Marriott Corporation Case Solution

Marriott Corporation: The Cost of Capital

Background  As the vice president of project finance of Marriott Corporation, we are conducting an analysis of our company (Marriott Corporation) for calculating the hurdle rates at each of our firm’s three divisions: lodging, restaurant and contract services. e use eighted Average Cost of Capital (ACC) as the hurdle rate. !he investment projects in our company are selected "y discounting the appropriate cash flows "y the appropriate hurdle r ate for each division.

Approach #irst of all, we will determine the cost of de"t ($d), cost of e%uity ($e) and the capital structure for the whole company. !hen we can get the ta& rate to calculate the ACC for the whole company. After this, we will determine the $is'free $ates ($f), $is' remiums ($p) and *etas (+) for lodging and restaurant divisions in order to calculate the Cost of %uity for these two divisions.  After finding out the cost of de"t and the fraction of de"t for lodging and restaurant divisions, we will "e a"le to calculate the ACC at each of the two divisions. -sing a weighted average method of the identifia"le assets of our company in /01, we will then "e a"le to find out the + and determine the cost of de"t and the fraction of de"t for contract services division. #inally, we will "e a"le to get the ACC for this division.

Financial Strategy !he divisional hurdle rates in our company would have a significant impact on our firm’s financial and operating strategies. e use cost of capital as the hurdle rate to discount future cash flows for the investment projects of the firm’s three divisions. e only invest in a project if the internal rate of return (2$$) is greater than the hurdle rate. 3owever, ACC of the project should "e considered and calculated separately for each division for different investments projects. e intend to remain a premier growth company, in each division, our goal is to "e the preferred employer, the preferred provider, and the most profita"le company. company.

Cost of Capital !he weighted average cost of capital for the whole company is 1.4/5. e can get the num"er as "elow evaluations: Marriott $f 6.405 Delever 

$d 7.845

$d.prem .975

Current ;< 65

Current ;< 4/5

7.147

+a

!arget ;<

!arget ;<

βd

7.4796 CAPM $f 6.405 ACC

=75

675

7.147

$p 1.695

+e 7.11/7

$e 7.915

$e

!arget ;<

!arget ;<

+e . Relever 

$d

$m 8.75 βd

7.845 7.915 =75 675 etailed calculation method please see attached e&cel file.

$m $f   βd 1.695 7.147 !a& rate 66.745 !a& rate 66.745

!a& rate 66.745

+a 7.4796 +e 7.11/7

ACC 1.4/5

e "elieved that the longer the time period of data, the "etter and the more e&act information. 2nformation "ased on the short period might "e distorted from such factors as inflation or economic crisis in some period of time. As shown in the &hi"it 6, the return rates in each period of time are rather fluctuated. !hus, return rate that is "ased on the longest period should "e the "est representative of the rate to "e used. e use the short term treasury "ill returns from /8=/01 for restaurants and contract services as the ris'free rate which is 9.465, "ecause those assets have shorter useful lives. e use long term -.>. government "ond returns from /8=/01 for Marriot and ?odging as the ris' free rate which is 6.405, "ecause lodging assets have long useful lives. !he ris' premium is the spread "etween >@ 477 composite returns and shortterm treasury "ill returns from /8=/01 which is 0.615 for restaurants and contract services. !he ris' premium for Marriot and ?odging is the spread "etween >@ 477 composite returns and longterm -.>. government "ond returns which is 1.695.

e calculate the cost of de"t "ased on the information provided in ta"le A and ta"le *. !he cost of de"t for Marriott is the de"t rate premium a"ove government plus 97 year government interest rate and it is 7.845. !he cost of de"t for ?odging is its de"t rate premium a"ove government plus 97 year government interest rate and that is 7.745. !he cost of de"t for  contract services is its de"t rate premium a"ove government plus  year government interest rate and it is 0.95. !he cost of de"t for restaurant is its de"t rate premium a"ove government plus  year government interest rate and that is 0.15. !he "eta for each division was measured "y calculating the lever "eta using an average unlevered "eta of the compara"le companies. #irst, we chose the companies in the same line of  "usiness of each division (lodging and restaurant). e&t, we used the e%uity "eta of those firms to calculate unlevered "eta. After that, we used total sales of those companies to calculate a weighted average unlevered "eta of those compara"le companies. #inally, we used the average unlevered "eta to calculate the "eta of each division from the formula: +e B +a  (+a D+d) & E(t) ;F. !he proportion of ; was from the mar'et value target leverage ratios in !a"le A. !hen, the cost of capital for the lodging and restaurant divisions of Marriott is =.75 and 1.4/5 respectively. !o estimate the e%uity costs of this division without compara"le companies, we did the mathematics "ased on the financial report (&hi"it 8). >ince we had the amount of unlevered "eta for the hotel as a whole and for the lodging and restaurant divisions, we used this information to solve for the unlevered "eta of the contract services division. !o estimate the amount of "eta as correct as possi"le, we decided to weight the amount of  unlevered "eta we had. e decided to use identifia"le assets to calculate the ratio for the weighting purpose. !he reason is that the company or the division normally uses cost of capital to purchase assets for the operation. !hus, assets should "e the "est item to weight the unlevered "eta.  After solving the e%uation for the unlevered "eta of the contract services division, we used this "eta to calculate the lever "eta. !he process to calculate the cost of capital is the same as what

we did for other divisions. !he cost of capital for Marriott’s contract services division is 7.=/5. Su!!ary >ince the hurdle rates would affect the firm’s financial and operating strategy, we consider all the aspects that related to this analysis, and calculate the rates very carefully. As the vice president of project finance, we prepare annual recommendations for the hurdle rates at each of  the firm’s three divisions are =.75 (lodging), /.765 (restaurant) and 7.=/5 (contract services). Summary  Marriott "odging Restaurants Contract Services

+d 7.16/ 1 7.607 4 7.884  7.=48 /

+e 7.11/7 6 7.968 1 .7717 9 .9871 /

$e

ACC

7.915

1.4/5

1.85

=.75

8.715

/.765

6.195

7.=/5