Marriott Corporation: The Cost of Capital (Abridged) Executive Summary: The case "Marriott Corporation: The Cost of Capital

(Abridged)" focuses on an ideal opportunity to review the capital asset pricing model and the weighted average cost of capital through calculation of the cost of capital for Marriott as a whole. Dan Cohrs is faced with making recommendations for the hurdle rates at Marriott Corporation and its three divisions utilizing CAPM and WACC. This case illustrates how to calculate beta based on comparable companies and to lever betas to adjust for capital structure; the appropriate risk-less rate and market risk premium; the choice of time period to estimate expected returns and the difference between the geometric and the arithmetic average as a measure of expected returns. SYNOPSIS Marriott Corporation began in 1927, and over the next 60 years, the company grew into one of the leading lodging and food service companies in the US. In 1987, the Marriott's annual report stated, "We intend to remain a premier growth company. Our goal is to be the preferred employer and provider, and the most profitable company". Marriott's profits were $223 million on sales of $6.5 billion. In April 1988, vice president of project finance at the Marriott Corporation, Dan Cohrs, must prepare annual recommendations for the hurdle rates at each of the firm's three divisions, including restaurant, lodging, and contract services, as well as Marriott Corporation as a whole. The company's restaurants, such as Roy Rogers and Hot Shoppes, provided 13 percent of 1987 sales and 16 percent of profits. Lodging operations included 361 hotels and more than 100,000 rooms, and generated 41 percent of 1987 sales and 51 percent of profits. Contract services provided food and services management to health-care and educational institutions and corporations, and accounted for 46 percent of 1987 sales and 33 percent of profits. It is important that Cohrs makes an appropriate recommendation for each division because hurdle rates influence project investment decisions. Cohrs is faced with 1) deciding which data he will use to calculate the rates and 2) calculating the weighted average cost of capital (WACC) with the little information given about the contract division and Marriott Corporation altogether. Cohrs recognized that the divisional hurdle rates at Marriott would have an impact on the company's financial and operating strategies. If hurdle rates decreased, Marriott's growth would hasten. The primary elements of Marriott's financial strategy were 1) managing rather than owning hotel assets, 2) investing in projects that increase shareholder value, 3) optimizing the use of debt in the capital structure, and 4) repurchasing undervalued shares. Managing hotel properties opposed to owning the

properties creates greater value than property ownership. Investing in projects that increase shareholder value enhances the probability of growth in the market value of the firm. Optimizing the debt used in the firm's capital structure would typically result in a decrease in the firm's average cost of capital. Repurchasing the undervalue shares may result in a strong return on investment. The first step would be to determine the appropriate tax rate. The average of the tax rates for 1926 thru 1987 can be used as the tax rate for the corporation and its divisions. Each year's tax rate can be calculated using the tax amount divided by each year's income before tax. Note the following table in order to compute the Tax Rate calculations: Year Tax Rate (%) Year Tax Rate (%) 1978 42.39 1983 41.40 1979 41.47 1984 42.70 1980 39.22 1985 43.38 1981 37.26 1986 46.77 1982 37.54 1987 44.10 Average Tax Rate = 41.62% In this case, use the effective tax rate in 1987 rather than the average tax rate in order to proxy for the tax rate, which is equal to income taxes in 1987 divided by taxable income in 1987, which is 175.9/398.9, or 0.44. The effective tax rate is 44 percent. Then, the second step would be to determine the cost of debt by summing the 1988 government interest rates and the debt rate premium above government. It would be best to use the 30 year government rate for the Marriott Corporation considering it has been established for more than 30 years (from Table A in the case). The third step would then be to determine the cost of equity by using CAPM. It would be best to use the arithmetic average of the spread between the S&P 500 Return to calculate the risk premium (from Exhibit 5 in the case). Note the following calculations that exhibit that the WACC for Marriott Corporation is 6.32 percent: CAPM = Risk Free Rate + (Risk Adjusted Beta * Risk Premium) = 4.58 + (1.50 * 7.43) = 15.73 WACC = (1-T) * (D/V) * (Cost of Debt) + (E/V) * (Cost of Equity)

