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Marriott Corporation: The Cost of Capital (Abridged)

The purpose of this memo is to estimate the weighted average cost of capital (WACC) for Marriott Corporation and its three divisions, as well as explain the logic behind the calculations. There are two Exhibits attached to this memo: The cost of capital calculations for Marriott and its three divisions (page 5) Estimated debt beta and asset beta from other corporations within the same industry (page 6)

First of all, we uses 8.95% as the risk-free rate for Marriott and lodging division and 8.72% as the risk-free rate for the restaurant and contract services divisions. Based on the information provided in this case, we could consider either using the Treasury bill yield or the U.S. government interest rate as the risk-free rate. By comparison, both Treasury bill yield and U.S. government interest rate do not have default risk or liquidity risk. However, the Treasury bill yield has more market risk than the U.S. government interest rate. Thus, we use the U.S. government interest rate in April 1988 as the risk-free rate for Marriott and each of its divisions. Since Marriott is a huge firm that has a long history, we choose to use the 30-year maturity U.S. government interest rate in April 1988 as the risk-free rate for Marriott. The case states Marriott used the cost of long-term debt for its lodging cost-of-capital calculations since lodging assets has long useful lives. Thus, we choose to use the 30-year maturity U.S. government interest rate in April 1988 as the risk-free rate for the lodging division. On the other side, Marriott used shorter-term debt as the cost of debt for its restaurant and contract services divisions since these assets has shorter useful lives. Thus, we choose to use the 10-year maturity U.S. government interest rate in April 1988 as the risk-free rate for the restaurant and contract services divisions.

For the risk premium, we choose to use 7.43%, which is the spread between S&P 500 composite returns and long-term U.S. government bond returns from year 1926 to year 1987. The logic behind this is this rate includes and reflects all the types of events that may affect stock prices in the period of 1926 to 1987.

1

After figuring out the risk-free rate and the risk premium, we are able to calculate the cost of debt, which is the yield on the company’s debt. To determine the cost of debt, we can apply the formula: cost of debt = debt rate premium above government + risk premium. It can be calculated with the data from Table A and Table B. From Table A, it is obvious that the debt rate premium above government differs between the company and each of its divisions. For example, for Marriott, its debt rate premium above government is 1.30%, and the risk premium is 8.95%. Thus, the cost of debt for the firm is 10.25%. In the same manner, we calculated the cost of debt for lodging, restaurant, and contract service to be 10.05%, 10.12%, and 10.52%. After calculating the cost of debt, we can use them to get debt betas using the formula: cost of debt = risk-free rate + beta (market risk premium – risk-free rate). Thus, the debt beta for Marriott is 0.17. And the debt betas for lodging, restaurant, and contract service are 0.15, 0.19, and 0.24.

The next step in our calculation is to measure asset and equity beta for each division under Marriott, we can look into the information on comparable companies for Hotel and Restaurant sections for reference. The unlevered asset beta of Marriott Corporation is calculated as 0.59*1.11+debt beta*0.41=0.73. This will stay the same if the leverage ratio changes. In order to estimate the asset beta for the divisions, we need to use the asset beta from each comparable firm in Exhibit 3. From the table, we know the equity beta and market leverage ratio for each firm. So it is necessary to obtain an estimated debt beta, which is a fraction related to the debt beta of the hotel division in Marriott. We will take Hilton Corporation of lodging as an example,

For Hilton, asset beta=0.76*(1-0.14) +0.05*0.14=0.66. We then calculate the asset beta of each remaining firm under both lodging and restaurant sections with identical methods and reasoning. Finally we use the average asset beta of each division within the industry as the benchmark for that of Marriott’s.

After calculating both debt and asset betas, we can calculate the equity beta based on the fact that asset beta remains the same after considering the new target leverage ratio. Debt ratios of each division are obtained from Table A and calculations are shown in Cost of Capital table.

