Marriott Case Study

        1. Marriot uses its cost of capital to run its firm’s operations. Marriot relies on measuring the opportunity cost of capital using the WACC formula.  Marriot has 4 key elements in its financial strategy to successfully run a firm, these are managing rather that own hotel assets, invest in projects that increase shareholder value, optimize the use of debt in the capital structure and repurchase undervalued shares. Dan Cohrs said that the divisional hurdle rates at the company would have an impact on their future financial and operating strategies. Marriott intended to continue its growth at a fast pace by relying on the best opportunities arising from their lodging, contract services and restaurants lines of businesses. So, for this the company needs to determine the WACC of other divisions, because if they only rely on their own WACC, this will result in accepting projects with returns below their WACC, which will end with losses. The importance of cost of capital is used to evaluate new projects of a company, so it has the minimum return that investors expect for providing investment to the firm. It has a huge importance in financial decision making.

2. According to the formula WACC=WE*RE+WD*RD(1-T). We must first find each element of this formula. To get RE, we need to use the CAPM formula which is the risk-free rate + Re-Levered Beta * Risk Free Premium rate. The risk-free rate used is found in table B using the 30-year maturity U.S Government Interest Rates, which is 8.95% using this rate because it is the appropriate rate to use to be consistent with Marriott’s long term outlook. The risk premium rate is the spread between the S&P 500 Composite Returns and Bond Rates from 1926 and 1987, so the risk premium rate is 7.43% (Exhibit 5). Lastly, we need to find the Beta value to get the final component of the cost of equity. The Equity beta of Marriott is .97, this is the levered beta, and we need to eliminate the effects of the leverage. To do this, we need to un-lever the beta, then re-lever the asset beta. First, we gather the raw data, the levered beta being .97 and the market leverage being 41%. The next step is to un-lever the Beta, we find D/E (41%/ (1-41%), which is .695, then we un-lever the beta by using the market leverage over the D/E ratio (41%/1+.695).  Finally, we re-lever the Asset Beta, we first look for the debt % in the capital (60%). Then we find D/E which is 1.50, lastly, we take the market leverage and we multiply it by 1+the D/E, we then figure out that the re-levered asset beta is 1.43. After finding this beta we return to the CAPM formula, and with this we find out that the Re is equal to 19.57%. Next component in the WACC we need is the cost of debt which is found by using the 30-year U.S Government Interest rate of 8.95% plus Debt rate premium above Government, which ends up being 10.25% (Table A). The other components of WACC is the market value of debt which is 60% (table A), V which is Equity plus Debt (40%+60%), and the market value of equity which is 40% (100%-60%). The tax rate component is given, being 34%.  Now use the WACC formula to get the cost of capital for Marriot, which is 11.89%. For these numbers, we chose the arithmetic average instead of the geometric average because the arithmetic is unbiased in finding the expected value. Investors typically chose to use the arithmetic average

3 Need for Divisional WACC

The WACC calculated above is for the corporation as a whole and can be used in making various investment decisions. However, the decision made using this particular WACC should be one that affects the entire corporation and not just one division or two divisions. This is because it would not be prudent to use one WACC for all the divisions. The three divisions all have a different capital structure which means their WACC will also be different. The lodging division capital structure is made up of more debt compared to those of restaurants and contract services divisions. Moreover, the assets useful life differs between the three divisions meaning their cost of debt will also differ.

It is, therefore, advisable that WACC is computed separately for every division and that these divisional WACC be used in making divisional decisions. To further elaborate on the need for divisional WACC, the three divisions WACC have been calculated below.

4 Lodging Division WACC

This division has a debt capital weight of 74% meaning that of equity capital is 26%. Since the assets useful life in this division is long term, the cost of long-term debt of 8.95% is used as the riskless rate. The corporation tax remains the same at 34%, and the cost of equity is determined using the CAPM model. Under this division, there are several hotels with different values of beta, riskless rate, and market leverage. Therefore the weighted average beta has been used. This is because the weighted average beta causes a less variance when estimating the cost of equity compared to the average beta. A smaller variance leads to a more accurate cost of equity and debt estimates. Using the CAPM model the cost of equity for this division is 20.95% and the cost of debt = 10.05. Applying the formula used in determining the corporation WACC, the divisional WACC for lodging is determined to be 10.36%.

5 Restaurant Division WACC

Unlike the lodging division, the restaurant division finances most of its operation using equity capital hence equity has a bigger weight than debt. 42% of the division capital is made up of debt. That leaves 58% for equity capital. The same reasoning used in determining the lodging division cost of equity has been applied in this division cost of equity calculation. However, the cost of debt is different from that of the lodging division. The risk-free rate used is that of short-term debts because the division assets have the short-term useful life. We find the beta for contract services by taking the unlevered beta and divided by 1 – Debt weight, the beta ended up 1.29. After that we find the cost of equity by multiply levered beta by Risk premium given and add RF, 6.90 % + (1.2% * 8.47%), so RE = 17.85%. the tax rate 34%. Find cost of debt by add RF to Debt premium given (Table A) which is 6.90% +1.29%, we find RD= 8.70, the using the WACC formula we find out that the WACC is equal to 12.77%