Marriott Corporation - Case Solution

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 βand 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

βe Current

D/V

Current

E/V

βd

Tax

rate

βa

1.11 41% 59% 0.1750 44.05% 0.5034 Relever

βa Target D/V Target E/V βd Tax

rate

βe

0.5034 60% 40% 0.1750 44.05% 0.7790 CAPM

Rf Rp βe Re

4.58% 7.43% 0.7790 10.37%

WACC

Rd Re Target D/V Target E/V Tax

rate

WACC

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