Case Study #6

Marriott Corporations: The Cost of

Capital

Ning Gong
Objectives of the Case Study
Calculating the WACC under the classical tax
system for the company as a whole and for each
division of the company
Current capital structure vs. target capital
structure
How to use a peer group to estimate divisional
equity beta
This technique is useful for estimating privately-held
companies
Company Background
Marriott had three major lines of business,
based on 1987 number:

Division Sales (%) Profits (%)
Lodging 41% 51%
Contract
Services
46% 33%
Restaurants 13% 16%
Uses of the Hurdle Rate
Investment projects were selected by
discounting the cash flows by the appropriate
hurdle rate for each division
The executive compensation plan would reflect
hurdle rates, making managers more sensitive
to Marriotts performance and capital market
conditions
EVA in essence

Cost of Debt for Marriott Corporation
We use the after tax WACC under the classical
tax system for Marriott Corporation
The target debt ratio is 60%, and the debt costs
1.30% +8.72% = 10.02% (See Tables A&B)
We will ignore the difference between floating rate vs.
fixed coupon rate debts here
The floating rate debt will be studied in Investments
elective
The Cost of Equity for Marriott Corp.
The cost of equity is based on the CAPM
The risk free rate was 8.72%.
Note: there is a debate whether we should use long-term or
short-term government bond rate as the risk-free benchmark.
However, it is typical to use the 10-year rate in the corporate
setting, as practiced by McKinsey & other consulting firms.

The equity risk premium was 7.43%.
However, based on the most recent data, it should be around
6.5%.
There are some ambiguities about the magnitude of the
equity risk premium.

The Cost of Equity (continued)
The historical equity beta was 1.11 (see Exhibit 3)
Can we use this beta directly?
If the target and the historical debt ratios are similar, we
could. Otherwise, we have to adjust the beta.
The beta was estimated as 1.11 at the time when the
debt/total capital ratio was 0.497 (based on the average
between 83-87). However, the target debt ratio was 60%, see
Table A.
The adjustment can be done by first finding the un-levered
beta for Marriott, and then adjust for the target debt capital
ratio. In doing so, we need to assume that the beta of debt is
zero, or you could find the beta of debt by regression.

Cost of Equity for Marriott as a Whole
The formula

The beta of debt is typically small. Without any
further information, lets assume it is zero. Thus,
the assets beta is =0.503*1.11=0.558
After adjusting for the target debt ratio, the beta
of equity for Marriott should be 0.558/0.4 = 1.396



a
E
D E
e
D
D E
d

E r
e
( ) . . * . . 872% 1396 743% 1909%
WACC for Marriott as a Whole

Choosing t = 44%, the effective tax rate from 1983-88
based on Exhibit 1,


However, using a single hurdle rate imposes a
systematic bias on project selection. Risky projects
appear more profitable, and less risky projects appear
less profitable.
For the calculation of the WACC for lodging division, see the
spreadsheet.
WACC

0 4 19 09% 0 6 1 44%) 8 72% 13%)

1100%
. * . . *( *( . .
.
Some Practical Considerations for
Calculating the Cost of Capital
Estimating the costs for many sources of capital
is not very precise. In practice, we often make
simplifying assumptions.
Non-interest-bearing liabilities, such as accounts
payable, are excluded from calculation of WACC to
avoid inconsistencies and simplify the valuation.
There are other long-term liabilities (such as pension
funds liabilities), which are often too complicated to
infer the required rate of return. There is no definitive
answer to the question.