Case Study #6

Marriott Corporations: The Cost of Capital

Ning Gong

Objectives of the Case Study

Calculating the WACC under the classical tax system for the company as a whole and for each division of the company Current capital structure vs. target capital structure How to use a peer group to estimate divisional equity beta

This technique is useful for estimating privately-held companies

Company Background

Marriott had three major lines of business, based on 1987 number:

Division Sales (%) Profits (%)

Lodging
Contract Services

41%
46%

51%
33%

Restaurants

13%

16%

Uses of the Hurdle Rate

Investment projects were selected by discounting the cash flows by the appropriate hurdle rate for each division The executive compensation plan would reflect hurdle rates, making managers more sensitive to Marriotts performance and capital market conditions

EVA in essence

Cost of Debt for Marriott Corporation

We use the after tax WACC under the classical tax system for Marriott Corporation

The target debt ratio is 60%, and the debt costs 1.30% +8.72% = 10.02% (See Tables A&B) We will ignore the difference between floating rate vs. fixed coupon rate debts here The floating rate debt will be studied in Investments elective

The Cost of Equity for Marriott Corp.

The cost of equity is based on the CAPM

The risk free rate was 8.72%.

Note: there is a debate whether we should use long-term or short-term government bond rate as the risk-free benchmark. However, it is typical to use the 10-year rate in the corporate setting, as practiced by McKinsey & other consulting firms.

The equity risk premium was 7.43%.

However, based on the most recent data, it should be around 6.5%. There are some ambiguities about the magnitude of the equity risk premium.

The Cost of Equity (continued)

The historical equity beta was 1.11 (see Exhibit 3) Can we use this beta directly?
If the target and the historical debt ratios are similar, we could. Otherwise, we have to adjust the beta. The beta was estimated as 1.11 at the time when the debt/total capital ratio was 0.497 (based on the average between 83-87). However, the target debt ratio was 60%, see Table A. The adjustment can be done by first finding the un-levered beta for Marriott, and then adjust for the target debt capital ratio. In doing so, we need to assume that the beta of debt is zero, or you could find the beta of debt by regression.

Cost of Equity for Marriott as a Whole

The formula
a

E D e d DE DE

The beta of debt is typically small. Without any further information, lets assume it is zero. Thus, the assets beta is =0.503*1.11=0.558 After adjusting for the target debt ratio, the beta of equity for Marriott should be 0.558/0.4 = 1.396

E( re ) 8.72% 1396 * 7.43% 19.09% .

WACC for Marriott as a Whole

Choosing t = 44%, the effective tax rate from 1983-88 based on Exhibit 1, WACC 0.4 *19.09% 0.6 *(1 44%) *(8.72% 13%) . 1100% . However, using a single hurdle rate imposes a systematic bias on project selection. Risky projects appear more profitable, and less risky projects appear less profitable.

For the calculation of the WACC for lodging division, see the spreadsheet.

Some Practical Considerations for Calculating the Cost of Capital

Estimating the costs for many sources of capital is not very precise. In practice, we often make simplifying assumptions.

Non-interest-bearing liabilities, such as accounts payable, are excluded from calculation of WACC to avoid inconsistencies and simplify the valuation. There are other long-term liabilities (such as pension funds liabilities), which are often too complicated to infer the required rate of return. There is no definitive answer to the question.