Case

Study: Marriott Corporation

The Cost of Capital





Teresa Cortez
Keith Gemmell
Brandon Papsidero
Robin Reschke



October 28, 2013

 Table of Contents

1. Are the four components of Marriotts financial strategy consistent with its growth
objective? ...................................................................................................................... 1

2. How does Marriott use its estimate of its cost of capital? Does this make sense? ...... 3

3. What is the weighted average cost of capital for Marriott Corporation? ..................... 4

4. What type of investments would you value using Marriotts WACC? ........................ 6

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? ......... 7

6. What is the cost of capital for the lodging and restaurant divisions of Marriott? ........ 8

7. What is the cost of capital for Marriotts contract services division? How can you
estimate its equity costs without publicly traded comparable companies? ................ 11

APPENDIX I Math Utilized to Derive WACC for Marriott .......................................... 13

APPENDIX II Math Utilized to Derive WACC for Divisions ...................................... 16

BA 626 Financial Decision Making ii

1. Are the four components of Marriotts financial strategy consistent with
its growth objective?

The four components of Marriotts financial strategy are to manage rather
than own hotel assets, to invest in projects that increase shareholder value, to
optimize the use of debt in the capital structure, and to repurchase undervalued
shares when necessary.

Marriotts growth objective is to become the preferred employer and
provider in lodging, contract services (such as catering), and restaurants, and to be
the most profitable company in their industry.

By choosing to manage hotel properties instead of owning them Marriott
lowers their accounting assets on the books, therefore increasing their return on
assets as compared to owning the properties outright. This strategy also effectively
shares the risk that comes from the properties, and lets Marriott operate with more
liquidity, offering them the opportunity to relocate their hotel or restaurant
operations without the need to sell properties, for instance.

Marriott can analyze potential projects and discount the future cash flows to
determine which projects will have a higher net present value, and ultimately which
will be most profitable to Marriott at the present time, therefore increasing
shareholder wealth.

Balance sheets reflect all company debt, so by reducing debt Marriott can
decrease their Debt to Equity ratio, becoming more attractive to new and existing
shareholders. Marriotts plan to repurchase shares when they are undervalued can
positively affect share price and therefore shareholder value, but it is not directly in
line with their project-based growth objective.

By repurchasing shares, they are removing shares from the market. As they
continue to make a profit, the profit per share is now higher due to the buyback,
theoretically causing the demand for shares to increase and the price to increase
accordingly.

This process does not guarantee increasing shareholder wealth in the long-
run, especially compared to their competitors or the market. Often, institutional
investors consider a stock buyback a sign that the company has found no
opportunities for growth projects that will provide an adequate net present value.

BA 626 Financial Decision Making 1

 Marriott should only consider this strategy when there are no projects in the
foreseeable future that will provide a positive net present value, and when they
have enough cash to both buyback shares and adequately fund future projects that
meet their hurdle rates. In other words, having excess cash on hand is sometimes a
value in itself.

Marriott should consider how they will become the preferred employer, as
this will positively affect the experience of guests in lodging and restaurants, and
ultimately affect their profit. They should examine their hiring procedures,
acquisition of talent, and corporate culture, and pay extra attention to their guests
experience as it relates to their employees ability to provide excellent customer
satisfaction.

Overall, Marriotts financial strategy aligns with their growth objective,
although planning to buy back shares when they are undervalued may not be a good
long-term plan. Additionally, their financial strategy does not address their interest
in becoming a preferred employer.

BA 626 Financial Decision Making 2

2. How does Marriott use its estimate of its cost of capital? Does this make
sense?

Marriott used the Weighted Average Cost of Capital calculation to measure
the opportunity costs for company investments that have similar risk. The formula
is as follows:

WACC = (1 t) rd (D / V) + rE (E/V)

T = corporate tax rate
rD = Cost of debt before tax
rE = Cost of equity after tax
D = Market value of Debt
E = Market value of Equity
V = Firm Value (D + E)

Marriott calculated the WACC for each of the three divisions (lodging,
restaurants, and contractor services) as well as for the company as a whole. They
updated their cost of capital annually.

