Marriott corporation (solution)

1) Are the four component of Marriott’s financial strategy consistent with

its growth objective?
Yes, the four strategies are consistent with the growth objectives of
Marriott. The first financial strategy was managing hotel assets as
opposed to owning. Marriott developed over $1 billion worth of hotel
properties. After development, Marriott sold the hotel assets to limited
partners while retaining operating control. In 1987, Marriott and
Courtyard hotels were syndicated for $890 million, Marriott operated
over $70 billion worth of syndicated hotels. The second financial
strategy was investing in projects that increase shareholder value.
Discounted cash flow methods were used to assess potential
investments. According to a Marriott Executive,” Our projects are like
a lot of similar little boxes...managers still have discretion over unit-
specific assumptions, but they must conform to the corporate
templates.” The third strategy was optimizing the use of debt in capital
structure. Marriott used an interest coverage target instead of a target
debt-to-equity ratio, 59% of total capital. The final strategy was
repurchasing undervalued shares. Marriott was focused on
repurchasing stocks that fell under their “warranted equity value.” The
company repurchased 13.6 million shares of common stock for $429
million.
2) How does Marriott use its estimates of its cost of capital? Does this make
sense?
This policy made complete sense as the hurdle rate is just like the
Internal Rate of Return. Marriott Corporation relied on measuring the
opportunity cost of capital for investments by utilizing the concept of
Weighted Average Cost of Capital (WACC). The divisional hurdle rates
at the company would have a key impact on their future financial and
operating strategies. Marriott intended to continue its growth at a fast
pace by relying on the best opportunities arising from their lodging,
contract services and restaurants lines of businesses. To make the
company managers more involved in its financial strategies, Marriott
also considered using the hurdle rates for determining the incentive
compensations.
3) What is the weighted average cost of capital for Marriott Corporation?
Marriott uses the Weighted Average Cost of Capital (WACC) as a metric for cost
of capital. The formula for calculation below:
𝐷 𝐸
𝑊𝐴𝐶𝐶 = (1 − 𝑇) (𝑟𝑑 × ) + (𝑟𝑒 × )
𝑉 𝑉

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 Where:
T Corporate tax
rd Cost of debt
D Market value of debt
V Firm’s Enterprise Value (Market Value of Debt + Market Value of Equity)
re Cost of equity
E Market value of equity
Calculations for Marriott Corporation:
Value Source
T 34% Provided

rd 10.25% See calculation on page 3

D 60% Given target debt ratio

V 100% 40%+60%

Re 20.72% See calculation on page

E 40% 100%-60%

𝑾𝑨𝑪𝑪 = (𝟏 − 𝟎. 𝟑𝟒)(𝟎. 𝟏𝟎𝟐𝟓)(𝟎. 𝟔𝟎) + (𝟎. 𝟐𝟎𝟕𝟐)(𝟎. 𝟒𝟎)

𝑾𝑨𝑪𝑪 = 𝟏𝟐. 𝟑𝟓%

a) What risk-free rate and risk premium did you use to calculate the cost of equity?
Calculating Cost of Equity:
Marriott Corp utilizes the Capital Asset Pricing Model (CAPM) to derive their cost
of equity:
𝑟𝑒 = 𝑅𝑓𝑟 + 𝛽(𝑅𝑚 − 𝐹𝑓𝑟 )
Market risk-premium is calculated by Rm-Rfr. The spread between S&P 500
Composite Returns and Long-Term U.S. Government bond returns for the year
1926-87 is 7.43%, given by Exhibit 5.
Rf is constituted by the government bond rate of 8.95%. Using the highest and
longest as the risk free interest rate provided by the U.S government in April 1988,
given by Table B.
Values Source
Equity β=1.1 Exhibit 3
Asset β=0.667 D/E=0.4/0.6
𝐷
𝛽𝐿 = 𝛽𝑈 {1 + (1 − 𝑇) 𝐸 }
= 1.1 (1 + (1 – .34) (.4/.6))
= 1.584 re = 8.95% + 1.584 (7.43%)
= 20.72%

