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MARRIOTT CORPORATION: THE COST OF CAPITAL

July 07, 2012 Rupesh Paterical Trojan Jacob Varghese Brijesh P Manoj Kumar A EPGP-04C-082 EPGP-04C-104 EPGP-04C-024 EPGP-04C-050

COMPANY BACKGROUND

Began with J. Willard Marriotts root beer stand Grew into one of the leading lodging and food service companies Lines of business:

Lodging Contract services Restaurants

COMPANY GOALS

Intend to remain premier growth company:


Aggressively developing appropriate opportunities within existing line of business To become preferred employer, preferred provider and the most profitable company in existing lines of business

FINANCIAL STRATEGY

Selection of investment project by discounting expected cash flow at hurdle rate for each divisions.
Hurdle rate is the minimum rate of return that must be met for a company to undertake a particular project. For example,

Typical Hotel Profit and Hurdle rates


50% 40% 30% 20% 10% 0% -10% -20% 1 2 3 4 5 6 Hurdle rate Profit rate

ELEMENTS
I.

OF

FINANCIAL STRATEGY

Manage rather than own hotel assets


Invest in projects that increase shareholder value Optimize the use of debt in the capital structure Repurchase undervalued share

II.

III.

IV.

COST

OF

CAPITAL

AND THE

COMAPNY

Company measures opportunity cost of capital for investment with similar risk using the Weighted Average Cost of Capital. WACC= (1-t)*rD*D/V + rE*E/V Where, t= corporate tax rate rD= cost of debt D/V= % of debt financing rE= cost of equity E/V= % of equity financing

ELEMENTS

OF

WACC

Unlevered beta
Levered beta Cost of equity Cost of debt

ELEMENTS

OF

WACC
Levered Beta

Unlevered Beta

Beta of a company without any debt (Published beta)

Beta of a leveraged required return

Unlevering a beta removes the financial effects from leverage

Hamada's formula: BL= Bu [1+ (1-t) D/E]

ELEMENTS

OF

WACC

rE: cost of equity (CAPM) rE= Rf + Beta*(Risk premium) where, Rf= risk free rate (generally, 3-month US treasury bill) Beta= the sensitivity of the asset returns to market returns Risk premium= rM-Rf

ELEMENTS

OF

WACC

rD: cost of debt rD= Government rate of borrowing + Premium above Government rate

In this case we have Govt. rate is 8.95% (30- year maturity- for Marriott and lodging operations) Govt. rate is 6.90% ( 1-year maturity for restaurant and contract services)

RISK PREMIUM FOR ALL THE DIVISION WAS FOUND TO BE FROM EXHIBIT GIVEN IN THE CASE PAPER, RISK PREMIUM(RESTAURANT & CONTRACT SERVICES) = MARKET RETURN RISK FREE RATE = 0.0523 0.0546 = -0.0023 RISK PREMIUM( MARRIOT & LODGING)= RM- RF = 0.0523 (-0.0269) = 0.0792
D/V E/V Beta Debt rate premium above Government 1.30% 1.10% 1.40% 1.80%

Marriott Lodging Contract Services Restaurants

0.60 0.74 0.40 0.42

0.40 0.26 0.60 0.58

1.11 1.09 1.11 1.082

MARRIOTT CORPORATION

Bl= Bu [ 1 + ( 1- T) D/E ] = 1.11 [ 1 + 0.56 * 0.6/0.4 ] = 2.04 rE= Rf + Bl * risk premium = -0.0269 + ( 2.04 * 0.0792) = 13.47%

rD= Govt. rate + Premium above Govt. Rate = 8.95% + 1.30% = 10.25%

MARRIOTT CORPORATION

WACC = (1-T) * rD * D/V + rE * E/V = 0.56 * 0.1025 * 0.6 + 0.1347 * 0.4 = 0.03444 + 0.054 = 8.84%

LODGING DIVISION

Bl= Bu [ 1 + ( 1- T) D/E ] = 1.09 [ 1 + 0.56 * 2.85 ] = 2.83 rE= Rf + Bl * risk premium = -0.0269 + 2.83 * 0.0792 = 19.72%

rD= Govt. rate + Premium above Govt. Rate = 8.95% + 1.10% = 10.05%

LODGING DIVISION

WACC = (1-T) * rD * D/V + rE * E/V = 0.56 * 0.1005 * 0.74 + 0.1972 * 0.26 = 0.042 + 0.0513 = 9.33%

IN

A SAME MANNER,

WACC of Restaurant division and Contract services can be found. Contract Services WACC 4.93%
WACC
10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Marriott ( Whole ) Lodging Contract Restaurants

Restaurants 5.00%

WACC

ANALYSIS & CONCLUSION


Marriott as a whole has WACC of 8.86%, which should be weighted avg of all of its divisions. Here, we found that WACC should be 6.42%. The higher WACC found above is because of higher equity financing in some of its divisions and lower debt financing vice versa. Higher WACC of lodging indicates that company should be careful enough in investing in lodging as it demands for high required rate of return compared to those of restaurant and contract services.

Thank

you