Marriotts WACC equation does make sense as it uses several variables in an
effort to weight each division appropriately against the firm value (V) and the
corporate tax rate (T). Furthermore, the divisions cost of debt before tax (rD), cost
of equity after tax (rE), market value of debt (D) and the market value of equity (E)
give Marriotts WACC equation appropriate weight per division and tie the cost of
debt and equity to the market values.

The WACC was integral in setting hurdle rates for each of Marriotts
divisions. Hurdle rates are a prerequisite return any project for any division must
provide in order to be approved. In this capacity, Marriott can ensure they invest
only in projects that have an adequate net present value to increase shareholder
wealth.

BA 626 Financial Decision Making 3

3. What is the weighted average cost of capital for Marriott Corporation?

To determine WACC, Marriott has used the following formula:

WACC = (1 t) rd (D / V) + rE (E/V)

T = corporate tax rate
r = Cost of debt before tax
D

r = Cost of equity after tax

E

D = Market value of Debt

E = Market value of Equity
V = Firm Value (D + E)

Once all variables are identified, WACC can be solved (Appendix I shows the
calculations to determine each variable):

WACC = (1 - .44) (.1010) (.60) + (.1017) (.40) =.0746

Marriotts WACC = 7.46%

3a. What risk-free rate and risk premium is used to calculate the cost of equity?

The risk-free rate of 8.95% and calculated risk premium of .95% were used
to calculate the cost of equity.

The risk-free rate was chosen as it is the highest rate offered on the
government fixed rates found within Table B. Since it is a government fixed rate, it is
the longest risk-free term rate available. Similarly, the geometric average expected
market return for Standard & Poors 500 Composite Stock Index Returns found on
Exhibit 4 was used for finding the market risk premium (MRP = Rm - Rf = 9.90 8.95
= .95). It was chosen over S&P 500 Composite and Long-term U. S. Government
Bond Returns geometric average of 5.63% to allow for the Risk Premium to be at a
positive, moderate risk level.

3b. How did you measure Marriotts cost of debt?

The case study provides U.S. government fixed-rates for the current time
period which shows what Marriott would likely be paying on debt. Also, it is key to
know that Marriott is comprised of three primary divisions, and one (lodging) uses

BA 626 Financial Decision Making 4

long-term debt while the other two (restaurant and contract services) use short-
term debt. To determine the exact rate of debt it is necessary to calculate a weighted
average amongst the potential interest rates for debt. From Table B, 30-year (long-
term) is 8.95% and 10-year (short-term) is at 8.72%.

Government Interest Paid = 8.95 + 8.72 + 8.72 = 8.80%
3
Full cost of debt is not just average government interest but also Marriotts
debt rate premium above the government average. As such:

rD = Government Interest Rate + Debt Rate Premium

Marriotts average debt rate premium is given on Table A as 1.30%

Therefore, rD = 8.80 + 1.30 = 10.10%

3c. Did you use arithmetic or geometric averages to measure rates of return?

Geometric averages were used to measure rates of return. Geometric
averages were chosen since annual investment returns are not independent of each
other. Since a bad or good year in returns will affect the capital available in the
succeeding year, geometric averages are a more accurate way of measuring the
affects over a wide range of time when compared to arithmetic average. By using the
geometric average, the actual rate of return is used and allows a more
comprehensive comparison between rates previously used and future hurdle rates
to be used by Marriott.

BA 626 Financial Decision Making 5

4. What type of investments would you value using Marriotts WACC?

One of the objectives of Marriotts financial goals is to invest properly.
Marriott would invest in projects that will increase the shareholder wealth.
Marriott would value investments that are similar to lodging, restaurant, and
contract service projects as these divisions represent Marriott as a whole. However,
each division should have and use its own WACC as each division has varying and
unique projects, risks, and returns.

For example, the lodging division should evaluate investments with similar
characteristics as the Marriott lodging division. An investment with similar unique
projects, risks and returns would yield a similar WACC and could therefore help
Marriotts market share prices. However, Marriott should also ensure their
investment portfolio is diverse enough to reduce risk. If Marriott strictly invested in
projects that are dependent on each others market share price, Marriotts risk
would increase more rapidly. Choosing investments where the risk/reward can
offset each other will result in the highest possible return for the shareholder.

