Marriot as a Registered International Corporation - Case Study Example

Name: Lecturer: Course name: Course code: Date Introduction Marriot limited Marriot is a registered international corporation with it’s headquartering in Bethesda Maryland USA. The company deals in hospitality industry and majorly deals in supply of food beverages and lodging services. The company was founded by J Willard and Alice Marriott In the year 2012, the business reported a net sale of $12 billion. The company has three main divisions: lodging, contract services and restaurants. The lodging generates the highest profit amounting to 51% of the total profit. Marriot limited is a levered firm since, it is financed by both debt and equity, this would lead to reduction of investment risk as well wider investment diversification and thus a higher turns inform of profit to shareholders is eminent as observed from the revenue of the fiscal year 2012 Risk and return relationship and the portfolio return Investment risk is the risk that a company might fail to realize investment inform of profit from the security venture invested. In order to minimize risk of a return investor should thus consider holding a portfolio of securities in order to diversify the degree of risk. In this regards, risky ventures will have been minimized since, according to weighted average cost of capital (WAAC), it depicts that the returns of a portfolio would provide a higher value with lower cost of capital unlike a single security investment that will depict a return with higher cost of capital with lower value which is too risky to invest in. It can therefore be concluded that the relation between risk and return is that of an inverse proportion since, the higher the risk of a return, the high the returns and consequently, to capitalize on this and at the same time reducing the risk from the investment, an investor should consider holding a portfolio of securities. Component cost of capital is ideal in ascertaining the value of the firm since, cost of capital provides guideline o calculating the cost of equity as well as cost of debt and consequently the weighted average cost of capital. By doing so, it will be easier in concluding on whether to invest or not an investment project. An empirical study depicts that, a levered firm (financed by Mix of debt and equity) commands a higher value with low component cost of capital unlike the unlevered firm and consequently, it implies that, an investors should consider investing in a levered firm since, there is low risk on investment thus investors will realize investment in form of profit within the short time. The component cost of capital of Marriot limited The component cost of capital of Marriott limited has been computed and analysis of the value of the company based on the component cost of capital is analyzed in detail below. Investment decision if Marriott was to use a single corporate hurdle rate of 11.39% A single hurdle rate is a cost is a weighted average cost of capital for the whole business and consequently, the hurdle rate of return will be employed ion calculating and as well as ascertaining the investment opportunity in a making a justifiable investment decision of whether to invest on a profect or not. The sub-division WACC is not used in this approach. The danger with hurdle rate is that, it only considers only venture with high returns implying that any investment that is below the hurdle rate will be drop since; it depicts a negative Net present value in which case, the statement will be misleading since, production line might have a rate of return that is below the hurdle rate but still generate returns relevant to its production capacity. WACC= WACC = (1 - τ)rD(D/V) + rE(E/V) D = market value of debt E = market value of equity V = value of the firm = D + E rD = pretax cost of debt rE = after tax cost of debt τ = tax rate = 175.9/398.9 = 44% Target debt ratio is 60%; actual is 41% [Exhibit 1] Βs = 1.11 βu = βs / (1 + (1 – τ) D/E) = 1.11/(1 + (1 – .44) (.41)) = 0.80 Using the target debt ratio of 60%: βTs = βu (1 + (1 – τ) D/E) = .8(1 + (1 – .44) (.6/.4)) βTs =1.47 Using CAPM: rf = 8.95% long-term rate on U.S. government bonds (rm – rf) = 7.43% average 1926-1987 rE = rf + βTs (rm – rf) = 8.95% + (1.47)(7.43%) = 19.87% Cost of Debt rD = government bond rate + credit spread = 8.95% + 1.30% = 10.25% WACC = (1 - τ)rD(D/V) + rE(1 - D/V) = (1 – .44) (.1025)(.6) + (.1987)(.4) = 11.39% From the company’s perspective, it can be concluded that the company has a single hurdle rate of 11.39% for the all operation. This is ideal since, a company that holds a group of portfolio under single rate would lead to diversification of risk as well as maximization of returns since, according to the weighted average cost of capital, a company will have a higher value of investment with low cost of capital since, the capital structure of the company contain An ideal mix of debt and equity which thus implies that net