Amanda Chrzan Lawrence Maksuta 3/28/2011

Marriott Case Study 1)What is the weighted average cost of capital for Marriott? The weighted average cost of capital for Marriott is 11.64%. .4(cost of equity) + .6(cost of debt)(1- tax) Tax = Income tax/Income before tax = 175.9/398.9 = 44% Cost of debt = .5(.0895) + .4(.0872) + .25(.069) + .5(.011) + .4(.014) +.25(.018) = 11.25% B = 1.1 when d/e = .41 target d/e is .6 so.. B(a) = B(e) / (1 + (1-tax) D/E) = 1.11 / (1+.56(2499/3596)) = .80 B = .8 * (1+.56(5394/3596)) = 1.47 Equity risk Prem = 7.43% (arithmetic average between 1926-1987) Cost of Equity = Rf + B(Risk Prem) = .0872 + 1.47(.0743) = 19.64% WACC = .4(.1964) + .6(.1125)(1-.44) = 11.64% i)What risk free rate and risk premium did you use to estimate the cost of equity? We used the risk free rate of a 10 year government bond (8.72%) to estimate the total risk free rate. We found the risk premium by looking at the arithmetic average between 1926-1987 of the spread between S&P 500 Composite returns and long-term U.S. government bond returns. ii)How did you estimate Marriotts cost of debt? We estimated the cost of debt by multiplying the fraction of debt at the floating rate for each division by the long term rate (for lodging) plus the premium or the shorter term rates (for the other 2 divisions) plus the premiums. We chose to use 30 year rate for lodging since that probably lasts the longest, 10 year rate for restaurants since they probably last more than a year, and the 1 year rate for contract services which we assumed were the shortest lives. 2)What type of investments would you value using Marriotts WACC? You would value investments that have similar characteristics as the divisions that were used to create the WACC.

Amanda Chrzan Lawrence Maksuta 3/28/2011

3)If Marriott used a single corporate hurdle rate to value investment opportunities in each of its line of business, what would happen to the company over time? To use a single hurdle rate would not be good for the company over time; each division has its own separate systematic risk so using one rate for all divisions would not be as accurate as Marriott needs it to be. For example; risky projects might appear more profitable and more appealing than they actually are, and less risky projects might appear less profitable and less appealing than they actually are. This could lead to Marriott not choose the projects that are the best for them. 4)What is the cost of capital for lodging and restaurant divisions of Marriott? Lodging: 74% debt % in capital B = B(a)* (1+(1-tax)(B/S) .74 = x / (x+3564) => x=10,143.69 / 3564 = B/S = 2.85 B = .422*(1+.56(10,235/3596)) = 1.09 Cost of Equity = .0872 + 1.09(.0743)= 16.82% Cost of Debt = 8.95% government rate + 1.1% Premium = 10.05% WACC (Lodging) = .74(.1005)(1-.44) + .26(.1682) = 8.54% Restaurant 42% debt B = B(a)* (1+(1-tax)(B/S) B = .959*(1+.56(2604/3596) = 1.35 .42x+1510.32 = x => x=debt=2604 Cost of Equity = .0872 + 1.35(.0743) = 18.75% Cost of Debt = .0872 government rate + .018 premium = 10.52% WACC (Restaurant) = .42(.1052)(.56) + .58(.1875) = 13.35% a)What risk free rate and risk premium did you use to estimate the cost of equity for each division? Why?

Amanda Chrzan Lawrence Maksuta 3/28/2011

We used 8.95% risk free rate for lodging because it was the longest term division and we assume they will get 30 years of usage out of this. It was stated that restaurant and contract services had shorter useful lives. We assumed the restaurant division would last at least 10 years so we used 8.72% and assumed that contract services would have useful lives of about a year and so we used the 6.90%. We used 7.43% risk premium for both restaurant and lodging since they both have pretty long term rates, and 7.43% is the spread between S&P500 composite returns and Longterm government bond returns. b)How did you measure the cost of debt for each division? Should the debt costs differ across division? Why? For the lodging division the cost of debt was calculated as the 30 year risk free rate plus the premium which was 8.95% + 1.10% or 10.05% before tax cost of debt. For the restaurant division we used the 10 year risk free rate plus the premium which was 8.72% + 1.80% or 10.52%. We assumed that the lodging would have a useful life of 30 years and the restaurant would have a useful life of 10 years, so they definitely need to have different debt costs across the divisions because you have to compare them with the government rates that are similar in duration/maturity to the division. c)How did you measure the beta for each division? (Hint: calculate asset betas for comparable companies) The asset betas were calculated as shown below and then we took the average of the asset betas for a final asset beta.
Hotel Hilton Hotels Holiday Corp La quinta motor inns Ramada inns inc B(e) 0.76 1.35 0.89 1.36 * 1.45 1.45 0.57 0.76 0.94 1.32 * % equity equals 0.86 0.21 0.31 0.35 % equity equals 0.96 0.9 0.94 0.99 0.77 0.79 B(a) 0.6536 0.2835 0.2759 0.476 0.42225 B(a) 1.392 1.305 0.5358 0.7524 0.7238 1.0428 0.958633

Restaurant B(e) Church's fried chicken Collins Foods International Frischs restuarants Lubys Cafeterias McDonalds Wendy's International

5)How did you estimate the cost of capital for Marriotts contract services division? How can you estimate its cost of equity without publicly traded comparable companies? (Hint: Asset beta for Marriott = weighted average of asset betas for the three divisions)

Amanda Chrzan Lawrence Maksuta 3/28/2011 Division Lodging Restaurants Contract Services % of Profits B(a) 0.51 0.422 0.16 0.959 0.33 0.8 0.21522 0.15344

So .8-.21522-.15344 = .43134 = .33*(B(a) of contract). B(a) of contract services therefore is 1.31. B = B(a)* (1+(1-tax)(B/S) B = 1.31*(1+.56(2397.33/3596) = 1.799 .40x+1438.4 = x => x=debt=2397.33 Cost of Equity for Contract services = .0872 + 1.799(.0847) = 23.96 Cost of Debt for contract services = 6.90% + 1.4% = 8.3% WACC(Contracts) = .40(.083)(.56) + .60(.2396) = 16.24%