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b) How did you measure Marriott’s cost of debt?
Calculating Cost of Debt:
Marriott risk free-rate is the government bond rate of 8.95%, obtained from Table
B. Marriott’s Debt Rate Premium is found as the credit spread on Table A, 1.30%.
Book definition: Cost of debt = Risk free rate +Spread
Thus,
Rd = government bond rate + credit spread= 8.95% + 1.30% = 10.25%
*Spread is based on riskiness of company
4) What type of investments would you value using Marriott’s WACC?
Since the WACC is 12.35%, any investments with a WACC equal or lower than
12.35% would be an investment to be considered of value by Marriott. The
company will continue to look at other investments that will lower their WACC.
The type of investment to be considered is issuing bonds to get the financing
more cheaply. The firm is built upon lodging, contract services and restaurants as
the three key operations. By continuing investments in their three key
operations has created different WACC for each operation versus the whole
company. Marriott can seek projects that will increase shareholders’ value by
expanding its investment interests. In 1976, Marriott attempted this by opening
two theme parks. Long term investments opportunities place Marriott in a
predicament when attempting to optimize their debt.
5) 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?
Investopedia online defines a hurdle rate as the minimum rate of return on a
project or investment required by a manager or investor. In order to compensate
for risk, the riskier the project, the higher the hurdle rate. The main use of the
hurdle rates is to assess investment decision in order to determine if it’s
reasonable. Using different rates for different divisions can be advantageous as
different projects amongst different divisions might have different risk and
reward. Companies should be careful when applying a single cost of capital across
various departments.
The numbers below were calculated for Marriott and its different divisions.
WACC for Marriott= 12.35%
WACC for lodging division = 10.37%
WACC for restaurant division =14.53%
WACC for Marriott’s contract division = 14.31%

Looking at the above WACC’s we can see that each division is different. The cost
of capital for lodging is lowest. It is even lower than the WACC for the entire
company. The cost of capital is often equated risk, therefore the risk in the lodging
department is lower when compared with other departments that have a higher
WACC.

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 If Marriott was to use a single corporate hurdle rate then they would be using the
12.35% rate which is the WACC for the entire company. By breaking down
WACC’s to each respective division it will prevent Marriott from using this rate
for every project. This is beneficial or any project that arises out of the lodging
division will be rejected since its cost of capital of 9.25% is lower than the cost of
capital for the company. Using a higher rate will result in a negative NPV as well
as a reduced cash flow. What would happen is eventually projects from the
restaurant and contract service division will be approved since they are evaluated
at a lower rate than the determined cost of these various divisions. Over time,
Marriott will be approving more high risk project from the restaurant and
contract service division by evaluating them at a lower rate, while they will be
rejecting lower risk projects from the lodging division because they are using a
higher rate. As this type of decision making continues Marriott will be assuming
higher risk as it to approve riskier projects.
6) What is the cost of capital for the lodging and restaurant divisions of Marriott?
Lodging Division Cost of Capital
𝑫 𝑬
𝑾𝑨𝑪𝑪 = {(𝟏 − 𝑻) × 𝒓𝒅 (𝑽 ) + 𝒓𝒆 × (𝑽)}
Values Source
T=34%
rd = 10.05%, See part a
D/V = 74%, Market-Value Target-Leverage Ratios and
Credit Spreads for Marriott and Its Divisions
in Table A page 4
E/V = 26%, 100%-D/V= 74%

Values Source
Rf=8.95% Part a
Market risk premium=7.43% Part a
β = 1.623 Part C

𝑟𝑒 = 𝑅𝑓𝑟 + 𝛽(𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)

𝑟𝑒 = 0.0895 + 1.623(.0743)
𝑟𝑒 = 0.2101
𝑟𝑒 = 21.01%
𝑾𝑨𝑪𝑪 = {(𝟏 − 𝟎. 𝟑𝟒) × 𝟎. 𝟏𝟎𝟎𝟓(𝟎. 𝟕𝟒) + 𝟎. 𝟐𝟏𝟎𝟏 × (𝟎. 𝟐𝟔)}
𝑾𝑨𝑪𝑪 𝒐𝒇 𝑳𝒐𝒅𝒈𝒊𝒏𝒈 𝑫𝒊𝒗𝒊𝒔𝒊𝒐𝒏 = 𝟏𝟎. 𝟑𝟕%
Restaurant Division Cost of Capital
𝑫 𝑬
𝑾𝑨𝑪𝑪 = {(𝟏 − 𝑻) × 𝒓𝒅 (𝑽 ) + 𝒓𝒆 × (𝑽)}
Values Source
T=34%
rd = 8.70%, See part a

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 D/V = 42%, Market-Value Target-Leverage Ratios and Credit Spreads
for E/V= Marriott and Its Divisions in Table A page 4
E/V = 58%, 100%-D/V= 58%

Values Source
Rf=6.90% Part a
Market risk premium=8.47% Part a
β = 1.653 Part C

𝑟𝑒 = 𝑅𝑓𝑟 + 𝛽(𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)

