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RSM1232- FINANCE II:

CORPORATE FINANCE
Jan Mahrt-Smith

May 2, 2023 - September 30, 2023


Harvard Business School 9-289-047
Rev. April 1, 1998

Marriott Corporation: The Cost of Capital

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
(Abridged)
In April 1988, Dan Cohrs, vice president of project finance at the Marriott Corporation, was
preparing his annual recommendations for the hurdle rates at each of the firm’s three divisions.
Investment projects at Marriott were selected by discounting the appropriate cash flows by the
appropriate hurdle rate for each division.

In 1987, Marriott’s sales grew by 24% and its return on equity (ROE) stood at 22%. Sales and
earnings per share had doubled over the previous four years, and the operating strategy was aimed
at continuing this trend. Marriott’s 1987 annual report stated that:

Use outside these parameters is a copyright violation.


We intend to remain a premier growth company. This means aggressively
developing appropriate opportunities within our chosen lines of business—lodging,
contract services, and related businesses. In each of these areas, our goal is to be the
preferred employer, the preferred provider, and the most profitable company.

Cohrs recognized that the


divisional hurdle rates at Marriott would
have a significant impact on the firm’s 40%

financial and operating strategies. As a


rule of thumb, increasing the hurdle rate 30%

by 1% (for example, from 12% to 20%


12.12%), decreased the present value of
profit rate

project inflows by 1%. Because costs 10%

remained roughly fixed, these changes


in the value of inflows translated into 0%

changes in the net present value of -10%


projects. Figure A shows the substantial
impact of hurdle rates on the anticipated -20%

net present value of projects. If hurdle 7% 8% 9% 10% 11% 12%

hurdle rate
rates were to increase, Marriott’s
growth would be reduced as once
Figure A: Typical Hotel Profit and Hurdle Rates
profitable projects no longer met the
hurdle rates. Conversely, if hurdle rates Source: Casewriter estimates. Profit rate for a hotel is its net
present value divided by its cost.
decreased, Marriott’s growth would
accelerate.

Professor Richard S. Ruback prepared this case as the basis for class discussion rather than to illustrate either the effective
or ineffective handling of an administrative situation.
Copyright © 1989 by the President and Fellows of Harvard College. To order copies or request permission to
reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No
part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the
permi ssion of Harvard Business School.

Page 12 of 14
289-047 Marriott Corporation: The Cost of Capital (Abridged)

Marriott also considered using the hurdle rates to determine incentive compensation.
Annual incentive compensation constituted a significant portion of total compensation, ranging from
30% to 50% of base pay. Criteria for bonus awards depended on specific job responsibilities but often
included the earnings level, the ability of managers to meet budgets, and overall corporate
performance. There was some interest, however, in basing the incentive compensation, in part, on a
comparison of the divisional return on net assets and the market-based divisional hurdle rate. The
compensation plan would then reflect hurdle rates, making managers more sensitive to Marriott’s
financial strategy and capital market conditions.

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Company Background

Marriott Corporation began in 1927 with J. Willard Marriott’s root beer stand. Over the next
60 years, the business grew into one of the leading lodging and food service companies in the United
States. Marriott’s 1987 profits were $223 million on sales of $6.5 billion. See Exhibit 1 for a summary
of Marriott’s 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 more
than 100,000 rooms in total. Hotels ranged from the full-service, high-quality Marriott hotels and

Use outside these parameters is a copyright violation.


suites 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 educational
institutions and corporations. It also provided airline catering and airline services through its
Marriott In-Flite Services and Host International operations. Contract services generated 46% of 1987
sales and 33% of profits.

Marriott’s restaurants included Bob’s Big Boy, Roy Rogers, and Hot Shoppes. Restaurants
provided 13% of 1987 sales and 16% of profits.

Financial Strategy

The four key elements of Marriott’s financial strategy were:

 Manage rather than own hotel assets;


 Invest in projects that increase shareholder value;
 Optimize the use of debt in the capital structure; and
 Repurchase undervalued shares.

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 United
States. With a fully integrated development process, Marriott identified markets, created
development plans, designed projects, and evaluated potential profitability.

