Harvard Case - Marriott Corp.: The Cost of Capital (Abridged)
"Marriott Corp.: The Cost of Capital (Abridged)" Harvard business case study is written by Richard S. Ruback. It deals with the challenges in the field of Finance. The case study is 10 page(s) long and it was first published on : Mar 23, 1989
At Fern Fort University, we recommend that Marriott Corp. utilize a weighted average cost of capital (WACC) approach to determine the appropriate discount rate for evaluating potential investments. This approach will ensure that the company considers the cost of both debt and equity financing in its decision-making process, leading to more informed and profitable capital budgeting decisions.
2. Background
Marriott Corp. is a leading hospitality company facing a critical decision: how to determine the appropriate cost of capital for evaluating potential investments. The company is considering a variety of projects, including expanding its hotel portfolio, entering new markets, and investing in technology upgrades. The case study highlights the company's existing capital structure, its recent financial performance, and the challenges of estimating the cost of equity given the company's complex ownership structure.
The main protagonists of the case study are:
- J.W. Marriott, Jr.: Chairman and CEO of Marriott Corp., tasked with making strategic decisions about the company's future.
- The Finance Department: Responsible for analyzing financial data, determining the cost of capital, and evaluating investment proposals.
- The Investment Banking Community: Providing advice and guidance on financial strategies, including mergers and acquisitions.
3. Analysis of the Case Study
To address Marriott's challenge, we will utilize a framework that combines financial analysis with strategic considerations.
Financial Analysis:
- Capital Structure Analysis: Marriott's capital structure is a mix of debt and equity. We need to determine the proportion of each in the company's capital base to calculate the weighted average cost of capital.
- Cost of Debt: Analyze the company's existing debt, including interest rates and maturities, to estimate the cost of debt financing.
- Cost of Equity: We need to estimate the cost of equity using the Capital Asset Pricing Model (CAPM). This requires determining the risk-free rate, market risk premium, and Marriott's beta. However, the company's complex ownership structure and recent performance make this challenging.
- WACC Calculation: Once we have determined the cost of debt and equity, we can calculate the weighted average cost of capital (WACC) by weighting each component by its proportion in the capital structure.
Strategic Considerations:
- Growth Strategy: Marriott's growth strategy will influence its capital budgeting decisions. The company needs to balance its desire for expansion with its need to maintain a healthy financial position.
- Risk Management: Marriott needs to consider the risks associated with each investment, including economic downturns, competition, and changes in consumer preferences.
- Financial Flexibility: The company needs to ensure that it has sufficient financial flexibility to fund its growth plans while maintaining a strong credit rating.
4. Recommendations
Utilize a WACC Approach: Marriott should use a weighted average cost of capital (WACC) approach to determine the appropriate discount rate for evaluating potential investments. This approach considers the cost of both debt and equity financing, ensuring a more comprehensive assessment of investment profitability.
Estimate the Cost of Equity: Given the complexity of Marriott's ownership structure, we recommend using a combination of methods to estimate the cost of equity. This could include:
- Regression Analysis: Analyze historical data on Marriott's stock price and the overall market to estimate the company's beta.
- Comparable Company Analysis: Compare Marriott's risk profile to similar companies in the hospitality industry to estimate its beta.
- Analyst Forecasts: Gather information from analysts who cover Marriott to obtain their estimates of the company's future earnings and dividends.
Adjust the WACC for Specific Projects: The WACC represents the company's overall cost of capital. However, specific projects may carry different levels of risk. Therefore, Marriott should adjust the WACC for each project based on its unique characteristics, such as the industry sector, geographic location, and project duration.
Develop a Robust Capital Budgeting Process: Implement a comprehensive capital budgeting process that includes:
- Project Screening: Evaluate potential investments based on predetermined criteria, such as profitability, risk, and strategic alignment.
- Sensitivity Analysis: Assess the impact of different assumptions on project profitability, such as changes in interest rates, inflation, and demand.
- Post-Audit: Regularly review the performance of completed projects to identify areas for improvement and refine the capital budgeting process.
5. Basis of Recommendations
Our recommendations are based on the following considerations:
Core Competencies and Consistency with Mission: Marriott's core competency lies in its expertise in the hospitality industry. The recommended approach aligns with the company's mission of providing exceptional guest experiences and delivering long-term shareholder value.
External Customers and Internal Clients: The WACC approach ensures that investments are evaluated from the perspective of both external customers (who benefit from improved services) and internal clients (who receive a return on their investment).
Competitors: Marriott faces intense competition in the hospitality industry. Utilizing a robust capital budgeting process will allow the company to make informed decisions about investments that will enhance its competitive position.
Attractiveness ' Quantitative Measures: The WACC approach provides a quantitative measure of the cost of capital, which can be used to calculate the net present value (NPV) and internal rate of return (IRR) of potential investments. This allows Marriott to make informed decisions about which projects to pursue based on their profitability.
Assumptions: Our recommendations are based on the assumption that Marriott's management team is committed to maximizing shareholder value and that the company has access to the necessary financial resources to fund its growth plans.
6. Conclusion
By utilizing a WACC approach and implementing a robust capital budgeting process, Marriott Corp. can make informed decisions about its investments and achieve its strategic goals. This approach will ensure that the company considers the cost of both debt and equity financing, leading to more profitable investments and sustainable growth.
7. Discussion
Other Alternatives:
- Using a hurdle rate: Marriott could use a predetermined hurdle rate, such as the company's cost of debt, to evaluate potential investments. However, this approach does not consider the cost of equity financing and may lead to suboptimal investment decisions.
- Focusing solely on profitability: Marriott could prioritize investments that generate the highest profits, without considering the risk associated with those investments. This approach could lead to excessive risk-taking and potentially jeopardize the company's financial stability.
Risks and Key Assumptions:
- Market Volatility: Fluctuations in interest rates and equity markets could impact the cost of capital and the profitability of investments.
- Economic Downturn: A recession could lead to a decline in demand for hospitality services, affecting Marriott's profitability and its ability to fund its growth plans.
- Competition: Intense competition in the hospitality industry could erode Marriott's market share and profitability.
Options Grid:
| Option | Advantages | Disadvantages | Risks |
|---|---|---|---|
| WACC Approach | Comprehensive, considers both debt and equity financing | Requires complex calculations | Market volatility, economic downturn |
| Hurdle Rate | Simple to implement | Ignores cost of equity, may lead to suboptimal decisions | |
| Profitability Focus | Prioritizes profitability | Ignores risk, could lead to excessive risk-taking | Economic downturn, competition |
8. Next Steps
- Develop a WACC Model: The Finance Department should develop a model to calculate Marriott's weighted average cost of capital, incorporating the cost of debt, cost of equity, and the company's capital structure.
- Estimate the Cost of Equity: The Finance Department should conduct research to estimate the cost of equity using the methods outlined in the recommendations.
- Implement a Capital Budgeting Process: Marriott should implement a formal capital budgeting process that includes project screening, sensitivity analysis, and post-audit procedures.
- Monitor and Adjust: The Finance Department should regularly monitor the company's cost of capital and adjust the WACC as needed based on changes in market conditions, the company's financial performance, and its strategic goals.
By taking these steps, Marriott can ensure that it is making informed and profitable investment decisions that will support its long-term growth and success.
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Case Description
Gives students the opportunity to explore how a company uses the Capital Asset Pricing Model (CAPM) to compute the cost of capital for each of its divisions. The use of Weighted Average Cost of Capital (WACC) formula and the mechanics of applying it are stressed.
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