The Cost of Capital
Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University
Table of Contents
The hurdle rate is the required return or opportunity cost of each division and company. Only project with positive NPV discounted by hurdle rate will be invested, and the total return of Marriott up to all projects invested. Though there are many subjective aspects in estimation of WACC, common view and accepted formula will be adopted to calculate WACC, discretion if prudent used. Key factors
1. Key factors of debt
a) Tax rate
Tax rate is based on state policy and net income of the company. Since tax rate of 1988 is not expected to change, tax rate of 1987 is the best estimation of rate of 1988, will be 44.10%. b) Bench mark bond
Lodging division uses long term debt for debt, and based on going concern, 30-year bond rate is selected as bench mark, which is 8.95%。 Contract services division and restaurant division uses short-term debt rate, that is 1-year U.S. Government rate equals to 6.9%, also taken as risk free rate. c) Bond rate of division and Marriott
As there are both floating and fixed rate bonds among divisions and Marriott, the bond rate can be calculated as Bond rate of Division or Company =
Fraction of Debt at Floating *(Bench Mark Rate +Premium)
+ Fraction of Debt at Fixed * Fixed bond rate
d) Weight of Debt and Equity
Leverage level of 1988 is 60% of total capital debt, 40% of total capital equity, and leverage ratio (total capital / total equity) is 2.5 2. Key factors of equity
a) β of equity
β is the asset’s contribution to market portfolio, that indicates the company operates solely in one industry should have same beta as the division within the same industry of another company, therefore based on long term equilibrium theory, as long as new competitors will entered the industry if there is a high return, eventually all entities operates in the industry will have nearly the same return. Thus, two criterions are introduced to select β are, firstly have the same operation field, secondly have approximately the same return. The return of Lodging division and restaurants division of Marriott are given in table below.
Since HILTON and HOLIDAY operate casinos, it always leads to a high profit margin. LA QUINTA MORTOR operates motor inns, quite different with lodging. The remaining RAMADA has almost the same operation as Marriott and mean return of 11.7%, approaches to Lodging’s 10.31%. Obviously, RAMADA’s beta is most appropriate for Lodging division. Both CHURCH’S and WENDY’S have far too low average return. Also, COLLINS FOODS and LUBY’S operations are different from Marriott’s restaurant division, which only leaves McDONALD’s beta to be adopted. Since beta of other companies are leveraged, to get the beta of each division, first unlever the beta of other company by the leverage of the company, and then multiply the leverage of Marriott for there is no clear division leverage here. The formulas are
The beta of Lodging is 1.36*(1-65%)*(1/(1-74%)) = 1.83.
The beta of restaurant division is 0.94*(1-23%)*(1/(1-42%))=1.25 The beta of Marriott 1988 is 1.11*(1-58.8%)*(1/(1-60%))=1.14
The beta of contract services division can be calculated as
1.14*(909.7+373.3+452.2) = 1.83*909.7 + 1.25*452.2 + *373.3
b) Risk free rate
One year US Treasury bill is usually taken as risk free rate, which is 6.90%. The reason is international settle currency and issue power of us Fed. C) Risk premium of stock
Character of stock market is higher return and higher risk compared to bond market. As stock market return heavily related to contemporary Government policies and social situations, historical...
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