FINANCIAL MANAGEMENT

Marriott Corporation: The

Cost of Capital

Group 10:
Vaibhav Arora I005
Sachin R C I007
Arpit Gwal I024
Rasika Kakade I028
Deshaj Pandit I048
Bakti Shetty I060
We the members of the Group Project, certify that the submitted written report is the original
work of our team and all the analysis and reporting text is entirely our own. Facts, figures and
other relevant information drawn from sources, where required is duly acknowledged.

Group Member Roll Number Signature

Vaibhav Arora I005
Sachin RC I007
Arpit Gwal I024
Rasika Kakde I028
Deshaj Pandit I048
Bakti Shetty I060
Table of Contents

Executive Summary .............................................................................................................................. 4

Assumptions........................................................................................................................................... 5
Marriott’s Weighted Average Cost of Capital ................................................................................... 5
Weighted Average Cost of Capital for Divisions ................................................................................ 7
Lodging Division ............................................................................................................................... 7
Restaurants Division ......................................................................................................................... 8
Contract Services Division ............................................................................................................. 10
Single corporate hurdle rate versus divisional hurdle rates ........................................................... 12
Conclusion ........................................................................................................................................... 12
Executive Summary

Marriott Corporation was started by J. Willard Marriott in 1927 with a root beer stand.
By 1987, Marriott corporation became one of the leading food service and lodging companies
in the United States with profits of $223 million on sales of $6.5 billion.
During that period of time, Marriott had three major lines of business: lodging, contract
services and restaurants.

Profit Sales
16% 13%

41%
51%
33%
46%

Lodging Contract Services Restaurants Lodging Contract Services Restaurants

Marriott had four key elements of financial strategy –

 Manage hotel assets rather than owning: Marriott corporation, while retaining the
operating control under a management contract, sold its hotel assets to limited
partners
 Invest in projects with the goal of increasing shareholder’s value: The company
used discounted cash flow method to evaluate potential investments that would allow
the company to invest only in profitable projects
 Optimize the use of debt: The company determined the amount of debt by keeping a
focus on its ability to service its debt
 Repurchase undervalued shares: The company bought back its undervalued shares
Marriott relied on the concept of Weighted Average Cost of Capital (WACC) to measure the
opportunity cost of capital for the investments. In 1987, Dan Cohrs, vice president of project
finance, recommended that the divisional hurdle rates would have significant impact on
firm’s financial strategy. The hurdle rates were also used to determine company’s incentive
compensation, in order to make managers more sensitive to company’s financial strategy.
 Assumptions

1) Debt structure is taken as per fixed and floating rates. Therefore, for floating rate we have considered 1-
Year U.S. Government bond fixed rate, because of the insufficient data.

2) Market risk premium is taken as arithmetic average.

3) Cost of debt for Marriott and Lodging Division is taken as 30-Year U.S. Government Bond and for
Restaurant and Contract Services Division is taken for 10-Year U.S. Governement Bond

Marriott’s Weighted Average Cost of Capital

Marriott used the Weighted Average Cost of Capital (WACC) technique to estimate the
opportunity cost of capital for investments of similar risk.
𝐷 𝐸
WACC = (Cost of Debt × (1-tax rate) × 𝐷+𝐸 ) + (Cost of Equity × 𝐷+𝐸 )

(i) Cost of Debt

Marriott Corporation has a mix of floating debt and fixed debt. The target debt is 40% at floating rate
and 60% at fixed rate as per Table A. Marriott has also projected a debt rate premium of 1.3% above
Government debt securities rate. It is assumed that the fixed rate corporate debt is going to match with
30-year maturity government debt, taken on the assumption that it matches on an average the
company’s profile and floating rate corporate debt is going to match with 1-year maturity government
debt. The resulting cost of debt is 9.43%.

