Case - Marriott Corporation: The Cost of Capital

What is the big picture here?

Who else did this happen with?

• Hershey’s
• Etc…..
Question -What is Marriott’s WACC?

Basic steps:

1. Identify !equity at the target debt-equity ratio

2. Identify appropriate estimate of risk-free rate rf

3. Identify appropriate estimate of market risk premium (rm – rf)

4. Use CAPM to estimate requity

5. Identify appropriate measure of rdebt

6. Use formula: rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity

1. Identify !equity at the target debt-equity ratio

Note that !equity at current debt-equity ratio is estimated at 0.97

Current debt value is $2498.8 million
Current equity value is ($30 x 118.8 mil. shares) = $3564 million
Current D/E ratio is 2498.8/3564 = .70

Target D/(D+E) ratio = 60% " Target D/E ratio = 1.5

How? D/V=.6…..E/V=.4 D/V*V/E=D/E=.6*(1/.4)=1.5

Use formula:

!equity at current ratio = [1 + (1-TC)Debt/Equity]!unlevered

0.97 = [1 + .66 x .70]!unlevered

.664 = !unlevered

!equity at target ratio = [1 + .66 x 1.5] x .664

!equity at target ratio = 1.32

2. Identify appropriate estimate of risk-free rate rf

Why do we need the rf ?

Intuitively….

Generally choose a risk-free rate that corresponds to the maturity to your assets

Since Marriott’s has a mix of short term and long term assets, use the 10-year
government bond rate of 8.72%
3. Identify appropriate estimate of market risk premium (rm – rf)

What should we use as the MRP?

What should we use as the risk free rate? Current or historicals? Why?

What is the idea of the CAPM?

Expected return on the market has to be what you would get for just sitting around and
waiting for your money (time value of money). This is captured in the CURRENT risk
free rate.

Above and beyond this you are compensated for the amount of systematic risk of the asset (
you get a bump up in returns based on the “spread” b/w the market and the risk free
rate).

Think about your “bump” up. CAPM can contradict itself (not consistent) if you use current
risk free rate. Why?

The assumption behind CAPM is that you get the current risk free rate plus a constant bump
up that is based on historicals (historically Ri>rf).
3. Identify appropriate estimate of market risk premium (rm – rf)

What about geometric vs. arithmetic.

Think back to FIN 300. Great!

Arithmetic average – return earned in an average period over multiple periods

Geometric average – average compound return per period over multiple periods

• Which is better? What is our “planning period”?

The answer depends on the planning period under consideration
• Short planning period use artithmetic
• Long planning period use geometric
3. Identify appropriate estimate of market risk premium (rm – rf)

Thinking about expected return? THE CAPM IS A _____ PERIOD MODEL?

The above refers to planning period.

“It's a perfectly valid way to determine an average, as long as it's used to frame a stand-
alone one-year return, said Knut Larsen, a partner with Brigus Group, a Toronto
education service for financial advisers.”
3. Identify appropriate estimate of market risk premium (rm – rf)

Difference of 7.43% is an estimate of market risk premium

Look at the “spreads” 5.63% vs. 7.43%

What is the difference if you use 5.63 instead of 7.43% ?

4. Use CAPM to estimate requity

requity = rf + !equity(rm – rf)

requity = 8.72% + 1.32(7.43%) = 18.53%
5. Identify appropriate measure of rdebt

Why don’t we “need” to mess with LIBOR?

Given: At Marriott’s TARGET D/V they will pay 1.30% above government.

But it has fixed and floating? The 1.30% is given that composition.

Why may we want to goof around with things?

Use: rdebt = 8.72% + 1.30% = 10.02%

6. Use formula: rWACC = [D/(D+E)](1-TC)rdebt + [E/(D+E)]requity

rWACC = (.60 x 10.02%)(1-.34)+ (.40 x 18.53%)

= 11.38%
Question -What are the divisional costs of capital?

What is Marriott’s cost of capital for lodging?

for restaurants?
for contract services?

Preliminary questions:

1. Why is breaking down cost of capital estimates by activity a good idea?

2. Could it lead to better investment decisions?

What are the “comparables”?

Is Wendy’s comparable to McDonald’s and BK?

What is important here?

