Marriott Cost Of Capital
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1) Executive Summary
Marriott needs to calculate hurdle rates which will be used in its investment project selection. The company chooses to use cost of capital as its hurdle rate. Since the company has three business divisions and the cost of capital in each division varies and differs from that of Marriott as a whole, each division needs to have its own hurdle rate. The reason behind this practice is the companys strategy which focuses on growth. Using a single hurdle rate for the whole company would be too low for some divisions and too high for others. When hurdle rate is too high, fewer projects would be considered profitable and preset value of project inflows would be reduced. As a result, Marriotts growth would be reduced too. On the other hand, if the hurdle rate is too low, projects that are not profitable will be selected. Consequently, the companys growth would be hurt as well. Hence, the calculation of costs of capital for use as hurdle rates is essential for managing the companys growth.
The cost of capital is computed using Weighted Average Cost of Capital (WACC) technique which is the weighted average of cost of equity and cost of debt of the firm or division. The cost of debt is the current borrowing rate at the time of the analysis (1988). The costs of floating rate debt and fixed rate debt are determined for each division as well as for Marriott as a whole.
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). This model takes risk-free rate, beta, and risk premium for each division as for Marriott as a whole. Betas for lodging and restaurants divisions can be calculated from comparable companies. However, information about comparable companies for contract services division is not available. Its beta is derived from the assumption that the overall companys beta is a weighted average of divisional betas.
The analysis shows that each division does have different cost of capital. Lodgings cost of capital is 6.651%, Restaurants 10.539%, and Contract Services 11.254%. The cost of capital for Marriotts as a whole is 8.299%. This shows that Marriott is correct to use divisional hurdle rate to value divisional projects instead of using the overall hurdle rate.
2) A Statement of the Problem
Marriott needs to calculate hurdle rates which will be used in its investment project selection. The company chooses to use cost of capital as their hurdle rate. Since the company has three business divisions and the cost of capital in each division may vary and differ from that of Marriott as a whole, each division needs to have its own hurdle rate. The problem is, therefore, to figure out Marriotts and divisional costs of capital for use as hurdle rates.
3) Methodology/Techniques
Cost of capital for investment is used as a hurdle rate. Weighted Average Cost of Capital (WACC) is used for calculating cost of capital. Since the companys capital consists of debt and equity, this technique of applying weighted average of the cost of equity and the cost of debt is reasonable.
Cost of equity used in WACC calculation is based on the Capital Asset Pricing Model (CAPM). Each of the business divisions will have its own cost of capital which may be different from that of Marriotts as a whole.
To estimate each divisions asset beta, average asset beta from comparable companies is used. Market leverage information is used to convert the given equity betas into asset betas. Since Market leverage uses book value of debt instead of market value, it is first converted to market value of debt percentage in capital using the market to book ratio of Marriotts debt. After finding the debt ratio and asset beta for each company, the average asset beta is then used as the divisional asset beta. Next, debt percentage in capital is used to convert the asset beta into equity beta for use in the CAPM model. In contract services division for which comparable companies are not given, I use the weighted average calculation to derive the asset beta. In other words, Marriotts asset beta is the weighted average of all divisional asset betas. Marriotts asset beta can be calculated from the given equity beta and debt percentage in capital. Then, I work backward and solve for contract services asset beta. The equity beta is calculated from asset beta using the same formula as in other divisions.
Cost of debt for WACC calculation is the borrowing rate at the present time. This is the combination of the rates for fixed rate debt and floating rate debt. Each rate is computed by adding debt rate premium above government to the government security interest rate for each division and for Marriott as a whole.
4) Data Requirement/ Sources
Cost of debt:
Debt rate premium above government from Table A
Government security interest rate from Table B
CAPM cost of equity:
Risk free rate from Exhibit 4
Industry beta from Exhibit 3
Tax rate from Exhibit 1
Risk premium from Exhibit 5
WACC:
Tax rate from Exhibit 1
Debt percentage in capital and equity percentage in capital from Table A
5) Key Assumptions
Project durations are close to 30 years for lodging, 10 years for restaurants and contract services.
Market value to book value ratios of debt for all companies in Exhibit 3 are equal.
Effective tax rate for all companies on Exhibit 3, except Marriott, is 30%.
6) Analysis
Cost of Debt
Floating rate debt is considered short-term debt, so the 1 year government interest rate is used to calculate the cost of debt for all divisions and Marriott as a whole.
Lodging division involves long-term assets so long term debt is used to finance them. Hence, cost of fixed rate debt for lodging is calculated by adding the corresponding debt rate premium above government from Table A with the 30-year U.S. Government security rate from Table B = 1.10% + 8.95% = 10.05%. Similarly, floating debt rate is 1.11% + 6.90% = 8.00%.
Sources of Capital
Effective Cost
Floating