1.How does Marriott use its estimate of cost of capital? Does this make sense?
Marriot use cost of capital as the hurdle rate (minimum rate of return required to accept the project) to discount future cash flows for the investment projects of the three lines of business (Lodging, Contract Services and Restaurants). They use this rate to calculate NPV and net present value over cost to decide for the profit rate. Since cost of the project stays constant, net present value and hurdle rate are used as variable to decide if they should accept the project or not. The higher the rate, the lower the net present value because future cash flows are discounting at a higher rate. The case clearly describes that WACC can only measure investment of similar risk class and for that reason we don't think the way Marriott uses to estimate cost of capital makes sense since we believe that WACC and net present value of the project must be separately calculated for each part of the company and for each of their projects.
2.What is the weighted average cost of capital for Marriott Corporation?
The WACC for Marriot Corp is 9.76%--See calculations bellow:
In order to find the WACC for Marriot Corporation we need to find the elements needed for such calculation:
Based on Exhibit 1, the average tax rate used from 1978 to 1987 is 41%. However the most recent tax rate used (1987) was 44%. We will use the most recent tax rate of 44% on our calculations.
COST OF DEBT
To find the cost of Debt is 0.1025 or 10.25% (See explanation on b)
On Table A we find that the Debt Percentage in Capital is 60%. With this information we can find the D/E Ratio:
D/E= 0.60 / (1-0.60) = 1.5
COST OF EQUITY
To calculate the cost of Equity (RE) we need to find the Risk-Free rate, the market risk premium, and the beta.
The risk free rate for Marriott is 4.58%. The Market Risk Premium is 7.43%.
The beta given on Exhibit 3(1.11) is levered. To finish our calculation for the cost of equity we must find the unlevered Beta and adjust it properly thus,
bU=bL/(1+(1-TAX)(D/E)) so 1.11/(1+(1-.044)(1.5) = 0.603
After adjusting for the target debt ratio, the beta of equity for Marriott should be 0.603/0.4 = 1.5075
We can now find the cost of equity:
RE = Risk Free rate + Beta x (Risk Premium)
RE = 0.0458 +1.5075 x (0.0743)
RE = 0.1579 or 15.78%
Now that we have all the elements needed to find WACC we just need to apply the formula and find that the WACC is 9.76%
WACC= (E/V) × RE + (D/V) × RD × (1- TC)= 0.4 x 0.1578 + 0.6 x 0.1025 x (1-0.44) WACC = 0.0976 or 9.76%
a.What risk-free rate and risk premium did you use to calculate the cost of equity?
The risk free rate for Marriott Corporation can be found on Exhibit 4. It's the average of Long Term US Government bond from 1926-1987 and that is 0.0458 or 4.58%. The Market Risk Premium is the Spread between S&P 500 Composite returns and Long Term US Government bond and that is 0.0743 or 7.43%. This information can be found on Exhibit 5
b.How did you measure Marriott’s cost of debt?
To find the cost of Debt, we will need to consider the Information provided on tables A&B. On table A we find that 1.30% is Company rate premium above Governments Long-term bonds. On table B we find that Government Long-Term Bonds (30 years to maturity) is 8.95%. Therefore, the sum of 8.95% and the Premium of 1.30% is the Cost of Debt we need, thus 0.0895+0.0130 = 0.1025 or 10.25%
3.What type of investments would you value using Marriott’s WACC?
You would value investments that give you a rate higher than 9.76%, because if Marriot chooses a project with a WACC lower than its 9.76% they run the risk of lowering their value on their stocks, and won’t be able to pay all of its investors, which includes stockholders, bondholders, and preferred stock holders. We would also value...