Case 1 (Marriott Case) Assignment

This is a team work. If Team 1 completes Case 1 analysis, they should name their work
as Case1Team1, save and submit it as a word document. Suppose John Smith is taking
this course, and he hasnt !oined in any team, then he has to finish this individually, and
name his work as Case1SmithJ. Case 1 assignment due 08/14/11 9:00 pm California
time.
Reading:
"ead the Case 1 #$arriott Case%. This case provides students with the opportunity to
e&plore how a company uses the capital asset pricing model #C'($% to compute the cost
of capital for the company and for each of its divisions. The weighted average cost of
capital #)'CC% formula and the mechanics of applying it are stressed. Students also
learn to calculate betas based on comparable companies and to lever betas to ad!ust for
capital structure.
Riskfree rate and riskpremium
The C'($ is a one*period model. $ulti*period applications of the C'($ rely on the
assumption that the C'($ holds in each period. 'nd the theoretically correct way to use
C'($ is to recompute an e&pected return in each period, using a different riskless rate,
beta, and risk*premium. +or many long*tem pro!ects, it is reasonable to assume that beta
and risk*premium are stable over the life of the pro!ect, and the yield on a long*term
riskless bond is used. In this case, the ,-*year ..S government interest rate in 'pril 1/00
#page 1, table 2% is used to pro&y for the riskless rate. 'nd the spread between S3 (
Composite returns and long*term ..S. government bonds for 1/45*1/06 period, 6.1,7
is used to reflect the risk*premium.
!nle"ered Asset #eta and $e"ered %&uit' #eta
The following e8uation shows the relationship between levered*e8uity beta #9:% and
unlevered asset beta #9.%;
9
:
< 9
u
=>1 ? #1@t%#AB:%C,
AB: < #ABD%B#:BD% < #ABD%B#1*ABD%, D< A?:. Eeverage < ABD,
Therefore, 9
:
< 9
.
=>1 ? #1@t%#AB:%C < 9
.
=>1 ? #1@t%=leverageB#1*leverage%C
Fr 9
.
< 9
:
B >1 ? #1@t%#AB:%C.
)here t is the ta& rate, A is market value of debt and : is market value of e8uity.
Therefore, firm value < A?:, assuming the firm use only debt and e8uity to finance its
capital. 9
.
is unlevered beta, also named asset beta. 'sset beta is the beta of a debt*free
company. It is also called beta of assets. 9
:
is e8uity beta, the beta of e8uity when debt is
used.
)e use the effective ta& rate in 1/06 to pro&y for the ta& rate, which is e8ual to income
ta&es in 1/06 divided by ta&able income in 1/06, that is 16G./B,/0./ < -.11 < 117.
:&hibit , shows that when $arriotts market leverage is 117, its e8uity beta is 1.11.
Eeverage < AB#A?:% < ABD < -.11, that is A < -.11D, so : < D @ A < -.G/D, AB: <
-.11DB-.G/D < -.5/,
So the unlevered beta of $arriott < 1.11B>1 ? #1*-.11%=-.5/C < -.0-.
Hiven the unlevered e8uity beta of $arriot is -.0-, )hen leverage is -.5-, the levered
e8uity beta < -.0- = >1 ? #1*-.11%=#-.5B-.1%C < 1.16
Then you may apply the C'($ to find out the cost of e8uity for $arriott under target
leverage level of -.5-. The cost of debt for $arriott is e8ual to $arriotts debt rate
premium above government plus ,-*year government interest rate < 1.,-7 ? 0./G7 <
1-.4G7. :ventually you will apply the )'CC formula to find $arrotts )'CC.
)hen you calculate the cost of capital for $arriotts divisions, note that each division
will have different e8uity beta and cost of debt.
(nstru)tions:
'fter you reading the case, connect with your teammates and decide on how best to
develop your answers to the 8uestions below. Iour answer should be clear and be easy
for reader to understand how you find out the answer and why. The teams should map out
critical path and ratably distribute work amongst the members. (lease adhere to the
prescribe format, $S )ord, double spaced, Times "oman, or other true*type*font, and
include the names of each team member on your final submission. +or e&ample team 1
should submit its work of Case 1 assignment as a word document named as Case1Team1,
and the names of each Team 1s members should be included in the file #The names
should be shown at the beginning of the file%. If 'llen Smith #who hasnt !oined in any
teams% finishes Case 1 assignment individually, then his submitted work #a word
document% should be named as Case1Smith'.
*+e grading ,ill -e -ased on:
Juality of analysis; Kave you analyLed all the pertinent issues correctly and avoided
obvious repetition of facts in the caseM
Juality of recommendations; Kave you offered specific plans of action and backed these
up with strong argumentsM
)riting; Ao you present the material in a logical, clear way with no grammarBspelling
errorsM
.our ,riteup s+ould -egin ,it+ an opening paragrap+ t+at s'nopsi/es t+e )ase (1
point)0 and ans,er all t+e follo,ing &uestions:
1. )hat is the weighted average cost of capital #)'CC% for $arriott Corporation #4
points%M
4. If $arriott used a single corporate hurdle rate for evaluating investment
opportunities in each of its line of business, what would happen to the company
over time #1 point%M
,. )hat is the )'CC for the lodging division of $arriott #4 points%M
1. )hat is the )'CC for the restaurant division $arriott #4 points%M
G. )hat is the )'CC for $arriotts contract services division #4 points%M Kint; the
asset beta of the whole company is !ust a weighted average of the asset betas of
the divisions.