Case 1 (Marriott Case) Assignment This is a team work.

If Team 1 completes Case 1 analysis, they should name their work as Case1Team1, save and submit it as a word document. Suppose John Smith is taking this course, and he hasnt joined in any team, then he has to finish this individually, and name his work as Case1SmithJ. Case 1 assignment due 08/14/11 9:00 pm California time. Reading: Read the Case 1 (Marriott Case). This case provides students with the opportunity to explore how a company uses the capital asset pricing model (CAPM) to compute the cost of capital for the company and for each of its divisions. The weighted average cost of capital (WACC) formula and the mechanics of applying it are stressed. Students also learn to calculate betas based on comparable companies and to lever betas to adjust for capital structure. Risk-free rate and risk-premium The CAPM is a one-period model. Multi-period applications of the CAPM rely on the assumption that the CAPM holds in each period. And the theoretically correct way to use CAPM is to recompute an expected return in each period, using a different riskless rate, beta, and risk-premium. For many long-tem projects, it is reasonable to assume that beta and risk-premium are stable over the life of the project, and the yield on a long-term riskless bond is used. In this case, the 30-year U.S government interest rate in April 1988 (page 4, table B) is used to proxy for the riskless rate. And the spread between S& P Composite returns and long-term U.S. government bonds for 1926-1987 period, 7.43% is used to reflect the risk-premium. Unlevered Asset Beta and Levered Equity Beta The following equation shows the relationship between levered-equity beta (E) and unlevered asset beta (U): E = u*[1 + (1t)(D/E)], D/E = (D/V)/(E/V) = (D/V)/(1-D/V), V= D+E. Leverage = D/V, Therefore, E = U*[1 + (1t)(D/E)] = U*[1 + (1t)*leverage/(1-leverage)] Or U = E / [1 + (1t)(D/E)]. Where t is the tax rate, D is market value of debt and E is market value of equity. Therefore, firm value = D+E, assuming the firm use only debt and equity to finance its capital. U is unlevered beta, also named asset beta. Asset beta is the beta of a debt-free company. It is also called beta of assets. E is equity beta, the beta of equity when debt is used.

We use the effective tax rate in 1987 to proxy for the tax rate, which is equal to income taxes in 1987 divided by taxable income in 1987, that is 175.9/398.9 = 0.44 = 44%. Exhibit 3 shows that when Marriotts market leverage is 41%, its equity beta is 1.11. Leverage = D/(D+E) = D/V = 0.41, that is D = 0.41V, so E = V D = 0.59V, D/E = 0.41V/0.59V = 0.69, So the unlevered beta of Marriott = 1.11/[1 + (1-0.44)*0.69] = 0.80. Given the unlevered equity beta of Marriot is 0.80, When leverage is 0.60, the levered equity beta = 0.80 * [1 + (1-0.44)*(0.6/0.4)] = 1.47 Then you may apply the CAPM to find out the cost of equity for Marriott under target leverage level of 0.60. The cost of debt for Marriott is equal to Marriotts debt rate premium above government plus 30-year government interest rate = 1.30% + 8.95% = 10.25%. Eventually you will apply the WACC formula to find Marrotts WACC. When you calculate the cost of capital for Marriotts divisions, note that each division will have different equity beta and cost of debt. Instructions: After you reading the case, connect with your teammates and decide on how best to develop your answers to the questions below. Your answer should be clear and be easy for reader to understand how you find out the answer and why. The teams should map out critical path and ratably distribute work amongst the members. Please adhere to the prescribe format, MS Word, double spaced, Times Roman, or other true-type-font, and include the names of each team member on your final submission. For example team 1 should submit its work of Case 1 assignment as a word document named as Case1Team1, and the names of each Team 1s members should be included in the file (The names should be shown at the beginning of the file). If Allen Smith (who hasnt joined in any teams) finishes Case 1 assignment individually, then his submitted work (a word document) should be named as Case1SmithA. The grading will be based on: Quality of analysis: Have you analyzed all the pertinent issues correctly and avoided obvious repetition of facts in the case? Quality of recommendations: Have you offered specific plans of action and backed these up with strong arguments? Writing: Do you present the material in a logical, clear way with no grammar/spelling errors?

Your write-up should begin with an opening paragraph that synopsizes the case (1 point), and answer all the following questions: 1. What is the weighted average cost of capital (WACC) for Marriott Corporation (2 points)? 2. If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its line of business, what would happen to the company over time (1 point)? 3. What is the WACC for the lodging division of Marriott (2 points)? 4. What is the WACC for the restaurant division Marriott (2 points)? 5. What is the WACC for Marriotts contract services division (2 points)? Hint: the asset beta of the whole company is just a weighted average of the asset betas of the divisions.