The above outlined diversified portfolio objective should be followed by each
division. In addition, the corporation as a whole should evaluate the potential
division portfolios to choose the combination that provides the lowest risk with the
highest return.

BA 626 Financial Decision Making 6

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?

The purpose of using different hurdle rates in each division allows the
division to pursue investments and projects in a low risk manner. As the divisions
are different types of industries, if a corporate hurdle rate was instantiated, this
would affect the types of future investments and projects pursued significantly. In
addition, risk is reduced by investing in a diverse portfolio. Each line of business
can reduce their risk in an effort to reduce Marriotts overall risk further.

Should Marriott use a single corporate hurdle rate for evaluating investment
opportunities in each of its lines of business, the Marriott would begin to commence
more risky opportunities over time. As more risky opportunities are invested in, the
returns must also increase. In addition, the NPV must increase. In many high risk
cases, the standard deviation also increases which could more easily result in
negative NPVs. Continuously more risky ventures resulting in negative NPVs will
affect the long-term profitability of Marriott and in-turn the shareholders wealth, a
strategic goal. Furthermore the growth of Marriott will also suffer.

If the Marriott would like to change their policy to utilize a single corporate
hurdle rate, the beta for each division would need to be the same for this change to
make sense. The case study has provided many reasons for different betas and
hurdle rates to be used.

BA 626 Financial Decision Making 7

6. What is the cost of capital for the lodging and restaurant divisions of
Marriott?

The Weighted Average Cost of Capital (WACC) for lodging is 5.80%.

The Weighted Average Cost of Capital (WACC) for restaurants is 1.87%

To determine the WACC for each division, the following formula was used:

WACC = (1 t) rd (D / V) + rE (E/V)

T = Corporate tax rate
RD = Cost of debt before tax for lodging or restaurants
RE = Cost of equity after tax for lodging or restaurants
D = Firms value of Debt
E = Firms value of Equity
V = Firms Value

Appendix II shows the steps in calculating WACC for each division.

6a. What risk-free rate and risk premium did you use to calculate the cost of
equity for each division? Why did you choose these numbers?

The market risk premium is Rm - Rf.

The rate used for market risk (Rm) is the S&Ps Stock Index for 1987 which is
9.9%, found in Exhibit 4 of Case Study.

The risk-free rate (Rf) is different for the lodging and restaurant division.
Since lodging is considered a long-term investment, the rate for long-term bond
(found in Exhibit 4 of Case Study) was used for lodging. Since the restaurant
division is considered a short-term investment, the rate for short-term treasury bills
was used.

Furthermore, the geometric average for the long-term bonds (4.27%) and
the geometric average for the short-term treasury bill (3.48%) was used versus the
arithmetic average since the geometric average takes opportunity costs into
consideration.

BA 626 Financial Decision Making 8



6b. How did you measure the cost of debt for each division? Should the debt cost
differ across divisions? Why?

Table A in the case study provided the Debt Rate Premium Above
Government for each division, as well as the US Government Interest Rates for both
a 30-year and a 1-year maturity.

Since lodging is considered a long-term investment, the 30-year maturity
rate was used in calculating the cost of debt:

Rd = US Government interest Rate30-year + Debt Rate Premium Above Government

8.95 + 1.10 = 10.05%

Since the restaurant division is considered a short-term investment, the 1-
year maturity rate was used in calculating the cost of debt:

Rd = US Government interest Rate1-year + Debt Rate Premium Above Government

6.90 + 1.80 = 8.70%

6c. How did you measure the beta of each division?

There were three steps in determining the beta for the lodging and
restaurant division.

1. Find companies similar to the appropriate division and get a weight
for each of those companies. The company most similar to the
division received a higher weight.

