The Year is 1988. The VP of project management is preparing his annual recommendations for hurdle rates for each of the 3 firms divisions. Investment projects are selected by discounting the appropriate cash flows by the appropriate hurdle rate for each division. In 1987 sales grew by 24% and ROE was 22%. As a rule of thumb, increasing the hurdle rate by 1% (for example from 12% to 12.12%), decreased the PV of project inflows by 1%. If hurdle rates were to increase, the company's growth would be reduced as once profitable projects no longer met the hurdle rates. If hurdle rates decreased, the company's growth would accelerate. Incentive compensation also determined by hurdle rates. 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 earnings level, the ability of managers to meet budgets and overall corporate performance.
The Company has 3 major lines of business: lodging, contract services and restaurants. Lodging included 361 hotels, with more than 100,000 rooms in total. Hotels ranged from full-service, high quality hotels and suites to moderately priced motels. Lodging generated 41% of 1987 sales and 51% of profits. Contract services provided food and service management to health-care and educational institutions and corporations. Contracts services generated 46% of 1987 sales and 33% of profits. Restaurants included 13% of 1987 sales and 16% of profits.
Financial strategy included:
Manage rather than own hotel assets
Invest in projects that increase shareholder value
Optimize the use of debt in capital structure
Repurchase undervalued shares
Manage rather than own: After development, the company sold the hotel assets to limited partners while retaining operating control as the general partner. Management fees typically equaled 3% of revenues plus 20% of the profits before depreciation and debt service. The 3% covered overhead cost of managing the hotel.
Invest in projects that increase shareholder value: The Company used discounted CF techniques to evaluate potential investments. The hurdle rate assigned to a specific project was based on the market interest rates, project risk and estimates of risk premiums.
Optimize the use of debt in capital structure: The Company used an interest coverage target instead of target debt to equity ratio. In 1987, the company had about 2.5million of debt, 59% of its total capital.
Repurchase undervalued shares: The Company was committed to repurchasing its stock whenever the market price fell 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 stock price of the company with comparable companies using price/earnings ratios for each business and by valuing each business under alternative ownership structure, such a leveraged buy out. In 1987 the company repurchased 13.6 million shares of its common stock for $429 million.
Cost of Capital:
WACC is used: = (1-t)r d(D/V) + r e(E/V)
D and E are the market value of debt and equity, r d is the pretax cost of debt, r e is the after tax cost of equity, and V is value of the firm. (V=D+E) and t is the corporate tax rate. This is used for the corporation as a whole and each division. For determining opportunity costs, the company requires 3 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.
In April 1988, the company's unsecured debt was A-rated. As a high quality corporate risk, the company 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 credit spread was the debt rate premium above the government rate required to induce investors to lend money. The company used 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.
Cost of equity: The company used the CAPM to estimate of cost of equity. 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. The company's beta is 1.11.
The solution explains the calculation of WACC for the company and also for its divisions