Marriott Corporation: The Cost of Capital

This case is based on Marriot Corporation, one of the leading lodging and food service company in
the United States. Founded in 1927, Marriott Corporation has been able to raise profit during the
years in every of its business lines: lodging, contract services and restaurants. In 1987 its profits
reached $223 million with sales of $6.5 billion.
In 1988, Dan Cohrs, the vice president of project finance at Marriott, was giving his advice
regarding the hurdle rate for all three divisions. The aim is to maintain the same good trend of the
previous years. However, the impact of the hurdle rate of Marriott may change significantly the
financial and operating strategies. Specifically, raising by 1% the hurdle rate, it automatically
decrease the present value of projects inflows by 1%, reducing Marriotts growth. Hurdle rates
become even more important when the Firm decided to use them to determine incentive
compensation. This would make managers more sensitive to the overall firms strategy.
Marriotts financial strategy was based on 4 main elements:
o Manage rather than own hotel assets. In 1987 Marriott developed more than $1 billion worth in
hotel properties. After this phase, it sold the hotel assets to partners, maintaining the operating
control with a long term management contract. Overheads costs were covered by the
management fees of 3% of revenues plus a 20% of the profits before depreciation and debt
service.
o Invest in projects that increase shareholder value. Investments were evaluated using discounting
cash flow method. The hurdle rate were based on market interest rate, project risk and estimates
of risk premiums.
o Optimize the use of debt in the capital structure. In 1987 the amount of Marriotts debt was $2.5
billion (59% of its total capital). The level of debt in the capital structure of Marriott is
determined by its ability to service its debt. Interest coverage target is used rather than target
debt-to-equity ratio.
o Repurchase undervalued shares. In 1987, Marriott repurchased 13.6 million shares of its
common stock for $429 million. Marriott was committed to repurchase its own stock if its
market price would fell below a certain value. Thus, a warranted equity value was regularly
calculated, discounting the equity cash flows of the firm using the equity cost of capital for the
company. Any gap between the warranted equity value and the market price would have
triggered the repurchasing process.
WACC formula was used to determine the cost of capital for the corporation as a whole, but also for
each division. Cost of capital for each division may change since the inputs (debt capacity, debt cost
and equity cost consistent with the amount of debt) may differ between them.
Marriott determine for each division the fraction of debt that should be floating-rate debt based on
the sensitivity of the divisions cash flows to interest rate changes. If interest rates change, it will
also change the interest rate on floating-rate debt. In 1988 Marriotts unsecured debt was A-rated.
The debt cost for each division is based on estimate of the divisions debt cost as an independent
company. Since that, each division had its own spread (debt rate government bond) because of
differences in risk.
CAPM formula was used to calculate the cost of equity. During 1986 and 1987, Marriotts beta was
0.97. However this number must be adjusted keeping into consideration two main factors in
calculating the hurdle rates. First, each business lines has its own beta, so the beta had to be a
weighted average of all the betas. Second, leverage directly affect beta.

Mr. Cohrs examined different data on the stock and bond market to calculate the appropriate risk
premium to use in the hurdle rate. He was also concerned about which measure of expected returns
should be used, especially because the arithmetic and the geometric average gives two different
measures of average annual return (the first 10%, the second 8.2%).