2. Determine the unlevered beta for each division by taking the sum of
each comparative companys weighted unlevered beta. To determine
each companys weighted unlevered beta, the following formula was
used:

u = /1+(1-T)(D/E)

u = Weighted unlevered beta for each comparative company

BA 626 Financial Decision Making 9

 = Weighted beta for comparative company
T = Corporate tax rate
D/E = Weighted Market Leverage for the comparative company. The
Market Leverage is found in Exhibit 3; this value was multiplied by the
comparative weight to compute the weighted market leverage value
for each comparative company.

3. Once the weighted unlevered beta for each division is calculated, that
beta is used in the following formula to calculate the beta for each
division:

L = u [1+(1-T)(D/E)]

L = Beta for the restaurants division (levered)
u = Weighted unlevered beta for the restaurants division
T = Corporate tax rate
D/E = Weighted Market Leverage for the restaurants division

Appendix II contains detailed information on the calculation to determine

each divisions beta under the Cost of Equity section.

BA 626 Financial Decision Making 10

7. What is the cost of capital for Marriotts contract services division? How
can you estimate its equity costs without publicly traded comparable
companies?

The weighted average cost of capital (WACC) for contract services is 5.91%.

The following formula was used to determine WACC:

WACC = (1 t) rd (D / V) + rE (E/V)

T = Corporate tax rate
RD = Cost of debt before tax for contract
RE = Cost of equity after tax for contract
D = Firms value of Debt
E = Firms value of Equity
V = Firms Value

The following formula is used to calculate cost of equity:

RE = Rf + (Rm - Rf)

RF = Risk-free rate which is 3.48% found in exhibit 4. The rate used is
the geometric average for a short-term bond as the contract division
is considered short-term investment.

Rm = Risk of the market. The geometric average for the S&P was used
which is 9.90%.

= Beta for the contract division.

Even though we do not have the beta for the contract division, we do have
Marriotts beta as well as the beta for the restaurants and lodging divisions. We can
therefore use the following formula to determine the beta for contracts:

C = [Marriott - (LWL + RWR )] / WC

C = [.97 - (.93*.44 + .74*.22)] / 0.33 = 1.17

BA 626 Financial Decision Making 11

 L = Beta for Lodging Division
WL = Weight of the lodging division (lodging sales/total sales)
R = Beta for Restaurant Division
WR = Weight of the restaurant division (restaurant sales/total sales)
WC = Weight of the contract division (contract sales/total sales)

BA 626 Financial Decision Making 12

 APPENDIX I Math Utilized to Derive WACC for Marriott

To determine WACC for Marriott has used the following formula:

WACC = (1 t) rd (D / V) + rE (E/V)

T = corporate tax rate
r = Cost of debt before tax
D

r = Cost of equity after tax

E

D = Market value of Debt

E = Market value of Equity
V = Firm Value (D + E)

Each the above variables are determined as follows:

T, Tax Rate

Tax Rate is equal to ____Total Taxes Paid_____ = 175.9 = .44 = 44%
Total Income Before Taxes 398.9

These numbers are provided by the case study in Exhibit 1 in year 1987.

D, Market Value of Debt

D = .60; provided from Table A given as a target value for Debt per capital

E, Market Value of Equity

E = .40; ascertained from Table A as it is assumed that that since 60% of
Marriotts target leverage goes to debt the remaining portion of its capital must go
to equity (as V = D+E, so E must equal V-D)

V, Firm Value

V = .40 + .60 = 1

The remaining two components of WACC are the most major and influential.
To solve for these one must determine more key variables.

BA 626 Financial Decision Making 13

r , Cost of debt
D

The case provides U.S. government fixed-rates for the current time period
which shows what Marriott would likely be paying on debt. Also, it is key to know
that Marriott is comprised of three primary divisions and one (lodging) uses long-
term debt and the other two (restaurant and contract services) use short-term debt.
To determine the exact rate of debt it is necessary to calculate a weighted average
amongst the potential interest rates for debt. From Table B, 30-year (long-term) is
8.95% and 10-year (short-term) is at 8.72%.

