Business Finance II Assignment 1 Syeda Sara Zafar Ali

ERP# 12108
Marriott Corporation: The Cost of Capital

Problem statement

To find out a suitable Hurdle rate, to be used as a discount rate for cash inflows, to evaluate various
projects that Marriot Corp. may undertake in future

Objectives

Calculating the WACC under the classical tax system for the company as a whole and for each division of
the company

Company Background

Marriott Corporation has 3 major lines of business: lodging operations, contract service and restaurants
business. Its growth objective is to remain a premier growth company. The four components of its
financial strategy are consistent with this growth objective for the reasons ‐

Manage rather than own hotel assets ‐ Marriott sold its hotel assets to limited partners to reduce
assets and thus, it can increase ROA and thereby increase potential profitability.
Invest in projects that increase shareholders’ value ‐ the discounted cash flow techniques to
evaluate potential investments allow the company to invest only in profitable projects. Therefore,
it can maximize the use of its cash flow to gain profits.
Optimize the use of debt in the capital structure ‐ Marriott uses this strategy to increase its value
and thereby increase its profitability.
Repurchase undervalued shares ‐ By buying back its undervalued shares, Marriott can increase PE
ration when needed and can make its investors’ holdings more valuable because share prices will
increase (increase in ROE)

Key facts and assumptions

 Marriott use the Weighted‐Average‐Cost‐of Capital (WACC) method to measure
the opportunity cost for investments

WACC = (1-Tax Rate) x Cost of Debt x D + Cost of Equity x E .

E+D E+D

 The RF for long term is the 10 Year US Government bond rate, 8.72% (Used by Marriott
and lodging Division)
 The RF for Short term is the 1 Year US Government bond rate, 6.90% (Used by
Restaurant and Contract Services Division)
 Risk Premium is RP = 6.50
Business Finance II Assignment 1 Syeda Sara Zafar Ali
ERP# 12108

 Risk free rate is assumed according to Table A and Table B given in the case
 Equity to Total Capital ratio and Debt to Total Capital ratio is calculated as per the formula
Equity Ratio = E . And Dent Ratio = D .
E+D E+D

 Effective Income tax rate has been calculated from the income statement as 44.1%
and is assumed to be the same for all the divisions
 All WACC calculations are based on target values for Debt and Equity
 Leveraged β’s have been used for WACC calculations
 CAPM has been used to calculate the cost of Equity
 The overall WACC for Marriot Corporation in the Weighted average sum of WACC of
all individual divisions

β Estimation

Equity Market 1987 Revenues Beta Unlevered

Beta Leverage ($ billion) Leverage Beta

Marriott corporation 1.11 41% 6.52

Hotels:
Hilton hotels corporation 0.76 14% 0.77 1.1628 0.654
Holiday corporation 1.35 79% 1.66 4.7619 0.284
La Quinta motor inns 0.89 69% 0.17 3.2258 0.276
Ramana inns, inc. 1.36 65% 0.75 2.8571 0.476
Average 0.422
Restaurants:
Church's fried chicken 1.45 4% 0.39 1.0417 1.392
Collins foods international 1.45 10% 0.57 1.1111 1.305
Frisch's restaurants 0.57 6% 0.14 1.0638 0.536
Luby's cafeterias 0.76 15% 0.23 1.1765 0.646
Mcdonald's 0.94 23% 4.89 1.2987 0.724
Wendy's International 1.32 21% 1.05 1.2658 1.043
Average 0.941

There is no publicly traded comparable company for comparison with the Contract Services. Therefore,
we can consider the company as a portfolio of three divisions. The asset beta of the whole company is
just a weighted average of the asset betas of the divisions. Weights should be the fraction of total equity
value in each division. The fraction of total identifiable assets can be taken as a proxy.

βM = ( AL / AM ) β L + ( AR / AM ) βR + ( ACS / AM ) βCS

Assets Ratio Beta

Lodging 2778 0.61 0.42
Contract Services 1238 0.27 βCS
Restaurant 568 0.12 0.94
Marriott 4584 0.57
 Business Finance II Assignment 1 Syeda Sara Zafar Ali
ERP# 12108
0.57= (0.61 × 0.42) + (0.12 × 0.94) + (βCS × 0.27)

βCS = 0.98

WACC Calculations

Lodging Contracts Restaurant Marriott Remarks

Cost of Debt 9.82% 8.30% 8.70% 9.27% Taken from Table A and Table B
D/V 74% 40% 42% 40% Target Ratios
Interest rate 44.10% 44.10% 44.10% 44.10% Calculated from the balance sheet

Cost of Equity
Average Bond rate for 10years and 1
Risk free rate 10.388% 7.435% 7.435% 9.22%
Year for Long and Short term resp.
Beta 0.422 0.980 0.941 0.57 Taken from the Table above
Leveraging according to the desired
Levered Beta 1.624 1.633 1.622 1.427
debt position
Market Premium 6.50% 6.50% 6.50% 6.50% Assumption based on Facts
Cost of Equity 20.94% 18.05% 17.98% 18.50%
E/V 26% 60% 58% 60% Desired position of Equity

WACC 9.508% 12.687% 12.472% 10.73%

Conclusions

The Hurdle rate that Marriott should use is 10.73%. This rate is subjected to variations as the market
premium changes. Marriott has to choose a risk value for each of the business and then go for
combining the Hurdle rates for different business to form a portfolio and decide upon which business to
invest in. As the risk in a business changes, the β value would change thus changing the hurdle rate. The
future rates that the firm has used to predict the WACC are themselves prone to change with time. Hence,
WACC needs to be updated regularly to make accurate decisions.