Marriott Corporation: the Cost of Capital

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Case 1- Marriott Corporation: The Cost of Capital

Some preliminary questions:

1. What do you think about Marriott’s policy of repurchasing shares?

Repurchase whenever stock price < warranted equity value

Does this mean the market is inefficient?

2. Why does Marriott manage rather than own hotel assets?

Finding limited partners on a hotel project is equivalent to selling private equity in the project

Is there any reason to expect the private equity market to work better/worse than the public equity market?

The main questions:

A. What is Marriott’s cost of capital?

B. What is Marriott’s cost of capital for lodging?
for restaurants?
for contract services

Question #1- Marriott’s WACC

Basic steps:

1. Identify (equity at the target debt-equity ratio

2. Identify appropriate estimate of risk-free rate rf

B.
C. 3. Identify appropriate estimate of market risk premium (rm – rf)

D. 4. Use CAPM to estimate requity

E. 5. Identify appropriate measure of rdebt

F. 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 1.11

Current debt value is $2498.8 million

Current equity value is ($30 x 118.8 mil. shares) = $3564 million

Current D/E ratio is 2498.8/3564 = .70

Target D/(D+E) ratio = 60% ( Target D/E ratio = 1.5

Use formula from class notes:

(equity at current ratio = [1 + (1-TC)Debt/Equity](unlevered

( 1.11 = [1 + .66 x .70](unlevered

(.759 = (unlevered

← (equity at target ratio = [1 + .66 x 1.5] x .759

← (equity at target ratio = 1.51

2. Identify appropriate estimate of risk-free rate rf

Generally choose a risk-free rate that corresponds to the

maturity to your assets

Since Marriott’s has a mix of short term and long term assets, use the 10-year government bond rate of 8.72%

3. Identify appropriate estimate of market risk premium (rm – rf)

Average annual return on market for 1926-1987 = 12.01%

Average annual return on long-term government bonds = 4.58%

Difference of 7.43% is an estimate of market risk premium

Some notes concerning Exhibit 4:

-stock market returns are the most volatile

-averages over shorter time periods are at times significantly different than averages over entire period

Should we place more weight on more recent observations?

4. Use CAPM to estimate requity

requity = rf + (equity(rm – rf)

requity = 8.72% + (1.51 x 7.43%) = 19.94%

5. Identify appropriate measure of rdebt

Marriott’s current overall debt rate is 1.30% above government. At target debt-equity this is unlikely to increase substantially.

Use rdebt = 8.72% + 1.30% = 10.02%

6. Use formula: rWACC = [D/(D+E)](1-TC)rdebt + [E/(D+E)]requity

rWACC = (.60 x 10.02%)(1-.34)+ (.40 x 19.94%)

= 11.94%

Question #2- 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:

To get estimate of (unlevered for lodging use the average for the 4 hotel firms

Hilton: (equity = .76, D/V = .14 ( D/E=.16
.76 = [1 + .66 x .16] (unlevered
.69 =...
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