Marriott Corporation Capital Structure and Financial Strategy

Company Overview and Financial Strategy

Marriott Corporation operates three major lines of business: lodging, contract services, and restaurants. Lodging operations include 361 hotels with a total room count of over 100,000. These establishments range from full-service, high-quality hotels and suites to more moderately priced properties, such as the Fairfield Inn. In 1987, lodging generated 41% of sales and 51% of profits.

Contract services entail food and service management for healthcare and educational institutions and corporations. Airline catering and services are also included through Marriott In-Flite Services and Host International operations. This division generated 46% of sales and 33% of profits in 1987. Restaurants — including Bob's Big Boy, Roy Rogers, and Hot Shoppes — accounted for 13% of sales and 16% of profits for the same year.

Marriott's financial strategy comprises four key elements: (1) manage rather than own hotel assets; (2) invest in projects that increase shareholder value; (3) optimize the use of debt in the capital structure; and (4) repurchase undervalued shares.

In 1987, Marriott was the developer of more than $1 billion in hotel properties, making it one of the ten largest commercial real estate developers in the United States. Its integrated development process included identifying markets, creating development plans, designing projects, and assessing possible profitability. Once properties are developed, they are sold to limited partners, allowing Marriott to relinquish ownership while retaining management under long-term partnership contracts. Management fees typically amounted to 3% of revenues plus 20% of profits, and Marriott also guaranteed a portion of each partnership's debt.

To enable investments that increase shareholder value, Marriott uses the discounted cash flow technique to identify the most viable candidates. Discount rates are based on market interest rates, project risk, and risk premium estimates. Cash flow forecasts draw on standard companywide assumptions to ensure consistency across projects, and these projects are audited throughout their lifespan to assess ongoing viability.

The use of debt in the capital structure is optimized by focusing on the company's ability to service its debt, which serves as a target for interest coverage rather than a debt-to-equity ratio. When repurchasing undervalued shares, Marriott calculates a warranted equity value for its common shares. Shares found to fall substantially below the calculated value are repurchased. Comparisons are made against similar companies' stock values, and repurchasing undervalued stock has proven a better use of capital than owning real estate or investing in additional stocks.

Historical Performance and Hurdle Rates

When examining historical performance patterns, Marriott's goals and strategies appear to have worked effectively. The company demonstrated substantial growth in sales and profits across its three core businesses. In 1987, lodging generated 41% of sales and 51% of profits; contract services provided 46% of sales and 33% of profits; and restaurants contributed 13% of sales and 16% of profits.

One potential pitfall in the company's financial strategy lies in its divisional hurdle rates. These rates can substantially affect profitability, since an increase in the hurdle rate reduces the present value of projected cash inflows and thereby the anticipated net value of future projects. Conversely, a decrease in hurdle rates would accelerate the company's growth. One approach to managing this dynamic is tying hurdle rates to executive incentive compensation, which can represent between 30% and 50% of base pay. Criteria for bonus payments include managers' ability to meet budgets, job responsibilities, and earnings level. Linking hurdle rates to these incentives would make managers more sensitive to Marriott's financial strategy and broader capital market conditions — a potentially optimal mechanism for encouraging loyalty and performance.

Before major investment decisions are made, the company would benefit from analyzing the performance of each business segment in isolation. The lodging business has historically generated the highest profits, followed by contract services, with restaurants at the lowest end. This hierarchy should guide capital allocation decisions, particularly in light of divisional hurdle rate sensitivity. The restaurant segment is most vulnerable to hurdle rate increases but also stands to gain the most when rates decline. Given that hurdle rates have historically trended downward, continued profitability across all three segments appears likely.

Cost of Capital Across Divisions

The cost of capital for Marriott is calculated using debt capacity, cost of debt, and cost of equity consistent with the level of debt carried. The three divisions vary considerably across these measures. For Marriott overall, the debt-to-capital ratio stands at 60%, with 40% of debt at floating rates, 60% at fixed rates, and a debt rate premium above government securities of 1.3%.

For the lodging division, these figures are 74%, 50%, 50%, and 1.1%, respectively. Contract services shows values of 40%, 40%, 60%, and 1.4%. The restaurant division carries a debt-to-capital ratio of 42%, with only 25% of debt at floating rates, 75% at fixed rates, and a rate premium of 1.8%. The substantial difference between the restaurant division's fixed-to-floating debt ratio and that of the other divisions is particularly notable.

Given this disparity, the company may find it prudent to direct greater financial attention toward the lodging and contract services components. For example, when implementing the share repurchase strategy, the restaurant segment might receive focus, while lodging should be the primary candidate for investments aimed at increasing shareholder value. Contract services occupies a middle position in terms of financial strength and offers meaningful room for growth without posing undue financial risk to the firm.