= (1-.44) * (.6) * (.013 + .0895) + (.4) * (15.73) = (.56) * (.6) * (.1025) + (.4) * (15.73) = .03 + 6.29 = 6.32% If Marriott (or any corporation for that matter) only used a single corporate hurdle rate for evaluating investment opportunities for its individual business lines, they would introduce error into their accept/reject decisions for new projects within each line of business since specific projects or divisions have significantly different risk than the firm's or division's average risk. While calculating a risk-appropriate WACC for every new project under consideration isn't usually feasible for large corporations like Marriot, calculating a divisional WACC would lead to less error in accept/reject decisions. Using a firm-wide WACC in evaluating new projects without using the divisional approach would tend to give advantage to projects riskier than the firm's average beta and disadvantage to safer, less risky projects. Overall, Marriott's bottom line would suffer if they used a firm-wide inappropriate benchmark, which could be avoided by calculating different divisions proxy for different average project risk levels, then using the divisional approach to calculate separate WACC's for each division. This will result in fewer errors and an improved bottom line as well as better pipeline for viable new opportunities. Failure to do so over time will result in Marriott making large investment mistakes, overfunding risky divisions and projects while underfunding or rejecting projects that should have been accepted. After making error after error in their investment choices, working capital would be diminished to such a point, and shareholders so unhappy, feasibly the company would not be able to continue operations without a complete overhaul of their investment evaluation technique. Using a single corporate hurdle rate for investment opportunity evaluation would clash directly with one of Marriott's four main investment strategies; Invest in projects that increase shareholder value. In Marriott's 1987 annual report it states, "We intend to remain a premier growth company. This means aggressively developing appropriate opportunities within our chosen lines of businesslodging, contract services, and related businesses." Aggressively developing opportunities does not equate to taking unnecessary risks. Marriott historically used the CAPM technique to find different costs of capital for each of their divisions, and the hurdle rate assigned to a specific project was wisely based on market interest rates, project risk, and estimates of risk premiums. This was mitigated by using standard company-wide assumptions in cash flow forecasts for consistency across projects,

while maintaining divisional manager control over unit-specific assumptions. Assigning a single corporate hurdle rate would not improve upon their historical method of evaluating opportunities within divisions and across them, but rather would result in investing in projects that decrease shareholder wealth instead. Using an objective approach to calculating divisional WACC's is more precise so we must start by computing the average beta per division, using these figures in the CAPM formula to calculate iE for each division, then using divisional estimates if iE to construct divisional WACC's. To find the WACC for the lodging division of Marriot we begin by computing the average equity beta for the lodging division as follows: From Exhibit 3 on page 8 of case: Hotels: Equity Beta HILTON HOTELS CORPORATION .76 HOLIDAY CORPORATION 1.35 LA QUINTA MOTOR INNS .89 RAMADA INNS, INC. 1.36 Average Equity Beta for lodging division: 1.09 Since lodging assets, like hotels, have long useful lives, Marriot used the cost of long term debt for its lodging cost-of-capital calculation. Using the average beta for the lodging division in the CAPM model we must solve the following equation: iE = if + E [E (iM) - if or CAPM = Risk Free Rate + (Risk Adjusted Beta * Risk Premium) We begin solving for the variables starting with the equation for the cost of debt, with Risk Free Rate in Table B from the case and Debt Rate Premium Above Government in Table A: Cost of Debt = Risk Free Rate + Debt Rate Premium Above Government Cost of Debt = 8.95% + 1.10% = 10.05% Weight Equity is calculated by subtracting Debt Percentages from 1. Thus Weight Equity for the restaurant is equal to (1-0.74), or 26 percent. Cost Equity was calculated with the following equation:

