Marriott Corporation: The Cost of Capital

Background

As the vice president of project finance of Marriott Corporation, we are conducting an analysis

of our company (Marriott Corporation) for calculating the hurdle rates at each of our firm’s three

divisions: lodging, restaurant and contract services. We use Weighted Average Cost of Capital

(WACC) as the hurdle rate. The investment projects in our company are selected by discounting

the appropriate cash flows by the appropriate hurdle rate for each division.

Approach

First of all, we will determine the cost of debt (Rd), cost of equity (Re) and the capital structure

for the whole company. Then we can get the tax rate to calculate the WACC for the whole

company. After this, we will determine the Risk-free Rates (Rf), Risk Premiums (Rp) and Betas (β)

for lodging and restaurant divisions in order to calculate the Cost of Equity for these two divisions.

After finding out the cost of debt and the fraction of debt for lodging and restaurant divisions, we

will be able to calculate the WACC at each of the two divisions. Using a weighted average method

of the identifiable assets of our company in 1987, we will then be able to find out the β and

determine the cost of debt and the fraction of debt for contract services division. Finally, we will be

able to get the WACC for this division.

Financial Strategy

The divisional hurdle rates in our company would have a significant impact on our firm’s

financial and operating strategies. We use cost of capital as the hurdle rate to discount future cash

flows for the investment projects of the firm’s three divisions. We only invest in a project if the

internal rate of return (IRR) is greater than the hurdle rate. However, WACC of the project should
be considered and calculated separately for each division for different investments projects. We

intend to remain a premier growth company, in each division, our goal is to be the preferred

employer, the preferred provider, and the most profitable company.

Cost of Capital

The weighted average cost of capital for the whole company is 7.59%. We can get the

number as below evaluations:

Marriott
Rf Rd Rd.prem Rm Rm -Rf βd
4.58% 10.25% 1.30% 12.01% 7.43% 0.1750
Delever
Current Current Tax
βe βd βa
D/V E/V rate
1.11 41% 59% 0.1750 44.05% 0.5034
Relever
Tax
βa Target D/V Target E/V βd βe
rate
0.5034 60% 40% 0.1750 44.05% 0.7790
CAPM
Rf Rp βe Re 　 　
4.58% 7.43% 0.7790 10.37%
WACC
Tax
Rd Re Target D/V Target E/V WACC
rate
10.25% 10.37% 60% 40% 44.05% 7.59%
Detailed calculation method please see attached excel file.

We believed that the longer the time period of data, the better and the more exact information.

Information based on the short period might be distorted from such factors as inflation or economic

crisis in some period of time. As shown in the Exhibit 4, the return rates in each period of time are

rather fluctuated. Thus, return rate that is based on the longest period should be the best

representative of the rate to be used.

We use the short term treasury bill returns from 1926-1987 for restaurants and contract

services as the risk-free rate which is 3.54%, because those assets have shorter useful lives. We

use long term U.S. government bond returns from 1926-1987 for Marriot and Lodging as the risk-
free rate which is 4.58%, because lodging assets have long useful lives. The risk premium is the

spread between S&P 500 composite returns and short-term treasury bill returns from 1926-1987

which is 8.47% for restaurants and contract services. The risk premium for Marriot and Lodging is

the spread between S&P 500 composite returns and long-term U.S. government bond returns

which is 7.43%.

We calculate the cost of debt based on the information provided in table A and table B. The

cost of debt for Marriott is the debt rate premium above government plus 30 year government

interest rate and it is 10.25%. The cost of debt for Lodging is its debt rate premium above

government plus 30 year government interest rate and that is 10.05%. The cost of debt for

contract services is its debt rate premium above government plus 1 year government interest rate

and it is 8.3%. The cost of debt for restaurant is its debt rate premium above government plus 1

year government interest rate and that is 8.7%.

The beta for each division was measured by calculating the lever beta using an average

unlevered beta of the comparable companies. First, we chose the companies in the same line of

business of each division (lodging and restaurant). Next, we used the equity beta of those firms to

calculate unlevered beta. After that, we used total sales of those companies to calculate a

weighted average unlevered beta of those comparable companies.

Finally, we used the average unlevered beta to calculate the beta of each division from the

formula: βe = βa + (βa –βd) x [1+(1-t) D/E]. The proportion of D/E was from the market value-

target leverage ratios in Table A.

Then, the cost of capital for the lodging and restaurant divisions of Marriott is 6.01% and

7.59% respectively.

To estimate the equity costs of this division without comparable companies, we did the

mathematics based on the financial report (Exhibit 2). Since we had the amount of unlevered beta

for the hotel as a whole and for the lodging and restaurant divisions, we used this information to
solve for the unlevered beta of the contract services division.

To estimate the amount of beta as correct as possible, we decided to weight the amount of

unlevered beta we had. We decided to use identifiable assets to calculate the ratio for the

weighting purpose. The reason is that the company or the division normally uses cost of capital to

purchase assets for the operation. Thus, assets should be the best item to weight the unlevered

beta.

After solving the equation for the unlevered beta of the contract services division, we used this

beta to calculate the lever beta. The process to calculate the cost of capital is the same as what

we did for other divisions.

The cost of capital for Marriott’s contract services division is 10.69%.

Summary

Since the hurdle rates would affect the firm’s financial and operating strategy, we consider all

the aspects that related to this analysis, and calculate the rates very carefully. As the vice

president of project finance, we prepare annual recommendations for the hurdle rates at each of

the firm’s three divisions are 6.01% (lodging), 9.04% (restaurant) and 10.69% (contract services).

Summary βd βe Re WACC
0.1749 0.7790
Marriott 10.37% 7.59%
7 4
0.1480 0.3421
Lodging 7.12% 6.01%
5 7
0.2125 1.0070
Restaurants 12.07% 9.04%
1 3
Contract 0.1652 1.3207
14.73% 10.69%
Services 9 9