MARRIOTT

CORPORATION – COST
OF CAPITAL
OVERVIEW
• Stock re-purchase
• Marriott is committed to using excess funds to repurchase stock.
• Since an alternative to any physical investment is a share repurchase, it is natural for Marriott to use external market-based
hurdle rates as a measure of the opportunity cost of funds.
• Syndication
• Syndication is a key control device for the whole capital budgeting system.
• Marriott builds hotels and sells them off in partnerships, maintaining its role as the general partner and hotel operator.
• Marriott invests $1 billion in assets each year, and sells off about $1 billion in assets each year in syndications.
• Projects face a quicker market test than in the typical industrial firm.
• Since the process turns over quickly—one or two years—valuation errors appear quickly.
• The partnership syndication market is the important capital market for Marriott.
• And Marriott’s experience is that projects with zero NPV just break even at syndication—which gives the corporation great
confidence in the cash flow and discount rate systems.
• Importance of hurdle rates
• Figure A in the case shows that a typical hotel breaks even at about a 10% hurdle rate.
• At a 12% hurdle rate, Marriott loses 15% of its investment.
• If Marriott used a 10% hurdle rate when the actual hurdle rate was 12%, it would lose 15% of its $1 billion in annual
development, or $150 million.
• In contrast, if the rate were actually 8%, Marriott would enjoy unanticipated gains of about $250 million.
• In summary, errors in the hurdle rate can lead to incorrect decisions about the type and amount of investment, trigger or fail to
trigger repurchases, and affect incentive compensation.
Objective
• Find cost of capital
• For Marriott as a whole
• For each division separately – lodging, restaurants and contract services
Cost of capital of Marriott
• Marriott measured the opportunity cost of capital for investments using the weighted average cost of capital
(WACC) as

THE COST AND AMOUNT OF DEBT (Table A and Table B)

• Focusing on Marriott as a whole, the target capital structure is 60% debt, and this debt costs 1.30% above long-term
U.S. government bonds.
• The 30-year fixed U.S. government rate was 8.95%.
• Thus, the debt cost for Marriott was 10.25%. (8.95% + 1.3%)

THE COST OF EQUITY

• According to the CAPM, the cost of equity, or equivalently, the expected return for equity, is determined as
• Expected return = r = riskless rate + beta * [risk premium]
• where the risk premium is the difference between the expected return on the market portfolio and the riskless rate. To
compute the expected return, three inputs are needed: beta, the riskless rate, and the risk premium.
Asset beta
• The levered equity beta of .97 reported in Exhibit 3 could be used in the CAPM to determine the cost of equity for Marriott if the
target debt ratio matched the actual debt ratio.
• Based on data in Exhibit 1, the value of long-term debt was $2,499 in 1987 and the equity value was $3,564. The actual debt ratio
is 41%, which is substantially below the 60% target.
• The beta has to be adjusted for the difference between the actual and target debt ratio.
• This can be adjusted by first unlevering the given equity beta (based on actual debt ratio) to get an unlevered asset beta.
• When debt ratio increases, the overall risk for the firm (asset beta) remains unchanged but only the risk to the equity
shareholders (equity beta) increases.
• Then this unlevered asset beta is levered to the target debt ratio to calculate the correct levered equity beta.
 
Unlevering the equity beta:
• The formula for unlevering betas is derived by noting that V = D + E
• The returns to the assets of the firm are simply a weighted average of the returns to debt and equity:
• Thus, asset beta can be computed as:
• Assuming that the debt is riskless with a beta of zero, the equation for asset beta simplifies to
• The unlevered asset beta of Marriott should be based on the actual market value leverage ratio—not on the target ratio. The
E / V ratio for unlevering the levered equity beta is 59%:
• Thus actual asset beta is :
• Thus,
Equity beta and riskless rate
 
Levered equity beta for the target debt ratio:
• After determining the asset beta, the next step is to calculate the levered equity beta consistent with Marriott’s target of
60% debt financing (Table A).
• The formula used to calculate the asset beta is inverted to compute an equity beta from an asset beta:
• Thus,

Riskless rate:
• The CAPM is a one-period model. Multiperiod applications of the CAPM rely on the assumption that the CAPM holds in each
period.
• The theoretically correct way of using the CAPM, therefore, is to recompute an expected return in each period, using a
different riskless rate, beta, and risk premium.
• For many projects, however, it is reasonable to assume that beta and risk premium are stable over the life of the project.
• Similarly, instead of using a sequence of forward rates, the yield on a long-term riskless bond is used.
• These assumptions lead to a single expected equity return over the life of the project.
• The case reports that the interest rate on long-term U.S. government bonds was 8.95% in April 1988.
Returns in Exhibit 4
Risk Premium
• The choice of a risk premium involves determining the type of average to use (arithmetic or geometric) and
selecting a time period. The plots of the returns in Exhibit 4 stresses two points:
• Less risky securities have lower realized returns.
• At one extreme, the safest security, short-term Treasury bills, have an arithmetic average annual return of 3.54% and an
annual standard deviation of .94% over the 1926 through 1987 period.
• At the other extreme, the S&P Composite has an arithmetic average annual return of 12% and an annual standard
deviation of 20.55% over the same period.
• The characteristics of the securities change over time.
• There is an increase in the volatility of the long-term bonds after 1976.
• In 1986, long-term U.S. government bonds had a higher return (24%) than the S&P Composite (18%) and about the same
annual standard deviation (17% vs. 18%).
 • Arithmetic average return

