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2015

Marriott Corporation The Cost


of Capital

CORPORATE FINANCE
SHUBHAM SARVAIYA
UPMA MEENA
SONAL GUPTA
SUDIPTA SANFUI
TANVI NARENDRA PEDNEKAR

0349/51 8585010349 shubhams2016@email.iimcal.ac.in


0353/51 8585010353 upmam2016@email.iimcal.ac.in
0358/51 8585010358 sonalg2016@email.iimcal.ac.in
0366/51 8585010366 sudiptas2016@email.iimcal.ac.in
0374/51 8585010374 tanvinp2016@email.iimcal.ac.in
1

Case Facts
J. Willard Marriott began Marriott Corporation in 1927 with a root brewskie stand, growing
it into a leading lodging and food service companies of USA of over $6 billion sales by 1987.
At the time, Marriott had three principle lines of business, lodging, contract administrations
and restaurants. The four key components of Marriott's monetary system were overseeing
hotel assets as opposed to owning, contributing in activities with the objective of expanding
shareholder quality, optimising use of
Profit & Revenue Sharing [1987]
debts, and repurchasing their undervalued
shares. Marriott Corporation depended
16%
Lodging
Weighted Average Cost of Capital
13%
(WACC) for determination of discount
41%
rate. In 1988, VP of venture account,
Contract
51%
Dan Cohrs proposed that the divisional
Services
33% 46%
hurdle rates at the organization would
Restaurants
have a key effect on their future monetary
and working methods.

Evaluate Marriott Corpns use its cost of capital


The company used the Weighted Average Cost of Capital for evaluation of projects in three
divisions it had. Each division had a separate discount rate, considering the business line is
not same. WACC= (1-t) rd (D/V) + rE (E/V)
Where, t= tax rate; rd = cost of debt before tax; (D/V) = Market leverage; rE = cost of equity
This technique for utilizing distinctive hurdle rates for diverse divisions functioned
excellently since each of these divisions are particular and the organization had diversified
business lines. Henceforth, they had diverse levels of risk and rate of return associated with
it. Where, hurdle rate denotes the minimum required return for a project. Marriott used
discount rates for three purposes, to determine financial and operating strategy, a partial base
for incentive and to measure growth of the firm.
Further, the firm had a concrete finance policy in place. They put resources into those
activities, which amplified the investor's cash and guaranteed that the organization executes
ventures, which offer a specific return for the duration of their life.
Marriot utilized three principle parameters to discover the discount rate, debt cost & equity
cost, debt-equity ratio. The company used coverage based financing strategies for its
divisions. It also mixed debts in terms of fixed and floating. Finally, for each department the
debt cost was calculated as an independent entity. Debt management was quite appropriate,
as we see A- rating in unsecured loans. The company used long-term debt in lodging and
short-term debt in the other two division considering useful life of assets.
For cost of equity, the CAPM method used. This included a risk factor , which was a hint
of the risk associated with the division.
Overall, the methods used for computing the cost of capital were very accurate, mainly
because it took into account diversified business lines into account. Which in turn reduces
the chances of taking up non-profitable projects and helps in long-term progress of the
corporation.

Compute the cost of capital for Marriott Corpn.

What risk-free rate and risk premium was used and the rationale for the same

What was taken as the estimated cost of debt


Marriot Corp used WACC (weighted average cost of capital) for determination of cost of capital.
= (1 )

t = Tax Rate
Rd = Cost of Debt
Re = Cost of Equity
D = Value of debt
E = Value of Equity
V= Value of Firm (D+E)

Cost of Equity
The risk-free rate is 30 years US Govt maturity rate RF =8.95%. The expected return on market
portfolio RM was considered to be the geometric average return on S & P 500 stocks (9.9%).
Hence, the risk premium was 0.95%.
This case provides Equity= 0.97 , however this is leveraged beta which will affect other beta
estimates. Hence asset unleveraged beta should be calculated and then converted into leveraged
beta with target debt-value ratio of 60%.
Asset =

1+(1)

0.97
1+(1.44)

.41
.59

= 0.6983

With target debt of 60% leveraged L will be

.4

L= [1 + (1 ) ] =0.6983 [1 + (1 .44) .6] = 1.284

RF= Risk Free rate


= Stock beta
(RM - RF) = Risk premium

Re=RF+(RM - RF) = 8.95% + 1.284* (9.9%-8.95%) = 10.17%


Cost of Debt
Marriot has three business lines, because lodging assets like assets has long useful lives, for
lodging long term government interest rate to be considered, whereas for restaurant and contract
services short-term debt rate to be considered.
1

Rd = Government Interest rate [ 3 30 years + 3 10 years rate]+ Debt rate premium for Marriot
= 8.71% + 1.3% =10.01%
WACC Calculation
Hence, = (1 ) + = (1 .44) 10.01%

0.6
1

+ 10.17%

0.4
1

= 7.43%

Compute the cost of capital of each division. Explain the process used for
estimation. What are the difficulties / issues in estimation?
Lodging
WACC for Lodging = (1-T)RD(D/V) + RE(E/V)
T = Corporate tax rate = 175.9/398.9 = 44% [ 1987]
RD =Cost of debt before tax for lodging
= 8.95% [RF =30 year maturity govt bond] + 1.10% [Risk premium for lodging] = 10.05%
RE = Cost of equity after tax for lodging = RF+(RM - RF) = 8.95% (RF) + (9.9% - 8.95%)
However, for lodging division to be estimated from the similar four companies for unlevered
. The companies more similar to lodging division were weighted more and weighted
determined by it. Finally, is levered by 74% Debt structure. =1.35, RE=10.23%
Hence, WACC =(1-44%)*10.05%*74% + 10.23%*26%= 6.82%
Restaurants
WACC for Restaurants= (1-T)RD(D/V) + RE(E/V)
T = Corporate tax rate = 175.9/398.9 = 44% [ 1987]
RD =Cost of debt before tax for restaurants
= 8.72% [RF =10 year maturity govt bond] + 1.8% [Risk premium for Restaurants] = 10.52%
RE = Cost of equity after tax for lodging = RF+(RM - RF) = 8.72% (RF) + (9.9% - 8.72%)
However, for lodging division to be estimated from the similar six companies for unlevered .
The companies more similar to restaurant division were weighted more and weighted
determined by it. Finally, is levered by 42% Debt structure. =1.28, RE=10.16%
Hence, WACC = (1-44%)*10.52%*42% + 10.16%*58%= 8.37%
Contract Services
WACC for Contract services= (1-T)RD(D/V) + RE(E/V)
T = Corporate tax rate = 175.9/398.9 = 44% [1987]
RD =Cost of debt before tax for contract services
= 8.72% [RF =10 year maturity govt bond] + 1.4% [Risk premium for Restaurants] = 10.12%
RE = Cost of equity after tax for lodging = RF+(RM - RF) = 8.72% (RF) + (9.9% - 8.72%)
However, for contract services division is determined by taking weighted average of of
lodging & restaurants considering assets. =1.13, RE=10.05%
Hence, WACC = (1-44%)*10.12%*40% + 10.05%*60%= 8.30%