Lodging Division – Cost of Equity Capital

To get estimate of !unlevered for lodging use the average for the 4 hotel firms

Hilton: !equity = .88, D/V = .14 ! D/E=.16

.88 = [1 + .66 x .16] !unlevered
.80 = !unlevered

Holiday: !equity = 1.46, D/V = .79 ! D/E=3.76

1.46 = [1 + .66 x 3.76] !unlevered
.42 = !unlevered

La Quinta: !equity = .38, D/V = .69 ! D/E=2.23

0.38 = [1 + .66 x 2.23] !unlevered
.15 = !unlevered

Ramada: !equity = .95, D/V = .65 ! D/E=1.86

0.95 = [1 + .66 x 1.86] !unlevered
.42 = !unlevered
• Average of these four estimates for !unlevered is .45

• Marriott target lodging D/(D+E) ratio is 74% ! target D/E ratio=2.85

Thus: !equity at target ratio = [1 + .66 x 2.85] x .45 =1.30

• For lodging, which is mostly long term assets, use risk-free rate based on 30 year
government bonds ! appropriate rf = 8.95%

Put this all into the CAPM:

requity at target ratio = 8.95 + 1.30 (7.43) = 18.61%

Lodging Division – Overall Cost of Capital

Some additional ingredients:

1. For lodging, debt rate is only 1.10% above government rate

rdebt = 8.95% + 1.10% = 10.05%

2. Marriott target lodging D/(D+E) ratio is 74%

3. TC at 34%

Put this all into the cost of capital formula:

rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity

rWACC = (1-.34)(.74 x 10.05%) + (.26 x 18.61%) = 9.75%
Estimate of overall cost of capital for restaurants

Exact same procedure as for lodging

Assets are shorter lived ! 10 year bond rate for risk-free rate
Estimate of overall cost of capital for restaurants (6)

Church’s: !equity = .75, D/V = .04 ! D/E=.04

.75 = [1 + .66 x.04] !unlevered
.73 = !unlevered

Collins: !equity = .6, D/V = .10 ! D/E=.11

.6 = [1 + .66 x .11] !unlevered
.56 = !unlevered

Frisch’s: !equity = .13, D/V = .06 ! D/E=.06

.13 = [1 + .66 x .06] !unlevered
.13 = !unlevered

Luby’s: !equity = .64, D/V = .01 ! D/E=.01

.64 = [1 + .66 x .01] !unlevered
.64 = !unlevered
Estimate of overall cost of capital for restaurants
McDonald’s: !equity = 1.00, D/V = .23! D/E=.3
1.00 = [1 + .66 x .3] !unlevered
.83 = !unlevered

Wendy’s: !equity = 1.08, D/V = .21 ! D/E=.27

1.08 = [1 + .66 x .27] !unlevered
.92 = !unlevered

Average of these four estimates for !unlevered is .64

Marriott target restaurants D/(D+E) ratio is 42% ! target D/E ratio=.72

Thus: !equity at target ratio = [1 + .66 x .72] x .64=.94

For restaurants, which is mostly short term assets, use risk-free rate based on 10 year government bonds
! appropriate rf = 8.72%

Put this all into the CAPM:

requity at target ratio = 8.72 + .94 (7.43) = 15.70%

Restaurant Division – Overall Cost of Capital

Some additional ingredients:

1. For restaurants, debt rate is 1.80% above government rate

rdebt = 8.72% + 1.80% = 10.52%

2. Marriott target restaurant D/(D+E) ratio is 42%

3. TC at 34%

Put this all into the cost of capital formula:

rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity

rWACC = (1-.34)(.42 x 10.52%) + (.58 x 15.70%) = 12.022%
Estimate the cost of capital for contract services

There are no firms that only produce contract services- what do we do?
Contract services – a solution

!unlevered for firm should be weighted average of the !unlevered for each activity.

“A company’s beta, therefore, was a weighted average of the betas of its different lines of business”-
THE CASE

Use as weights book value of assets in each activity. WHY?

% assets in lodging = 2,777 / (2,777+1,237+567) = .61

% assets in contract services = 1,237 / 4,581 = .27
% assets in restaurants = 567 / 4,581= .12

!unlev firm = .61 x !unlev. lodging + .27 x !unlev. contract + .12 x !unlev restaurant
.664=.61*.45+ .27* !unlev. contract + .12*.64
!unlev. contract =1.16

Plug in !unlev firm, !unlev. lodging, and !unlev restaurant from above to calculate !unlev. contract

Once you have !unlev. contract, cost of capital at the target debt ratio calculated follows same procedure
as for lodging and restaurants
Contract services – a solution

!unlev. contract =1.16

!equity at target ratio = [1 + .66 x .67] x 1.16=1.67

For contract services, which is mostly short term assets, use risk-free rate based on 10 year
government bonds ! appropriate rf = 8.72%

Put this all into the CAPM:

requity at target ratio = 8.72 + 1.67 (7.43) = 21.13%

Contract services – a solution

Some additional ingredients:

1. For contract services, debt rate is 1.40% above government rate

rdebt = 8.72% + 1.40% = 10.12%

2. Marriott services D/(D+E) ratio is 40%

3. TC at 34%

Put this all into the cost of capital formula:

rWACC = (1-TC)[D/(D+E)]rdebt + [E/(D+E)]requity

rWACC = (1-.34)(.40 x 10.12%) + (.60 x 21.13%) = 15.35%