Executive Memo for Marriott’s Case

EXECUTIVE MEMO FOR MARRIOTT’S CASE

As we intend to remain a premier growth company, aggressively invest in appropriate opportunities is needed. To evaluate different investment opportunities, we need to determine the appropriate hurdle rates (cost of capital) at each of the firm's three divisions.

Marriot’s weighted average cost of capital (WACC)

Re: We use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity:R_E=r_f+β*(risk premium). We used a current 30-year U.S. government interest rate 8.95% (Table B) as risk-free rate because (1) Marriott has many assets with long useful lives; (2) on a risk-free asset, the actual return is equal to the expected return. For risk premium, we choose Geometric mean from 1926 to 1987 of long-term government bond returns (Exhibit 4), 4.27%, as historical risk-free rate, and Geometric mean from 1926 to 1987 of Standard & Poor’s 500 Composite Stock Index Returns (Exhibit 4), 9.90%, as the expected return on the market portfolio. We choose the longest term (1926 to 1987), because a risk premium comes with a standard error, so we need to go back as far as we can to get more data to minimize the standard error .We use the geometric risk premium, because it is closer to how investors think about risk premiums over long periods. The equity beta of Marriott is 0.97. Then we got the cost of equity of 14.41%.

Calculation: Re = Rf + beta * (Rm- Rf )= 8.95% + 0.97* (9.9%-4.27%)= 14.41%

Rd: The cost of debt used was 10.05%, which was risk-free rate (8.95%)(Table B) plus the debt risk premium (1.3%).

E/V & D/V: D/V for Marriott is 41%(Exhibit 3), so E/V=1-41%=59%

The Marriott’s WACC was then solved for: WACC=[(1-t)*D/V*Rd]+E/V*Rs=(1-35%)*10.05%*41%+(1-41%)*14.41%=11.23%

Marriott has three major business lines: lodging, contract service, and restaurant. It’s convenient to use WACC of the company as hurdle rate to for evaluating investment opportunities in each of its lines of

business. When comes to projects in a new industry, the method works well. But when comes to projects belong to Marriott’s major business lines, use WACC of the company in evaluating projects generates inefficiency and may be misleading. Because different divisions have different capability and capital structure, and different industries have different nature risk. To achieve our business goal, we need WACC for each major business line to evaluate specific projects.

Lodging Division and Restaurant Division’s WACC

Re: Our first step