FSMA 312

Marriott Corporation: The Cost of Capital

Introduction
One of the most memorable quotes of J.W. Marriott Sr., founder of Marriott Corporation,
says: Great companies are built by people who never stop thinking about ways to improve
business. 1
J. Willard Marriott started Marriott Corporation in 1927 with a root beer stand, expanding it
into a one of if not the leading lodging and food service company with sales of over $6
billion by 1987. Out of three main lines of business, lodging, contract services and
restaurants, lodging is generating about 51% of companys profits.
As noted in the case study, the four key elements of Marriotts financial strategy were
managing hotel assets rather than owning, investing in projects with the goal of increasing
shareholder value, optimizing the use of debt, and repurchasing their undervalued shares. It
must be underlined that Marriotts management relied on measuring the opportunity cost of
capital for investments by utilizing the concept of Weighted Average Cost of Capital
(WACC). During April 1988, Dan Cohrs, VP of project finance, made a suggestion that the
divisional hurdle rates at the company would have a major impact on their future strategies.
Marriott intended to continue its growth at a fast pace. Thus, with aim to make management
more engaged in design of financial strategies, decision to start using the hurdle rates for
determining the incentive compensations was considered.

1 Lesonsky, Rieva, and Inc Media. "Balance Sheet." Start Your Own Business: The Only Startup Book You'll
Ever Need. 6th ed. Irvine, Calif.: Entrepreneur, 2007. Print.

Questions and answers

1.

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

With regard to financial strategy Manage rather than own one could argue that this is
consistent with growth strategy as the company sold the hotel assets to limited partners
while retaining operating control as the general partner under a long-term management
contract. With this strategy, Marriot attracts additional capital that can be invested into future
project while sharing some risks with limited partners.
Similar position is with strategy where company Invest in projects that increase
Shareholder value as it is also consistent with growth plans. Using discounted cash flows
technique for evaluations divisional managers still have discretion over unit-specific
assumptions, but they must conform to the corporate templates that contains macro data on
inflation, margins, project lives, terminal values, percent of sales required to remodel, and so
on.
In order to remain consistent with growth strategy, Marriott was more determined on
Optimizing capital structure by giving focus on its ability to service debt rather than
setting a target on debt-to-equity ratio. By controlling possible default risk, company create
an optimal capital structure which lead to a higher shareholder value.
Finally, when strategy of repurchase of undervalued assets is in question, it can be argued
that this could lead to reduction of growth due to fact that company uses its free funds to
buy back shares instead of investing into new projects. However, buying back shares can
also be an easy way to make a business look more attractive to investors. By reducing the
number of outstanding shares, a company's earnings per share ratio is automatically
increased. In addition, it is simple way to pay off investors and reduce the overall cost of
capital.

2. How does Marriott use its estimate of its cost of capital? Does this make sense?
As presented in the case study, Marriott measured the opportunity cost of capital for
investments of similar risk using the weighted average cost of capital (WACC):
WACC = (1 t)rE (D/V) + rD(E/V)
In this equation, D and E are the market values of the debt and equity, respectively, rD is the
pre-tax cost of debt, rE is the after-tax cost of equity, V is the value of the firm (V = D + E),
and is the corporate tax rate. Marriott used this approach to determine the cost of capital
for the corporation as a whole and for each division.
With a fact that capital varies across the three divisions because all three of the cost-ofcapital inputs could differ for each division. So to make the cost of capital calculation
eventually make Marriott required should distinguish rE (cost of equity) for each division
using CAMP model.
3. What is the weighted average cost of capital for Marriott Corporation?
Using WACC equation the opportunity cost of capital for Marriott Corp is 11.89% (9.63
Lodging, 15.65 Restaurant, 16.39 Contract Services)
a. What risk-free rate and risk premium did you use to calculate the cost of
capital?
The risk-free rate was US Government Bonds (4.58%) for the longest period because of the
most precise estimate and a risk premium was 7.43% (Spread between S&P Index and LT
US Govt. Bonds).
b. How did you measure Marriotts cost of debt?
kd = 1.3% + 8.95% = 10.25%
WACC = (1-0.44) (.60) (10.25)+ (.40) (21.14) = 11.894%

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

None, as investments in Lodging, Contract services, or Restaurants would all use their own
WACC to measure cost of capital and not that of the whole corporation.

5. If Marriott used a single corporate cost of capital for evaluating investment

opportunities in each of its lines of business, what would happen to the company
over time?
WACC for Marriott Corp is 11.89% while for Lodging is 9.63%, Restaurant is 15.65% and
Contract Services is 16.39%.
It is obvious that the WACC values are different where the cost of capital for lodging is
lower than for the entire company, while that of the other departments are higher. This also
means that the risks in each division are different.
So, if Marriott was to use a single corporate hurdle rate then they will be using the 11.89% in
which case any project related to the lodging division (most profitable one) would be
rejected since its cost of capital of 9.63% is lower and would result in a negative NPV. On
the other hand, any project 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.
This means that Marriott would be assume more risk from projects related to restaurant and
contract service division while in the same time rejecting lower risk projects from the
lodging division because they are using higher rate.

