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How does Marriott create value for its shareholders?

1. Marriott operates via three lines of business: lodging, contract services and restaurants and its
operating strategy indicates its focus on high growth and profitability in these businesses.
2. Despite being in the cyclical hotel industry, Marriott reduced the operating risk by managing
rather than owning assets. This improves Return on Assets (ROA) ratio.
3. Every project had to meet the hurdle rate which was decided on the basis of market interest
rates, project risk and other risk premiums, failing which the project would not be implemented.
4. Cash flow forecasts and risk premiums were checked consistently to ensure that the underlying
assumptions were realistic.
5. Rather than Debt/equity ratio, Interest coverage ratio was used to determine the capital
structure. This was a prudent strategy from the perspective of shareholders as the debt level
was sensitive to the operating profits made by the company i.e. if the operating profits were
lower than expected, the debt level was pared accordingly. It can be seen that Marriott has
maintained a healthy Interest Coverage Ratio over the years.
Year Interest Coverage Ratio
1978 4.52
1979 4.80
1980 3.21
1981 3.33
1982 2.86
1983 3.95
1984 4.83
1985 4.91
1986 6.97
1987 5.41

6. Repurchasing undervalued shares had a positive signaling effect on the shareholders and was
anti-dilutive as the same earnings were distributed among fewer shareholders. Also, the
strategy was better than investing in risky acquisitions or unproductive real estate.

Why does it need hurdle rates?


1. Every project has an opportunity cost in terms of market interest rates that the company would
forego if it invested in the project.
2. Every project may have a different level of intrinsic risk probably because of uncertainty of
execution in different geographies or bigger timeline involved in executing the project.
3. Other risk premiums such as country risk premium are added to this rate.
4. Also, Marriott Corporation is planning to base incentive compensation on the hurdle rate.
Hence, if implemented, the employees’ incentive compensation would be based on the hurdle
rate of the division they belong to.

1
For what type of investment decisions should Marriott use its corporate WACC?
Its divisional WACCs?
1. Corporate WACC should be used when Marriott is being evaluated against its peers such as
Hilton Hotels, Ramada Inns etc with respect to profitability, solvency and valuation ratios by
prospective investors.
2. When the effectiveness of financial strategy (reducing the cost of debt) of Marriott is to be
evaluated over a period of time, corporate WACC is appropriate.
3. Divisional WACC is appropriate when a specific project belonging to one of the 3 divisions is to
be evaluated. The risks for projects belonging to a particular division are likely to be similar.
Also, the capital structure along with the nature of debt (short term vs long term, floating vs
fixed) varies between divisions due to the nature of the business. Hence, divisional WACC must
be used here.

What are the advantages and disadvantages of using a single corporate WACC?

Advantages:
1. Useful when we talk about the performance of Marriott as a whole company.

Disadvantages:
1. Inappropriate when investors wish to value a particular division separately.
2. Inappropriate when management wants to take a corporate restructuring decision with respect
to spin-off of a particular division.

What hurdle rate would you recommend for the lodging division? [For the
purposes of this case, assume a beta for Marriott debt of 0.15.]

The hurdle rate (WACC) for lodging division is determined using the equation:
WACC = wd x kd + we x ke ,

Where wd, we refer to the weights of debt and equity respectively and
kd, ke refer to cost of debt and cost of equity respectively

wd = 0.74, we = 0.26 (given)

kd (for fixed-rate debt) = 8.72% + 1.1% = 9.82%,


where 8.72% is the 10-year US government interest rate and 1.1% is the debt premium paid by lodging
division over the US government interest rate

t= 44.75% (assumed to be the average of the tax rates over the past three years)

Therefore, kd x (1-t) = 9.82 x (1-0.4475) = 5.43%

ke = risk free rate + beta x (market portfolio return – risk free rate)

2
= 8.72 + 0.15 x (12.01- 8.72)
= 9.21%

Assumptions:
The period 1926-1987 has been used as proxy for market portfolio return
10-year US government interest rate has been used as the risk-free rate

WACC = 0.74 x 5.43 + 0.26 x 9.21 = 6.41%

What if its investments in lodging were all-equity financed?

Ke = risk free rate + beta x (market portfolio return – risk free rate)
= 8.72 + 0.15 x (12.01- 8.72)
= 9.21%

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