Marriott Corporation: The Cost of Capital

October 14, 2008 Nroop Bhavsar Prerak shah

Company Background
Began with J. Willard Marriotts root beer stand Grew into one of the leading lodging and food service companies Lines of business: Lodging Contract services Restaurants

Company Goals

Intend to remain premier growth company:

Aggressively developing appropriate opportunities within existing line of business To become preferred employer, preferred provider and the most profitable company in existing lines of business

Financial Strategy
Selection of investment project by discounting expected cash flow at hurdle rate for each divisions.
Hurdle rate is the minimum rate of return that must be met for a company to undertake a particular project. For example,
Typical Hotel Profit and Hurdle rates
50% 40% 30% 20% 10% 0% Hurdle rate

Profit rate

1
-10% -20%

Elements of Financial Strategy

I.

Manage rather than own hotel assets

II. Invest in projects that increase shareholder value III. Optimize the use of debt in the capital structure IV. Repurchase undervalued share

Cost of Capital and the Comapny

Company measures opportunity cost of capital for investment with similar risk using the Weighted Average Cost of Capital. WACC= (1-t)*rD*D/V + rE*E/V Where, t= corporate tax rate rD= cost of debt D/V= % of debt financing rE= cost of equity E/V= % of equity financing

Elements of WACC

Unlevered beta
Levered beta Cost of equity Cost of debt

Elements of WACC

Unlevered Beta

Levered Beta

Beta of a company without any debt (Published beta)

Beta of a leveraged required return

Unlevering a beta removes the financial effects from leverage

Hamada's formula: BL= Bu [1+ (1-t) D/E]

Elements of WACC
rE: cost of equity (CAPM) rE= Rf + Beta*(Risk premium) where, Rf= risk free rate (generally, 3-month US treasury bill) Beta= the sensitivity of the asset returns to market returns Risk premium= rM-Rf

Elements of WACC
rD: cost of debt rD= Government rate of borrowing + Premium above Government rate In this case we have Govt. rate is 8.95% (30- year maturityfor Marriott and lodging operations) Govt. rate is 6.90% ( 1-year maturity for restaurant and contract services)

Risk Premium for all the division was found to be from exhibit given in the case paper, Risk Premium(Restaurant & Contract services) = Market Return Risk free rate = 0.0523 0.0546 = -0.0023 Risk Premium( Marriot & Lodging)= Rm- Rf = 0.0523 (-0.0269) = 0.0792
D/V E/V Beta Debt rate premium above Government 1.30% 1.10% 1.40% 1.80%

Marriott Lodging Contract Services Restaurants

0.60 0.74 0.40 0.42

0.40 0.26 0.60 0.58

1.11 1.09 1.11 1.082

Marriott Corporation
Bl= Bu [ 1 + ( 1- T) D/E ] = 1.11 [ 1 + 0.56 * 0.6/0.4 ] = 2.04 rE= Rf + Bl * risk premium = -0.0269 + ( 2.04 * 0.0792) = 13.47%

rD= Govt. rate + Premium above Govt. Rate = 8.95% + 1.30% = 10.25%

Marriott Corporation

WACC = (1-T) * rD * D/V + rE * E/V = 0.56 * 0.1025 * 0.6 + 0.1347 * 0.4 = 0.03444 + 0.054 = 8.84%

Lodging Division
Bl= Bu [ 1 + ( 1- T) D/E ] = 1.09 [ 1 + 0.56 * 2.85 ] = 2.83 rE= Rf + Bl * risk premium = -0.0269 + 2.83 * 0.0792 = 19.72%

rD= Govt. rate + Premium above Govt. Rate = 8.95% + 1.10% = 10.05%

Lodging Division

WACC = (1-T) * rD * D/V + rE * E/V = 0.56 * 0.1005 * 0.74 + 0.1972 * 0.26 = 0.042 + 0.0513 = 9.33%

In a same manner,
WACC of Restaurant division and Contract services can be found. Contract Services WACC 4.93%
WACC
10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Marriott ( Whole ) Lodging Contract Restaurants

Restaurants 5.00%

WACC

Analysis & Conclusion

Marriott as a whole has WACC of 8.86%, which should be weighted avg of all of its divisions. Here, we found that WACC should be 6.42%. The higher WACC found above is because of higher equity financing in some of its divisions and lower debt financing vice versa. Higher WACC of lodging indicates that company should be careful enough in investing in lodging as it demands for high required rate of return compared to those of restaurant and contract services.

References
Financial Theory and Corporate policy by Copeland, Weston and Shastri Principles of Managerial Finance by Lawrence Gitman Reference of Dr. Karen Denning Internet sources like www.marriott.com and www.investopedia.com

 Thank you