Class 5 - Marriott Corporation

Corporate Finance (15.425) – David THESMAR

1. Using Exhibit 2, perform a small financial analysis of Marriott (a short
paragraph is enough). How is the share buyback plan consistent with the
capital structure strategy laid out by the CFO?

Hint: Describe trends in profitability, investment and financing. Given these

trends, and Gary Wilson’s strategy as described in page 4, explain why the
company wants to repurchase shares.

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Corporate Finance (15.425) – David THESMAR
Financial analysis

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Corporate Finance (15.425) – David THESMAR
Financial analysis

1. Net Income margin = NI/Sales: grows fast

• Reflects improvement in operations

2. ROE doubles! From 9 to 17%

• Not leverage effect (see below)
• Profits increase while capital barely does

3. Investment slow
• Total capital grows from 740 to 890: 4% / year (inflation = double digit!)
• Company goes “asset lite” while maintaining profitability

4. Leverage decreases fast

• g = 4% << sustainable growth rate (low payout, high ROE)

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Corporate Finance (15.425) – David THESMAR
How does buyback fit with capital structure
strategy?
• “maintain senior funded debt at 45-50% of total capital”

• 1979 : 41%

• ... Decreasing:
• Sustainable growth = 17% x (1-.17/1.95) ≈ 16%
• Asset growth = 4%
→ Marriott way too profitable for its growth

→ Needs to re-lever → needs to make a large payout

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Corporate Finance (15.425) – David THESMAR
2. Marriott thinks about repurchasing 10 million shares for $235
millions. Use MM to predict the effect of such a buyback on the
P/E ratio. What does the predicted effect on the P/E ratio say
about value creation?

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Corporate Finance (15.425) – David THESMAR
Effect of share buyback

• What happens to the P/E ratio?

Corporate Finance (15.425) – David THESMAR 7

Effect of share buyback

• What happens to the P/E ratio?

→ first, assume no tax: basic MM applies

→ in 1979: E = 32 x 19.625 (text) = 627

→ Earnings = 71 (Ex 2)
→ PER = 627 / 71 = 8.8

→ after buyback E’ + D’+235 = E + D

→ assume D’=D (safe debt) → E’=E-235=392
→ post buyback earnings = 56 (Ex 4)
→ new PER = 392 / 56 = 7

→ but of course, tax shield can’t be ignored

→ new debt very high
→ tax rate very high

Corporate Finance (15.425) – David THESMAR 8

Effect of share buyback

• What happens to the P/E ratio?

→ now, introduce taxes

→after buyback E’ + (1-t)D’+235 = E + D(1-t)

→ assume D’=D (safe debt or small effect on debt risk)
→ E’=E-235(1-t)=486
→ post buyback earnings = 56 (Ex 4, again)
→ new PER = 392 / 56 = 8.7 (v 8.8)

→ PER still decreases, very slightly

Corporate Finance (15.425) – David THESMAR 9

Effect of share buyback (2)

• PER goes down: What is the effect of buyback on value ?

Corporate Finance (15.425) – David THESMAR 10

Effect of share buyback (2)

• PER goes down: What is the effect of buyback on value ?

• Value goes up by 15%!

• Upon announcement, existing equity is worth:
D’-D + E – (1-t)x(D’-D) = E + t(D’-D)
= 627 + 94
• Value of existing equity increases by amount of tax shield (+15%)

→ P/E decreases, value increases

→ P/E is not a reliable diagnostic tool for value
• Yet, value is the only metric that matters

Corporate Finance (15.425) – David THESMAR 11

3. Is Wilson’s reasoning in page 5 correct? Why or why not?

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Corporate Finance (15.425) – David THESMAR
The Determinants of Capital Structure

• Wilson’s justification:
“Capital, which is the stuff by which investments are made , is
comprised of two components: equity and debt. Equity in the case of
Marriott costs about 17% after tax, that is, investors expect to earn
17% on an investment in Marriott’s stock. Debts costs about only 5%
after tax. Given an investment that earns about 10% after tax, it is
evident that the more debt that I have in my capital structure, the
lower will be my cost of capital, and the more return I will have left
over the holders of my common stock” (Wilson in page 5)

Corporate Finance (15.425) – David THESMAR 13

The Determinants of Capital Structure (2)
• Wilson’s point:
• re = 17% and rd = 5% ➔ re > rd
• Debt is cheap, so Marriott should borrow more

• Do you agree with this statement?