𝑟𝑒 = 0.0690 + 1.653(0.0847)
𝑟𝑒 = 0.2090
𝑾𝑨𝑪𝑪 = {(𝟏 − 𝟎. 𝟑𝟒) × 𝟎. 𝟎𝟖𝟕𝟎(𝟎. 𝟒𝟐) + 𝟎. 𝟐𝟎𝟗𝟎 × (𝟎. 𝟓𝟖)}
𝑾𝑨𝑪𝑪 𝒐𝒇 𝐑𝐞𝐬𝐭𝐚𝐮𝐫𝐚𝐧𝐭 𝐃𝐢𝐯𝐢𝐬𝐢𝐨𝐧 = 𝟏𝟒. 𝟓𝟑%
a) What risk-free rate and risk premium did you use in calculating the cost of equity
for each division? Why did you choose these numbers?
The risk-free rate used for Marriott’s lodging division is 8.95%, which used a long-
term 30-year risk-free rate. Marriott’s restaurant division has a 6.90% risk-free
rate, which used a short-term 1-year risk-free rate. The values for the risk-free
rates are given in Table B on page 4. The risk premium for the lodging division is
7.43%. The risk premium for the restaurant division is 8.47%. We used the spread
between using 19261987 periods as the market risk premium in Exhibit 5 page
10. Since the lodging division is long term, we used the spread between S&P 500
Composite returns and long-term U.S. government bond returns. Since the
restaurant division is short term, we used the spread between S&P 500
Composite returns and short-term U.S. Treasury bill returns.
b) How did you measure the cost of debt for each division? Should the debt cost differ
across divisions? Why?
To measure the cost of debt for each division we used, cost of debt rd = rf + spread.
The risk-free rates for the lodging and restaurant divisions are 8.95% and 6.90%
respectively. The risk-free rate is given in Table B page 4 based on the maturity
of U.S Government interest rates, 30-year and 1-year. The spread is the debt rate
premium above government in Table A page 4. The spread for the lodging and
restaurant divisions are 1.10% and 1.80% respectively. The pre-tax cost of debt
for the lodging division is 10.05%, 8.95%(risk-free) + 1.10(debt rate premium
above government). The pre-tax cost of debt for the restaurant division is 8.70%,
6.90%(risk-free) + 1.80%(debt rate premium above government). The tax rate
used is 34%, the highest corporate tax between 1986-1992. The after-tax cost of
debt is (1-t) x rd. The after-tax cost of debt for the lodging division is 6.63%, (1-
.34) x 10.05%. The after-tax cost of debt for the restaurant division is 5.74%, (1-
.34) x 8.70%.
The cost of debt should be different across each division because each division is
treated as an independent company. The maturity of U.S interest rates are

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 different for the two divisions because the lodging division uses long-term 30-
year and the restaurant division uses short-term 1-year. The spread between the
debt rate and the government bond rate varied by division because of differences
in risk
c) How did you measure the beta of each division?
To measure the beta of each division you need to collect the raw equity(levered)
beta and D/E of other firms in the same industry. The equity(levered) beta and
market leverage of comparable firms is found on Exhibit 3 page 8. To the
unlevered beta use the following formula for each firm: Bu= BL / (1+ (D/E) * (1-
T)). To find the D/E, divide market leverage by 1 minus market leverage, D/E =
market leverage / (1-market leverage). Once you have the D/E you can plug it
into the unlevered beta formula. Once you obtain the unlevered beta for each
comparable firm, get the average. Next, re-lever beta by plugging the unlevered
average beta into the following formula:
𝐷
𝛽𝐿 = 𝛽𝑈 {1 + (𝐸 ) × (1 − 𝑇)}
To find the D/E use the debt percentage in capital for the division found in Table
A page 4. To get D/E from debt percentage in capital use the following formula:
D/E= debt % / (1- debt %). Now the unlevered(asset) beta can be
releveled(equity) beta using:
𝐷
𝛽𝐿 = 𝛽𝑈 {1 + (𝐸 ) × (1 − 𝑇)}
Note the tax rate is 0 since there is no information of tax rates for other firms.

Beta for Lodging Division

Step 1) Gather raw equity beta of other firms
Hilton Hotels Hilton Hotels LaQuinta Ramada
Corporation Corporation Motor Inns Inns, Inc.
Levered(equity) beta .76 1.35 .89 1.36
Market leverage 14% 79% 69% 65%
Step 2) Unlever the betas and convert Market leverage to D/E.
Tax = 0

Hilton Hotels Hilton Hotels LaQuinta Ramada Inns,

Corporation Corporation Motor Inns Inc.