2

As the contract service division information of other publicly traded comparable firms is unknown, we figured to calculate its asset beta and cost of equity based on its relationship with other two divisions and Marriott. (

)

(

)

(

)

In the above formula, we have already known the beta for M, R and L, we could calculate beta for contract services if we have the weight of asset for each division. We use the fraction of identifiable assets of each division from Exhibit 2 as proxy for relative value. The asset ratio for Lodging, Restaurant and Contact Services are 60.61%, 12.39% and 27.01% respectively. From the data given above, we then calculate 𝑎𝑠𝑠

𝐶𝑆=0.27 and equity 𝐶𝑆=0.28. By applying the

CAPM model, cost of equity for contact services = risk free rate+risk premium* equity 𝐶𝑆 =10.82%. Finally we calculate the WACC using the formula: WACC = rE*(E/E+D)+(1-T)*rD*(D/E+D). Primarily, Marriott uses its estimated cost of capital as a hurdle rate to discount future cash flows for all the investments of the firm and its three divisions. Marriott will calculate the net present value (NPV) of each investment and decide if they should accept the project. The higher the estimated cost of capital, or the hurdle rate, the lower the NPV since cash flows are discounted at a higher rate. However, this logic does not make sense, because WACC and NPV should be calculated independently for each division. The firm and its divisions will have different risks, which will give them different cost of capital. WACC only measures investments with similar risks. Therefore, we could use Marriott’s WACC to evaluate the investments that have the similar leverage ratio and the same operating risk as Marriott. For example, assuming we are in the position of the potential investors of Marriott’s stocks, we could use Marriott’s WACC to assess the cash flows from investing in Marriott’s stocks to figure out the advantages and disadvantages. Moreover, assuming we are on the Marriott’s management team, we could use Marriott’s WACC to evaluate the benefits and losses of plan of repurchasing Marriott’s own stock shares.

3

However, if Marriott uses a single corporate hurdle rate for every division, Marriott might undertake the inefficient project and reject the market-efficient project. As a result, the operating risk of Marriott will increase in the long-term perspective, while at the same time the profitability level of the company will deteriorate. Marriott’s growth will be affected if the same cost of capital is used for the three business divisions.

4

Exhibit 1 Marriott Corpration: The Cost of Capital Input Information: Tax Rate 34%

Lodging Restaurant Conntract Marriott

Identifiable Asset 2777.40 567.60 1237.70 4582.70

Asset ratio 60.61% 12.39% 27.01% 100.00%

Marriott Lodging Retaurant Contract

Risk-Free Rate 8.95% 8.95% 8.72% 8.72%

Risk Premium 7.43% 7.43% 7.43% 7.43%

Cost of Debt 10.25% 10.05% 10.12% 10.52%

Cost of Equity 20.50% 21.86% 20.10% 10.82%

5

Asset Beta 0.73 0.56 0.97 0.27

Debt Beta 0.17 0.15 0.19 0.24

Equity Beta 1.55 1.74 1.53 0.28

WACC 10.90% 10.59% 14.73% 9.19%

Exhibit 2 Arithmetica Average Return MARRIOTT CORPORATION

Marketc Leverage

Equityb Beta

1987 Revenues ($ billions)

Estimated Debt Beta

Asset Beta

22.4%

1.11

41%

6.52

HILTON HOTELS CORPORATION HOLIDAY CORPORATION LA QUINTA MOTOR INNS RAMADA INNS, INC. Averages

13.3 28.8 -6.4 11.7

0.76 1.35 0.89 1.36

14% 79% 69% 65%

0.77 1.66 0.17 0.75

0.05 0.29 0.25 0.23

0.66 0.51 0.45 0.63 0.56

CHURCH’S FRIED CHICKEN COLLINS FOODS INTERNATIONAL FRISCH’S RESTAURANTS LUBY’S CAFETERIAS McDONALD’S WENDY’S INTERNATIONAL Averages

