Case ID: 289047

Solution ID: 31

Words: 2473

Price $ 75

Marriott Corporation has three divisions - lodging, contract services and restaurants - with various methods. The business uses three separate hurdle rates for your three divisions to value the recommended projects. It's thought this method is suitable that employing a single firm-wide discount rate because the methods in the three divisions differ drastically. However, the business must make certain the organization utilizes a appropriate discount rate for each division. Therefore, we calculate the best cost of capital for Marriott Corp too for all the three divisions. An thorough analysis is presented in regards to the appropriate calculation inputs for all the three divisions along with other presumptions, made while undertaking the data, are justified.

RD and RE are the pretax
cost of debt and cost of equity respectively and t is the corporate tax rate.
The Numbers Used in Marriott Corp cost of capital WACC. A 34% tax rate rate will be assumed for
simplicity's sake so more effort can be focused on other issues. The
above WACC calculation uses market value of debt. Cost of debt can be observed
directly by calculating the yield to maturity of outstanding bonds, but since
the bond market is not very transparent and we know Marriott's unsecured debt
is A-rated, the company can expect to pay a spread above some base rate. Which
index to use should be determined by project life, and as lodging is based on a
long term business model, a 30-year treasury bond is appropriate.

In this case, the base is
8.95% according to Tabe B and the spread for the overall company is 130 basis
points according to Table A. Also found in Table A, Marriott Corp set a target of
the debt percentage in its capital structure to be 60% for the overall company.
Because there is no way of directly observing the return that equity investors
require, we rely on a couple of methods to estimate it. A dividend growth model
can be used, and although simply to use, this approach assumes steady dividend
growth. This approach also does not directly adjust for the riskiness of a
project. An alternative approach is to use CAPM, which does not rely on dividend
growth and does take both the market risk premium and systematic risk into
consideration. Using CAPM to estimate the cost of capital pdf we use the following
formula: E(R)=Rf+ {draw:frame} *MRP_. Rf is the same risk-free base rate used
to calculate cost of debt, in this case, 8.95% from Table A. The {draw:frame}
is obtained from regression using market data and therefore is affected by
leverage.

To adjust for this, the B is
unlevered and then relevered so that it is the B for business risk only,
independent of capital structure. With due consideration given to each input,
Appendix A is a computation of Marriott's WACC, 11.87%, which is also the
required rate of return for the company overall. The Use of Marriott's WACC in
Divisional Decisions

Marriott can use the computed WACC to support its stock
repurchasing decisions because it allows the equity cash flows to be discounted
at a company level rate. But because each cost of capital solution xls could differ
amongst its divisions, the cost of capital varies across each. If Marriott Corp used
the above calculated WACC for all divisional decisions, it would cause the
company to take on riskier projects, projects that once risk adjusted would
likely cause the company to lose money in the long run. A better approach would
be to use individual {draw:frame} for each project with CAPM to
calculate the WACC for each project and compare it to IRR. Determining
Divisional WACC

To estimate the WACC for each division, we need their corresponding {draw:frame} . To do this we use comparable companies for each division; this is because we cannot run regressions at the divisional level as that information is not available. For the lodging division, we compare other hotel companies, for the restaurant division, we compare other restaurants, and for the contract services division we use the identity: {draw:frame} M=WL* {draw:frame} L+WR {draw:frame} R+WCS {draw:frame} CS. The identifiable assets in Exhibit 2 will be used to compute the weights of each division. Once again, because the information is actual market numbers, {draw:frame} E is affected by leverage and must be unlevered by multiplying it by 1 - market leverage. This results in {draw:frame} A which is business risk, independent of capital structure. Asset risk is the only thing that is comparable across firms. Within each divisional comparison to comparable companies, weighted average of {draw:frame} A is used as smaller companies have less impact on the overall segment.

Cost of Debt Calculation

*Debt Premium, Risk-free Rate, Return on Debt *

Cost of Equity Calculation

*Equity Beta, Market Risk Premium, Return on Equity*

Tax Rate

WACC

Asset Beta Calculation

*Lodging Beta, **Restaurants Beta, Contract Services Beta*

1) Are the four components of Marriott's financial strategy consistent with its growth objective?

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

3) What is the weighted average cost of capital for Marriott Corporation as a whole? What risk-free rate and risk premium do you use to calculate the cost of equity? How do you measure Marriott's cost of debt?

4) What type of investments would you value using Marriott's cost of capital?

5) If Marriott used a single hurdle rate for evaluating projects in each of its divisions, what would happen to the company over time?

6) What are the costs of capital for the lodging and restaurant divisions of Marriott?

a) What risk-free rate and market risk premium do you use in calculating the cost of equity capital for each division? How do you choose these numbers?

b) Did you use arithmetic or geometric averages to measure rates of returns? Why?

c) How do you measure the cost of debt for each division? Should the cost of debt differ across divisions? Why?

d) How do you measure the beta of each division?

7) What is the cost of capital for Marriott's contract services division? How can you estimate its cost of equity **when there are no publicly traded comparables**?

8) Marriott also considered using the hurdle rates to determine incentive compensation. How do we link this with the Economic Value Added (EVA) approach?