Marriott-Solution

Questions for Marriott Corporation

MGMT 611G

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What is the weighted average cost of capital for Marriott Corporation? Assume that the corporate tax rate for all companies is 44%.

Marriott Corporation: The Cost of Capital

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If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time?

Raghu Rau

Cost of Capital for the Entire Firm ■

Cost of Equity : • Target Debt Ratio is 60%, actual is (2499/(2499 + 3564) = 41% • ßs = 1.11 • ßu = ßs /(1 + (1 - t) B/S) • t = 0.44 • B = 2499 • S = 3564 • B/S = 0.70 = 0.80 • ßu

Questions for Marriott Corporation

• Note : Use arithmetic average risk premiums. Ignore floating rate debt.

Using the target debt ratio of : 60.00%

What was the economic value added (EVA) of each of the divisions last year (1987)? Assume operating profits of 1987 are generated by the average invested capital of 86-87.

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Cost of Equity, rs ■

What is the cost of capital for the lodging, restaurant and contract service divisions of Marriott?

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After Tax Cost of Debt ■

• βTS = βu (1 + (1 - t) B/S) • B/S= 1.50 = 1.47 • βTS ■

Using the Capital Asset Pricing Model : • rf = 8.72% (Long-term rate on US Gov't Bonds) • rm-rf = 7.43% (Arithmetic Average, 1926-87) • rs = rf + (rm - rf) βTS • rs = 19.64%

After tax rb = (Gov't Bond Rate + Credit Spread) x (1 - t) • Gov't Bond Rate • Credit Spread

■ rb ■

=

8.72% 1.30%

5.61%

WACC : • WACC = (B/V) x After tax rb + (S/V) x rs = 11.22%

1

Cost of Capital for Lodging Division

Cost of Equity for lodging division ■

Sample of Lodging Companies

Hilton Holiday La Quinta Ramada

Market Value Leverage 14.00% 79.00% 69.00% 65.00%

Beta

0.76 1.35 0.89 1.36

Tax Rate (Assumed = Rate) 44.00% 44.00% 44.00% 44.00% Average Sales Weighted Average

Unlevered Beta

Sales

0.70 0.43 0.40 0.67 0.55

0.77 1.66 0.17 0.75

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βu = 0.93

1.45 1.45 0.57 0.76 0.94 1.32

Unlevered Beta 1.42 1.37 0.55 0.76 0.81 1.15 1.01

= =

0.39 0.57 0.14 0.23 4.89 1.05 0.93

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8.95% 1.10%

WACC : • WACC = (B/V) x after tax rb + (S/V) x rs = 9.16%

x (rm - rf) 19.22%

After Tax Cost of Debt

Using the target debt ratio of : 42.00% • βTS = βu (1 + (1 - t) B/S) • B/S= 0.72 • βTS = 1.31

Sales

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rf + βTS

Cost of Equity

Sample of Restaurant Companies Tax Rate (Assumed = Rate) 44.00% 44.00% 44.00% 44.00% 44.00% 44.00% Average Sales Weighted Average

• Gov't Bond Rate • Credit Spread = 5.63% • rb

rf = 8.72% Long-term rate on US Gov't Bonds • rm-rf =7.43% Arithmetic Average, 1926-87

■ rs

After tax rb= (Gov't Bond Rate + Credit Spread) x (1 - t)

Using the Capital Asset Pricing Model :

■ rs

Beta

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•

0.54

Cost of Capital for Restaurant Division

Church's Collins Foods Frisch's Luby's McDonald's Wendy's

Using the target debt ratio of : 74.00% • βTS = βu (1 + (1 - t) B/S) • B/S= 2.85 • βTS = 1.41

βu = 0.54

Market Value Leverage 4.00% 10.00% 6.00% 1.00% 23.00% 21.00%

After Tax Cost of Debt, kd

Using the Capital Asset Pricing Model : • rf = 8.72% Long-term rate on US Gov't Bonds • rm-rf = 7.43% Arithmetic Average, 1926-87

■ rs = rf + βTS ■ rs

=

* (rm - rf) 18.44%

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After tax rb = • (Gov't Bond Rate + Credit Spread) x (1 - t)

Gov't Bond Rate ■ Credit Spread ■ rb = 5.89% ■ WACC : ■

8.72% 1.80%

• WACC = (B/V) x rb + (S/V) x rs = 13.17%

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Cost of Capital for Contract Services Division

Cost of Equity

There is no sample of Contract Services Companies, but the βu for Marriott must be the weighted average of the Divisional βu's.

L od g in g R estauran ts C o ntra ct S e rv .

Identifiab le A ssets $ 2 ,77 7 .4 $5 6 7.6 $ 1 ,23 7 .7 $ 4 ,58 2 .7

R atio 0.6 1 0.1 2 0.2 7

B eta U nlev ered 0 .54 0 .93 1 .3 1 0 .80

Unlevered Beta 0.80 0.54 0.93 1.31

Target Levered Cost of Debt Equity Debt Beta Ratio 60.00% 1.47 5.61% 74.00% 1.41 5.63% 42.00% 1.31 5.89% 40.00% 1.80 5.67%

Marginal Tax Rate is44.00% Market Risk Premium is7.43%

Cost of Equity

• rf = Bonds • rm-rf = 87

=

• Gov't Bond Rate • Credit Spread • rb = 5.67%

8.72% Long-term rate on US Gov't ■

7.43% Arithmetic Average, 1926-

=(Gov't Bond Rate + Credit Spread) x (1 - t) 8.72% 1.40%

WACC : • WACC = (B/V) x after tax rb + (S/V) * rs = 15.51%

rf + * (rm - rf) = 22.08%

EVA Invested Capital (average 86-87)

WACC

19.64% 11.22% 19.22% 9.16% 18.44% 13.17% 22.08% 15.51%

■ rb

Using the Capital Asset Pricing Model :

■ rs

Summary of Marriott Corporation Cost of Capital Estimates

After Tax Cost of Debt

Using the target debt ratio of : 40.00% • βTS = βu (1 + (1 - t) B/S) • B/S= 0.67 = 1.80 • βTS

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β u = 1.31

MARRIOTT Lodging Restaurants Contract Serv.

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Lodging

2507

Contract Services

1155

565

ROIC

263.9(1 − 0.44) = 59% . 2507

170.6(1 − 0.44) = 8.3% 1155

82.5(1 − 0.44) = 8.2% 565

WACC

EVA

9.16%

-82

13.17%

-57

15.51%

-41

Restaurants

3