• Geometric average return

• The arithmetic average statistically approximates the mean when the number of observations is large. Thus,
arithmetic average returns are to be considered for analysis and not the geometric averages.
Risk Premium
• The choice of the benchmark riskless rate determines the spread in Exhibit 5 that is used as a risk premium.
• The most popular textbook choice for a risk premium corresponds to a spread between the S&P 500 Composite
returns and short-term U.S.
• Treasury bills for the 1926-1987 period, which equals 8.47%.
• That rate would be appropriate for short-term projects.
• However, the arguments for using the long-term U.S. government bond rate as a measure of the riskless rate in a
multiperiod setting apply here.
• The spread between the S&P Composite returns and long-term U.S. government bonds for the 1926-1987 period
is 7.43%.
• Thus, risk premium is 7.43%
Equity returns and cost of capital
•• The cost of equity for Marriott as a whole can be calculated directly with the estimate of the riskless rate, beta, and the risk
 
premium.
• Using the long-term government bond rate of 8.95%, an estimate of a levered beta of 1.43, and a risk premium of 7.43%, the
cost of equity is
Expected return, r = riskless rate + beta X [risk premium]
= 8.95% + 1.43 X [7.43%]
= 19.57%
• Combining the expected return on equity with the information on debt rates and leverage in the WACC formula provides the cost
of capital for Marriott as a whole:

= (1 - .34) X 10.25% X 60% + 19.57% X 40%

= 4.06% + 7.82%
= 11.89%
Calculation summarised
Cost of capital of lodging services
• The first step in computing the cost of equity for lodging is to estimate the levered equity beta.
• This is accomplished by unlevering the comparable lodging firms listed in Exhibit 3 to determine an asset or
unlevered beta.
• The comparable lodging firms are – Hilton hotels, Holiday corp, La Quinta Motor Inns, Ramada Inns

.76+
  .32+.12+.34
4

(.76
  ∗.77+.32 ∗1.66 +.12∗ .17+.34 ∗.75)
3.35
Cost of capital for lodging services
•• After determining the asset beta, the next step is to calculate the equity beta consistent with Marriott’s target of 74% debt
 financing for lodging (Table A).

=3.85*.42
=1.62
• Using the long-term government bond rate of 8.95%, an estimate of a levered beta of 1.62, and a risk premium of 7.43%,
the cost of equity is
Expected return, r = riskless rate + beta X [risk premium]
= 8.95% + 1.62 X [7.43%]
= 20.99%
• Combining the expected return on equity with the information on debt rates and leverage (Table A) in the WACC formula
provides the cost of capital for lodging:

= (1 - .34) X 10.05% X 74% + 20.99% X 26%

= 4.91% + 5.46%
= 10.37%
Calculation summarised
Cost of capital of restaurants
• The first step in computing the cost of equity for restaurants is to estimate the levered equity beta.
• This is accomplished by unlevering the comparable restuarants listed in Exhibit 3 to determine an asset or
unlevered beta.
• The comparable lodging firms are – Church’s Fried chicken, Collins foods, Frisch’s, McDonalds and Wendy’s

.72+.54+
  .12+.77+.85
5

(.72∗
  .39+.54 ∗.57 +.12∗ .14+.77 ∗ 4.89+.85 ∗1.05)
7.04
Cost of capital for restaurants
•• After determining the asset beta, the next step is to calculate the equity beta consistent with Marriott’s target of
 42% debt financing for restaurants (Table A).

=1.72*.74
=1.28
• Using the long-term government bond rate of 8.95%, an estimate of a levered beta of 1.28, and a risk premium of
7.43%, the cost of equity is
Expected return, r = riskless rate + beta X [risk premium]
= 8.95% + 1.28 X [7.43%]
= 18.46%
• Combining the expected return on equity with the information on debt rates and leverage (Table A) in the WACC
formula provides the cost of capital for lodging:

= (1 - .34) X 10.52% X 42% + 18.46% X 58%

= 13.62%
Calculation summarised
Cost of capital for contract services
• The cost of capital for the contract services division is more difficult to obtain because there are no publicly traded
comparable companies.
• However, the information on the unlevered asset betas of Marriott as a whole and the asset betas of the lodging
and restaurant divisions can be used to infer the beta of contract services.
• The asset beta of the whole company is just a weighted average of the asset betas of the divisions.
• The weights should be the fraction of total equity value in each division.
• One plausible proxy for these weights is the fraction of the total identifiable assets from each division (Exhibit 2).
 
Cost of capital for contract services
•• Using
  the fraction of identifiable assets from each division as a proxy of relative value and the previously
calculated asset betas,
.57 = 61% X .42 + 12% X .74 + 27% X
=.83
• The equity beta at the 40% leverage rate in Table A is
/60%

1.38
• The equity cost of capital is 8.95% + 1.38 X 7.43% = 19.2%
• The WACC for the contract services division is
WACC = (1-.34) X 40% X (8.72% + 1.40%) + 60% X 19.2%
= 2.67 + 11.52%
= 14.19%
 OVERALL SUMMARY
Debt/  
  Unlevered Asset Value Levered Cost of Cost of  
Beta Ratio Equity Beta Debt Equity
WACC
Marriott .57 60% 1.43 10.25% 19.57% 11.89%
Lodging .42 74 1.62 10.05 20.99 10.37
Restaurants .74 42 1.28 10.52 18.46 13.62
Contract Services .83 40 1.38 10.12 19.2 14.19