Cost of Debt
Debt Weight Debt Rate Net Rate
Fixed 60% 8.95% 5.37%
Floating 40% 6.90% 2.76%
Total 8.13%
Add:Premium 1.30%
Cost of Debt 9.43%

(ii) Cost of Equity

To measure the cost of equity, Marriott uses Capital Asset Pricing Model (CAPM), which describes
the relationship between the rate of return on an investment and its systematic risk. As per CAPM,
the cost of equity can be determined as –
Re = Rf + β*[Risk Premium]
where, Re is cost of equity, Rf is risk-free rate, risk premium is the difference between expected return
on market portfolio and risk-free rate and β coefficient defines the systematic risk.
β Calculation
In 1987, the company had a market leverage of 41%, for which beta of 0.97 was calculated by least-
squares regression using daily data over 1986-1987 (Exhibit 3). However, the target debt percentage
is given by 60% and taken as debt-value ratio. For this target debt percentage, beta must be unlevered
and then relevered. For this purpose, the following equation is used –

𝑬𝒒𝒖𝒊𝒕𝒚 𝑩𝒆𝒕𝒂
𝑫
𝟏 + (𝑬)

Using the above equation, the β has been calculated as follows –

β Calculation
Equity Beta 0.97
Market Leverage 41%
Unlevered Asset Beta 0.572
Target Debt/EV 60%
Adjusted Beta 1.431

The risk-free rate has been taken as 8.95%, which is the 30-year U.S. Government bond
maturity rate, based on the assumptions that Marriott is a huge firm and has a long-history.
Risk premium, on the other hand, has been taken as 7.43%, that is the Spread between S&P
500 composite returns and Long-term U.S. Government bond returns from year 1926-1987.
The logic behind taking this risk premium is that it covers all the possibilities that may have
affected the stock prices in the given period.
Based on the above assumptions, the cost of equity for Marriott corporation has been
calculated as follows –

Cost of Equity
Risk free rate 8.95%
Market Premium 7.43%
β 1.4308
Cost of Equity (CAPM) 19.58%

Now, given the cost of debt and cost of equity, the WACC for Marriott at the target debt of
60% and the tax-rate of 44%, has been calculated below –

WACC Calculation

Equity/EV 40%
Debt/EV 60%
Tax Rate 44%
Cost of Debt 9.43%
Cost of Equity 19.58%
WACC 11.00%

Therefore, WACC for Marriott Corporation is 11%.

Weighted Average Cost of Capital for Divisions

Lodging Division

(i) Cost of Debt

Applying the same assumption of mix of floating debt and fixed debt, the cost of
debt for the lodging division has been calculated. The target debt is 50% at
floating rate and 50% at fixed rate as per Table A. Debt rate premium is projected
at 1.1% above Government debt securities rate. It is assumed that the fixed rate
corporate debt is going to match with 30-year maturity government debt, based
on the assumption that lodging assets have a long useful life and floating rate
corporate debt is going to match with 1-year maturity government debt, based on
the assumption that interest rate fluctuations occur on the short-term basis. The
resulting cost of debt is 9.03%.

Cost of Debt
Debt Weight Debt Rate Net Rate
Fixed 50% 8.95% 4.48%
Floating 50% 6.90% 3.45%
Total 7.93%
Add:Premium 1.10%
9.03%

(ii) Cost of Equity

β Calculation
To determine the β for the lodging division, the data for the peer companies is
gathered from Exhibit 3. The data is related to capital structure, revenue and equity
beta of the companies and is used to calculate the weighted average unlevered beta
for the group. The unlevered beta calculated is then levered based upon the target
debt of the lodging division, i.e. 74% (Table A).

β Calculation
Revenues (In Market Equity Beta Unlevered Equity
Peers $Billion) Leverage (Levered) Beta
Hilton Hotels
Corporation 0.77 14% 0.88 0.76
Holiday Corporation 1.66 79% 1.46 0.31
La Quinta Motor
Inns 0.17 69% 0.38 0.12
Ramada Inns 0.75 65% 0.95 0.33
Average 0.38

