Marriott Corporation: The Cost of Capital

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]
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))
βTs =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%

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.





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 "69.00 "0.89 "44.00 "0.40 "
"Quinta " " " " "
"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 "10.00 "1.45 "44.00 "1.37 "
"Foods " " " " "
"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 "
"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 "
" "Assets " "Unlevered "
"Lodging "$2,777.4 "0.61 "0.55 "
"Restaurants "$567.60 "0.12 "1.01 "
"Contract "$1,237.70 "0.27 " "
"Services " " " "
" "$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))
= 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%