How Does Marriott Use Its Estimate of Its Cost of Capital? Does This Make Sense?

How does Marriott use its estimate of its cost of capital? Does this make sense?

Marriott uses the weighted average cost of capital WACC) to estimate the opportunity cost of capital for investments with similar risks. Marriott used this approach for to determine the cost of capital for the each of its division and for the corporation as a whole. The cost of capital for each division for each division was also updated annually. This makes sense because each division’s debt capacity, debt cost and equity cost is likely to differ so calculating it separately gives an accurate weight per division and tie the cost of debt and equity to the market value. Secondly, The WACC is an important factor in determining hurdle rate. Since most of the projects are division related, by capturing the individual inputs and hence WACC for each divisions, Marriott ensures that it embarks on projects with valuable expected NPV and finally, optimize the use of debt in the capital structure

2. What is the WACC for Marriott Corporation? Discuss and defend the assumptions you make concerning the risk free rate, the market risk premium and Marriott’s cost of debt. 

Marriott WACC is 9.72%.

Risk free rate (rf): is 8.72% taken from the 10 year U.S government interest rates in Table B. Marriott lodging division is long term so we picked the 10 year risk free term rate.

Expected market return (rm): is 12.01%. This was taken from Standard & Poor’s 500 Composite Stock Index. We picked this as the ideal Rm because it gives us the average of all stock returns from 1926-1987. This gives us a market risk premium of 3.29% (12.01-8.72).

Leverage ratio: Exhibit 3 provides us with market leverage of 41% (D/D+E). Therefore the equity value will be 59%

Tax rate: Corporate tax rate is 44%. In exhibit 1 of the case, income before income taxes is 398.9 and income taxes is 175.9. Therefore, [(175.9/398.9) * 100]

Cost of debt: We calculated Marriott’s cost of debt as 10.02% using the 10-year U.S. Government Interest rate in April 1998 provided in Table B (8.72%) and the debt rate premium of 1.30% per Table A. This is a conservative estimate based on the mix of long-term and short-term assets within Marriott’s three divisions.

Cost of equity: Capital Asset Pricing Model (CAPM) was used to calculate the cost of equity. rf as shown above is 8.72%, Rm is 12.01%, Table A provides us beta of 1.11 which we unlevered to get βu = 0.817 and re-levered to get βl = 1.171. Market leverage as provided in Exhibit 3 is 41%.

CAPM re= rf + (rm-rf) β = 12.57%

Plugging in all the details above, Marriott WACC will be:

WACC = (1-t) rd (D/V) + re (E/V)

(1-0.44) (0.1002) (0.41) + (.1257) (0.59) = 9.72%

3. What is the cost of capital (WACC) for the lodging and the restaurant divisions of Marriott?