1、Harvard Business School9-298-101Rev. March 18, 1998Professor Richard Ruback prepared this case as the basis for class discussion rather than to illustrate either effective orineffective handling of an administrative situation.Copyright 1998 by the President and Fellows of Harvard College. To order c
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3、any meanselectronic, mechanical, photocopying,recording, or otherwisewithout the permission of Harvard Business School.1Marriott Corporation: The Cost of CapitalIn April 1988, Dan Cohrs, vice president of project finance at the Marriott Corporation, waspreparing his annual recommendations for the hu
4、rdle rates at each of the firms three divisions.Investment projects at Marriott were selected by discounting the appropriate cash flows by theappropriate hurdle rate for each division.In 1987, Marriotts sales grew by 24% and its return on equity stood at 22%. Sales andearnings per share had doubled
5、over the previous four years, and the operating strategy was aimedat continuing this trend. Marriotts 1987 annual report stated:We intend to remain a premier growth company. This means aggressivelydeveloping appropriate opportunities within our chosen lines of businesslodging,contract services, and
6、related businesses. In each of these areas our goal is to be thepreferred employer, the preferred provider, and the most profitable company.Mr. Cohrs recognized that the divisional hurdle rates at Marriott would have a significanteffect on the firms financial and operating strategies. As a rule of t
7、humb, increasing the hurdle rateby 1% (for example, from 12% to 12.12%), decreases the present value of project inflows by 1%.Because costs remained roughly fixed, these changes in the value of inflows translated into changesin the net present value of projects. Figure A shows the substantial effect
8、 of hurdle rates on theanticipated net present value of projects. If hurdle rates were to increase, Marriotts growth would bereduced as once profitable projects no longer met the hurdle rates. Alternatively, if hurdle ratesdecreased, Marriotts growth would accelerate.Marriott also considered using t
9、he hurdle rates to determine incentive compensation. Annualincentive compensation constituted a significant portion of total compensation, ranging from 30% to50% of base pay. Criteria for bonus awards depended on specific job responsibilities but oftenincluded the earnings level, the ability of mana
10、gers to meet budgets, and overall corporateperformance. There was some interest, however, in basing the incentive compensation, in part, on acomparison of the divisional return on net assets and the market-based divisional hurdle rate. Thecompensation plan would then reflect hurdle rates, making man
11、agers more sensitive to Marriottsfinancial strategy and capital market conditions.298-101Marriott Corporation: The Cost of Capital2Figure ATypical Hotel Profit and Hurdle Rates-20-10010203040789101112Hurdle rate (%)Profit rate (%)Source:Casewriters estimates.Note:Profit rate for a hotel is its net p
12、resent value divided by its cost.Company BackgroundMarriott Corporation began in 1927 with J. Willard Marriotts root beer stand. Over the next60 years, the business grew into one of the leading lodging and food service companies in the UnitedStates. Marriotts 1987 profits were $223 million on sales
13、of $6.5 billion. See Exhibit 1 for a summaryof Marriotts financial history.Marriott had three major lines of business: lodging, contract services, and restaurants.Exhibit 2 summarizes its line-of-business data. Lodging operations included 361 hotels, with morethan 100,000 rooms in total. Hotels rang
14、ed from the full-service, high-quality Marriott hotels andsuites to the moderately priced Fairfield Inn. Lodging generated 41% of 1987 sales and 51% of profits.Contract services provided food and services management to health care and educationalinstitutions and corporations. It also provided airlin
15、e catering and airline services through itsMarriott In-Flite Services and Host International operations. Contract services generated 46% of 1987sales and 33% of profits.Marriotts restaurants included Bobs Big Boy, Roy Rogers, and Hot Shoppes. Restaurantsprovided 13% of 1987 sales and 16% of profits.