• This is a fallacy because there are two effects:

• Levering up leads to use more debt which is cheap: re > rd
• but equity (& debt) become risker and thus more expensive
• Both re and rd increase

• In MM, the two effects cancel each other exactly

1. First, numerical example
2. Then, use MM to derive the relation btw re and (D/E)
• This formula is a restatement of MM in terms of returns instead of values
• This formula shows that the two effects cancel each other exactly in the cost of capital

Corporate Finance (15.425) – David THESMAR 14

The Determinants of Capital Structure (2)
• Wilson’s point:
• re = 17% and rd = 5% ➔ re > rd
• Debt is cheap, so Marriott should borrow more

• Do you agree with this statement?

• This is a fallacy because there are two effects:

• Levering up leads to use more debt which is cheap: re > rd
• but equity (& debt) become risker and thus more expensive
• Both re and rd increase

• In MM, the two effects cancel each other exactly

1. First, numerical example
2. Then, use MM to derive the relation btw re and (D/E)
• This formula is a restatement of MM in terms of returns instead of values
• This formula shows that the two effects cancel each other exactly in the cost of capital

Corporate Finance (15.425) – David THESMAR 15

Example
120
1/2

1/2
100

• Firm U will generate cash-flows 120 or 100 in 1 year

• These cash-flows are risky: discount rate = 10%, but safe rate=0%

• Firm U has no debt

• U = 110/1.1= 100 ; expected equity return rU = 10%

• Now, assume M&M applies

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Corporate Finance (15.425) – David THESMAR
Example
120
1/2

1/2
100

• Firm U will generate cash-flows 120 or 100 in 1 year

• These cash-flows are risky: discount rate = 10%, but safe rate=0%

• Firm U has no debt

• U = 110/1.1= 100 ; expected equity return rU = 10%

• Now, assume M&M applies

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Corporate Finance (15.425) – David THESMAR
Example (2)

1/2
120

1/2
100

• Firm L has same cash-flows as U, but debt with promised payment 50

• Value of debt D ? Value of equity E ? Expected equity return ?

• D = 50 (debt is safe here) ➔ E =50 (M&M)

➔ re = [ (120-50 + 100-50)/ 2 ] / E - 1 ➔ re = 20% > ru = 10%

• Equity returns go up: equity is riskier

• Higher/lower return do not indicate value creation/destruction (MM
here)
• Overall cost of capital does not change: 10% or (20%+0%)/2
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Corporate Finance (15.425) – David THESMAR
Example (2)

1/2
120

1/2
100

• Firm L has same cash-flows as U, but debt with promised payment 50

• Value of debt D ? Value of equity E ? Expected equity return ?

• D = 50 (debt is safe here) ➔ E =50 (M&M)

➔ re = [ (120-50 + 100-50)/ 2 ] / E - 1 ➔ re = 20% > ru = 10%

• Equity returns go up: equity is riskier

• Higher/lower return do not indicate value creation/destruction (MM here)
• Overall cost of capital does not change: 10% or (20%+0%)/2

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Corporate Finance (15.425) – David THESMAR
General formula

• note U = CFU / (1+rU)

• U = value of unlevered firm
• CFU = expected cash-flows; rU = expected return of U
• CFU = CF to debt + CF to equity = (1+re)E + (1+rd)D
• Careful: re and rd are expected market returns
• As a result, E and D are current market values
• Now, if U=E+D (M&M):

ru =(re E + rd D)/(E+D) ➔ re = ru + (D/E) (ru - rd)

• These formulas are a restatement of MM, but with market returns

• Cost of equity re always increases with leverage (as ru>rd)
• Average cost of capital does not change = rU

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Corporate Finance (15.425) – David THESMAR
4. Marriott thinks its stock price is undervalued. The market price is
$19.6. Marriott’s management think the true price is closer to
$27.38. Under each one of these assumptions, compute the effect
of the repurchase on the value of shares held by long-term
shareholders (i.e. those who do not sell in the buyback). Who
gains, who loses? Explain.

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Corporate Finance (15.425) – David THESMAR
How much is left to LT shareholders?

assume buyback goes through, effect on long-term shareholders?

It depends on the true value of Marriott

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Corporate Finance (15.425) – David THESMAR
Assume true price = $19.6 (market is right)

• Long-term shareholders will get:

P’ = (627-235+40% x 235) / (32-10) = $22.1 per share

• Tendering shareholders? $23.5

• Pre repurchase stock price ? $19.6

• How the pie is split ?

• Tendering shareholders get: 10m x (23.5-19.62) = $39m
• Long-term shareholders get: 22m x (22.1 – 19.62) = $ 55m
• Repurchase premium (39) < tax shield gain (tD=94=39+55)
• Long-term shareholders benefit too

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Corporate Finance (15.425) – David THESMAR
Assume true price = $19.6 (market is right)

• Long-term shareholders will get:

P’ = (627-235+40% x 235) / (32-10) = $22.1 per share

• Tendering shareholders? $23.5

• Pre repurchase stock price ? $19.6

• How the pie is split ?

