Marriott Corporation: The Cost of Capital (Abridged) 1. How does Marriott use its estimate of cost of capital? Does this make sense? Marriot use cost of capital as the hurdle rate (minimum rate of return required to accept the project) to discount future cash flows for the investment projects of the three lines of business (Lodging, Contract Services and Restaurants). They use this rate to calculate NPV and net present value over cost to decide for the profit rate. Since cost of the project stays constant, net present value and hurdle rate are used as variable to decide if they should accept the project or not.
The higher the rate, the lower the net present value because future cash flows are discounting at a higher rate. The case clearly describes that WACC can only measure investment of similar risk class and for that reason we don’t think the way Marriott uses to estimate cost of capital makes sense since we believe that WACC and net present value of the project must be separately calculated for each part of the company and for each of their projects.
2. What is the weighted average cost of capital for Marriott Corporation? The WACC for Marriot Corp is 9. 76%–See calculations bellow:
In order to find the WACC for Marriot Corporation we need to find the elements needed for such calculation: TAX RATE. Based on Exhibit 1, the average tax rate used from 1978 to 1987 is 41%. However the most recent tax rate used (1987) was 44%. We will use the most recent tax rate of 44% on our calculations. COST OF DEBT To find the cost of Debt is 0. 1025 or 10. 25% (See explanation on b) DEBT/EQUITY RATIO On Table A we find that the Debt Percentage in Capital is 60%. With this information we can find the D/E Ratio: D/E= 0. 60 / (1-0. 60) = 1. 5 COST OF EQUITY
To calculate the cost of Equity (RE) we need to find the Risk-Free rate, the market risk premium, and the beta. The risk free rate for Marriott is 4. 58%. The Market Risk Premium is 7. 43%. The beta given on Exhibit 3(1. 11) is levered. To finish our calculation for the cost of equity we must find the unlevered Beta and adjust it properly thus, bU=bL/(1+(1-TAX)(D/E)) so 1. 11/(1+(1-. 044)(1. 5) = 0. 603 After adjusting for the target debt ratio, the beta of equity for Marriott should be 0. 603/0. 4 = 1. 5075 We can now find the cost of equity: RE = Risk Free rate + Beta x (Risk Premium)
RE = 0. 0458 +1. 5075 x (0. 0743) RE = 0. 1579 or 15. 78% WACC Now that we have all the elements needed to find WACC we just need to apply the formula and find that the WACC is 9. 76% WACC= (E/V) ? RE + (D/V) ? RD ? (1- TC)= 0. 4 x 0. 1578 + 0. 6 x 0. 1025 x (1-0. 44) WACC = 0. 0976 or 9. 76% a. What risk-free rate and risk premium did you use to calculate the cost of equity? The risk free rate for Marriott Corporation can be found on Exhibit 4. It’s the average of Long Term US Government bond from 1926-1987 and that is 0. 0458 or 4. 58%. The Market Risk Premium is the Spread between S&P 00 Composite returns and Long Term US Government bond and that is 0. 0743 or 7. 43%. This information can be found on Exhibit 5 b. How did you measure Marriott’s cost of debt? To find the cost of Debt, we will need to consider the Information provided on tables A&B. On table A we find that 1. 30% is Company rate premium above Governments Long-term bonds. On table B we find that Government Long-Term Bonds (30 years to maturity) is 8. 95%. Therefore, the sum of 8. 95% and the Premium of 1. 30% is the Cost of Debt we need, thus 0. 0895+0. 0130 = 0. 1025 or 10. 25% . What type of investments would you value using Marriott’s WACC? You would value investments that give you a rate higher than 9. 76%, because if Marriot chooses a project with a WACC lower than its 9. 76% they run the risk of lowering their value on their stocks, and won’t be able to pay all of its investors, which includes stockholders, bondholders, and preferred stock holders. We would also value long term investments because that’s the WACC Marriot is using and you have to compare it to other long term investments to make the correct decisions for the company. 4.