16、Financial StrategyThe four key elements of Marriotts financial strategy were the following: Manage rather than own hotel assets. Invest in projects that increase shareholder value. Optimize the use of debt in the capital structure. Repurchase undervalued shares.Marriott Corporation: The Cost of Capi
17、tal298-1013Manage rather than own hotel assets In 1987, Marriott developed more than $1 billion worth ofhotel properties, making it one of the 10 largest commercial real estate developers in the UnitedStates. With a fully integrated development process, Marriott identified markets, createddevelopmen
18、t plans, designed projects, and evaluated potential profitability.After development, the company sold the hotel assets to limited partners while retainingoperating control as the general partner under a long-term management contract. Management feestypically equaled 3% of revenues plus 20% of the pr
19、ofits before depreciation and debt service. The 3%of revenues usually covered the overhead cost of managing the hotel. Marriotts 20% of profits beforedepreciation and debt service often required it to stand aside until investors earned a prespecifiedreturn. Marriott also guaranteed a portion of the
20、partnerships debt. During 1987 3 Marriott hotelsand 70 Courtyard hotels were syndicated for $890 million. In total, the company operated about $7billion worth of syndicated hotels.Invest in projects that increase shareholder valueThe company used discounted cash flowtechniques to evaluate potential
21、investments. The hurdle rate assigned to a specific project was basedon market interest rates, project risk, and estimates of risk premiums. Cash flow forecastsincorporated standard companywide assumptions that limited discretion in cash flow estimates andinstilled some consistency across projects.
22、As one Marriott executive put it,Our projects are like a lot of similar little boxes. This similarity disciplines thepro forma analysis. There are corporate macro data on inflation, margins, projectlives, terminal values, percent of sales required to remodel, and so on. Projects areaudited throughou
23、t their lives to check and update these standard pro formatemplate assumptions. Divisional managers still have discretion over unit-specificassumptions, but they must conform to the corporate templates.Optimize the use of debt in the capital structure Marriott determined the amount of debt in itscap
24、ital structure by focusing on its ability to service its debt. It used an interest coverage targetinstead of a target debt-to-equity ratio. In 1987, Marriott had about $2.5 billion of debt, 59% of its totalcapital.Repurchase undervalued shares Marriott regularly calculated a warranted equity value f
25、or itscommon shares and was committed to repurchasing its stock whenever its market price fellsubstantially below that value. The warranted equity value was calculated by discounting the equitycash flows of the firm using the equity cost of capital for the company. It was checked by comparingMarriot
26、ts stock price with that of comparable companies using price-earnings ratios for eachbusiness and by valuing each business under alternative ownership structures, such as a leveragedbuyout. Marriott had more confidence in its measure of warranted value than in the day-to-daymarket price of its stock
27、. A gap between warranted value and market price, therefore, usuallytriggered repurchases instead of a revision in the warranted value by, for example, revising thehurdle rate. Furthermore, the company believed that repurchases of shares below warranted equityvalue were a better use of its cash flow
28、 and debt capacity than acquisitions or owning real estate. In1987, Marriott repurchased 13.6 million shares of its common stock for $429 million.Cost of CapitalMarriott measured the opportunity cost of capital for investments of similar risk using theweighted average cost of capital (WACC): WACCt r
29、D VrE VDE / /=()()+()1298-101Marriott Corporation: The Cost of Capital4where D and E are the market values of the debt and equity, respectively, rD is the pre-tax cost ofdebt, rE is the after-tax cost of equity, V is the value of the firm (V = D + E), and is the corporate taxrate. Marriott used this
30、 approach to determine the cost of capital for the corporation as a whole andfor each division.To determine the opportunity cost of capital, Marriott required three inputs: debt capacity,debt cost, and equity cost consistent with the amount of debt. The cost of capital varied across thethree divisio
31、ns because all three of the cost-of-capital inputs could differ for each division. Thecost-of-capital for each division was updated annually.Debt Capacity and the Cost of DebtMarriott applied its coverage-based financing policy to each of its divisions. It alsodetermined for each division the fracti
32、on of debt that should be floating-rate debt based on thesensitivity of the divisions cash flows to interest rate changes. The interest rate on floating-rate debtchanged as interest rates changed. If cash flows increased as the interest rate increased, usingfloating-rate debt expanded debt capacity.