-3.2 20.3 56.9 15.1 22.5 4.6

1.45 1.45 0.57 0.76 0.94 1.32

4% 10% 6% 1% 23% 21%

0.39 0.57 0.14 0.23 4.89 1.05

0.02 0.05 0.03 0.00 0.11 0.10

1.39 1.31 0.54 0.75 0.75 1.06 0.97

6

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The purpose of this memo is to estimate the weighted average cost of capital (WACC) for Marriott Corporation and its three divisions, as well as explain the logic behind the calculations. There are two Exhibits attached to this memo: The cost of capital calculations for Marriott and its three divisions (page 5) Estimated debt beta and asset beta from other corporations within the same industry (page 6)

First of all, we uses 8.95% as the risk-free rate for Marriott and lodging division and 8.72% as the risk-free rate for the restaurant and contract services divisions. Based on the information provided in this case, we could consider either using the Treasury bill yield or the U.S. government interest rate as the risk-free rate. By comparison, both Treasury bill yield and U.S. government interest rate do not have default risk or liquidity risk. However, the Treasury bill yield has more market risk than the U.S. government interest rate. Thus, we use the U.S. government interest rate in April 1988 as the risk-free rate for Marriott and each of its divisions. Since Marriott is a huge firm that has a long history, we choose to use the 30-year maturity U.S. government interest rate in April 1988 as the risk-free rate for Marriott. The case states Marriott used the cost of long-term debt for its lodging cost-of-capital calculations since lodging assets has long useful lives. Thus, we choose to use the 30-year maturity U.S. government interest rate in April 1988 as the risk-free rate for the lodging division. On the other side, Marriott used shorter-term debt as the cost of debt for its restaurant and contract services divisions since these assets has shorter useful lives. Thus, we choose to use the 10-year maturity U.S. government interest rate in April 1988 as the risk-free rate for the restaurant and contract services divisions.

For the risk premium, we choose to use 7.43%, which is the spread between S&P 500 composite returns and long-term U.S. government bond returns from year 1926 to year 1987. The logic behind this is this rate includes and reflects all the types of events that may affect stock prices in the period of 1926 to 1987.

1

After figuring out the risk-free rate and the risk premium, we are able to calculate the cost of debt, which is the yield on the company’s debt. To determine the cost of debt, we can apply the formula: cost of debt = debt rate premium above government + risk premium. It can be calculated with the data from Table A and Table B. From Table A, it is obvious that the debt rate premium above government differs between the company and each of its divisions. For example, for Marriott, its debt rate premium above government is 1.30%, and the risk premium is 8.95%. Thus, the cost of debt for the firm is 10.25%. In the same manner, we calculated the cost of debt for lodging, restaurant, and contract service to be 10.05%, 10.12%, and 10.52%. After calculating the cost of debt, we can use them to get debt betas using the formula: cost of debt = risk-free rate + beta (market risk premium – risk-free rate). Thus, the debt beta for Marriott is 0.17. And the debt betas for lodging, restaurant, and contract service are 0.15, 0.19, and 0.24.

The next step in our calculation is to measure asset and equity beta for each division under Marriott, we can look into the information on comparable companies for Hotel and Restaurant sections for reference. The unlevered asset beta of Marriott Corporation is calculated as 0.59*1.11+debt beta*0.41=0.73. This will stay the same if the leverage ratio changes. In order to estimate the asset beta for the divisions, we need to use the asset beta from each comparable firm in Exhibit 3. From the table, we know the equity beta and market leverage ratio for each firm. So it is necessary to obtain an estimated debt beta, which is a fraction related to the debt beta of the hotel division in Marriott. We will take Hilton Corporation of lodging as an example,

For Hilton, asset beta=0.76*(1-0.14) +0.05*0.14=0.66. We then calculate the asset beta of each remaining firm under both lodging and restaurant sections with identical methods and reasoning. Finally we use the average asset beta of each division within the industry as the benchmark for that of Marriott’s.

After calculating both debt and asset betas, we can calculate the equity beta based on the fact that asset beta remains the same after considering the new target leverage ratio. Debt ratios of each division are obtained from Table A and calculations are shown in Cost of Capital table.

