Marriott Corporation” the Cost of Capital
Case #3 “Marriott Corporation” The Cost of Capital”
What is the weighted average cost of capital for the Marriott Corporation and cost of capital for each of its divisions? – What risk-free rate and risk premium did you use to calculate the cost of equity? – How did you measure the cost of debt? – How did you measure the beta for each division?
Solution
What risk-free rate and risk premium did you use to calculate the cost of equity?
– Risk-free rate proxy
The risk-free rate is determined using the yields of U.S. Treasury securities, which are risk-free from default risk. U.S. Treasuries are subject to interest rate risk, therefore, the selected maturity should correspond to an investment horizon[1].
– Investment horizon
According to the cost-of-capital calculation methodology used by Marriott Corporation, lodging division was treated as long-term, while restaurant and contract services divisions were treated as short-term because those assets had shorter useful lives.
– Expected return proxy
Arithmetic average return is more suitable than geometric mean as it is better in estimating an investment’s expected return over a future horizon based on its past performance (geometric mean is a better description of long-term historical performance of an investment).
– Risk-free interest rate
Taking into account the above, arithmetic average annual returns of long-term U.S. government bonds for the period 1951-1987 (4.88%, see Appendix 1) is considered to be risk-free rate for lodging division. Arithmetic average annual returns of short-term U.S. government bonds for year 1987 (5.46%, see Case Exhibit 4) is considered to be risk-free rate for restaurant and contract services divisions.
– Market proxy
S&P 500 index is selected as a market proxy as it is believed to be close to the true market portfolio. As it is important to use historical returns for the same market index used to calculate beta (which is given), an
What is the weighted average cost of capital for the Marriott Corporation and cost of capital for each of its divisions? – What risk-free rate and risk premium did you use to calculate the cost of equity? – How did you measure the cost of debt? – How did you measure the beta for each division?
Solution
What risk-free rate and risk premium did you use to calculate the cost of equity?
– Risk-free rate proxy
The risk-free rate is determined using the yields of U.S. Treasury securities, which are risk-free from default risk. U.S. Treasuries are subject to interest rate risk, therefore, the selected maturity should correspond to an investment horizon[1].
– Investment horizon
According to the cost-of-capital calculation methodology used by Marriott Corporation, lodging division was treated as long-term, while restaurant and contract services divisions were treated as short-term because those assets had shorter useful lives.
– Expected return proxy
Arithmetic average return is more suitable than geometric mean as it is better in estimating an investment’s expected return over a future horizon based on its past performance (geometric mean is a better description of long-term historical performance of an investment).
– Risk-free interest rate
Taking into account the above, arithmetic average annual returns of long-term U.S. government bonds for the period 1951-1987 (4.88%, see Appendix 1) is considered to be risk-free rate for lodging division. Arithmetic average annual returns of short-term U.S. government bonds for year 1987 (5.46%, see Case Exhibit 4) is considered to be risk-free rate for restaurant and contract services divisions.
– Market proxy
S&P 500 index is selected as a market proxy as it is believed to be close to the true market portfolio. As it is important to use historical returns for the same market index used to calculate beta (which is given), an