profit to the business will be positive since, there will be a positive net present value from investment. The company should ensure that the intrinsic value is kept at a higher value and the cost of capital be kept minimal in order to guarantee the value of the firm remains high and at the same time, the steady growth rate on dividend is uphold. In return, this will lead to increase in the value of the company as well as ensure that capital structure of the company is kept minimal. As a result, investors will be encouraged into the business since, the liquidity position as well as the value of the company will remain high. Investment decision based on WACC of every production line Marritot limited has a sub-division of production line and thus every department generates returns relevant to allotted capital. In this regard, it is important to ascertain performance of each investment based on their component cost of capital and conclude on the adequacy of their returns in relation to allotted capital for investment. The details of weighted average cost of capital of each department is analysis below Production line WACC % WACC for Marriott 11.39% WACC for lodging division 9.25% WACC for restaurant division 13.84% WACC for Marriott’s contract division 23.07% The WACC for the restaurant division Marriott Market Value Leverage D/V Beta βs Tax Rate τ Unlevered Beta = βs / (1 + (1 – τ) D/E) Church’s 4.00 1.45 44.00 1.42 Collins Foods 10.00 1.45 44.00 1.37 Frisch’s 6.00 0.57 44.00 0.55 Luby’s 1.00 0.76 44.00 0.76 McDonald’s 23.00 0.94 44.00 0.81 Wendy’s 21.00 1.32 44.00 1.15 Total Average Unlevered Beta 1.01 βu = 1.01 Cost of Equity Using the target debt ratio of 42%: βTs = βu (1 + (1 – τ) D/E) =1.01(1 + (1 - .44)*.42/.58) = 1.420 Using CAPM: rE = rf + βTs (rm – rf) = 8.95% + 1.42(7.43%) = 19.50% Cost of Debt rD = government bond rate + credit spread = 8.95% + 1.80% = 10.75% WACC = (1 - τ)rD(D/V) + rE(1 - D/V) = (1 - .44)(.1075)(.42) + (.1950)(.58) = 13.84% The WACC for Marriott’s contract services division βu for Marriott is the weighted average of the Divisional βu’s: Identifiable Assets Ratio Beta Unlevered Lodging $2,777.4 0.61 0.55 Restaurants $567.60 0.12 1.01 Contract Services $1,237.70 0.27 $4,582.70 0.80 .61(.55) + .12(1.01) + .27(βu) = .80 βu = 2.514 Cost of Equity Using the target debt ratio of 40%: βTs = βu (1 + (1 – τ) D/E) = 2.514 (1 + (1 – .44) (.4/.6)) = 3.45 Using CAPM: rE = rf + βTs (rm – rf) = 8.95% + 3.45(7.43%) = 34.58 From the above analysis, it is apparent that, the WACC for contact division is high, followed by restaurant division and then lodging division. The overall WACC for Marriott is 11.39%.In this regards, every division depicts different cost of capital implying that an investment decision commands that high value investment will first be consider until the lowest component cost is realized. This investment strategy will make the company realize profit from returns in different value and also other project with minimal returns will be dropped based on the overall WACC of Marriott/This analysis is ideal since, the general waacc is ideal and implying that an investor will realize profit from investment. An ideal investment strategy is to consider weighted average cost of capital (WACC) for a portfolio or diversified asset since, a levered firm provides a general cost of capital to the business that be employed in provide an ideal investment decision on whether to invest on a [project or a company. Valuing each division on a single basis is not ideal since, the investment opportunity will not be reliable and thus might be misleading. This is due to the fact, every production line generates different profits and thus commands different source of capital, The WACC of every production line depicts a favorable trend and thus in making an overall investment decision based on the hurdle rate, other profitable venture will be dropped since, high value investment will be considered and a production line with low returns will be dropped. The disadvantage with the huddle rate is that, valuing each investment would lead to drop of some production line since, the weighted average cost of capital of those division which are below the hurdle rate as much as they are performing well will be forced to be dropped and high value investment be considered for investment decision. The company may conclude a wrong investment decision that might create a loss to the business. In this regard, the company thus considers valuing the cost of the company using a single rate of return in order to provide the general trend and performance of the company’s investment. The levered and unlevered firm A levered firm is a company that is financed using both debt and equity and thus it is deal in that, an ultimate mix of debt and equity will minimize chances of investment risk to the company. Unlevered firm is a whole equity financed business and thus poses a threat of investment risk since, whole equity financed company