Marriott Corp: the Cost of Capital

To President, Marriott Corporation From FLO299 Subject Marriott Corporation The Cost of Capital Date April 6, 2010 The Importance of the Cost of Capital The cost of groovy is important as it forms the basis for Marriotts investing and financial decisions. By understanding and knowing the cost of capital, Marriott is fit to select relevant investment projects for the company, regulate incentive compensation, and repurchase undervalued sh ars when needed. The returns of a project were found by discounting the appropriate cash flows against the appropriate hurdle rates.Without knowing the cost of capital, Marriott would not be able to determine hurdle rates that would help Marriotts growth. Also, knowing the cost of debt would allow Marriott to optimize the enjoyment of debt in the companys capital structure. lettered the hurdle rates on a divisional level would also enable Marriott to reward their managers using incentive compensation. By using hurdle rates, Marriott managers would be more than sensitive to Marriotts financial strategy and capital market conditions and would give the company a more accountable method of rewarding their employees.Lastly, Marriotts method of calculating a warranted equity value for its common shares required knowing the companys equity cost of capital. A share worth that was below the warranted equity value signaled to Marriott when the company needed to step in to repurchase its stock as the company believed that repurchases of shares were a better use of Marriotts cash flow and debt capacity than acquisitions or owning real estate. Computing Marriotts WACC The cost-of-capital was computed both divisionally and overall for the company. It required using the formula WACC = (1-t_)RD(D/V) + RE(E/V). D and E are the market values of the debt and equity respectively and V (market value) = D+E. RD and RE are the pretax income cost of debt and cost of equity respectively and t is the corporate tax rate. The Numbers Used in Ma rriotts WACC A 34% tax rate rate will be assumed for simplicitys sake so more effort rout out be focused on other issues. The above WACC calculation uses market value of debt. Cost of debt can be observed at one time by calculating the yield to maturity of outstanding bonds, but since the bond market is not very transparent and we know Marriotts unsecured debt is A-rated, the company can expect to pay a pass out above some origin rate.Which index to use should be determined by project life, and as inhabit is based on a long term business model, a 30-year treasury bond is appropriate. In this case, the base is 8. 95% according to Tabe B and the spread for the overall company is 130 basis points according to Table A. Also found in Table A, Marriott set a target of the debt percentage in its capital structure to be 60% for the overall company. Because there is no way of directly observing the return that equity investors require, we rely on a couple of methods to estimate it.A div idend growth model can be used, and although simply to use, this approach assumes steady dividend growth. This approach also does not directly aline for the riskiness of a project. An alternative approach is to use CAPM, which does not rely on dividend growth and does take both the market risk premium and imperious risk into consideration. Using CAPM to estimate the cost of equity we use the following formula _E(R)=Rf+ nurse skirt *MRP_. Rf is the same risk-free base rate used to calculate cost of debt, in this case, 8. 95% from Table A.The draw haul up is obtained from regression using market data and therefore is touched by leverage. To adjust for this, the B is unlevered and then relevered so that it is the B for business risk only, independent of capital structure. With due consideration given to each input, supplement A is a computation of Marriotts WACC, 11. 87%, which is also the required rate of return for the company overall. The Use of Marriotts WACC in Divisional Deci sions Marriott can use the computed WACC to support its stock repurchasing decisions because it allows the equity cash flows to be discounted at a company level rate.But because each cost of capital input could discord amongst its divisions, the cost of capital varies across each. If Marriott used the above calculated WACC for all divisional decisions, it would cause the company to take on riskier projects, projects that once risk familiarized would likely cause the company to lose money in the long run. A better approach would be to use individual draw skeleton for each project with CAPM to calculate the WACC for each project and compare it to IRR. Determining Divisional WACCTo estimate the WACC for each division, we need their corresponding drawframe . To do this we use comparable companies for each division this is because we cannot run regressions at the divisional level as that information is not available. For the lodging division, we compare other hotel companies, for the eating place division, we compare other restaurants, and for the obligation services division we use the identity drawframe M=WL* drawframe L+WR drawframe R+WCS drawframe CS. The identifiable assets in Exhibit 2 will be used to compute the weights of each division.Once again, because the information is real market poesy, drawframe E is affected by leverage and must be unlevered by multiplying it by 1 market leverage. This results in drawframe A which is business risk, independent of capital structure. Asset risk is the only thing that is comparable across firms. Within each divisional equivalence to comparable companies, weighted average of drawframe A is used as smaller companies have less impact on the overall segment. These numbers are shown in Exhibit 3. The WACC for each division is found in Appendix B to D. Differences in WACCAppendix A Marriotts Overall WACC count Appendix B Marriotts WACC for Lodging Appendix C Marriotts WACC for Restaurants Appendix D Marriotts WACC f or Contract Services Identifiable lodging assets = 2777. 4 WL = 60. 61% drawframe L = . 57 Identifiable restaurant assets = 567. 6 WR = 12. 39% drawframe R = . 75 Identifiable contract services assets = 1237. 7 WCS= 27. 00% drawframe CS = solve for this below drawframe M=WL* drawframe L+WR drawframe R+WCS drawframe CS 0. 57 = . 6061*0. 42 + . 12390. 75 + . 2700 drawframe CS drawframe CS = 0. 57