Case 1- Marriott Corporation: The Cost of Capital  

Overview Company background - Established in 1927. - One of the leading lodging and food service companies. - Three major lines of business: lodging, contract services, and restaurants. The role of the cost of capital - Used as a hurdle rate for its investments. Excess funds are used to repurchase shares. Important to use a right hurdle rate. Two questions: - What is Marriott’s WACC: the cost of capital for Marriott as a whole. - What are the divisional costs of capital?

Question #1- What is Marriott’s WACC: the cost of capital for Marriott as a whole   rWACC = [D/(D+E)](1-TC)rdebt + [E/(D+E)]requity Basic steps:        1. Identify equity at the target debt-equity ratio 2. Identify appropriate estimate of risk-free rate rf             3. Identify appropriate estimate of market risk premium (rm – rf)               4. Use CAPM to estimate requity 5. Identify appropriate measure of rdebt 6. Use formula: rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity

1. Identify equity at the target debt-equity ratio   Note that equity at current debt-equity ratio is estimated at -- The current equity could be used if the target debt ratio matched the actual debt ratio. Target D/(D+E) ratio =  Target D/E ratio = -- The beta has to be adjusted for the difference between the actual and target debt ratio by unlevering the beta and levering it at the target debt rate. equity = [1 + (1-TC)Debt/Equity]unlevered Based on data in Exhibit 1, Current debt value is $ million Current market value of equity is Current D/E ratio is 0.97 = [1 + .66 x .70]unlevered unlevered = equity at target ratio =

2. Identify appropriate estimate of risk-free rate rf Reasonably assume that beta, risk premium, and a risk-free rate are stable: choose the yield on a long-term government bond as a risk-free rate. General to choose a risk-free rate that corresponds to the maturity to your assets   3. Identify appropriate estimate of market risk premium (rm – rf)    Spread between S&P 500 Composite returns and Long-term US Government returns = 7.43% (Exhibit 5)    an estimate of market risk premium Some notes concerning Exhibit 5: -stock market returns are the most volatile -avg. over short time periods are often significantly different from overall avg. -should we place more weight on more recent observations? Since Marriott’s has a mix of short term and long term assets, use the 10-year government bond rate of 8.72% (Table B)

4. Use CAPM to estimate requity  requity = rf + equity(rm – rf)   5. Identify appropriate measure of rdebt   Marriott’s current overall debt rate is 1.30% above government (Table A). At target debt-equity this is unlikely to increase substantially. Use: 6. Use formula: rWACC = [D/(D+E)](1-TC)rdebt + [E/(D+E)]requity requity = rdebt = 8.72% + 1.30% = 10.02%, where 8.72% is the 10-year government interest rate from Table B rWACC = =

Question #2- What are the divisional costs of capital? What is Marriott’s cost of capital for lodging? for restaurants? for contract services?   Preliminary questions: Why is breaking down cost of capital estimates by activity a good idea? Could it lead to better investment decisions?

Lodging Division – Cost of Equity Capital   The unlevered beta (or asset beta) measures the riskiness of firm’s operation, so we can use asset betas of comparable firms in the same industry to get estimates of divisional asset betas. To get an estimate of unlevered for lodging use the average for the 4 hotel firms Hilton: equity = .88, D/V = .14 Holiday: equity = 1.46, D/V = .79  D/E=3.76 1.46 = [1 + .66 x 3.76] unlevered unlevered = .42   La Quinta: equity = .38, D/V = .69  D/E=2.23 .38 = [1 + .66 x 2.23] unlevered unlevered = .15 Ramada: equity = .95, D/V = .65  D/E=1.86 .95 = [1 + .66 x 1.86] unlevered unlevered = .43  D/E=.16 .88 = [1 + .66 x .16] unlevered unlevered = .80

Average of these four estimates for unlevered is .45   Marriott target lodging D/(D+E) ratio is 74% (Table A)  target D/E ratio=2.85   Thus: Put this into the CAPM:   For lodging which is mostly long term assets, use risk-free rate based on 30 year government bonds  appropriate rf = 8.95% requity at target ratio = equity at target ratio = [1 + .66 x 2.85] x .45 =1.30 8.95 + 1.30 (7.43) = 18.61%

Lodging Division – Overall Cost of Capital Some additional ingredients:   1. For lodging, debt rate is only 1.10% above government rate (Table A) rdebt = 8.95% + 1.10% = 10.05% 2. Marriott target lodging D/(D+E) ratio is 74%   3. TC was .34 Put this all into the cost of capital formula: rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity   rWACC = (1-.34)(.74 x 10.05%) + (.26 x 18.61%) = 9.75%

Estimate of overall cost of capital for restaurants   Exactly same procedure as for lodging Assets are shorter lived  10 year bond rate for risk-free rate Estimate the cost of capital for contract services There are no publicly traded comparable firms that produce contract services. what do we do?

Contract services – a solution unlevered for firm should be a weighted average of the unlevered for each activity.   Use as weights book value of assets in each activity (Exhibit 2) % assets in lodging = 2,777 / (2,777+1,237+567) = .61 % assets in contract services = 1,237 / 4,581 = .27 % assets in restaurants = 567 / 4,581= .12 unlev firm = .61 x unlev. lodging + .27 x unlev. contract + .12 x unlev restaurant Plug in unlev firm, unlev. lodging, and unlev restaurant from above to calculate unlev. contract Once you have unlev. contract, cost of capital at the target debt ratio calculated follows same procedure as for lodging and restaurants