Southern Methodist University

Marriott Corporation: The Cost of Capital (Abridged)

FINA 4325: Advanced Financial Management Professor: Stacy Jacobsen

Team 5-1
Catalina Garza 31201759 Humberto Garza 31289041 Fernando Juan Marcos ####### Pablo Zapata 31217879

BACKGROUND: Marriott Corporation is an American company in the lodging and food service industry. J. Willard Marriot founded the company in 1927. During this time the corporation only had a root beer stand in Washington. The first few years the company had slow growth and focused mainly in food services. Currently, Marriott Corporation has three main areas: lodging, contract services and restaurants. The company has approximately 3,150 properties in 68 countries (including the United States). In the last few years, the company has been experiencing rapid growth. In 1995 it bought out 49% of the Ritz hotel chain and for that reason it now has the following hotel brands: Marriott Hotels & Resorts, JW Marriott Hotels & Resorts, Renaissance Hotels & Resorts, Marriott Conference Centers, Ritz-Carlton Hotels & Resorts, BVLGARI Hotels & Resorts, Edition Hotels & Resorts, Autograph Collection Hotels & Resorts Courtyard by Marriott, and Fairfield Inn by Marriott among others. This company has kept customers loyal by having a rewards system for distinguished and/or frequent guests.

CALCULATING COST OF CAPITAL: The following chart contains information provided by Marriott Corporation: BT Cost Debt 0.1025 0.1005 0.083 0.087

Service: Marriott Overall Lodging Services Contract Services Restaurants

D/V 60% 74% 40% 42%

Debt Premium 0.013 0.011 0.014 0.018

Risk Free 0.0895 0.0895 0.069 0.069

E/V 40% 26% 60% 58%

* Because lodging assets, like hotels, had long useful lives, Marriott used the cost of long-term debt (30 year) for its lodging cost-of-capital calculations. It used shorter-term debt (1 year) as the cost of debt for its restaurant and contract services divisions because those assets had shorter useful lives. ** Before Tax cost of debt was calculated by adding the debt premium to the appropriate risk free rate

From this point forward it is also assumed that Marriotts Tax rate is 44.10% (this was found by dividing last years income tax by income before income tax)

MARRIOTT OVERALL WACC (2 Different Approaches): 1. Using Comparable Companies Betas: WACC = (D/V) * Kd (1-T) + (E/V) * Ke D/V 60% Kd 0.1025 (1-T) 0.559 E/V 40% Ke = Rf + B (Rm-Rf) 0.12272905 WACC = 8.34701200%

Rf = B= Rm = S&P

0.0895 1.085916667 0.1201

The following process was used to calculate beta: Weighted Average: Lodging Restaurant Services

51% 16% 33%

(compared to Hilton, Holiday, La Quinta and Ramada) (compared to Church, Frisch, McDonalds, Collins, Wendy and Luby's)

BETAS:

Hilton Holiday La Quinta Ramada

0.76 1.35 0.89 1.36

Church Frisch McDonalds Collins Wendy Luby's

1.45 0.57 0.94 1.45 1.32 0.76

b = lodging (lodging average) + (restaurants + services) (average)

1.085916667 Long-term averages were used to determine cost of equity in order to keep all inputs in the most similar time frame. The risk free rate has a long-term 30-year maturity and the Standard and Poors Market Return is the average from 1926-1987. We decided to use this return because the company is expected to continue operating in the future, and markets are constantly changing, so we believe the longer the market average the more conservative the measure.

2. Using Marriott Corporations Levered Beta: WACC = (D/V) * Kd (1-T) + (E/V) * Ke D/V 60% Kd 0.1025 (1-T) 0.559 E/V 40% Ke = Rf + B (Rm-Rf) 0.134475426 WACC = 8.81686702% The following process was used to calculate beta: Bl=Bu(1+(1-t)* D/E) B- levered Marriott 1.11

Rf = B= Rm = S&P

0.0895 1.469785148 0.1201

Leverage

B-unlevered 41 0.799488

Using the same formula, Beta was re-levered using the current optimal capital structure that has 60% leverage.

LODGING SERVICES WACC: WACC = (D/V) * Kd (1-T) + (E/V) * Ke D/V 74% Kd 0.1005 (1-T) 0.559 E/V 26% Ke = Rf + B (Rm-Rf) 0.133013371 WACC = 7.61563064%

Rf = B= Rm = S&P

0.0895 1.422005575 0.1201

The following process was used to calculate beta:

Bl=Bu(1+(1-t)* D/E) Hilton Holiday La Quinta Ramada Average = Debt Equity D/E Beta Levered = B- levered 0.76 1.35 0.89 1.36 Leverage 14 79 69 65 B-unlevered 0.6966 0.435 0.3965 0.6672 0.548825

74% 26% 2.846153846 1.422005575

RESTAURANT SERVICES WACC: WACC = (D/V) * Kd (1-T) + (E/V) * Ke D/V 42% Kd 0.087 (1-T) 0.559 E/V 58% Ke = Rf + B (Rm-Rf) 0.141299843 WACC = 10.23797689% The following process was used to calculate beta: B-levered 1.45 0.57 0.94 1.45 1.32 0.76 Leverage 4 6 23 10 21 1 B-unlevered 1.417 0.550363 0.805502 1.36521 1.14923 0.755733 1.007173

Rf = B= Rm = S&P

0.069 1.414869723 0.1201

Church Frisch McDonalds Collins Wendy Lubys Average = Debt Equity D/E Beta Levered =

42% 58% 0.724138 1.414869723

CONTRACT SERVICES WACC: WACC = (D/V) * Kd (1-T) + (E/V) * Ke D/V 40% Kd 0.083 (1-T) 0.559 E/V 60% Ke = Rf + B (Rm-Rf) 0.139646404 WACC = 10.23466426%

Rf = B= Rm = S&P

0.069 1.382512805 0.1201

The following process was used to calculate beta (the same companies as in the restaurant services were used because this service has a similar capital structure):

Bl=Bu(1+(1-t)* D/E) Church Frisch McDonalds Collins Wendy Luby's Average = Debt Equity D/E Beta Levered = B-levered 1.45 0.57 0.94 1.45 1.32 0.76 Leverage 4 6 23 10 21 1 B-unlevered 1.417 0.550363 0.805502 1.36521 1.14923 0.755733 1.007173

40% 60% 0.666667 1.382512805

HURDLE RATES ACROSS DIVISIONS: As shown in the chart below, divisions with similar capital structures have a similar cost of capital.

Service: Marriott Overall Lodging Services Contract Services Restaurants

D/V 60% 74% 40% 42%

E/V 40% 26% 60% 58%

WACC 8.82% 7.62% 10.23% 10.24%

Marriott Corporation should use the different cost of capitals for each division to valuate future projects. By using the different divisions WACCs the company takes into consideration the different capital structures as well as the different risks involved in each of the divisions. Contract Services and Restaurants, for example, take into consideration the fact that their riskless rate is of a shorter term than that of Lodging or the overall firm.

If the firm were to use the overall WACC it would have to compare it to the overall earnings, not to those of individual divisions, for this would create discrepancies.

Finally, it is important to realize that Marriotts cost of capital depends on many factors and assumptions. When one key factor, like the risk free rate, changes the cost of capital changes as well. To try to keep the hurdle rates as fair as possible, the company should update the risk free rate constantly to bring it up to date, using the most recent data possible. Moreover, assumptions, like the fact that tax rates will continue to be the same, also greatly affect the cost of capital. Assumptions should also be revised in order to match the hurdle rates to the current market and company conditions.