Government Interest Paid = 8.95 + 8.72 + 8.72 = 8.80%
3
Full cost of debt is not just average government interest but also Marriotts
debt rate premium above the government average. As such:

rD = Government Interest Rate + Debt Rate Premium

Marriotts average debt rate is given on Table A as 1.30%

Therefore, rD =8.80 + 1.30 = 10.10%

rE, Cost of Equity

Of the three methods to find Cost of Equity, Marriott uses the Capital Asset
Pricing Model (CPAM). Within CAPM there are three main components to
determine:

Rf = Risk-free Rate

Rf = 8.95%

This is the highest rate offered on the government fixed rates found on Table
B. Since it is a government and fixed market rate it comes as the longest risk-free
term rate.

Rm = Expected Market Return

Rm = 9.90%

This rate is the geometric average (of all years from 1926 1987) for
Standard & Poors 500 Composite Stock Index Returns found on Exhibit 4. It is an

BA 626 Financial Decision Making 14

ideal rate as it shows a comprehensive average of all stock returns since 1926. It
was chosen over S&P 500 Composite and Long-term U. S. Government Bond Returns
geometric average of 5.63% to allow for the Market Risk Premium (MRP = Rm - Rf)
to be at a positive moderate risk level.

= Beta of the Asset

The case provides equity beta as .97. However, this is a leveraged beta that
will affect other beta estimates. To avoid this influence, an asset beta must be
calculated and then converted into an unleveraged beta. From exhibit 3, equity beta
(.97) and market leverage of 41% are provided. It should be noted that market
leverage is the book value of debt divided by the sum of the book value of debt plus
the market value of equity. Therefore, if E = V-D, which V=E+D=1, then E=1-.41=.59

= [ 1+ (1-T) ]
L u and u =

u = = .6983

To be converted back to a firm leverage level, apply the market value of debt
and equity for D and E of the equations

= .6983 [1 + (1 - .44) ] = 1.2849
L

CAPM re = Rf + (Rm Rf)

= .0895 + (.990 - .0895) (1.2849) = .1017 = 10.17%

With all variables identified, WACC can be solved:

WACC = (1 - .44) (.1010) (.60) + (.1017) (.40) =.0746

Marriotts WACC = 7.46%

BA 626 Financial Decision Making 15

 APPENDIX II Math Utilized to Derive WACC for Divisions

WACC for Lodging = (1-T) RD(D/V) + RE(E/V)

T = Corporate tax rate
RD = Cost of debt before tax for lodging
RE = Cost of equity after tax for lodging
D = Firms value of Debt
E = Firms value of Equity
V = Firms Value

Each of the variables are determined as follows:

T, Tax Rate

Total Taxes Paid/Total Income Before Taxes = 175.9/398.9 = 44%

*Numbers are from year 1987.

D, Firms Value of Debt

The firms debt from 1987 is provided in exhibit 1: $2,498.8million

E, Firms Value of Equity

The firms equity from 1987 is provided in exhibit 1: $810.8million

V, Firms Value

The firms value is Debt + Equity: $3,309.6million

RD, Cost of Debt Before Taxes

Table A in the case study provides the Debt Rate Premium Above
Government for lodging (1.10). Table B provides the government interest rates for
1988 for a 30-year maturity (8.95); a 30-year maturity was used since the lodging
division is consider long-term. In determining the cost of debt for lodging, the
following formula was used:

RD = Government Interest Rate + Debt Rate Premium for Lodging

therefore, RD = 8.95 + 1.10 = 10.05%

BA 626 Financial Decision Making 16

RE, Cost of Equity After Taxes

Ultimately, the CAPM formula (RF + [RF - RM]*) was used to determine the
cost of equity. However, in order to use this formula, we must first determine the
unlevered for lodging. To find the unleveraged , the of the weighted unlevered
betas was used. Four companies were used in calculating the unlevered beta; the
companies most similar to the lodging division were weighted more heavily. Once
the weight was determined, the weighted beta was determined. The unlevered beta
was then calculated for each comparative hotel using the following formula:

u = /1+(1-T)(D/E)

u = Weighted unlevered beta for each comparative company
= Weighted beta for comparative company
T = Corporate tax rate
D/E = Weighted Market Leverage for the comparative company. The Market
Leverage is found in Exhibit 3; this value was multiplied by the comparative
weight to compute the weighted market leverage value for each comparative
company.

