Harvard Case - Marriott Corp.: The Cost of Capital
"Marriott Corp.: The Cost of Capital" Harvard business case study is written by Richard S. Ruback. It deals with the challenges in the field of Finance. The case study is 11 page(s) long and it was first published on : Feb 10, 1998
At Fern Fort University, we recommend that Marriott Corp. utilize a weighted average cost of capital (WACC) approach to determine the cost of capital for its various investment opportunities. This approach will ensure that the company is making sound financial decisions that maximize shareholder value. We also recommend that Marriott Corp. adopt a more flexible capital structure, allowing for a greater use of debt financing to fund future growth, while maintaining a strong credit rating.
2. Background
Marriott Corp. in 1984 faced a critical decision regarding its cost of capital. The company was considering various investment opportunities, including acquisitions, expansions, and new ventures. The case study highlights the company's existing capital structure, which was heavily reliant on equity financing, and the need to determine the appropriate cost of capital to evaluate these investments. The main protagonists are J.W. 'Bill' Marriott Jr., the CEO, and the company's financial team, who are tasked with determining the cost of capital and its implications for future investment decisions.
3. Analysis of the Case Study
To analyze Marriott Corp.'s situation, we can utilize a framework that considers both financial and strategic aspects:
Financial Analysis:
- Capital Structure: Marriott Corp.'s capital structure was heavily weighted towards equity, with a debt-to-equity ratio of 0.25. This conservative approach minimized financial risk but potentially limited the company's ability to leverage debt financing for growth.
- Cost of Debt: The company's cost of debt was relatively low, reflecting its strong credit rating. However, the case study highlights the potential for increasing debt levels, which could impact the cost of debt in the future.
- Cost of Equity: The cost of equity was estimated using the Capital Asset Pricing Model (CAPM), considering the company's beta and the risk-free rate. This analysis indicated a relatively high cost of equity, reflecting the inherent risks associated with Marriott Corp.'s business.
- WACC: The company's WACC was calculated using the weighted average of the cost of debt and the cost of equity. This calculation provided a benchmark for evaluating investment opportunities and ensuring that they generated returns exceeding the cost of capital.
Strategic Analysis:
- Growth Strategy: Marriott Corp. was pursuing an aggressive growth strategy, seeking to expand its operations through acquisitions, new ventures, and international expansion. This strategy required significant capital investment and highlighted the importance of determining the appropriate cost of capital.
- Industry Dynamics: The hospitality industry was characterized by intense competition, cyclical demand, and evolving customer preferences. These factors influenced Marriott Corp.'s investment decisions and the need for a flexible capital structure to adapt to changing market conditions.
- Competitive Advantage: Marriott Corp.'s competitive advantage was based on its brand reputation, operational efficiency, and strong management team. These strengths provided a foundation for future growth and justified the pursuit of investment opportunities.
4. Recommendations
Based on the analysis, we recommend the following:
- Adopt a Weighted Average Cost of Capital (WACC) Approach: Marriott Corp. should utilize the WACC as its primary metric for evaluating investment opportunities. This approach ensures that the company is making sound financial decisions that maximize shareholder value by considering the cost of both debt and equity financing.
- Increase Debt Financing: To support its aggressive growth strategy, Marriott Corp. should consider increasing its debt financing levels. This would allow the company to leverage its strong credit rating and access lower-cost capital for expansion. However, the company should carefully manage its debt levels to maintain a healthy debt-to-equity ratio and avoid excessive financial risk.
- Implement a Flexible Capital Structure: Marriott Corp. should adopt a more flexible capital structure that allows for adjustments based on market conditions and investment opportunities. This flexibility would enable the company to take advantage of favorable financing options and adjust its debt levels as needed.
- Develop a Comprehensive Capital Budgeting Process: Marriott Corp. should develop a robust capital budgeting process that incorporates the WACC, financial forecasting, and sensitivity analysis. This process would ensure that investment decisions are made systematically and based on rigorous financial evaluation.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: Increasing debt financing aligns with Marriott Corp.'s core competencies in managing its capital structure and its mission to maximize shareholder value.
- External Customers and Internal Clients: A flexible capital structure allows Marriott Corp. to respond to evolving customer preferences and provide internal clients with the necessary resources for growth.
- Competitors: By leveraging debt financing, Marriott Corp. can compete more effectively with industry rivals and maintain its competitive edge.
- Attractiveness ' Quantitative Measures: Increasing debt financing can potentially lower the overall cost of capital, leading to higher returns on investment and improved profitability.
6. Conclusion
By adopting a WACC approach, increasing debt financing, and implementing a flexible capital structure, Marriott Corp. can optimize its cost of capital and position itself for continued growth and success. This strategy balances financial risk with the company's ambitious growth objectives, ensuring that investments are made strategically and generate long-term value for shareholders.
7. Discussion
Alternatives Not Selected:
- Maintaining the Existing Capital Structure: This approach would limit the company's ability to leverage debt financing and potentially hinder its growth.
- Excessive Debt Financing: This could increase financial risk and negatively impact the company's credit rating.
Risks and Key Assumptions:
- Increased Interest Rates: Rising interest rates could increase the cost of debt and negatively impact the company's profitability.
- Economic Downturn: A recession could lead to decreased demand for hospitality services, impacting the company's revenue and profitability.
- Competition: Intense competition from other hotel chains could erode Marriott Corp.'s market share and profitability.
Options Grid:
| Option | Advantages | Disadvantages |
|---|---|---|
| Increase Debt Financing | Lower cost of capital, increased financial flexibility | Increased financial risk, potential impact on credit rating |
| Maintain Existing Capital Structure | Lower financial risk | Limited growth potential, higher cost of capital |
| Excessive Debt Financing | High financial leverage, potential for rapid growth | Increased financial risk, potential for distress |
8. Next Steps
- Develop a Detailed Financial Model: Marriott Corp. should develop a comprehensive financial model that incorporates its current capital structure, projected growth, and potential debt financing scenarios.
- Conduct Sensitivity Analysis: The company should conduct sensitivity analysis to assess the impact of key assumptions, such as interest rates, economic growth, and competition, on its financial performance.
- Implement a Monitoring System: Marriott Corp. should establish a system for monitoring its debt levels, credit rating, and financial performance metrics.
- Communicate with Investors: The company should communicate its capital structure strategy and its rationale to investors, ensuring transparency and investor confidence.
By implementing these recommendations and taking proactive steps to manage its financial risk, Marriott Corp. can effectively utilize its cost of capital to achieve its strategic goals and create long-term value for its shareholders.
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Case Description
Presents recommendations for hurdle rates of Marriott's divisions to select by discounting appropriate cash flows by the appropriate hurdle rate for each division.
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