Unlevered Asset Beta 0.38

Target Debt/EV 74%
Adjusted Beta 1.455
The risk-free rate has been taken as 8.95%, which is the 30-year U.S. Government bond
maturity rate, based on the assumptions that lodging assets have long useful lives.
Risk premium, on the other hand, has been taken as 7.43%, that is the Spread between S&P
500 composite returns and Long-term U.S. Government bond returns from year 1926-1987.
The logic behind taking this risk premium is that it covers all the possibilities that may have
affected the stock prices in the given period.
Based on the above assumptions, the cost of equity for Lodging Division has been calculated
as follows –

Cost of Equity
Risk free rate 8.95%
Market Premium 7.43%
Β 1.455
Cost of Equity (CAPM) 19.76%
Now, given the cost of debt and cost of equity, the WACC for Lodging Division at the target
debt of 74% and the tax-rate of 44%, has been calculated below –

WACC Calculation

Equity/EV 26%
Debt/EV 74%
Tax Rate 44%
Cost of Debt 9.03%
Cost of Equity 19.76%
WACC 8.88%

Restaurants Division

(i) Cost of Debt

Applying the same assumption of mix of floating debt and fixed debt, the cost of
debt for the lodging division has been calculated. The target debt is 25% at
floating rate and 75% at fixed rate as per Table A. Debt rate premium is projected
at 1.8% above Government debt securities rate. It is assumed that the fixed rate
corporate debt is going to match with 10-year maturity government debt, based
on the assumption that restaurant assets have shorter useful lives as compared to
lodging assets and floating rate corporate debt is going to match with 1-year
maturity government debt, based on the assumption that interest rate fluctuations
occur on the short-term basis. The resulting cost of debt is 10.07%.

Cost of Debt
Debt Weight Debt Rate Net Rate
Fixed 75% 8.72% 6.54%
Floating 25% 6.90% 1.73%
Total 8.27%
Add:Premium 1.80%
10.07%
 (ii) Cost of Equity
β Calculation
To determine the β for the restaurant division, the data for the peer companies is gathered
from Exhibit 3. The data is related to capital structure, revenue and equity beta of the
companies and is used to calculate the weighted average unlevered beta for the group. The
unlevered beta calculated is then levered based upon the target debt of the lodging
division, i.e. 42% (Table A).

β Calculation
Revenues (In Market Equity Beta Unlevered Equity
Peers $Billion) Leverage (Levered) Beta
Church's Fried
Chicken 0.39 4% 0.75 0.72
Collins Foods
International 0.57 10% 0.6 0.54
Frisch's Restaurants 0.14 6% 0.13 0.12
Luby's Cafeteria 0.23 1% 0.64 0.63
McDonalds 4.89 23% 1 0.77
Wendys International 1.05 21% 1.08 0.85
Average 0.61

Unlevered Asset Beta 0.61

Target Debt/EV 42%
Adjusted Beta 1.046

The risk-free rate has been taken as 8.72%, which is the 10-year U.S. Government bond
maturity rate, based on the assumptions that restaurant assets have shorter lives compared to
lodging assets.
Risk premium, on the other hand, has been taken as 7.43%, that is the Spread between S&P
500 composite returns and Long-term U.S. Government bond returns from year 1926-1987.
The logic behind taking this risk premium is that it covers all the possibilities that may have
affected the stock prices in the given period.
Based on the above assumptions, the cost of equity for Restaurant Division has been
calculated as follows –

Cost of Equity
Risk free rate 8.72%
Market Premium 7.43%
Β 1.046
Cost of Equity (CAPM) 16.49%

Now, given the cost of debt and cost of equity, the WACC for Restaurant Division at the
target debt of 42% and the tax-rate of 44%, has been calculated below –
 WACC Calculation

Equity/EV 58%
Debt/EV 42%
Tax Rate 44%
Cost of Debt 10.07%
Cost of Equity 16.49%
WACC 11.93%

Contract Services Division

(i) Cost of Debt

Applying the same assumption of mix of floating debt and fixed debt, the cost of
debt for the lodging division has been calculated. The target debt is 40% at
floating rate and 60% at fixed rate as per Table A. Debt rate premium is projected
at 1.4% above Government debt securities rate. It is assumed that the fixed rate
corporate debt is going to match with 10-year maturity government debt, based
on the assumption that contract services assets have shorter useful lives as
compared to lodging assets and floating rate corporate debt is going to match
with 1-year maturity government debt, based on the assumption that interest rate
fluctuations occur on the short-term basis. The resulting cost of debt is 9.39%.

