Marriott Corporation’s Vice-President of Project Finance, Mr. Dan Cohrs has been tasked with determining appropriate hurdle rates for the three operating divisions in the upcoming year, 1988. The three operating divisions include lodging, contract services, and restaurants. The overall company strategy is to “remain a premier growth company”, which is evidenced in the previous year through sales growth of 24% return on equity of 22%. Mr. Cohrs has hired Limitless Financial Consulting to assist with the calculation of appropriate hurdle rates for Marriott Corporation.
J. William Marriott started the Marriott Corporation in 1927 as a root beer stand. Over the ...view middle of the document...
These rates also need to be updated annually as firm and market conditions constantly change. Marriott determines target debt levels for the company and each division based on interest coverage measures rather then a debt to equity ratio. This means that a change in income could result in an adjustment to approved debt levels.
Marriott has clearly defined its financial strategy to include the following four elements:
Manage rather than own hotel assets:
Marriott prefers to sell off its hotel assets to limited partners while retaining operating control as a general partner under a long-term management contract. This arrangement decreased the amount of cash tied up in capital investments and allowed Marriott to earn management fees, which normally include 3% of revenues and 20% of profits before depreciation and debt services. Typically the 3% fee covered overhead costs of operating the hotel and they collect a healthy 20% of profits after other investors earn a prescribed rate. As of 1987, Marriott operated almost $7 billion worth of syndicated hotels.
Invest in projects that increase shareholder value:
Discounted cash flow analysis based on a prescribed hurdle rate is used to evaluate potential investments. The hurdle rate is typically based on market interest rates, project risk, and estimates of market risk premiums.
Optimize the use of debt in the capital structure:
Marriott has decided that the amount of debt to be held in the capital structure will be based on its ability to service the debt. An interest coverage target is used to instead of a target debt-to-equity ratio. In 1987, Marriott held almost $2.5 billion worth of debt making up 59% of its total capital.
Repurchase undervalued shares:
Marriott has committed to repurchasing shares whenever the market price declines substantially below a prescribed ‘warranted equity value’. This warranted value is regularly calculated using several approaches. They are confident in this method and a gap between this value and the market price never results in an adjusted warranted value.
The following four objectives will be considered for further analysis, followed by a recommendation:
1) Calculating the Cost of Debt
2) Calculating the Cost of Equity
3) Calculating the Weighted Average Cost of Capital
4) Significance of Hurdle Rates
1) The capital asset pricing model (CAPM) is used to calculate the cost of equity.
2) The before tax cost of debt is calculated as the risk free rate plus a spread.
3) The weighted average cost of capital (WACC) is used to calculate hurdle rates.
4) A tax rate of 44% is used in calculations for Marriott Corporation.
5) Tax terms are assumed away when evaluating other firms because they are unknown.
6) The corporate WACC is not considered a weighted average of the divisional rates and therefore it will be calculated separately.
Cost of Debt
As mentioned before the before tax cost of debt is calculated as the risk free rate...