If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time? If Marriot uses a single corporate we believe the company will eventually go bankrupt, because it will reject some positive net present value projects. It will also accept some negative net present value projects. It will favor high risk projects over low risks projects, and it will increase its overall level of risk over time. In conclusion it will ultimately lead to poor decisions. 5. What is the cost of capital for the lodging and restaurant divisions of Marriott? Use pure play approach. Do not forget to adjust beta for leverage. Show your calculations clearly. ) The cost of Capital for Lodging is 8. 1% and the Cost of Capital for Restaurants is 11. 05% – Bellow you will find a detailed explanation of all calculations. To complete the following tables, we used the Beta for each company as listed on Exhibit 3 and use the same tax rate used for Marriott (44%). To find D/E Ratio and Unlevered Beta we used the following Calculations: D/E Ratio: To find D/E Ratio we need to use the data provided in Exhibit 3. Market Leverage is the same as D/V Ratio.
With that information we can find D/E Ratio by applying the formula: D/E= D/V / (1-D/V) Unlevered Beta: To find Unlevered Beta we just need to add the data provided of the table to the formula: bU=bL/(1+(1-TAX)*(D/E) for each company Lodging Division – See Spreadsheet for details. CompetitorsBetaD/ETax rateUnlevered Beta HILTON HOTELS CORPORATION0. 760. 162844. 00%0. 6965 HOLIDAY CORPORATION1. 353. 761944. 00%0. 4345 LA QUINTA MOTOR INNS0. 892. 225844. 00%0. 3962 RAMADA INNS, INC. 1. 361. 857144. 00%0. 6667 Average Unlevered Beta: (0. 6965+0. 4345+0. 3962+ 0. 6667)/4=0. 485 Levered Beta: 0. 5485*[1+ (1-44%) (0. 74/0. 26)]=1. 4227 Cost of Equity = RE = Risk Free rate + Beta x (Risk Premium) RE = 0. 0458+1. 4227*(0. 0743) = 0. 1515 or 15. 15%. WACC: = E/V*RE+ D/V*RD*(1-T), where E/V=0. 26, D/V=0. 76 (Table A), Taxes=44%, RE=15. 15%, RD=10. 05%. Therefore, WACC= 0. 26*0. 1515+0. 74*0. 1005*( 1-0. 44) =0. 081 or 8. 10% Restaurant Division – See Spreadsheet for details. CompetitorsBetaD/ETax rateUnlevered Beta COLLINS FOODS INTERNATIONAL1. 450. 111144. 00%1. 3651 FRISCH’S RESTAURANTS0. 570. 063844. 00%0. 5503 McDONALD’S0. 940. 298744. 00%0. 053 CHURCH’S FRIED CHICKEN1. 450. 041744. 00%1. 4169 LUBY’S CAFETERIAS0. 760. 010144. 00%0. 7557 WENDY’S INTERNATIONAL1. 320. 265844. 00%1. 1490 Average Unlevered Beta: (1. 3651+0. 5503+0. 8053+ 1. 4169+0. 7557+1. 1490)/6=1. 0071 Levered Beta: 1. 0071*[1+ (1-44%)*(0. 42/0. 58)]=1. 4154 Cost of Equity = RE = Risk Free rate + Beta x (Risk Premium) RE = 0. 0354+1. 4154*(0. 0847) = 0. 1553 or 15. 53%. WACC: = E/V*RE+ D/V*RD*(1-T), where E/V=0. 58, D/V=0. 42 (Table A), Taxes=44%, RE=15. 53%, RD=8. 7%. Therefore, WACC= 0. 58*0. 1553+0. 42*0. 087*( 1-0. 44) =0. 1105 or 11. 05% a.
What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers? (Hint: Risk premium is calculated over a risk-free rate. See Ch. 12) For the Lodging division we used Long-term US. government bond returns (4. 58%) as the Risk Free rate and the spread between S&P 500 and long-term U. S government bond returns (7. 43%) for the Risk Premium. This data can be found on Exhibit 4 and 5 respectively. Lodging investments are long-term investments since its assets have a long life period. For that reason, we strongly believe that Long-term US.
