Marriott Corporation: The Cost of Capital Case Analysis
Essay Preview: Marriott Corporation: The Cost of Capital Case Analysis
1 rating(s)
Report this essay
Marriott Corporation: The Cost of Capital Case Analysis
By: Harry Menzies and Kyle Speed
FINA 463- Case Studies in Corporate Finance
Professor Josh Pierce
January 31, 2013
What is the WACC for Marriott Corporation?
When calculating the WACC for the Marriott Corporation as a whole, the first step is to decipher what the given beta is at the current equity-to-total capital ratio. The information shows that the equity beta is estimated at 0.97 when the equity-to-total capital ratio is .59 (1- 0.41). Knowing that the target debt-to-total capital ratio is 0.6, as shown in Table A, we must find the unlevered beta value, so that we can estimate the firms equity beta at the optimal leverage ratio.
Calculating the Beta at the optimal capital structure is as follows:
Next, we use this new equity beta in the calculation of the cost of equity for Marriott Corporation as a whole. When calculating the cost of equity, we use the risk-free rate that is equal to the 10-year US Government bond interest rate, which is given as 8.72%. We also set the market risk premium as the spread between the S&P 500 and long-term US Government bond rates, which is given as 7.43%. Therefore:
E (re) = 8.72% + (7.43% x 1.28) = 18.23%
When calculating the cost of debt for Marriott Corporation as a whole, we again use the risk-free rate of 8.72%, and also have to add in the debt rate premium above the government rate, which is given as 1.3%. This risk premium includes the companys risk of default. Therefore:
E (rd) = 8.72% + 1.3% = 10.02%
Knowing the target debt/ total capital ratio of 0.60, we can now calculate the WACC for the Marriott Corporation. We assume that the corporate tax rate is 44% because of the ratio of income taxes to the income before taxes in 1987 (175.9/398.9 = 0.44). The calculation is at follows:
WACC= 10.66%
Whats the cost of capital for the lodging & restaurant divisions of Marriott?
Lodging
When calculating the cost of capital for each division of the Marriott Corporation, we must first make assumptions that make firms in similar business industry comparable to Marriotts specific divisions. For example, when calculating the WACC of Marriotts lodging division, we made an assumption that Ramada Inn, Inc. was a comparable firm to Marriotts lodging division due to similar nature of business processes. We must take into account Ramadas estimated equity beta based on a specific market leverage level. In this instance, Ramadas estimated equity beta is 0.95 for a market leverage level of 65%. Therefore, Ramadas equity-to-total capital ratio is given at 0.35. So we use this information to calculate the unlevered beta for the lodging division:
For the lodging division, we also make the assumption to use the 30-year US Government bond interest rate of 8.95% and also market risk premium is the spread between the S&P 500 and long-term US Government bond rate, which is given at 7.43%. We use the same corporate tax rate as above, and also make similar assumptions in the cost of debt, that it calculated as the risk-free rate plus the debt rate premium above the government bond rate. Therefore the calculations for the cost of equity and the cost of debt are as follows:
RE = 8.95% + (1.21 x 7.43%) = 17.94%
RD = 8.95 + 1.1% = 10.05%
Again, we are given the target debt-to-total capital ratio for the lodging division, which is given as 0.74, therefore:
Restaurants
Again, when calculating the cost of capital for the restaurant division of Marriott Corporation, we need to use another firm that operates in a similar line of business to Marriotts division in order to use it as a comparable firm. Forward, we will use McDonalds as a comparable to Marriotts restaurant division. As given in Exhibit 3, McDonalds estimated equity beta is given as 1.00 when their market leverage level is at 23%. Therefore, we can conclude that McDonalds equity-to-total capital ratio is at 0.77 for the estimated equity beta. Since this debt-to-total capital ratio is not equal to the target debt-to-total capital ratio for Marriott, we must first find the unlevered beta for the restaurant division.
For the restaurant division, we assumed that we use a short-term US Government bond rate, which is 6.90%. We also use the spread between S&P 500 composite returns and short-term Treasury bill returns, which is given as 8.47%. Again, we use the same corporate tax rate of 44% for calculating the cost of capital and also make similar assumptions in terms of adding the debt rate premium above the government bond rate to the cost of debt.
RE = 6.90% + (1.20 x 8.47%) = 17.06%
RD = 6.90% + 1.80% = 8.70%
Because we have the target debt-to-total capital ratio for the Marriott Corporation, which is given as 0.42, we can calculate the WACC for the restaurant division as follows:
What is the cost of capital for Marriots contract