Marriott Corporation

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Marriott Corporation: The Cost of Capital
Simrith Sidhu, Amy-Jane Miocevich, Jacques Rousset, Jing Tao

Task One:

Marriott uses the Weighted Average Cost of Capital (WACC) to measure the opportunity cost for investments. WACC is calculated using the 1987 financial data provided in the Marriot Corporation: The Cost of Capital (Abridged) case study and estimators. WACC = Cost of Equity x (Equity/Debt +Equity) + Cost of Debt x (Debt/(Debt + Equity)) x (1 – Tax Rate) This method is applied for Marriott as a whole and its three divisions (lodging, contract services and restaurants). Marriott uses their WACC’s to discount appropriate cash flows by the appropriate and related divisional hurdle rate. This allows them to calculate the Net Present Value (NPV) of investment projects and evaluate their future and current investments. Also, Marriott has considered using their hurdle rates as a method of determining incentive compensation for managers.

Calculating Marriott’s WACC:

In order to calculate the WACC for the whole of Marriott, we are required to use the equity beta provided in exhibit 3 of the case study. We use the market leverage percentage (also in exhibit 3) to get the book debt/equity ratio and find the unlevered beta. We chose to use the market leverage ratio of 41% instead of the market debt to equity ratio in exhibit 1 of 58.8% so that we are consistent with the calculations WACC for the three divisions of Marriott. To calculate the unlevered beta we use Hamada’s formula (Fernandez, 2003). Unlevered Beta = Equity Beta / (1 + (1 – tax rate) x (Debt/Equity))

= 1.11 / (1 + (1 – 0.34) x 0.6949
= 0.7610

We use the unlevered beta and the market value target leverage ratios (from table A of the case study) to calculate the levered beta and subsequently, calculate the return on equity. This is shown below and in appendix 1.1 and 1.2.

Levered Beta = Unlevered Beta x (1 + (1 – tax rate) x (Target Debt/Target Equity)
= 0.7610 x (1 + 1 – 0.34) x 1.5
= 1.8948

Return on Equity = Risk free Rate of Equity + (Market Risk Premium x Levered Beta)
= 5.24% + (6.77% x 1.8948)
= 18.07%

We get the risk free rate of equity of 5.24% from exhibit 4. It is the long-term high grade corporate bonds return from 1926-87. Our decision to use this rate was based on the basis that Marriott’s assets had long useful lives and the similarity we found on Marriott’s equity (in regards to growth and risk) and long-term high grade corporate bonds. We also chose to use this rate so that we remain consistent with our use of the arithmetic averages as we use 6.77% as our market risk premium for Marriott’s return on equity. The rate of 6.77% is the spread between S&P 500 Composite returns and long-term high grade corporate bonds returns which can found in exhibit 5 of the case study. Return on Debt = Risk Free Rate + Debt Rate Premium above Government

= 8.95% + 1.30%
= 10.25%
The return on debt is calculated using the 30-year maturity rate of US Government Interest Rates in April 1988 (8.95% from table B). We use this rate for Marriott because it is the longest term rate. The debt rate premium is given in table A of the case study as 1.3%.

Once we have established the return on equity and return on debt, we use the target equity to value and debt to value ratios to calculate the WACC where our tax rate is 34%. WACC = Cost of Equity x (Equity/Debt +Equity) + Cost of Debt x (Debt/(Debt + Equity)) x (1 – Tax Rate)

= 19.32% x 0.4 + 10.25% x 0.6 x (1 – 0.34)
= 11.79%
This method of finding the unlevered beta and the levered beta and estimating the return on equity and debt is used also for finding Marriott’s division WACC’s for lodging and restaurants.

Calculating Marriott’s Lodging Division WACC:

To calculate the levered beta for Marriott’s lodging division, we used the information on the four comparable hotel companies (exhibit 3 in the case study). The equity beta for...
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