• Tendering shareholders get: 10m x (23.5-19.62) = $39m
• Long-term shareholders get: 22m x (22.1 – 19.62) = $ 55m
• Repurchase premium (39) < tax shield gain (tD=94=39+55)
• Long-term shareholders benefit too

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Corporate Finance (15.425) – David THESMAR
Assume true price = $27.38 (management is
right)
• Then, true E value = 32m x $27.38 = $876m

• Assume purchase 10m shares @ $23.5, what is the value of shares kept
by long-term shareholders ?
• P = (876 + 40%235 - 235) / 22 ≈ $33.4
• Buyback boosts LT shareholder value by $132m
• $132m = ($33.4-$27.38) x22m
• But sellers make: 10x(23.5-19.6)=39m
• Combined gain = 39+132=171 > 94 = tax shield, how come?
• firm arbitrage underpricing on behalf of LT shareholders
• Sellers don’t make 39m, but 10x(23.5-27.38)=-$39m
• True overall gain = -39 + 132 = 94 = tax shield, as before → it all fits
• But big transfer ($39m) from ST to LT shareholders
→ In buybacks, companies arbitrage mispricing on the behalf of LT shareholders

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Corporate Finance (15.425) – David THESMAR
As a shareholder, should you sell @ $23.5 ?

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Corporate Finance (15.425) – David THESMAR
As a shareholder, should you sell @ $23.5 ?

• Depends on who you believe: management or market

• Good signal: Marriott family does not sell.

• Their name is on the door -- they know what they’re doing
• Their money is on the line – their stake should increase from 20 to 29%

• Potential danger
• Book debt will go up by 235, to 365+235=600
• i.e. 600/(365/41%)=67% of total capital, i.e. above target
• Too much leverage, loss of financial flexibility in case of downturn /
aggressive competition
• Growth could slow

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Corporate Finance (15.425) – David THESMAR
why not buy from open market, instead of
tender offer?
• After all: current market price = $19.62 < $23.5
• SEC prevents buying more than 15% of daily volume
• Monthly volume in 000’s shares

1980 Volume 15% Volume

OCT 17825 2673.75
NOV 5844 876.6
DEC 7014 1052.1
➔ Buying 10m would take 10 months – long and risky

• Need to buy 10x monthly volume: liquidity costs !

• “the huge size of the program would require a tender price of 23.5”

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Corporate Finance (15.425) – David THESMAR
Wrapping up
• Marriott faces two decisions simultaneously:
→ Financing decision: Change in capital structure (Use debt to buy equity)
→ Payout decision: Repurchase shares at $23.5 (is 23.5 the right price?)

• big payout → big relereving

→ Cost of equity goes up, P/E falls (
→ slightly dampened by tax shield, which creates 94m of value here

• Who benefits and who loses from repurchase at incorrect price?

→ LT shareholders, as residual claimants!

• Mariott grows profits while reducing assets (“asset lite”)

→ Given low payout, leverage decreases fast
→ risk of being underlevered, leaving too much tax shield money on the table
→ buyback implements relevering
→ of course, too much debt is bad: next class

Corporate Finance (15.425) – David THESMAR 29

Additional material

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Corporate Finance (15.425) – David THESMAR
Hydraulics of P/E ratio
Yet another leverage formula
P = market cap ; E = Net Income
Let B = $ amount of the buyback, r = cost of debt

 log (P/E) = P / P – E / E
= - B/P + B.r.(1-t)/E
since pretax earnings are reduced by Br(1-t)
& assume tax MM (P =-B(1-t))
= (B/E)(1-t) x (r - E/P)

→if r < E/P, P/E decreases, even if value increases (by tax shield)
Note: In Ex 4, effective r = (NetIncome/(60%x235)) = 10.6%, while E/P=11.3%

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Corporate Finance (15.425) – David THESMAR
Application to marriott

• how does repurchase plan affect cost of equity ?

• First, get rU, expected returns of unlevered Marriott:

• Before payout: re = 17% , rd =13%
• Ex 4: 31 (interest payment on new debt)/235=13%
• Hence, rU = (re E + rd D) / (E+D) = 15.4%
• E = 627, D =392 from Ex 4 (capital leases, senior debt, sub. debt)

• Relevering: D’/E’ = (392+235)/(627-235) = 1.6

➔ re = 15.4% + 1.6 (15.4% - 13%) = 19.2%
• explains decrease in PER ratio
• Can be done with tax shield of course (more later)

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Corporate Finance (15.425) – David THESMAR