Marriott Case
Cost of Capital

Facts:
Dan Cohrs is preparing the annual hurdle rates for the three divisions of Marriot Corporation (Lodging, Contracts, and Restaurants) which will have a significant impact on the firm’s financial and operating strategies. Marriott’s has been truthful to its operating strategy to remain a premier growth company, Marriott’s sales and earnings per share have doubled over the last four years. In 1987 Marriot’s sales rose 24%, the return on equity was 22% and profits were $223 million. Lodging consisted of 51% of Marriott’s profits, while contracts services and restaurants amounted to 33% and 16% respectively. However, the sales mix is not proportionate to relative profits, where 41% of sales are generated from lodging, 46% from contract services and 13% from restaurants. One of the main factors in Marriot’s lodging success has been their strategy to syndicate hotels to limited partners with a three percent management fee and 20% of profits before depreciation and debt service. One of Marriot’s key strategic elements is to optimize the use of debt in the capital structure for which it uses an interest coverage target instead of debt to equity ratio to determine the ideal amount of debt to hold.
Problems:
In order to calculate the WACC (hurdle rate) for each division, many different variables need to be analyzed in detail so that the WACC is a good evaluator of the profitability of future projects. A firm can only use its own cost of capital to evaluate projects when the firm is a single product or single division firm. For conglomerate firms such as Marriott, investment projects in different divisions usually do not have the same level of risk thus it is necessary to determine the required return (risk) for each of its division. Moreover, we need to estimate the beta or the asset risk of each division in order to determine the discount rate to use when evaluating investment projects. Marriott needs to identify firms that are only in the specific same business as each of their divisions (“pure plays”) and calculate unlevered betas from those companies which we can then adjust for the leverage and tax of Marriott. We also need to decide what to use as the risk free rat, market premium and debt to equity ratio for each division to calculate the cost of equity and among others find the tax rate to compute the cost of debt and therewith the weighted average cost of capital. Last but not least, we will evaluate whether repurchasing stock violates the mission statement of remaining a premier growth company.
Analysis
First we need to figure out divisional WACC, as well as Marriott’s WACC given the data presented. WACC is essentially a calculation of a firm's cost of capital in which each category of capital (debt and equity) is proportionately weighted. The exact formula Marriott uses to determine WACC is:
WACC=rD*(1T)*(D/V)+(rE*E/V)
(where rE = cost of Equity, rD = cost of debt, T=tax rate, E=market value of the firms equity, D=market value of the firms debt and V=E+D. )
In order to determine an accurate WACC for each division, we must look at data from other companies that are considered “pure plays,” i.e. their operations run nearly identical to a certain division of a multidivisional corporation. For the lodging division we have used data from Hilton, Holiday, La Quinta, and Ramada Inns. For the restaurant portion, we have used data from Church’s, Collins, Frisch’s, Luby’s, McDonald’s, and Wendy’s. Unfortunately, we have no “pure plays” for the contracts division but we will be able to compute its beta by subtracting the weighted betas from the two other divisions from Marriotts Beta.
Cost of Equity
We were given the equity betas for the comparable companies, but because leverage amplifies the market risk of a firm’s assets, raising the market risk of the equity we had to take the risk of the equity and separate the risk of leverage to...