After development, the company sold the hotel assets to limited partners while retaining
operating control as the general partner under a long-term management contract. Management fees
typically equalled 3% of revenues plus 20% of the profits before depreciation and debt service. The
3% of revenues usually covered the overhead cost of managing the hotel. Marriott’s 20% of profits
before depreciation and debt service often required it to “stand aside” until investors earned a
prespecified return. Marriott also guaranteed a portion of the partnership’s debt. During 1987, three
Marriott hotels and 70 Courtyard hotels were syndicated for $890 million. In total, the company
operated about $7 billion worth of syndicated hotels.

Page 13 of 14
Marriott Corporation: The Cost of Capital (Abridged) 289-047

Invest in projects that increase shareholder value The company used discounted cash flow
techniques to evaluate potential investments. The hurdle rate assigned to a specific project was based
on market interest rates, project risk, and estimates of risk premiums. Cash flow forecasts
incorporated standard companywide assumptions that instilled some consistency across projects. As
one Marriott executive put it:

Our projects are like a lot of similar little boxes. This similarity disciplines
the pro forma analysis. There are corporate macro data on inflation, margins, project
lives, terminal values, percent of sales required to remodel, and so on. Projects are

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
audited throughout their lives to check and update these standard pro forma
template assumptions. Divisional managers still have discretion over unit-specific
assumptions, but they must conform to the corporate templates.

Optimize the use of debt in the capital structure Marriott determined the amount of debt in its
capital structure by focusing on its ability to service its debt. It used an interest coverage target
instead of a target debt-to-equity ratio. In 1987, Marriott had about $2.5 billion of debt, 59% of its total
capital.

Repurchase undervalued shares Marriott regularly calculated a “warranted equity value” for its
common shares and was committed to repurchasing its stock whenever its market price fell

Use outside these parameters is a copyright violation.


substantially below that value. The warranted equity value was calculated by discounting the firm’s
equity cash flows by its equity cost of capital. It was checked by comparing Marriott’s stock price
with that of comparable companies using price/earnings ratios for each business and by valuing each
business under alternative ownership structures, such as a leveraged buyout. Marriott had more
confidence in its measure of warranted value than in the day-to-day market price of its stock. A gap
between warranted value and market price, therefore, usually triggered repurchases instead of a
revision in the warranted value by, for example, revising the hurdle rate. Furthermore, the company
believed that repurchases of shares below warranted equity value were a better use of its cash flow
and debt capacity than acquisitions or owning real estate. In 1987, Marriott repurchased 13.6 million
shares of its common stock for $429 million.

The Cost of Capital

Marriott measured the opportunity cost of capital for investments of similar risk using the
Weighted Average Cost of Capital (WACC) as:

WACC = (1 - )rD- (D/V) +r E- (E/V)

where D and E are the market value of the debt and equity, respectively, r - D is the pretax cost of
debt, r- E is the after-tax cost of equity, and V is the value of the firm. (V = D+E), and  is the corporate
tax rate. Marriott used this approach to determine the cost of capital for the corporation as a whole
and for 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 the
three divisions because all three of the cost-of-capital inputs could differ for each division. The cost
of capital for each division was updated annually.

Debt capacity and the cost of debt Marriott applied its coverage-based financing policy to each of
its divisions. It also determined for each division the fraction of debt that should be floating rate debt
based on the sensitivity of the division’s cash flows to interest rate changes. The interest rate on
floating rate debt changed as interest rates changed. If cash flows increased as the interest rate
increased, using floating rate debt expanded debt capacity.

Page 14 of 14
289-047 Marriott Corporation: The Cost of Capital (Abridged)

In April 1988, Marriott’s 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
cost for each division on an estimate of the division’s debt cost as an independent company. The
spread between the debt rate and the government bond rate varied by division because of differences
in risk. Table A provides the market value target leverage rates, the fraction of the debt at floating
rate, the fraction at fixed rates, and the credit spread for Marriott as a whole and for each division.
The credit spread was the debt rate premium above the government rate required to induce investors
to lend money to Marriott.

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Table A Market-Value Target-Leverage Ratios and Credit Spreads for Marriott
and Its Divisions

Debt Fraction Fraction Debt Rate


Percentage of Debt of Debt Premium Above
in Capital at Floating at Fixed Government

Marriott 60% 40% 60% 1.30%

Use outside these parameters is a copyright violation.


Lodging 74% 50% 50% 1.10%
Contract services 40% 40% 60% 1.40%
Restaurants 42% 25% 75% 1.80%

Because lodging assets, like hotels, had long useful lives, Marriott used the cost of long-term
debt for its lodging cost-of-capital calculations. It used shorter-term debt as the cost of debt for its
restaurant and contract services divisions because those assets had shorter useful lives.

