Marriott Corporation: the Cost of Capital

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Marriott Case

1. What is the WACC for Marriott Corporation?

Cost of Debt

Tax Rate
We determined this number by taking income taxes paid/EBITDA = 175.9/398.9 = 44.1%

Return on debt
There are two clear components of debt: fixed and floating.
In order to get the fixed debt rate we took the interest rates on fixed-rate government securities and added the premium above the government rate.
The floating aspect is priced into the premium above the government rate.
We used the 30-year maturity for the cost of debt on Marriott Corp and the Lodging division. We did this because both the Lodging division’s assets and the company have long useful lives.

We used a 10-year maturity for the cost of debt on the Restaurant division. We did this because the useful life of the assets in a restaurant are not as long-term as those in Lodging, but are also not extremely short-term.

We used a 1-year maturity for the cost of debt on the Contract Services division. We did this because the useful life of the assets in this division is very short.

COST OF DEBT| | | | |
Fixed-rate US Government Securities| |
Maturity| Rate| | | | |
30 year| 8.95%| | | | |
10 year| 8.72%| | | | |
1 year| 6.90%| | | | |
| | | | | |
| | | Rate| Debt Rate Premium| Total Fixed Cost of Debt| Marriott| | | 8.95%| 1.3%| 10.2500%|
Lodging| | | 8.95%| 1.1%| 10.0500%|
Restaurants| | | 8.72%| 1.4%| 10.1200%|
Contract Services| | 6.9%| 1.8%| 8.700%|

Debt part of WACCMAR = (1-TC)(RD)(WD) =
(1-.441)(.1025)(.6) = 3.44%

Cost of Equity
RE = CAPM = RF + (RM – RF)

Determining a risk-free rate:
We always want to use duration matching; considering that we are estimating the equity return on a long-term investment, such as the valuation of a business where the value can be equated to the present value of a series of future cash flows over many years, then the yield on a long-term U.S. government bond is commonly used in benchmarking the risk premium estimate. Most business investments have long durations and suffer from a reinvestment risk comparable to that of long-term U.S. government bonds. Long-term bonds more closely match the investment horizon that the firm faces when making capital allocation decisions.

It is important to remember that risk free rates can VARY; we do not simply plug one risk free rate into all the RF holes.

Risk Premium = RM – RF = spread between return on the market and the risk free rate

RM (S&P 500 Returns) = 12.01%
RF (T-Bill)= 5.46%
Risk Premium = 7.43%

The firm’s historical equity beta was regressed between 1986 and 1987 and came out to be .97 with a market leverage of 41% meaning that the D/E was .6949. To get an adjusted beta that will reflect a more accurate picture of the target debt level we un-levered this equity beta and then levered it back up based on the target debt level, which is 60% debt meaning a D/E of 1.5: equity = [1 + (1-TC)*D/E]unlevered

.97 = [1 + (1-.441)*.6949] unlevered
unlevered = .97/[1 + (1-.441)*.6949 = .6986
Re-lever based on target D/E of 1.5
equity = [1 + (1-TC)*D/E]unlevered
equity = [1 + (1-.441)*1.5].6986 = 1.284

This number makes sense because the company wants to increase its amount of leverage and increasing leverage increases overall risk. A higher beta reflects higher risk, which is consistent with our findings.

Now we can apply our target levered beta to CAPM
RF + (Risk Premium)
5.46% + 1.284(7.43%) = 15% = cost of equity

Equity part of WACCMAR = RE*WE = .15*.40 = 6%

If we put the whole equation together we get:...