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MARIOTT CASE STUDY

Q1. How does Marriot use its estimate of its cost of capital? Does this make any sense? Marriot uses the following formula for calculation of its opportunity cost of capital for investments of similar risk using the weighted average cost of capital WACC= (1-t) rD (D/V) + rE (E/V) Where, D and E are the market values of debt and equity, respectively, rD is the pre-tax cost of debt, rE is the after tax cost of equity, V is the value of the firm (V=D+E), and t is the corporate tax rate. Marriot used this approach to determine the cost of capital for the corporation as a whole and for each division. To calculate the Cost of debt for lodging, contract services, restaurants and Marriot Corporation as a whole we need to add up the debt rate premium above the government rate to the U.S. Government interest rates. Mariott used the cost of long-term debt for its lodging cost of capital calculations, while short term debt for restaurant and contract services. To calculate the Cost of Equity, Mariott has used the CAPM (capital asset pricing model). We use Bottoms up Beta for calculation of Cost of Equity of Lodging, Restaurant and contract services. The method used by Mariott corporation for estimating cost of capital makes sense.They have detrmined Cost of Capital for different divisions and mariott corporation as a whole.So,it takes into account time horizon or life of project as well as the inherent risk associated with different lines of business.It will help in making right investment decisions and add value to shareholders wealth.The use of different Cost of Capital for different divisions helps in choosing the right projects in different lines of business.

2. What is the weighted average cost of capital for Marriott Corporation? For Marriott Corporation, Market beta = 0.97 Calculation of Target Beta for Mariott corporation U = L / (1+(1-t)D/E) =0.97/(1+(0.56*(41/59)) [We take Tax rate t= 44%,1-t =0.56] =0.698 L = U * (1+(1-t)D/E) [Target Beta of Mariott corporation] = 0.698* (1+(1-0.44) 60/40) = 1.284

Cost of Equity = Rf + (Rm-Rf) [CAPM MODEL] = 4.27 + (1.284*5.63) = 11.49% Rf =Risk free rate=4.27% (Average return of Long term US Treasury Bonds) Rm-Rf = Market Risk premium Rm = average market return Pre Tax Cost of Debt = Debt Rate Premium above Government + US Government Interest Rate = 8.95% + 1.1% = 10.05% Post Tax Cost of Debt = 10.05*0.56 = 5.63%

Cost of Debt = Interest (1-t) = (8.95+1.3)*(1-0.44) = 5.74% Weighted Average Cost Of Capital(WACC) = We*Ce + Wd*Cd *(1-t) = 0.40*11.49%+0.56*0.60*10.05% =7.98% Alternate Method Cost Of Capital For Marriott Corporation is taken as the weighted average Cost of capital of different divisions of Marriott Corporation. WACC of Mariott Corporation(COCMarriott) = WL *COCLodging + WR*COCRestaurants + WC*COCContract services =(0.41*6.92%)+(0.13*7.48%)+(0.46*8.95%) =7.93% Here weights of each divisions are taken as a percentage contribution of different divisions to total sales. 3. If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time? Each line of business has its own risk associated with it. It might be different from the companys risk as a whole. If the company uses a single corporate hurdle rate, it does not take into account the line specific risk. So the company might take wrong investment decisions

thereby not being able to add value to shareholders wealth in the long run.Time period or life of projects of different line of businesses are different.For instance,lodging is long term and restaurants are short term businesses. Here, the single hurdle rate for Marriott Corporation = 7.93% Hurdle rate for Lodging division = 6.92% Hurdle rate for Restaurant division = 7.48% Hurdle rate for Contract Services = 8.95% Therefore, if the company takes up a project in Restaurant division with a hurdle rate of 7.34 (single hurdle rate for Marriott Corporation) it will make loss for the firm and erode shareholders wealth in the long run.

4. What is the cost of capital for its Lodging business? Calculation of Cost of Capital for lodging business Cost of equity = Rf + (Rm-Rf) [CAPM Model]

Calculation of Beta (By Bottoms up Beta method) We assume that target asset beta of Lodging division will be same as the asset betas of its competitors. average =(0.88+1.46+.38+.95)/4=0.9175 D/E (Average) = (0.16+3.76+2.22+1.85)/4 = 2.001 u (Unlevered beta) = L/(1+(1-t)*D/E) = 0.433 L (Lodging) = u*(1+(1-t)*D/E) = 1.122

Cost of equity = Rf + (Rm-Rf) = 4.27 + (5.63*1.122) = 10.59% Rf =4.27% (Average return of Long term US Treasury Bonds) Rm-Rf = Market Risk premium

Rm = average market return Pre Tax Cost of Debt = Debt Rate Premium above Government + US Government Interest Rate = 8.95% + 1.1% = 10.05% Post Tax Cost of Debt = 10.05*0.56 = 5.63% WACC (Lodging) = (1-t)rd*wd + re*we = (10.05 * 0.74) * 0.56 + (10.59 * 0.26) = 6.92%

5. What is the cost of capital for its Restaurant business? Calculation of Cost of Capital for Restaurant business Cost of equity = Rf + (Rm-Rf) [CAPM Model]

Calculation of Beta (By Bottoms up Beta method) average =(0.750+0.6+.13+.64+1+1.08)/6=0.7 D/E (Average) = (0.04+0.11+0.06+0.01+0.3+0.27)/6 = 0.132 We assume that target asset beta of restaurants division will be same as the asset betas of its competitors.

u = L/(1+(1-t)*D/E) = 0.652 L (Restaurant) = u*(1+(1-t)*D/E) = 0.916

Cost of equity = Rf + (Rm-Rf) = 3.48 + (6.42*0.916) = 9.36% Risk premium =6.42% Rf =3.48%

Pre Tax Cost of Debt = Debt Rate Premium above Government + US Government Interest Rate = 6.9% + 1.8% = 8.7% Post Tax Cost of Debt = 8.7*0.56 = 4.87% WACC (Restaurant) = (1-t)rd*wd + re*we = (8.7 * 0.42) * 0.56 + (9.36 * 0.58) = 7.48%

6. What is the cost of capital for its Contract services division? Calculation Of Unlevered Beta for contract Service Since there are no publicly traded companies in contract services,we use bottoms up beta for estimating beta of contract services. WL L + WRR + WCC = Marriott 0.41*0.433 + 0.13*0.652 + 0.46*C = 0.698 C = 0.947* [Unlevered beta] L (Contract Service) = u*(1+(1-t)*D/E) = 0.947 * (1 + (0.56*40/60)) =1.301 Cost of equity = Rf + (Rm-Rf) = 3.48 + (6.42*1.301) = 11.82% Pre Tax Cost of Debt = Debt Rate Premium above Government + US Government Interest Rate = 6.9% + 1.4% = 8.3% Post Tax Cost of Debt = 8.3*0.56 = 4.65%

WACC (Contract Services) = (1-t)rd*wd + re*we = 8.7*0.56*0.4 + 0.6 * 11.82 =8.95%

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