Table B lists the interest rates on fixed-rate U.S. government securities in April 1988.

Table B U.S. Government Interest Rates


in April 1988

Maturity Rate

30-year 8.95%
10-year 8.72%
1-year 6.90%

The cost of equity Marriott recognized that meeting its financial strategy of embarking only on
projects that increased shareholder values 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. The
CAPM, originally developed by John Lintner and William Sharpe in the early 1960s, had gained wide
acceptance among financial professionals. According to the CAPM, the cost of equity, or,
equivalently, the expected return for equity, was determined as:

expected return = r = riskless rate + beta * [risk premium]

where the risk premium is the difference between the expected return on the market portfolio and the
riskless rate.

Page 15 of 14
Marriott Corporation: The Cost of Capital (Abridged) 289-047

The key insight in the CAPM was that risk should be measured relative to a fully diversified
portfolio of risky assets such as common stocks. The simple adage “Don’t put all your eggs in one
basket” dictated that investors could minimize their risks by holding assets in fully diversified
portfolios. An asset’s risk was not measured as its individual risk. Instead, the asset’s contribution to
the risk of a fully diversified or market portfolio was what mattered. This risk, usually called
systematic risk, was measured by the beta coefficient.

Betas could be calculated from historical data on common stock returns using simple linear
regression analysis. Marriott’s beta, calculated using five years of monthly stock returns was 1.11.

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Two problems limited the use of the historical estimates of beta in calculating the hurdle rates
for projects. First, corporations generally had multiple lines of business. A company’s 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 even if the riskiness of the firm’s assets
remained unchanged, because the safest cash flows went to the debt holders. As debt increased, the
cash flows remaining for stockholders became more risky. The historical beta of a firm, therefore,
had to be interpreted and adjusted before it could be used as a project’s beta, unless the project had
the same risk and the same leverage as the firm overall.

Exhibit 3 contains the beta, leverage, and other related information for Marriott and

Use outside these parameters is a copyright violation.


potentially comparable companies in the lodging and restaurant businesses.

To select the appropriate risk premium to use in the hurdle rate calculations, Cohrs examined
a variety of data on the stock and bond markets. Exhibit 4 provides historical information on the
holding-period returns on government and corporate bonds and the S&P 500 Composite Index of
common stocks. Holding-period returns were the returns realized by the security holder, including
any cash payment (e.g., dividends for common stocks, coupons for bonds) received by the holder
plus any capital gain or loss on the security. As examples, the 5.23% holding-period return for the
S&P 500 Composite Index of common stocks in 1987 was the sum of the dividend yield of 3.20% and
the capital gain of 2.03%. The -2.69% holding-period return for the index of long-term U.S.
government bonds in 1987 was the sum of the coupon yield of 7.96% and a capital gain of -10.65%.1

Exhibit 5 provides statistics on the spread between the S&P 500 Composite Returns and the
holding-period returns on U.S. government bills, U.S. government bonds, and high-grade, long-term
corporate bonds. Cohrs was concerned about the correct time interval to measure these averages,
especially given the high returns and volatility of the bond markets shown in Exhibits 4 and 5.

1
Cash payments are assumed to be invested in the respective securities monthly.

Page 16 of 14
289-047 -6-

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Exhibit 1 Financial History of Marriott Corporation (dollars in millions, except per share amounts)

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

Summary of Operations
Sales 1,174.1 1,426.0 1,633.9 1,905.7 2,458.9 2,950.5 3,524.9 4,241.7 5,266.5 6,522.2
Earnings before interest expense
and income taxes 107.1 133.5 150.3 173.3 205.5 247.9 297.7 371.3 420.5 489.4
Interest expense 23.7 27.8 46.8 52.0 71.8 62.8 61.6 75.6 60.3 90.5
Income before income taxes 83.5 105.6 103.5 121.3 133.7 185.1 236.1 295.7 360.2 398.9
Income taxes 35.4 43.8 40.6 45.2 50.2 76.7 100.8 128.3 168.5 175.9
Income from continuing operationsa 48.1 61.8 62.9 76.1 83.5 108.4 135.3 167.4 191.7 223.0

Use outside these parameters is a copyright violation.


