To calculate the WACC we need to identify the different factors included in the WACC-method, to be able to measure the opportunity cost for investments. First we need to identify the debt, equity and the firm value, which is equity plus debt. Then we identify the debt cost (rD), which is a pre-tax cost, and then we need to identify the cost of equity (rE). As we can observe in table A, the debt percentage in capital is 60 %, which implies that the equity is 40 %.

Don't use plagiarized sources. Get Your Custom Essay on

Finding Marriott’s WACC

Just from $13,9/Page

By dividing the income taxes by the company’s income before taxes, we find that t = 175,9 / 398,9 = 0,44 To find the risk-free rate, we chose to use the arithmetic average on long-term U. S. government bond returns for the longest time period (1926-1987), 4,58%. We chose this because it’s the most precise estimator, and the years 1981-1987 have been highly unstable, making it difficult to estimate an average. To be consistent, we used the long-term spread between S&P Composite returns and long-term U.

S. government bond returns, 7,43%, which is the arithmetic average over the years 1927-1987.

Although the last years have been unstable, the number is very close to the spread in 1987. For the entire company, we use the equity beta mentioned in Exhibit 3, beta equity 1,11. rE = rF + b * MP Calculating the cost of debt, rD: To keep things simple, and because of the fact that the company uses a combination of both long-term and short-term bonds to finance their investments, we have chosen to use the 10-year U. S. government interest rate and Marriott’s debt rate premium above government for the whole division to find the cost of debt. Tables A & B) rD = 8,72% + 1,3% = 10,02% This implies that Marriott’s WACC is: Investments using Marriott’s WACC The WACC we have calculated will preferably suit inter-divisional projects, due to the fact that this WACC is not applicable on every individual division. It’s important to considerate the factors we have used in this calculation, i. e. debt percentage and long-term vs. short-term debt. This WACC can only be used on project with comparable risk to the investments the company already undertakes.

Using one single cost of capital across the different divisions: Using a single corporate cost of capital for every single one of the different divisions would be negative for the company’s profitability in the long run, because important components in the WACC formula such as debt and equity ratios varies between the different divisions within the company, with the consequence that the expected return for the investors will be based on incorrect numbers which may not be suitable for that particular division.

Therefore, we need to set up a WACC for each of the divisions, so that we have a clear cost of capital to reach for. As we will mention in question 3, one single corporate cost can result in one division accepting an investment which will not result in profit, whilst another division might reject profitable opportunities. Though is the WACC we calculated for the entire company not useless. Marriott might have inter-division projects that are difficult to place in just one of their main divisions.

But it is important to take into consideration the different time-aspects and different ways to finance these investments, i. e. floating rate and debt vs. equity. Finding the cost of capital for the lodging and restaurant divisions. WACC lodging = (1 – 0,44) * 0,74 * 9,025% + 0,26 * 17,05% = 8,173% WACC restaurant = (1 – 0,44) * 0,42 * 10,065% + 0,58 * 16,744% = 12,21% Determining the cost of debt for the lodging and restaurant divisions For the lodging division, which is financed by long-term debt, we use the 30-year U.

S. government rates to find the risk-free rate (table B), which is 8,95%, and according to table A, the spread for such an investment is 1,10%. rD for lodging division = 8,95% + 1,10% = 10,05%. We think that the financing of the restaurant division is a bit different. Since we’re told that Marriott in a higher degree uses more short-term debt to finance this division, we use only 10-year interest rates, which, according to table B is 8,72%. The restaurant-division has a significantly higher spread, which is 1,80%. D for restaurant division = 8,72% + 1,80% = 10,52%. These are only the fixed part of the cost of debt. For the floating part of the debt we use one-year bonds. This means that the floating part of the cost of debt is for the lodging division 6,90% + 1,10% = 8,00%, and for the restaurant division it’s 6,90% + 1,80% = 8,70%, due to the different spreads. The lodging division has 50% fixed debt rate and 50 % floating rate, whilst the restaurant division has 25% floating rate and 75% fixed rate.

These numbers gives the following calculation for the different costs of debt: Lodging cost of debt: 50% * 8,00% + 50% * 10,05% = 9,025% Restaurant cost of debt: 75% * 8,70% + 25% * 10,52% = 10,065% These different divisions need a different cost of debt because of the fact that assets in the restaurant and contracting services have shorter useful lives. Marriott also finances their different assets with different amount of floating debt. The company WACC which we calculated earlier, should not be used on for divisional project.

This can lead to, for instance, that one division accepting an investment resulting in losses, while another division rejects an investment which would’ve led to profit. Measuring the equity beta for respectively lodging and restaurants: Since we don’t know the equity beta for each division, it’s difficult to calculate the cost of equity. But we have chosen to use the average of the companies in the same business line as the ones Marriott is operating in. We have of course separated each division. The average equity beta for the lodging division is 1,09 and the restaurant division it’s 1,08.

When we then calculate the cost of equity for the lodging division, we get this calculation: Lodging cost of equity = 8,95% + 1,09 * 7,43% = 17,05% Restaurant cost of equity = 8,72% + 1,08 * 7,43% = 16,744% The cost of capital for the contract services division We found these asset values in Exhibit 2. This is one of the ways to estimate the cost of equity when we don’t have any comparable companies. vL / vM = 2774,4 / 4582,6 = 0,606 vR / vM = 567,6 / 4582,7 = 0,124 vCS / vM = 1237,7 / 4582,5 = 0,27 WACC contract services = (1 – 0,44) * 10,12% * 0,4 + 7,419% * 0,6 = 6,672%