Advanced Corporate Financial Management

Marriott Corporation: The Cost of Capital(Abridged) by Team C

Fatimah Adel dun Anthony Caneva Claudia Lomeli Rahul Pandey

1. What is the weighted average cost of capital (WACC) for Marriott Corporation?
(a) What risk-free rate and risk premium did you use to calculate the cost of
equity?
(b) How did you estimate Marriotts cost of debt?

Marriott employs weighted Average Cost of capital to estimate the hurdle rate for
each division and whole corporation.
WACC= (1-Tax rate) *cost of pretax debt *(D/D+E) + cost of equity*(E/D+E)
Tax rate = 34 %

(a) Calculating the cost of equity

The cost of equity can be calculated by using the Capital Asset Pricing model
Cost of Equity =Rf + beta *Risk premium
Where Rf is risk free rate and risk premium is expected return on market portfolio

We consider that Marriot assets have useful lives of thirty years and their
Liquidation value is very high in case of bankruptcy or financial stress. The value of
the assets would not be diminished even it change its ownership as these assets are
creditworthy. So, we use 30-year Government Interest rates (the borrowing rate
available to US government) as risk free rate.

Our calculation of risk premium is based on arithmetic average of spread between

S& P return and long term US Government Bond returns from 1926 to 1987.We
believe that historical premium is the best estimate of the risk premium looking
forward and by considering premium over long period of time, we will be able to get
the reasonable standard errors and reduce the noise (shocks in return) associated
with short period of time.

Rf = 8.95% (US Government 30-year Bond)

Risk premium = 7.43 % (Spread between S & P return and Long Term Government
Bond)

Assumption considered here: -

For our convenience, we assume that debt carries no market risk (has a beta of
zero), the beta of equity alone can be written as a function of the unlevered beta
and the debt-equity ratio
L = u (1+ ((1-t) D/E))
Calculate the unlevered beta to remove the beneficial effect (Tax effect) gained by
adding debt to capital structure.
Unlevered Beta = levered Beta/ (1 + (1- tax rate) (Debt/Equity))
Bu =1.11/ [1+(1-0.34) *0.41/0.59] = 0.76
Adjusting Unlevered Beta for financial leverage: -Calculate the Levered beta
to achieve target leverage ratio of 60 % for Marriott corporation
Levered Beta = Unlevered Beta* (1 + (1- tax rate) (Debt/Equity))
Bl =0.76 *(1+(1-0.34) *0.6/0.4)
Bl = 1.51
Cost of Equity =Rf + beta *Risk premium
Re =8.94+1.51*7.43 = 20.20%

(b)Calculating the Cost of Debt

Marriotts capital structure has different proportion of fixed and floating debt. It
targets a debt structure of 60% fixed debt and 40 % floating debt in near future. For
fixed debt, we can consider fixed rate us government securities rate with 30-year
maturity. Since Floating rate is a debt instrument with a variable interest rate based
on various benchmark such as the U.S. Treasury bill rate, LIBOR, the fed funds, it
would be based on one year maturity US Government Interest rate.
The ideal way to calculate the cost of debt is by using the weighted average of
floating debt and fixed debt. But since we dont know how the floating rate would
change after one year. We are not in position to calculate the cost of debt based on
floating and fixed rate for thirty year. So, we ignore the distinction between fixed
and floating rate and use fixed rate for our calculation. Marriot also pays a premium
above Government bond rates because it issues A rated unsecured debt.

Cost of Debt =Government borrowing rate for thirty years +Debt premium (for
corporate borrowing)
=8.95+1.3 =>10.25%
WACC= (1-0.34) *10.25*0.6 +20.20*0.40 =>12.14

2. How does Marriott use its cost of capital in operating its businesses?
Marriott uses the cost of capital structure to determine the hurdle rate for each
project in lodging, restaurant and contacts division where the hurdle rate represents
the minimum return required from a company for any specific project. It selects
future projects across different business units by employing cash flow discounts to
an appropriate hurdle rate and evaluates the worthiness of project by comparing
with the opportunity cost of capital. This has a key impact on companys financial
and operating strategies because each division has different capital structure, and
Time Value of Money, Risk and Return. It also uses hurdle rate to determine
compensation plan.

3. What is the cost of capital for the lodging and restaurants of Marriott?
(a) What risk-free rate and risk premium did you use while calculating the cost of
equity for each division?
(b) How did you measure the cost of debt for each division? Should the debt cost
be different across the divisions? Why?
(c) How did you measure the beta of each division?

(a)Our estimate on risk free rate and risk premium is based on the value of assets
that each business unit holds. As Lodging assets, such as hotels have useful lives
and are creditworthy, we use 30 year US government interest rate 8.95 % as risk
free rate. We also think that the Restaurant and contract services have shorter
useful lives and generate a considerable amount of revenue for Marriott corporation
but the value of assets in case of liquidation is very low in case of financial distress
because sales and revenue generated out of these businesses are volatile thus it
will be based on 1 year US Government interest rate. Therefore, we use 6.90 as risk
free rate.
To maintain the consistency between risk free rate and risk premium. We also use
the risk premium based on assets useful lives and liquidation value. We use 7.43%
as risk premium (Spread between S&P Index and Long Term US Govt. Bonds), which
is being calculated as difference between average Long term US Government bond
returns and S & P 500 returns for period 1926-1987.
For Restaurant and contract division, we used 8.47 %(Spread between S&P 500
returns and short term treasury returns)

(b) We measure the cost of debt for each division based on two criteria because
assets associated with each business units have different time value and each
business unit have different debt structure.
(1) by comparing them with fixed Government securities having similar
maturity dates
(2) by adding the debt premium as based of the creditworthiness of assets of
each business unit.
Assumption: - While calculating the cost of debt of each business units, we ignore
the distinction between fixed and floating rate and use fixed rate for our calculation
because we dont know how the floating rate would change after one year

(C) Calculating beta for each division is important in estimating the value of equity,
which contributes to the cost of capital in case of levered firm.
Before doing this, it is very important to understand the structure of Marriott.
Marriott owns 100 percent stakes in three subsidiary i.e. Lodging, Contract and
restaurant division. Under this structure, Capital are raised at parent company buts
cash flow and operation are carried out at business unit. So, decision regarding
getting debt from creditors and issuing equity to stockholders are taken at top level.
Therefore, the stocks of these business units are not traded in market. Thus, it is not
possible to estimate the cost of equity by using the market value. Therefore, we
look toward comparable public traded companies in each segment and measure the
beta of each division by using the weighted average of unlevered beta for a group
of comparable hotel and restaurant companies in respective division and then
relevering the beta to achieve a desired capital structure for each business unit of
Marriott.

WACC For Marriott Lodging Division =10.08%

Worksheet -1
WACC For Marriott Restaurant Division 13.64%
Worksheet 2

4.What is the cost of capital for Marriotts contract services division? How can you
estimate its equity cost without any publicly traded comparable companies?
We can estimate the equity cost of contact services division without any publicly
traded companies
because Bottom-up Unlevered beta of Marriott is equal to weighted average of the
unlevered betas of
the individual business unit as identified by assets. Unlevered beta can be levered
further to achieve
target leverage ratio for Marriotts contract Services Division.

u[Marriott] = W[Lodging] * u[Lodging] + W[Contract] *u[Contract] +

W[Restaurant] * u[Restaurant]
WACC for Marriotts contract Services Division =8.61%

Worksheet-3