restaurants comparable debt / asset ratio =
= 0.1083
d)
e)
= 1.06610
APPENDIX 6:
RISK PREMIUM CALCULATION
1976-1980 arithmetic average; 12.86%
1981-1985 arithmetic average; -2.36%
Geometric Average of Arithmetic Averages
**this premium is close to what we would expect from knowledge of implied premiums, so we are confident with employing it.
Appendix 7:
COST OF EQUITY CALCULATION
Marriott
Lodging
Restaurants
Contract Services
Risk Free, Rf
8.96%
8.96%
8.72%
8.72%
Beta, β
1.514
1.681
11.480
1.536
Risk Premium, (Rm-Rf)
5%
5%
5%
5%
Cost of Equity, Ke
16.522%
17.357%
16.120%
16.402%
Appendix 8:
COST OF CAPITAL CALCULATION
Marriott
Lodging
Restaurants
Contract Services
Cost of Debt
6.765%
6.663%
6.943%
6.679%
Cost of Equity
16.522%
17.357%
16.120%
16.402%
Target Debt/Assets
0.6
0.74
0.4
0.42
Cost of Capital
10.668%
9.421%
12.266%
11.361%
[1] See graphical representation of this scenario in appendix 1
[2] See table B
[3] See appendix 2
[4] See Exhibit 3
[5] See appendix 3a
[6] See appendix 4a
[7] See appendix 4b
[8] See appendix 5a
[9] See appendix 5b
[10] See appendix 5c
[11] See appendix 3b
[12] See appendix 4a
[13]See appendix 4c
[14]See exhibit 2
[15] See Appendix 3c
[16] See appendix 5d
[17] See appendix 5e
[18] See table A
[19] See appendix 4d
[20] See Exhibit 5, “Spreads between S&P500 Composite Returns and Bond Rates, 1926-1987.”
[21] See risk premium calculation in appendix 6
[22] See cost of equity calculations in appendix 7
[23] See cost of capital calculations in appendix 8