D/E .14/(1-.14) .79/(1-.79) .69/(1-.69) .65/(1-.65)

= .163 = 3.762 = 2.226 = 1.857

.89/(1+2.226) 1.36/(1+1.857)
Unlevered
.76/(1+.163(1-t)) 1.35/(1+3.762) =0 .276 = 0.476
beta
= 0.653 = 0.283
formula

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 Step 3) Compute the average of the asset betas
Unlevered(asset) beta .653 .283 .276 .476
Average (.653+.283+.276+.476)/4
unlevered(asset) beta = .422
Step 4) Re-lever the average asset beta
𝑫
𝜷𝑳 = 𝜷𝑼 {𝟏 + 𝑬 × (𝟏 − 𝑻)}
Debt % in capital for lodging division = 74%
D/E = debt % in capital / 1- debt % in capital = .74/ (1-.74) = 2.846

BL =0 .422(1+2.846(1-0))
BL = .422(3.846)
BL = 1.623
Re-levered(equity) beta of Marriott Lodging division = 1.623

Beta for Restaurant Division

Step 1) Gather raw equity beta of other firms
Church’s Collins Frisch’s Luby’s McDonald’s Wendy’s
Fried Food Rest. Cafe. Int.
Chicken Int.
Levered 1.45 1.45 0.57 0.76 0.94 1.32
(equity) beta
Market 4% 10% 6% 1% 23% 21%
Leverage

Step 2) Unlever the betas and convert Market leverage to D/E.

tax = 0
Church’s Collins Frisch’s Luby’s Cafe. McDonald’s Wendy’s
Fried Food Int. Rest. Int.
Chicken
D/E .04/(1.04) .10/(1.10) .06/(1-.06) .01/(1-.01) .23/(1-.23) .21/(1-.21)
= 0.042 = 0.111 =0 .064 = 0.010 = 0.299 =0 .266
Unlever 1.45/(1+.04 1.45/(1+.1 .57/(1+.06 .94/(1+.299) 1.32/(1+.2
.76/(1+.010)
ed beta 2(1-t)) 11) 4) = .724 66)
= 0.752
formula = 1.392 = 1.305 =0 .536 = 1.043

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Step 3) Compute the average of the asset betas
Unlevered 1.392 1.305 .536 .752 .724 1.043
(asset) beta
Average
(1.392+1.305+.536+.752+.724+1.043)/6
unlevered
= .959
(asset) beta

Step 4) Re-lever the average asset beta

𝑫
𝜷𝑳 = 𝑩𝑼 {𝟏 + 𝑬 × (𝟏 − 𝑻)}
Debt % in capital for Restaurant division = 42%
D/E = debt % in capital / 1- debt % in capital, .42/(1-.42) = 0.724
BL = .959(1+.724(1-0))
BL = .959(1.724)
BL = 1.653
Re-levered(equity) beta of Marriott Restaurant division = 1.653

7) What is the cost of capital for Marriott’s contract services division? How can you
estimate its equity costs without publicly traded comparable companies?
To calculate the cost of capital for the contract services is more complex because
there aren’t any publicly traded peer companies to compare against and
privately held firms either do not report their results or do not report results
compliant with the financial reporting requirements of publicly traded
companies. Based on the projected mix of fixed and floating debt, the cost of debt
for the contract services division is estimated at 10.07%
To calculate the cost of capital for the contract services is more complex because
there aren’t any publicly traded peer companies to compare against. Privately
held companies do not report their results because they do not have to be
compliant with the financial reporting requirements of publicly traded
companies.
What is the WACC for Marriott’s contract services division?
βu for Marriott is the weighted average of the Divisional βu’s:

Identifiable Assets Ratio Beta Unlevered

Lodging $2,777.4 0.61 0.422
Restaurants $567.60 0.12 0.959
Contract Services $1,237.70 0.27
Marriott $4,582.70 1 0.667
0.61(.422) + .12(.959) + .27(βu)
= .667 βu
= 1.0907

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Cost of Debt
𝑟𝑑 = 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑡𝑛 𝑏𝑜𝑛𝑑 𝑟𝑎𝑡𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑝𝑟𝑒𝑎𝑑
𝑟𝑑 = 6.90% + 1.40%
𝑟𝑑 = 8.30%
Cost of Equity for Contract Services:
Using the target debt ratio of 40%:
𝐷
𝛽𝑐𝑠 = 𝛽𝑈 {1 + (1 − 𝑇) (𝐸 )}
0.4
𝛽𝑐𝑠 = 1.0907 {1 + (1 − 0.34) (0.6)}
𝛽𝑐𝑠 = 1.571

Using CAPM:
𝒓𝒆 = 𝑹𝒇𝒓 + 𝜷𝑻𝒔 (𝑹𝒎 − 𝑹𝒇𝒓 )
𝒓𝒆 = 6.9% + 1.571(8.47%)
𝒓𝒆 = 20.20%
𝐷 𝐸
𝑊𝐴𝐶𝐶 = {(1 − 𝑇) × 𝑟𝑑 (𝑉 ) + 𝑟𝑒 (𝑉)}
𝑊𝐴𝐶𝐶 = {(1 − 0.34)(0.083)(0.4) + (0.2020)(0.6)}
𝑊𝐴𝐶𝐶 = 14.31%