2

As the contract service division information of other publicly traded comparable firms is unknown, we figured to calculate its asset beta and cost of equity based on its relationship with other two divisions and Marriott. (

)

(

)

(

)

In the above formula, we have already known the beta for M, R and L, we could calculate beta for contract services if we have the weight of asset for each division. We use the fraction of identifiable assets of each division from Exhibit 2 as proxy for relative value. The asset ratio for Lodging, Restaurant and Contact Services are 60.61%, 12.39% and 27.01% respectively. From the data given above, we then calculate 𝑎𝑠𝑠

𝐶𝑆=0.27 and equity 𝐶𝑆=0.28. By applying the

CAPM model, cost of equity for contact services = risk free rate+risk premium* equity 𝐶𝑆 =10.82%. Finally we calculate the WACC using the formula: WACC = rE*(E/E+D)+(1-T)*rD*(D/E+D). Primarily, Marriott uses its estimated cost of capital as a hurdle rate to discount future cash flows for all the investments of the firm and its three divisions. Marriott will calculate the net present value (NPV) of each investment and decide if they should accept the project. The higher the estimated cost of capital, or the hurdle rate, the lower the NPV since cash flows are discounted at a higher rate. However, this logic does not make sense, because WACC and NPV should be calculated independently for each division. The firm and its divisions will have different risks, which will give them different cost of capital. WACC only measures investments with similar risks. Therefore, we could use Marriott’s WACC to evaluate the investments that have the similar leverage ratio and the same operating risk as Marriott. For example, assuming we are in the position of the potential investors of Marriott’s stocks, we could use Marriott’s WACC to assess the cash flows from investing in Marriott’s stocks to figure out the advantages and disadvantages. Moreover, assuming we are on the Marriott’s management team, we could use Marriott’s WACC to evaluate the benefits and losses of plan of repurchasing Marriott’s own stock shares.

3

However, if Marriott uses a single corporate hurdle rate for every division, Marriott might undertake the inefficient project and reject the market-efficient project. As a result, the operating risk of Marriott will increase in the long-term perspective, while at the same time the profitability level of the company will deteriorate. Marriott’s growth will be affected if the same cost of capital is used for the three business divisions.

4

Exhibit 1 Marriott Corpration: The Cost of Capital Input Information: Tax Rate 34%

Lodging Restaurant Conntract Marriott

Identifiable Asset 2777.40 567.60 1237.70 4582.70

Asset ratio 60.61% 12.39% 27.01% 100.00%

Marriott Lodging Retaurant Contract

Risk-Free Rate 8.95% 8.95% 8.72% 8.72%

Risk Premium 7.43% 7.43% 7.43% 7.43%

Cost of Debt 10.25% 10.05% 10.12% 10.52%

Cost of Equity 20.50% 21.86% 20.10% 10.82%

5

Asset Beta 0.73 0.56 0.97 0.27

Debt Beta 0.17 0.15 0.19 0.24

Equity Beta 1.55 1.74 1.53 0.28

WACC 10.90% 10.59% 14.73% 9.19%

Exhibit 2 Arithmetica Average Return MARRIOTT CORPORATION

Marketc Leverage

Equityb Beta

1987 Revenues ($ billions)

Estimated Debt Beta

Asset Beta

22.4%

1.11

41%

6.52

HILTON HOTELS CORPORATION HOLIDAY CORPORATION LA QUINTA MOTOR INNS RAMADA INNS, INC. Averages

13.3 28.8 -6.4 11.7

0.76 1.35 0.89 1.36

14% 79% 69% 65%

0.77 1.66 0.17 0.75

0.05 0.29 0.25 0.23

0.66 0.51 0.45 0.63 0.56

CHURCH’S FRIED CHICKEN COLLINS FOODS INTERNATIONAL FRISCH’S RESTAURANTS LUBY’S CAFETERIAS McDONALD’S WENDY’S INTERNATIONAL Averages

-3.2 20.3 56.9 15.1 22.5 4.6

1.45 1.45 0.57 0.76 0.94 1.32

4% 10% 6% 1% 23% 21%

0.39 0.57 0.14 0.23 4.89 1.05

0.02 0.05 0.03 0.00 0.11 0.10

1.39 1.31 0.54 0.75 0.75 1.06 0.97

6

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