have a high cost of capital. Unlevered beta of Marriott = 1.11/ [1 + (1-0.44)*0.69] = 0.80. The levered equity beta = 0.80 * [1 + (1-0.44)*(0.6/0.4)] = 1.47 Cost of debt for Marriott= {1.30% + 8.95%} = 10.25%. WACC = (1 - τ)rD(D/V) + rE(1 - D/V) = (1 – .44) (.1025) (.6) + (.1987) (.4) WACC = 11.39% Marriot limited is a levered firm and consequently, the value of the firm is high since, a levered firm commands a mix of debt and equity that provides a low cost on capital. In this regard, invesmtnetn in this company will be relevant since, the company is going to derive profit from investment due to low component cost of capital with high value on capital. An investment is going to realize investment in form of profit from investment in Marriott limited. Cost of equity Cost of debt WACC Marriot ltd 0.8% 10.25% 11.39% Cost of equity and cost of debt Target debt ratio is 60%; actual is 41% [Exhibit 1] βs = 1.11 βu = βs / (1 + (1 – τ) D/E) = 1.11/(1 + (1 – .44) (.41)) = 0.80 If Marriott is to be a whole equity financed company, the cost of equity will be 80% implying that the company will have a low value from investment worth 20%.This is deem risk to an investor due to the fact that the company is having a high cost of equity with low value, It therefore implies that an whole equity financed company is risky for investment. Cost of debt rD = government bond rate + credit spread = 8.95% + 1.30% = 10.25% The cost of debt of the company is low as compared to the cost of equity. But the company cannot be fully financed using debt since, the company will be having a huge obligation of repaying the interest net of tax to debt holders consequently, the business will not depict a steady growth rate from investment. The mix of debt and equity (WACC) WACC = (1 - τ)rD(D/V) + rE(1 - D/V) = (1 – .44) (.1025) (.6) + (.1987) (.4) = 11.39% Where the company combines both dent and equity, the weighted average cost of capital will 11.39% which is quite below the cost of equity and cost of debt. It therefore implies that, an ideal capital structure is a mix of debt and equity since, the company will have a high value with a low cost of capital.IN this regard, Marriott limited should ensure that it as an ideal mix of debt and equity in order to fiancé its daily operation. The company has employed weighted average cost of capital in its all division and consequently, the financing option is ideal to the business since, the returns of every investment will be evaluated separately and conclusion will be made on whether to drop or add a production line based on the data of the WACC. This will consequently provides a clear understanding of the company’s overall perfoamance as far as the cost of capital as a tool for investment decision making is concerned. Investment decision In summary, Investment in Marriott limited is ideal in that, the company is going to realize return inform of profit from investment. This is depicted by the fact that the company is a levered firm implying that the business is going to be financed by both debt and equity. A levered firm will have a low cost of capital with higher value hence, the capital structure of the company will ensure that maximum return is realized form investment by way of low cost in form of interest on cost of debt as well as favorable dividend to shareholders. It therefore signify that the risk of investment is going to be minimized by way of diversification of investment as well as a mix of debt and equity which provides a low cost of capital with higher value. From the above analysis on component cost of capital, it can as well be concluded that an investment in Marriott limited is relevant since the company’s is going to realize returns within the shortest time possible as well as the intrinsic value of the company is going to increase in relation to the growth rate of dividend to shareholders. The company should as well consider other external factors that might affect the business situation such as the effect of exchange rate and inflation that might affect the returns as well as the budget of the company. It is eminent that Marriott is a multinational corporation and thus the effect of exchange loss as well inflation may affect the component cost of capital of the company as well as achievability of the budgeted estimates. This in return might lead to loss to the business. In this regard, both internal and external factors that affect the business performance must be considered in making an investment decision of whether to invest in Marriott limited or not. Otherwise, the component cost of capital of Marriott limited depict a favorable trend and thus it portray the business as an ideal business venture to an investor and consequently, a one year investment would be relevant in order to ascertain the business situation of the company at the end of the fiscal year since, a long term investment as some dangers such as uncertainty that may affect the business in the future. Read More