33、In April 1988, Marriotts unsecured debt was A-rated. As a high-quality corporate risk,Marriott could expect to pay a spread above the current government bond rates. It based the debt costfor each division on an estimate of the divisions debt cost as an independent company. The spreadbetween the debt
34、 rate and the government bond rate varied by division because of differences in risk.Table A provides the market value-target leverage ratios, the fraction of the debt at floating rate, thefraction at fixed rate, and the credit spread for Marriott as a whole and for each division. The creditspread w
35、as the debt rate premium above the government rate required to induce investors to lendmoney to Marriott.Because lodging assets, like hotels, had long useful lives, Marriott used the cost of long-termdebt for its lodging cost-of-capital calculations. It used shorterterm debt as the cost of debt for
36、itsrestaurant and contract services divisions because those assets had shorter useful lives.Table AMarket Value-Target Leverage Ratios and Credit Spreads for Marriott and Its DivisionsDebtPercentagein CapitalFractionof Debtat FloatingFractionof Debtat FixedDebt RatePremium aboveGovernmentMarriott60%
37、40%60%1.30%Lodging7450501.10Contract services4040601.40Restaurants4225751.80Table B lists the interest rates on fixed-rate U.S. government securities in April 1988.Table BU.S. Government Interest Rates, April 1988MaturityRate30-year8.95%10-year8.72Marriott Corporation: The Cost of Capital298-1015Mat
38、urityRate1-year6.90Cost of EquityMarriott recognized that meeting its financial strategy of embarking only on projects thatincreased shareholder value meant that it had to use its shareholders measure of equity costs.Marriott used the Capital Asset Pricing Model (CAPM) to estimate the cost of equity
39、. The CAPM,originally developed by John Lintner and William Sharpe in the early 1960s, had gained wideacceptance among financial professionals. According to the CAPM, the cost of equity or, equivalently,the expected return for equity was determined asExpected return = R = Risk-free rate + Risk premi
40、umwhere the risk premium is the difference between the expected return on the market portfolio and therisk-free rate.The key insight in the CAPM was that risk should be measured relative to a fully diversifiedportfolio of risky assets such as common stocks. The simple adage, dont put all your eggs i
41、n onebasket, dictated that investors could minimize their risks by holding assets in fully diversifiedportfolios. An assets risk was not measured as an individual risk. Instead, the assets contribution tothe risk of a fully diversified or market portfolio was what mattered. This risk, usually called
42、systematic risk, was measured by the beta coefficient ().Betas could be calculated from historical data on common stock returns using simple linearregression analysis. Marriotts beta, calculated using daily stock returns during 1986 and 1987, was.97.Two problems limited the use of the historical est
43、imates of beta in calculating the hurdle ratesfor projects. First, corporations generally had multiple lines of business. A companys beta, therefore,was a weighted average of the betas of its different lines of business. Second, leverage affected beta.Adding debt to a firm increased its equity beta
44、even if the riskiness of the firms assets remainedunchanged, because the safest cash flows went to the debt holders. As debt increased, the cash flowsremaining for stockholders became more risky. The historical beta of a firm, therefore, had to beinterpreted and adjusted before it could be used as a
45、 projects beta, unless the project had the samerisk and the same leverage as the firm overall.Exhibit 3 contains the beta, leverage, and other related information for Marriott andcomparable companies in the lodging and restaurant businesses.To select the appropriate risk premium to use in the hurdle
46、 rate calculations, Mr. Cohrsexamined a variety of data on the stock and bond markets. Exhibit 4 provides historical informationon the holding-period returns on government and corporate bonds and the S&P 500 Composite Indexof common stocks. Holding-period returns are the returns realized by the secu
47、rity holder, includingany cash payment (e.g., dividends for common stocks, coupons for bonds) received by the holderplus any capital gain or loss on the security. As examples, the 5.23% holding-period return for theS&P 500 Composite Index of common stocks in 1987 is the sum of the dividend yield of
48、3.20% and thecapital gain of 2.03%. The -2.69% holding-period return for the index of long-term U.S. governmentbonds in 1987 is the sum of the coupon yield of 7.96% and a capital gain of -10.65%.1 1 Cash payments are assumed to be invested in the respective securities monthly.298-101Marriott Corpora
49、tion: The Cost of Capital6Exhibit 5 provides statistics on the spread between the S&P 500 Composite returns and theholding-period returns on Treasury bills, U.S. government bonds, and high-grade, long-termcorporate bonds.Mr. Cohrs was concerned about the correct time interval to measure these averag
50、es,especially given the high returns and volatility of the bond markets shown in Exhibits 4 and 5. Hewas concerned also about which measure of expected returns should be used. Exhibits 4 and 5present two different measures of average annual return, the arithmetic and the geometric. Thearithmetic ave