Net income 54.3 71.0 72.0 86.1 94.3 115.2 139.8 167.4 191.7 223.0
Funds provided from cont. operationsb 101.2 117.5 125.8 160.8 203.6 272.7 322.5 372.3 430.3 472.8

Capitalization and Returns


Total assets 1,000.3 1,080.4 1,214.3 1,454.9 2,062.6 2,501.4 2,904.7 3,663.8 4,579.3 5,370.5
Total capital c 826.9 891.9 977.7 1,167.5 1,634.5 2.007.5 2,330.7 2,861.4 3,561.8 4,247.8
Long-term debt 309.9 365.3 536.6 607.7 889.3 1,071.6 1,115.3 1,192.3 1,662.8 2,498.8
Percent to total capita 37.5% 41.0% 54.9% 52.1% 54.4% 53.4% 47.9% 41.7% 46.7% 58.8%
Shareholders’ equity 418.7 413.5 311.5 421.7 516.0 628.2 675.6 848.5 991.0 810.8

Per Share and Other Data


Earnings per share:
Continuing operationsa .25 .34 .45 .57 .61 .78 1.00 1.24 1.40 1.67
Net income .29 .39 .52 .64 .69 .83 1.04 1.24 1.40 1.67
Cash dividends .026 .034 .042 .051 .063 .076 .093 .113 .136 .17
Shareholders’ equity 2.28 2.58 2.49 3.22 3.89 4.67 5.25 6.48 7.59 6.82
Market price at year end 2.43 3.48 6.35 7.18 11.70 14.25 14.70 21.58 29.75 30.00
Shares outstanding (in millions) 183.6 160.5 125.3 130.8 132.8 134.4 128.8 131.0 130.6 118.8
Return on avg. shareholders’ equity 13.9% 17.0% 23.8% 23.4% 20.0% 20.0% 22.1% 22.1% 20.6% 22.2%

Source: Company reports.

aThe company’s theme-park operations were discontinued in 1984.


bFunds provided from continuing operations consist of income from continuing operations plus depreciation, deferred income taxes, and other items not currently affecting working capital.
cTotal capital represents total assets less current liabilities.

Page 17 of 25
Marriott Corporation: The Cost of Capital (Abridged) 289-047

Exhibit 2 Financial Summary of Marriott by Business Segment, 1982-1987 (dollars in millions)

1982 1983 1984 1985 1986 1987

Lodging:

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Sales $1,091.7 $1,320.5 $1,640.8 $1,898.4 $2,233.1 $2,673.3
Operating profit 132.6 139.7 161.2 185.8 215.7 263.9
Identifiable assets 909.7 1,264.6 1,786.3 2,108.9 2,236.7 2,777.4
Depreciation 22.7 27.4 31.3 32.4 37.1 43.9
Capital expenditures 371.5 377.2 366.4 808.3 966.6 1,241.9

Contract Services:

Sales 819.8 950.6 1,111.3 1,586.3 2,236.1 2,969.0


Operating profit 51.0 71.1 86.8 118.6 154.9 170.6

Use outside these parameters is a copyright violation.


Identifiable assets 373.3 391.6 403.9 624.4 1,070.2 1,237.7
Depreciation 22.9 26.1 28.9 40.2 61.1 75.3
Capital expenditures 127.7 43.8 55.6 125.9 448.7 112.7

Restaurants:

Sales 547.4 679.4 707.0 757.0 797.3 879.9


Operating profit 48.5 63.8 79.7 78.2 79.1 82.4
Identifiable assets 452.2 483.0 496.7 582.6 562.3 567.6
Depreciation 25.1 31.8 35.5 34.8 38.1 42.1
Capital expenditures 199.6 65.0 72.3 128.4 64.0 79.6

Source: Company reports.

Page 18 of 14
289-047 Marriott Corporation: The Cost of Capital (Abridged)

Exhibit 3 Information on Comparable Hotel and Restaurant Companies

Arithmetic 1987
a Average Equityb Market c Revenues
Return Beta Leverage ($ billions)

MARRIOTT CORPORATION 22.4 % 1.11 41% 6.52

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
(Owns, operates, and manages hotels, restaurants, and
airline and institutional food services.)

Hotels :

HILTON HOTELS CORPORATION 13.3 .76 14% 0.77


(Owns, manages, and licenses hotels. Operates casinos.)

HOLIDAY CORPORATION 28.8 1.35 79% 1.66


(Owns, manages, and licenses hotels and restaurants.
Operates casinos.)

