Objective: 1) Calculate the divisional and the company cost of capital and explain the calculation.
2) Evaluate Marriott's use of company cost-of-capital rate for the individual divisions.
Cost of Capital for Lodging Division can be expressed as CC = We*Ce + Wd*Cd.
For the weights of debt and equity (We and Wd), the 1988 target-schedule rates of debt-to-assets and debt-to-equity were used as the only measures available in the case.
Cost of Equity (Ce) was calculated based on the CAPM formula. 30-year T-bond was used as a long-term risk-free security to get the risk-free rate, since Marriott used the cost of long-term debt for its lodging cost-of-capital calculations. The market premium 8.47 was the arithmetic-average spread between the S&P 500 returns and the short-term US T-bills between 1926-1987. This market premium is consistent with the current academic suggestions and it was used in all calculations of this exercise.
The leveraged Beta (Bl) of the lodging division, needed for CAPM, was derived from the following equation: Bl=Bu(1+D/E), where Bu is the unleveraged Beta. Bu was in turn derived from the weighted-average of the Bu's of the lodging businesses given in the case. The weighted-average method rather than a simple arithmetic-average method was used to allow a more accurate Bu of the overall industry.
Cost of Debt (Cd) is defined as (risk-free rate)+the premium (Table A of the case). Once again, the 30 T-bond rate was used for the risk-free rate. Cost of Capital for Lodging is 13.24%.
The WA Bu of today's lodging industry is slightly higher than that in 1987, indicating a slight increase in the business risk associated with the industry.
Cost of Capital for Restaurant Division was calculated in the same manner. The 1-year T-bill was used as a usual shorter-term security to obtain the risk-free rate. The unleveraged Beta, used to obtain the leveraged Beta for the CAPM, was...