After the weighted unlevered beta was found for each comparative company,
these were added together to calculate the unlevered beta for the lodging division.
Additionally, the weighted market leverages were added together to find a weighted
market leverage value for the lodging division. These two calculations are then used
to calculate the beta for the lodging division by using the following formula:

L = u [1+(1-T)(D/E)]

L = Beta for the lodging division (levered)

u = Weighted unlevered beta for the lodging division
T = Corporate tax rate
D/E = Weighted Market Leverage for the lodging division

The final step to calculate the cost of equity is to use the beta for the lodging
division in the CAPM formula:

Rf + (Rm - Rf)

RF = Risk-free rate which is 4.27% found in exhibit 4. The rate used is the
geometric average for a long-term bond as the lodging division is considered
long-term investment.

BA 626 Financial Decision Making 17

 Rm = Risk of the market. The geometric average for the S&P was used which is
9.90%.

= Beta for the lodging division.

Therefore, the Cost of Equity is 8.18%

WACC for Restaurants = (1-T) RD(D/V) + RE(E/V)

T = Corporate tax rate
RD = Cost of debt before tax for restaurants
RE = Cost of equity after tax for restaurants
D = Firms value of Debt
E = Firms value of Equity
V = Firms Value

Each of the variables are determined as follows:

T, Tax Rate

Total Taxes Paid/Total Income Before Taxes = 175.9/398.9 = 44%

*Numbers are from year 1987

D, Firms Value of Debt

The firms debt from 1987 is provided in exhibit 1: $2,498.8million

E, Firms Value of Equity

The firms equity from 1987 is provided in exhibit 1: $810.8million

V, Firms Value

The firms value is Debt + Equity: $3,309.6million

RD, Cost of Debt Before Taxes

Table A in the case study provides the Debt Rate Premium Above
Government for restaurants (1.80). Table B provides the government interest rates
for 1988 for a 1-year maturity (6.90); a 1-year maturity was used since the
restaurants division is consider short-term. In determining the cost of debt for
restaurants, the following formula was used:

BA 626 Financial Decision Making 18

RD = Government Interest Rate + Debt Rate Premium for Restaurants
therefore, RD = 6.90 + 1.80 = 8.70%

RE, Cost of Equity After Taxes

Ultimately, the CAPM formula (RF + [RF - RM]*) was used to determine the
cost of equity. However, in order to use this formula, we must first determine they
unlevered for restaurants. To find the unleveraged , we took the sum of the
weighted unlevered betas. Six companies were used in calculating the unlevered
beta; the companies most similar to the restaurants division were weighted more
heavily. Once the weight was determined, the weighted beta was determined. The
unlevered beta was then calculated for each comparative restaurant using the
following formula:

u = /1+(1-T)(D/E)

u = Weighted unlevered beta for each comparative company
= Weighted beta for comparative company
T = Corporate tax rate
D/E = Weighted Market Leverage for the comparative company. The Market
Leverage is found in Exhibit 3; this value was multiplied by the comparative
weight to compute the weighted market leverage value for each comparative
company.

After the weighted unlevered beta was found for each comparative company,
these were added together to calculate the unlevered beta for the restaurants
division. Additionally, the weighted market leverages were added together to find a
weighted market leverage value for the restaurants division. These two calculations
are then used to calculate the beta for the restaurants division by using the
following formula:

L = u [1+(1-T)(D/E)]

L = Beta for the restaurants division (levered)

u = Weighted unlevered beta for the restaurants division
T = Corporate tax rate
D/E = Weighted Market Leverage for the restaurants division

The final step to calculate the cost of equity is to use the beta for the
restaurants division in the CAPM formula:

Rf + (Rm - Rf)

BA 626 Financial Decision Making 19


Rf = Risk-free rate which is 3.48% found in exhibit 4. The rate used is the
geometric average for a short-term bond as the restaurants division is
considered short-term investment.

Rm = Risk of the market. The geometric average for the S&P was used which is
9.90%.

= Beta for the restaurants division.

Therefore, the Cost of Equity is 8.23%

BA 626 Financial Decision Making 20