Use outside these parameters is a copyright violation.


LA QUINTA MOTOR INNS -6.4 .89 69% 0.17
(Owns, operates, and licenses motor inns.)

RAMADA INNS, INC. 11.7 1.36 65% 0.75


(Owns and operates hotels and restaurants.)

Restaurants :

CHURCH’S FRIED CHICKEN -3.2 1.45 4% 0.39


(Owns and franchises restaurants and
gaming businesses.)

COLLINS FOODS INTERNATIONAL 20.3 1.45 10% 0.57


(Operates Kentucky Fried Chicken franchise and
moderately priced restaurants.)

FRISCH’S RESTAURANTS 56.9 .57 6% 0.14


(Operates and franchises restaurants.)

LUBY’S CAFETERIAS 15.1 .76 1% 0.23


(Operates cafeterias.)

McDONALD’S 22.5 .94 23% 4.89


(Operates, franchises, and services restaurants.)

WENDY’S INTERNATIONAL 4.6 1.32 21% 1.05


(Operates, franchises, and services restaurants.)

Source: Casewriter estimates.


aCalculated over the five-year period 1983-1987.
bEstimated using five years of monthly data over the 1983-1987 period.
cBook value of debt divided by the sum of the book value of debt plus the market value of equity.

Page 19 of 14
Marriott Corporation: The Cost of Capital (Abridged) 289-047

Exhibit 4 Annual Holding-Period Returns for


Selected Securities and Market Indexes, 1926-1987

Arithmetic Standard
Years Average Deviation

Short-term Treasury bills:

For use only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
1926-87 3.54% 0.94%
1926-50 1.01% 0.40%
1951-75 3.67% 0.56%
1976-80 7.80% 0.83%
1981-85 10.32% 0.75%
1986 6.16% 0.19%
1987 5.46% 0.22%

Long-term U.S. government


bond returns:

1926-87 4.58% 7.58%

Use outside these parameters is a copyright violation.


1926-50 4.14% 4.17%
1951-75 2.39% 6.45%
1976-80 1.95% 11.15%
1980-85 17.85% 14.26%
1986 24.44% 17.30%
1987 -2.69% 10.28%

Long-term, high-grade
corporate bonds returns:

1926-87 5.24% 6.97%


1926-50 4.82% 3.45%
1951-75 3.05% 6.04%
1976-80 2.70% 10.87%
1981-85 18.96% 14.17%
1986 19.85% 8.19%
1987 -0.27% 9.64%

Standard & Poor’s 500


Composite Stock Index
returns:
1926-87 12.01% 20.55%
1926-50 10.90% 27.18%
1951-75 11.87% 13.57%
1976-80 14.81% 14.60%
1981-85 15.49% 13.92%
1986 18.47% 17.94%
1987 5.23% 30.50%

Source: Casewriter estimates based on data from the University of Chicago


’s Center for Research in Security Prices.

Page 20 of 14
289-047 Marriott Corporation: The Cost of Capital (Abridged)

Exhibit 5 Spreads between S&P 500 Composite Returns and Bond Rates

se only in the course RSM1232- Finance II: Corporate Finance at Rotman School of Management from 5/2/2023 to 9/30/2023.
Arithmetic Standard
Years Average Deviation

Spread between S&P 500 Composite returns


and short-term U.S. Treasury bill returns:

1926-87 8.47% 20.60%


1926-50 9.89% 27.18%
1951-75 8.20% 13.71%
1976-80 7.01% 14.60%
1981-85 5.17% 14.15%
1986 12.31% 17.92%
1987 -0.23% 30.61%

Use outside these parameters is a copyright violation.


Spread between S&P 500 Composite returns
and long-term U.S. government bond returns:

1926-87 7.43% 20.78%


1926-50 6.76% 26.94%
1951-75 9.48% 14.35%
1976-80 12.86% 15.58%
1981-85 -2.36% 13.70%
1986 -5.97% 14.76%
1987 7.92% 35.35%

Spread between S&P 500 Composite returns


and long-term, high-grade corporate bonds:

1926-87 6.77% 20.31%


1926-50 6.06% 26.70%
1951-75 8.82% 13.15%
1976-80 12.11% 15.84%
1981-85 -3.47% 13.59%
1986 -1.38% 14.72%
1987 5.50% 34.06%

Source: Casewriter estimates based on data from the University of Chicago ’s Center for Research in Security Prices.

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