Marriott Cost of Capital

Marriott Corporation:

The Cost of Capital

Contents

Financial Strategy: 3

Marriott Cost of Capital 3

Beta Calculation: 3

Cost of Equity : 4

Cost of Debt 4

Project/Division Cost of Capital 4

WACC Lodging 5

Beta Calculation : 5

Cost of Equity : 5

Cost of Debt 5

WACC Restaurants: 6

Beta Calculation : 6

Cost of Equity : 6

Cost of Debt 6

Contract Services 6

Beta Calculation: 6

Cost of Equity : 7

Cost of Debt 7

Company vs. Project/Division Cost of Capital 7

Appendix 1: 8

WACC 8

Appendix 2: WACC Lodging 9

Appendix 3: WACC Restaurants 10

Dan Cohrs, vice president of project finance, has been tasked with determining the appropriate hurdle rates for each of Marriott's three divisions such that individual division projects can be evaluated properly. He understands that by switching to division hurdle rates the NPV of project inflows will be decreased as a result of this. It is critical for him to maintain the corporate financial strategy of growth, as stated in the annual report Marriott intends to remain a premier growth company by aggressively developing opportunities related to lodging, contract services and related businesses.

Financial Strategy:

Marriot has identified four key components that will be used to ensure they meet their growth objectives. These financial components include managing rather than owning hotel assets, investing in projects that increase shareholder value, optimizing the use of debt in the capital structure and repurchasing undervalued shares. These objectives will allow Marriott to achieve their objectives for the following reasons.

1) Managing rather than owning hotel assets : This will allow Marriott to keep their fixed assets low while also minimizing depreciation. This will allow for net income to increase resulting in higher profits. Furthermore is the fixed assets are low their total assets will be low resulting in a higher return on assets.

2) Invest in projects that increase shareholder value: from the ROE aspect, if the return on the projects is higher than the return on daily business, the projects are worth investing and the company will become more profitable.

3) Optimize the use of debt in the capital structure: by focusing its ability to service its debt, Marriott optimizes its debt as much as possible based on EBIT. This strategy can help Marriott shield taxes and increase net income.

4) Repurchase undervalued shares: Marriott invest money on its undervalued stock as treasury stock. Also, the stock price will rise and increase market values.

Marriott Cost of Capital

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: SEE Appendix 1 (WACC). Below we have identified how the difference components of WACC have been estimated

Beta Calculation:

Equity Beta = 0.97 (Given in the case Exhibit 3). The Beta given as part of the case was developed using stock return data from 1986 and 1987. We do not want to use this Beta to assess the projects going forward because the desired capital structure is different than it was during 1986 and 1987. So, we need to remove the old market leverage and implement the future (desired) market leverage in order to accurately assess projects going forward.

Market leverage is 41% Market Leverage is the book value of debt divided by the sum of debt + equity. In order to determine the unleveraged Beta we use the formula

When we put the values in this equation we get Bu = 0.67. In order to re-leverage this B we use the target debt to equity ratio which is calculated as D/E=.60/.40= 1.5. Thus the final levered Beta for Marriott Corporation is Given as Bm = 0.67/(1+(1-.34)*1.5) = 1.32

Cost of Equity :

Re = Rf+beta (Rm-Rf). Rf as defined by the textbook is close to the 1-year treasury bill's return. This according to exhibit 4 is the arithmetic average return which is 3.54%

Rm-Rf is known as the risk premium which is the spread between S&P 500 composite returns and short-term Treasury bill returns. Since Rm is the stock return in the market. So the risk premium is 8.47%. Re= 3.54%+1.32*8.47 = Re = 14.75%

Cost of Debt

Rd is the interest rate of the bonds Marriott issues. As the case says, the debt rate Marriott pays is above the current government bond rates. Marriott uses the cost of long term debt for lodging and short term debt for its contract services division. We use 10 year Bond rate for lodging and contract services since 1 year bond rate is close to risk free investment. Thefore for the whole Marriott Company we calculate the identifiable assets and the their percentage as weights to determine the Rd

Assets Assets %

Lodging 2777.4 0.606

Restaurants 567.6 0.124

Contract Services 1237.7 0.270

Marriott 4582.7 1.000

Thus we get the Government interest rates as = .61*8.95 + .124*8.72+.270*8.72 = 8.86%

The premium is 1.30 which is then added to get Rd= 10.16%

From the Formulae above we get

WACC=(1-0.34)*10.16*60% + 14.75*40%= 9.92%

Project/Division Cost of Capital

Below we have identified our methodology for estimating the individual risk or the divisions, how we estimated different components of WACC and the appropriate benchmark returns.

WACC Lodging

Beta