6. What is the correct cost of capital for the lodging and restaurant division of
Marriott?
Restaurant COC
Unlevered asset beta = 0.96
Target debt/value = .42 (from table A)
Levered Equity Beta:
Be= (V/Et)*BA= (1/0.58)*0.96= 1.72*0.96= 1.6528

Levered Equity Beta =E = 1.65

Equity Cost -Restaurant
KE= rF+E x RPM
KE= 8.72% + 1.65 * 8.47%(from Exhibit 5)
KE= 22.72%
WACC = (1 -T)(D/V)KD+ (E/V)KE
WACC = (1-0.44)(0.42)(10.52%) + (0.58)(17.58%)
WACC = 15.65%
Lodging COC
Unlevered asset beta = 0.42
Target debt/value = .74 (from table A)
Levered Equity Beta:
Be= (V/Et)*BA= (1/0.26)*0.42= 1.6240
Levered Equity Beta =E = 1.62
Equity Cost -Restaurant
KE= rF+E x RPM
KE= 8.95% + 1.62 * 7.43%(from Exhibit 5)
KE= 21.02%
WACC = (1 -T)(D/V)KD+ (E/V)KE
WACC = (1-0.44)(0.74)(10.05%) + (0.26)(21.02%)
WACC = 9.63%

a. 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?
For lodging, the risk free rate of 8.95% was used because it was the longest-term division
(30 years) while case study states that restaurant and contract services had shorter useful
lives. Under assumption that the restaurant & Contract Service division would last at least
10 years risk free rate of 8.72% was used. Concerning risk premium a rate of 7.43% was as
it is the spread between S&P500 composite returns and Long-term government bond returns.
On the other side the Restaurant and Contract Service Business have a short-term rates so
8.47% rate was used.

b. How did you measure the cost of debt for each division? Should the debt cost
differ across divisions? Why?
For the lodging division the cost of debt was calculated as the 30 year risk free rate plus the
premium which was 8.95% + 1.10% or 10.05% before tax cost of debt. For the restaurant
division the 10 year risk free rate was used plus the premium which was 8.72% + 1.80% or
10.52%. Under assumption that the lodging would have a useful life of 30 years and the
restaurant would have 10 years, they should have a different debt costs across the divisions
because they need to be compared with the government rates that are similar in
duration/maturity to each particular division.
c. How did you measure the beta of each division?
Restaurant COC
Unlevered asset beta = 0.96
Target debt/value = .42 (from table A)
Levered Equity Beta:
Be= (V/Et)*BA= (1/0.58)*0.96= 1.72*0.96= 1.6528
Levered Equity Beta =E = 1.65
Lodging COC
Unlevered asset beta = 0.42
Target debt/value = .74 (from table A)
Levered Equity Beta:
Be= (V/Et)*BA= (1/0.26)*0.42= 1.6240
Levered Equity Beta =E = 1.62

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

Contract service COC

Unlevered asset beta = 1.05
Target debt/value = .40 (from table A)
Levered Equity Beta: Be= (V/Et)*BA= (1/0.60)*0.1.05= 1.67*1.05= 1.75
Levered Equity Beta =E= 1.75

Equity Cost Contract service

KE= rF+E x RPM
KE= 8.72% + 1.75 * 8.47%(from Exhibit 5)
KE= 23.54%
WACC = (1 -T)(D/V)KD+ (E/V)KE
WACC = (1-0.44)(0.40)(10.12%) + 0.60)(23.54%)
WACC = 16.39
In the attempt to estimate equity costs without publicly traded comparable companies the
company should consider period of investment (long-term project or short-term project).
Moreover, estimating appropriate Betas, is of high significance due to relationship of Beta
and financial risk. Finally, the company must use information from the past in order to
establish reliable future trends.

Reference:
-

Lesonsky, Rieva, and Inc Media. "Balance Sheet." Start Your Own Business: The

Only Startup Book You'll Ever Need. 6th ed. Irvine, Calif.: Entrepreneur, 2007. Print.
Our Story. (n.d.)., from http://www.marriott.com/about/culture-and-values/history.mi
Ruback, Richard S. "Marriott Corporation: The Cost of Capital." Harvard Business

School Case 298-101, February 1998. (Revised March 1998.)

Brigham, E. F., & Daves, P. R. (2007). Intermediate financial management. Mason,
OH: Thomson/South-Western.