Bond returns would provide a more accurate estimated. On the other hand, for the Restaurant Division we used Short-term US. treasury bills (3. 54%) as the Risk Free rate and the spread between S&P 500 and short-term U. S Treasury Bills returns (8. 47%) as the Risk Premium. This data can also be found on Exhibit 4 and 5 respectively. Contrary to Lodging, Restaurant investors expect a relative short return on their capital when investing in this business since restaurant assets have a short life period. Therefore, we decided to use short-term returns to estimate the cost of capital for this division. . How did you measure the cost of debt for each division? Should the debt cost differ across divisions? The cost of debt should differ across divisions since each division has its own market risk as stated above. To find the cost of Debt, we will need to consider the Information provided on tables A&B. On table A we find the Company rate premium above Governments interest rates. On table B we find the Government Long/Short term interest rates. Therefore, the sums of both give us the cost of debt to be used in each division. For lodging (long-term) we found 10. 05% as the cost of Debt: 8. 5 %( 30 years – table B) + 1. 10% (Loading Premium – Table A). For restaurant (short-term) we found 8. 7% as the cost of Debt: 6. 90 %( 1 year – table B) + 1. 80% (Restaurant Premium – Table A) c. How did you measure beta of each division? To find beta, we first needed to group all of the companies listed on Exhibit 3 into two different categories: Lodging and Restaurant. After that we have to calculate the D/E Ratio and then calculate Unlevered Beta for each of the companies using the formulas D/E= D/V / (1-D/V) for D/E Ratio and bU=bL/(1+(1-TAX)*(D/E) for Unlevered Beta.
Once we had the Unlevered Beta for each company we had to take the average of Unlevered Beta from all the companies in each category. With that number we can now levered the Beta back for the division using the formula bL=bU*[1+ (1-TAX)*(D/E)] 6. What is the cost of capital for Marriott’s contract services division? How can you estimate its equity costs without publicly traded comparable companies? (Hint: The asset beta (unlevered beta) of the company is just a weighted average of the asset betas of the divisions. The weights should be the fraction of total equity value in each division)
The Capital Cost for Marriott Contract Services Division is 9. 60% – See calculations Bellow TAX RATE: 44% (same as used previously) COST OF DEBT: 8. 7% (same as restaurant, please see explanation on question 5b) DEBT/EQUITY RATIO On Table A we find that the Debt Percentage in Capital for Contract Service Division 40%. With this information we can find the D/E Ratio: D/E= 0. 40 / (1-0. 40) = 0. 67 COST OF EQUITY To calculate the cost of Equity (RE) we need to find the Risk-Free rate, the market risk premium, and the beta. The risk free is 3. 54%. The Market Risk Premium is 8. 7%. (same as restaurant, see explanation on question 5b) Since we don’t have the beta for Contract Service Division we will need to calculate. Using the formula: Asset Beta for Marriott = (weight of restaurant) X Asset Beta for restaurant + (weight of lodging) X Asset Beta for lodging + (weight of contract services) X Asset Beta for contract service. First we need to find Asset Beta for Marriott using Debt to Value Ratio of 41% as shown on Exhibit 3, thus, bU=bL/(1+(1-TAX)(D/E)) so 1. 11/(1+(1-. 044)(0. 41/0. 59) = 0. 7990 Second, we need to find the weights for each division.
Weights can be found on page 2 of the case. The betas for the companies were already calculated on the previously so we just need to plug the numbers to the formula: 0. 7990=0. 16(1. 0071)+0. 51(0. 5485)+0. 33X 0. 7990=0. 16+0. 28+0. 33X 0. 7990=0. 44+0. 33X 0. 33X=0. 7990-0. 44 0. 33X=0. 359 X=0. 359/0. 33 = 1. 0878 – This is the Asset Beta for Contract Services Third, with the asset Beta we can now find the Leverage Beta Levered Beta: 1. 0878*[1+ (1-44%)*(0. 4/0. 6)]=1. 4939 Finally, We can now find the cost of equity: RE = Risk Free rate + Beta x (Risk Premium) RE = 0. 0354 +1. 4939 x (0. 847) RE = 0. 1619 or 16. 19% WACC Now that we have all the elements needed to find WACC we just need to apply the formula and find that the WACC is WACC= (E/V) ? RE + (D/V) ? RD ? (1- TC)= 0. 6 x 0. 1619 + 0. 4 x 0. 087 x (1-0. 44) WACC = 0. 1166 or 11. 66% 7. Prepare a summary table like below: Unlevered Asset BetaDebt/Value RatioLevered Equity BetaCost of DebtCost of EquityWACC Marriott0. 60321. 50001. 507510. 25%15. 78%9. 76% Lodging0. 54852. 84621. 422710. 05%15. 15%8. 10% Restaurants1. 00710. 72411. 41548. 70%15. 53%11. 05% Contract Services1. 08780. 66671. 49398. 70%16. 19%11. 66%
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