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page 2 Sandals Inc

Finance

page 2
Sandals Inc. — Estimating ‘All-Inclusive’ and Divisional Hurdle Rates

It’s early spring 2015 and Jessica Marchek, managing director of Marchek Consulting, a mid-
sized consulting firm in downtown Manhattan, has been given the opportunity of a lifetime! After a
strongly competitive bidding process, Jessica and her team snagged the contract as lead consultants for
Sandals Inc. Sandals is a well-known Caribbean resort chain, with four brands and 26 properties in
seven countries throughout the Caribbean, including Bahamas, Grenada, Barbados, Jamaica, Saint
Lucia, Curacao, and Turks & Caicos. Since its inception in 1985 the company has emerged as a best-in-
class leader of the Caribbean vacation experience.

“Our aim is to provide the quintessential vacation experience for our guests while maintaining a strong
growth and expansion thrust throughout the Caribbean and abroad. We therefore take the lead in
searching out and developing growth opportunities in line with our business.” - Annual Report 2014

Jessica and her team are excited to get to work. Their first and most pressing task is to
recommend appropriate hurdle rates for each of the two divisions of Sandals — Resorts and Restaurants.
At Sandals, major investment projects were evaluated by a company-wide (all-inclusive) hurdle rate
which was used to discount all expected cash flows, but Jessica and her Team advocated the use of
divisional rates.

The hurdle rate was applied to a variety of scenarios. Firstly, the rate was central to a company-
wide compensation plan. It determined from 10% to 40% of compensation of various employee pay
packages. Secondly, the hurdle rate determined the profitability of all capital investment projects and by
extension the company’s growth. Finally, the rate was used to evaluate the timing of share repurchases.

Financial Strategy at Sandals Inc.

The company’s financial strategy was organized along four key objectives: share buybacks,
optimal investment projects, resort management, and debt management.

Share Buybacks Sandals had a different approach to share repurchases. The company
calculated what they referred to as a “justifiable share price” and repurchased shares when the market
price fell below this value. This share price was determined by discounting its equity cash flows by the
equity cost of capital (or equity hurdle rate) and further adjusted based on a complex analysis of the
value of key leadership personnel in comparable firms. The idea was that company leadership
commanded a premium or discount on firm value.

Optimal Investment Projects Although projects had specific risk and return profiles, all
investment projects were subject to the same company-wide hurdle rate and were aimed at maximizing
shareholder value. This hurdle rate considered market interest rates and estimates of risk premiums.
Further, divisional managers presented standardized templates of project details such as profit margin,
initial investment, projected return etc., to gain approval from the capital investment committee.

Hotel Management Sandals’ strategy was different from the typical firm. Instead of owning
hotels, the company opted to purchase facilities in strategic locations, remodel and sell them (within 2
years of purchase) to limited partners. Sandals then maintained operating control of these hotels using a
long-term management contract. For this they received a 5% management fee and 25% of profits.

Debt Management Here the company also adopted a unique approach. Instead of the usual
practice of holding debt in relation to its optimal target capital structure the company determined its
amount of leverage based on its ability to service this debt. At Sandals, the capital structure was
therefore based on an interest-coverage target.

Estimating Hurdle Rates at Sandals Inc.
Sandals used the weighted average cost of capital (WACC) to estimate its hurdle rate:
WACC = re (E/V) + ra (1- te) (D/V),
where D and E are the respective market values of debt and equity, re and raare the respective costs of
equity and debt, t, is the corporate tax rate and V = D + E. The company’s tax rate is 35%.

page 3

The Cost of Debt: Overall Sandals was A-rated by Moody’s. This afforded the company a lower
spread between the yield on government debt and the yield on the company’s debt. Table 1 outlines
details of Sandals Inc.’s optimal capital structure and its cost of debt expressed as a spread over
government debt. Table 2 outlines the interest rates on fixed-rate U.S. government securities in April
2015.

Table 1: Optimal target capital structure and
Credit Spreads for Sandals and its divisions Spreads for Sandals and its divisions Table 2: Government Interest Rates, April 2015
Optimal Debt ' Spread Maturi : Interest Rate (%)
Sandals Inc. 55% i 1.30% — ELE
ee 30-year 7.65
Divisions: 10-year 735
Resorts | 63% — | 1.10% ; 625
Restaurants 45% i 1.80% year |

The Cost of Equity: Jessica and her team determined that the cost of equity capital would be

calculated using the Capital Asset Pricing Model (CAPM) which is represented as:
Expected Return = Ry + B (Risk Premium).

Beta: For Sandals Inc. the company-wide beta was calculated from historical daily stock returns
and was estimated at 0.95. To estimate divisional betas, however, the team at Marchck Consulting
would rely on data from comparable firms. In estimating or re-cestimating the relevant betas for Sandals,
the consultants recognized that there was need for additional caution, since the betas provided were
affected by leverage and therefore required some adjustment to reflect Sandal Inc.’s optimal target
capital structure!. Table 3 outlines the details of comparable firms in the Resort and Restaurant
business.

Risk Premium: To select the risk premium the challenge for Jessica and her team was to
identify the relevant period and measure of excess return. Table 4 outlines the spreads between the S&P
500 Index and fixed-income yields from 1926 — 2014.

Finally, Table 5 presents details of the financial position of Sandals Inc. and its divisions.

' Asset (Unlevered) beta: Ba = (E/V) Be
Table 3: Comparables — Resort and Restaurant Companies
Company | Average Equity | Market Debt/Value
: Return (%) Beta Ratio (%)
Sandals Inc. | 22.4 0.95 | 41
Resort Comps. | !
Surfside Corp. 13.3 0.88 | 14
Charlottesville Inc. ( 28.8 1.46 | 79
Plantations Inc. -6.4 0.38 69
Cara Suites Corp. | 11.7 095 | 65
Average Resorts | 11.85 | 0.92 | 56.75
Restaurant Comps. | | |
Fish and Chips Inc. | 20.3 0.60 | 10
Denny’s Dining 22.5 1.00 23
Café Caribbean | 46 1.08 | 21
Average Restaurants 15.8 | 0.89 | 18

page 4
Table 4: Spreads between the S&P 500 Index and
Bond Rates, 1926 - 2014
Average
motu Table 5: Sandals Inc. Selected Fi ial Dat
Spread between S&P 500 able 5: Sandals Inc. Se ected Financial Data
Index and T-Bills (millions of dollars except per share data)
Be ee
1926 - 2014 8.47 2012 2015 2014
1926 - 1980 7.01 Operational Data
1981 - 1986 5.17 Sales | $4,241.7 | $5,226.5 | $6,522.2
1986 - 2014 21.31 EBIT 371.3 420.5 489.4
2014 8.20 Net Income | 167.4 | 191.7 223.0
Market Value Data
Spread between S&P 500 Long-term Debt | 1,192.3 | 1,662.8 | 2,499
Index & Long-Term T-Bonds Share price | 21.56 | 29.75 30.00
1926 - 2014 7.43 Shares outstanding | 131.0 Mn ; 130.6 Mn | 118.8 Mn
1926 - 1980 6.76
1981 - 1986 9.48
1986 - 2014 7.92
2014 3.47

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