Cost Equity = Risk Free Rate + Equity Beta (Market Risk Premium) Risk free rate and Market Risk Premium are already known. Equity Beta, or 1.09, can be found in the table from the previous page. Thus, the Cost of Equity is 8.95% + 1.09(7.43%) = 17.05 percent. The WACC for the lodging division of Marriott is 8.6 percent and can be calculated using the CAPM figures above to solve for the divisional WACC: WACC = (1-T) * (D/V) * (Cost of Debt) + (E/V) * (Cost of Equity) WACC = 74%(1-0.44) * 10.05% + 26% * 17.05% WACC = .0859772 or 8.6% It is important to keep in mind that the values for the risk premium as well as the values used for the risk free rates might not be accurate because they are arithmetic averages and are based on the past and we are trying to look for future rates. Using the arithmetic average assumes that the rates will remain the same in the future and this is not always true. Weight Debt is equal to the Debt Percentage in Capital which was reported in Table A of the case as 42 percent. Cost of Debt is equal to the Risk Free Rate + Debt Rate Premium Above Government. Both of these are reported in the case. Risk Free Rate in Table B was reported at 8.95 percent and Debt Rate Premium Above Government in Table A was reported at 1.08 percent. Cost of Debt = 8.95% + 1.80% = 10.75% Weight Equity is calculated by subtracting Debt Percentages from 1. The Debt Percentage was reported in Table A of the case at a value of 42 percent. Thus, the weight equity is equal to 58 percent. Cost of Equity is equal to the Risk Free Rate + Equity Beta (Market Risk Premium). The Risk Free Rate and Market Risk Premium are already known from the case. To calculate Equity Beta the average beta for the restaurant division must be calculated as follows: From Exhibit 3: Restaurants: Equity Beta CHURCH'S FRIED CHICKEN 1.45 COLLINS FOODS INTERNATIONAL 1.45

FRISCH'S RESTAURANTS .57 LUBY'S CAFETERIAS .76 McDONALD'S .94 WENDY'S INTERNATIONAL 1.32 Average Beta for restaurant division: 1.07 Cost of Equity = 8.95% + 1.07(7.43%) = 16.9% Now that all the required numbers are known, the WACC for the restaurant division Marriott can be calculated as follows: WACC = 42%(1-0.44) * 10.75% + 58% * 16.9% WACC = 12.33% The WACC for the restaurant division is 12.33 percent. The weight debt for contract services is given in Table A of the case study as 40 percent. The given Tax rate for the company is 44 percent. The cost of debt is equal to the Risk Free Rate + Debt Rate Premium Above Government. Tables A and B of the case study report the Risk Free Rate to be 8.95% and the Debt Rate Premium Above Government to be 1.4 percent. 8.95% + 1.4% = 10.35% The weight equity is equal to 1 Debt percentage, which is given for contract services as 40 percent. 1-40% = 60%. Cost Equity is equal to the Risk Free Rate + Equity Beta (Market Risk Premium). Risk Free Rate and Market Risk Premium are given in the case. Contract services have no available comparable information. However, the asset beta of the entire company is the weighted average of all the divisions. After knowing the beta of the company as a whole, and the weighted betas of the other divisions, the asset beta of the contract services division can be calculated by: 1.11 = 2,777.4/4582.7 * 1.09 + 567/4582.7 * 1.07 + 1237.7/4582.7 * CSAB 1.11 = .6606 + .1323 + .27 (CSAB) Asset beta of contract services = 1.174 The cost of equity can then be calculated as:

8.95% + 1.174 (7.43%) = 17.673% All information needed to compute WACC is resolved and can now be entered into the weighted-average cost of capital formula: WACC = Weight Debt (1-Tax rate) Cost Debt + Weight Equity * Cost Equity WACC= .4(1-.44) * .1035 + .6 * 17.673 WACC = .1292 or 12.92% The WACC for the contract services division is 12.92 percent. RECOMMENDATIONS & CONCLUSION The weighted-average cost of capital for each division varies from each other, and the company as a whole. This finding is expected because of the differences in debt, equity, and risk involved in each division. The differences in WACC serve as reinforcement of the Marriott's decision to create different hurdle rates for different divisions. The closer look at the divisional hurdle rates will help Marriott achieve one of its goals of increasing shareholder value by allowing each division to make decisions based on their own circumstances. Since Marriot Corporation uses some project specific inputs in calculating WACC as well as some inputs consistent with firm wide values used in calculating the firm wide WACC, each of Marriot's divisions; lodging, restaurants, and contract services, they have minimized making false accept/reject decisions for new projects that could occur if they were to use one single company-wide hurdle rate. If risk were to increase because the firm decides to take on a project that is particularly different from existing lines of business, Marriot will have to reflect this risk in their beta for each business line. Then they could use pure-play proxies (example in question 3 for average beta for lodging division calculations) to make inferences for a particularly unique new project/investment. Overall Marriot should use the objective approach to calculating divisional WACC and would therefore be able to be more precise, make more meaningful inferences in terms of risk, and result in fewer incorrect accept/reject decisions. Marriot may also consider using a flotationadjusted cost of equity if they externally fund a project for any of their three divisions to account for commission costs.