Case 1 FIN500

Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Marriott Corporation: The Cost of Capital

Executive Summary

J. Willard Marriott started Marriott Corporation in 1927 with a root beer stand, expanding it into a

leading lodging and food service company with sales of over $6 billion by 1987. At the time, Marriott

had three main lines of business, lodging, contract services and restaurants, with lodging generating

about 51% of company’s profits. The four key elements of Marriott’s financial strategy were managing

hotel assets rather than owning, investing in projects with the goal of increasing shareholder value,

optimizing the use of debt, and repurchasing their undervalued shares. Marriott Corporation relied on

measuring the opportunity cost of capital for investments by utilizing the concept of Weighted Average

Cost of Capital (WACC). In April 1988, VP of project finance, Dan Cohrs suggested that the divisional

hurdle rates at the company would have a key 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. To make the company managers

more involved in its financial strategies, Marriott also considered using the hurdle rates for determining

the incentive compensations.

What is the weighted average cost of capital (WACC) for Marriott Corporation?

WACC = (1 - τ)rD(D/V) + rE(E/V)

D = market value of debt
E = market value of equity
V = value of the firm = D + E
rD = pretax cost of debt
rE = after tax cost of debt

τ = tax rate = 175.9/398.9 = 44%

Cost of Equity
Target debt ratio is 60%; actual is 41% [Exhibit 1]

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

βs = 1.11

βu = βs / (1 + (1 – τ) D/E)
= 1.11/(1 + (1 – .44) (.41))
= 0.80

Using the target debt ratio of 60%:

βTs = βu (1 + (1 – τ) D/E)
= .8(1 + (1 – .44) (.6/.4))
T
β s =1.47

Using CAPM:
rf = 8.95% long-term rate on U.S. government bonds
(rm – rf) = 7.43% average 1926-1987

rE = rf + βTs (rm – rf)

= 8.95% + (1.47)(7.43%)
= 19.87%

Cost of Debt
rD = government bond rate + credit spread
= 8.95% + 1.30%
= 10.25%

WACC = (1 - τ)rD(D/V) + rE(1 - D/V)

= (1 – .44) (.1025)(.6) + (.1987)(.4)
= 11.39%

If Marriott 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?

WACC for Marriott= 11.39%

WACC for lodging division = 9.25%

WACC for restaurant division = 13.84%

WACC for Marriott’s contract division = 23.07%

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

The main use of the hurdle rates is to assess investment decision in order to determine if it’s reasonable.

Using different rates for different division is also good, but one has to be careful when applying a single

cost of capital across the various departments.

Based on the WACCs stated above for the company and its various departments it’s obvious that the

values are different. The cost of capital for lodging is lower than for the entire company, while that of

the other departments are higher. We can equate the cost of capital with risk, so therefore the risk in the

lodging department is lower when compared with other departments that have a higher WACC. If

Marriott was to use a single corporate hurdle rate then they will be using the 11.39% rate which is for

the entire company. By Marriott using this rate, then any project that arises out of the lodging division

will be rejected since its cost of capital of 9.25% is lower than the cost of capital for the company. Using

a higher rate will result in a negative NPV as well as a reduced cash flow. Projects from the restaurant

and contract service division will be approved since they are evaluated at a lower rate than the

determined cost of these various divisions. Over time, Marriott will be approving more high risk project

from the restaurant and contract service division by evaluating them at a lower rate, while they will be

rejecting lower risk projects from the lodging division because they are using a higher rate. In summary,

the risk that Marriott will be assuming will increase over time as it continues to approve high risk

projects.

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

What is the WACC for the lodging division of Marriott?

Market Value Unlevered

Leverage Beta Tax Rate Beta
D/V βs τ = βs / (1 + (1 – τ) D/E)
Hilton 14.00 0.76 44.00 0.70
Holiday 79.00 1.35 44.00 0.43
La Quinta 69.00 0.89 44.00 0.40
Ramada 65.00 1.36 44.00 0.67
Total
Average Unlevered Beta 0.55

βu = 0.55

Cost of Equity
Using the target debt ratio of 74%:
βTs = βu (1 + (1 - τ) D/E)
βTs = .55 (1 + (1 - .44)(.74/.26))
βTs = 1.427

Using CAPM:
rE = rf + βTs (rm – rf)
= 8.95% + 1.427(7.43%)
= 19.55%

Cost of Debt
rD = government bond rate + credit spread
= 8.95% + 1.10%
= 10.05%

WACC = (1 – τ)rD(D/V) + rE(E/V)

= (1 - .44)(.1005)(.74) + (.1955)(.26)
= 9.25%

What is the WACC for the restaurant division Marriott?

Market Value Unlevered

Leverage Beta Tax Rate Beta
D/V βs τ = βs / (1 + (1 – τ) D/E)
Church’s 4.00 1.45 44.00 1.42
Collins Foods 10.00 1.45 44.00 1.37
Frisch’s 6.00 0.57 44.00 0.55
Luby’s 1.00 0.76 44.00 0.76
McDonald’s 23.00 0.94 44.00 0.81
Wendy’s 21.00 1.32 44.00 1.15

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Total
Average Unlevered Beta 1.01

βu = 1.01

Cost of Equity
Using the target debt ratio of 42%:
βTs = βu (1 + (1 – τ) D/E)
=1.01(1 + (1 - .44)*.42/.58)
= 1.420

Using CAPM:
rE = rf + βTs (rm – rf)
= 8.95% + 1.42(7.43%)
= 19.50%

Cost of Debt
rD = government bond rate + credit spread
= 8.95% + 1.80%
= 10.75%

WACC = (1 - τ)rD(D/V) + rE(1 - D/V)

= (1 - .44)(.1075)(.42) + (.1950)(.58)
= 13.84%

What is the WACC for Marriott’s contract services division?

βu for Marriott is the weighted average of the Divisional βu’s:

Identifiable Ratio Beta Unlevered

Assets
Lodging $2,777.4 0.61 0.55
Restaurants $567.60 0.12 1.01
Contract Services $1,237.70 0.27
$4,582.70 0.80

.61(.55) + .12(1.01) + .27(βu) = .80

βu = 2.514

Cost of Equity

Using the target debt ratio of 40%:

βTs = βu (1 + (1 – τ) D/E)
= 2.514 (1 + (1 – .44) (.4/.6))

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

= 3.45

Using CAPM:
rE = rf + βTs (rm – rf)
= 8.95% + 3.45(7.43%)
= 34.58%

Cost of Debt
rD = government bond rate + credit spread
rD = 8.95% + 1.40%
= 10.35%

WACC = (1 - τ)rD(D/V) + rE(E/V)

= (1 - .44)(.1035)(.4) + (.3458)(.6)
= 23.07%

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