Marriott Corporation: The cost of Capital (Abridged)
Dan Cohrs, the Vice President of the project finance as the Marriott Corporation has to deal with making recommendation for the hurdle rates at Marriott Corporation and its three divisions are lodging, contract services and restaurant. In his task, it is important to decide whether it is better to use one hurdle rate for all divisions or use single hurdle rates for each respective division. In addition, it is very important for him to choose the most relevant dataset for each division in order to get the most accurate hurdle rate.
In this case, in Table A, it has shown that the target leverage ratio for Marriott is 60%, but in reality, Exhibit 3 has shown that market leverage is 41%, which is estimated using five years of monthly data over the 1983-1987 period. This could be calculated based on the data in Exhibit 1,which Long-term debt/(Market price * Shares outstanding + Long-term debt)= 2498.8/(30*118.8+2498.8)= 41%. Therefore, we believed that equity beta for the target leverage ratio of 60% need to be adjusted.
It is important to know that the asset beta measures the inherent riskiness of the underling assets with respect to the market. However based on he MM theorem that the capital structure is irrelevant to the value of the firm, therefore, the change in debt and equity ratio has no influence on the underlying riskiness of the assets.
Value of the firm (V)= Debt (D) + Equity (E)
Expected return of the firm’s assets (ra)
=Expected return of debt (rd)*(D/V)+ Expected return on equity (re)*(E/V)
We could obtain that:
= Cov(rd*(D/V)+re*(E/V), rm) )/Var(rm)
=(E/V)*Be (if the company is unlevered, D=0, E/V=1)
Ba=(E/V)*Be => Be=(V/E)* Ba
Exhibit 3 has shown that beta for Marriot’s equity is 1.11, market leverage (D/V) is 41%, therefore Ba=(E/V)*Be= (1-0.41)*1.11=0.655....