Marriot Corporation Cost of Capital

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1. What is the weighted average cost of capital for Marriot Corporation? Briefly outline the key assumptions that you made in computing the WACC. 2. What is the cost of capital for the lodging and restaurant divisions of Marriot Corporation? Briefly outline the key assumptions that you made in computing the cost of capital and outline any limitations that are presented by your analysis. 3. If Marriot uses a single company-wide cost of capital for evaluating investment opportunities in each of its line of business, what do you think will happen to the company over time? 4. Briefly describe how each of the following events will likely impact Marriot’s cost of capital: (a) An increase in the long-term T-Bond rate by 2%. (b) Increased competition in the restaurant business. (c) A mild recession that causes companies to cut back on their overall travel and business expense budgets.

Marriot Corporation: Cost of Capital
Question 1
The cost of capital is computed using Weighted Average Cost of Capital (WACC) technique which is the weighted average of cost of equity and cost of debt of the firm. The cost of debt is the current borrowing rate at the time of the analysis (1988). Marriot calculates its Weighted Average Cost of Capital (WACC). Using the following equation: WACC = (1-corporate tax rate)(Pretax rate of cost of debt)(Market value of debt/ D+E))+ After tax rate of cost of equity(market value of equity/D+E)) Cost of Debt Floating rate debt is considered short-term debt, so the 1 year government interest rate is used to calculate the cost of debt for all divisions and Marriott as a whole. (6.90%). For fixed debt the long term rate would be a better estimate. We could consider the returns on 30 year Government Bonds in April 1988, (8.95%). Floating Debt (40%) - 6,9% Fixed Debt (60%) - 8,95% Total debt = 40%*6,9% + 60%*8,95% = 8,13% Premium above Gov. rates – 1,3% Rd = 8,13% + 1,3% = 9,43% Cost of Equity The cost of equity re, is calculated using the Capital Asset Pricing Model (CPAM): re = rf + β (MRP) Where rf is the risk free rate we estimated earlier, β is the systematic risk and MRP is the market risk premium. β-Beta at 41% leverage is 1.11 (Exhibit 3) and does not specifically addresses Marriot’s target capital structure levered at 60% (Table A). Therefore, we would first need to un-lever this β-Beta and then lever it back, using the following equation: t- Corporate tax rate 1987 = income taxes / income before income taxes = 175.9/398.9 = 44% β – Beta = 1.472 D/E = 41/59 = 0,695 (Exhibit 3) βL = βU [1+ (1-t) D/E] βU = 0,8 β - Levered at 60%

Marriot Corporation: Cost of Capital
Question 1/continued
βL = βU [1+ (1-t) 60/40] βL = 1,472 MRP is the expected excess return investors demand. MRP = E [Rm] – rf For the purpose of our analysis we’ll consider the spread between S&P 500 composite returns and long-term US government bond returns from 1926 to 1987 in exhibit 5 = 7,43%. Now, with the help of our estimations above we can calculate Marriott’s Cost of Equity as follows: re = rf + β (MRP) = 8,72% + 1,472 * 7,43% = 19,66% Rf=8,72% (Table B) Finally, we can now estimate the overall WACC for Marriott Corporation, based on the given debt and equity amounts (Debt = 2499, Equity = (30 X 118.8) = 3564) WACC = (1-t)Rd*D/V + Re*E/V = (1-44%)*9,43%*2499/(2499+3564)+19,66%*3564/(6063)= WACC=13,73%

Marriot Corporation: Cost of Capital
Question 2
We’ll use the same framework for calculating the weighted average cost of capital for Marriott’s lodging and restaurant divisions. Cost of Debt - Lodging and Restaurant divisions Considering the same tax rate as estimated above, we start looking at Table A for the target levels of debt for both Lodging and restaurant divisions (Lodging - 74%, restaurants - 42%). With the target denominations in hand we consider the proportions of floating and fixed rate debts in each of the divisions respectively and determine the floating and fixed cost of debts in order to infer the total...
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