Cost of Debt
Debt Weight Debt Rate Net Rate
Fixed 60% 8.72% 5.23%
Floating 40% 6.90% 2.76%
Total 7.99%
Add:Premium 1.40%
Cost of Debt 9.39%

(ii) Cost of Equity

β Calculation
As per the case, the β of a firm is the weighted average of the betas of its
individual divisions. Using the same approach, β for the contract services be
calculated using the below equation –

βfirm = WL. βL + WR. βR + WC. βC

It is important to note that the betas used in the above equation are unlevered
betas, which will help in calculating the unlevered beta for contract services. The
unlevered beta will then be relevered as per the target debt of the contract
services. The target debt of contract services is given as 40% as per Table A. Also,
 the betas are weighted by the identifiable assets (Exhibit 2), since the betas used in
the above equation are unlevered.

β Calculation
Divisions Assets Weightage Unlevered Beta
Lodging 2,777.40 61% 0.38
Restaurants 567.60 12% 0.61
Contract Services 1,237.70 27% 0.99
Total (Marriott) 4,582.70 100% 0.57

Unlevered Asset Beta 0.99

Target Debt/EV 40.00%
Adjusted Beta 1.653

The risk-free rate has been taken as 8.72%, which is the 10-year U.S. Government bond
maturity rate, based on the assumptions that contract services assets have shorter lives
compared to lodging assets.
Risk premium, on the other hand, has been taken as 7.43%, that is the Spread between S&P
500 composite returns and Long-term U.S. Government bond returns from year 1926-1987.
The logic behind taking this risk premium is that it covers all the possibilities that may have
affected the stock prices in the given period.
Based on the above assumptions, the cost of equity for Contract Services Division has been
calculated as follows –

Cost of Equity
Risk free rate 8.72%
Market Premium 7.43%
Β 1.653
Cost of Equity (CAPM) 21.00%

Now, given the cost of debt and cost of equity, the WACC for Contract Services Division at
the target debt of 40% and the tax-rate of 44%, has been calculated below –

WACC Calculation

Equity/EV 60%
Debt/EV 40%
Tax Rate 44%
Cost of Debt 9.39%
Cost of Equity 21.00%
WACC 14.70%
Therefore, the WACC for lodging, restaurant and contract services division are 8.88%,
11.93% and 14.70% respectively.

Single corporate hurdle rate versus divisional hurdle rates

Since Marriott is a diversified company, it cannot use single corporate hurdle rate to make
investment decisions. As it can be observed, WACC for all the divisions are different from
WACC for Marriott Corporation. Lodging Division has the lowest cost of capital, whereas
contract services and restaurant divisions have higher cost of capital. Lower cost of capital
implies lower risk, which implies lodging division has lower risk as compared to other
divisions.
Now let’s assume single corporate hurdle rate is used for the Marriott Corporation, i.e. 11%.
If this rate is used, then any project arising out of lodging division will be rejected, since its
cost of capital is 8.88% and using a higher rate will result in negative net present value and
reduced cash flows. On the other hand, projects arising out of restaurants and corporate
division will be accepted at a lower rate than the determined cost. Therefore, Marriott will be
approving higher risk projects by evaluating those projects at lower rate and rejecting lower
risk projects because Marriott will be using a higher rate. Consequently, the risk assumed by
the Marriott will continue to rise.
Therefore, separate hurdle rate should be used for each division as the level of risk varies
across divisions and those risks must be accounted for by the company.

Conclusion

The analysis hurdle rates to be considered to invest in different projects, WACC for Marriott
corporation and its separate divisions were calculated. Observing the variation in risks across
divisions, it will be beneficial for the company to use separate hurdle rates for the division rather than
using a single corporate hurdle rate. Also, as the business risks keep on varying, the value of β also
changes with such variations, which ultimately changes the hurdle rate. Hence, WACC has to be
updated regularly in order to make accurate investment decisions.