Case Study

1
Case Study 6

• Marriott Corporations The Cost of Capital
• Ning Gong

2
Objectives of the Case Study

• Calculating the WACC under the classical tax
  system for the company as a whole and for each
  division of the company
• Current capital structure vs. target capital
  structure
• How to use a peer group to estimate divisional
  equity beta
• This technique is useful for estimating
  privately-held companies

3
Company Background

• Marriott had three major lines of business, based
  on 1987 number

4
Uses of the Hurdle Rate

• Investment projects were selected by discounting
  the cash flows by the appropriate hurdle rate for
  each division
• The executive compensation plan would reflect
  hurdle rates, making managers more sensitive to
  Marriotts performance and capital market
  conditions
• EVA in essence

5
Cost of Debt for Marriott Corporation

• We use the after tax WACC under the classical tax
  system for Marriott Corporation
• The target debt ratio is 60, and the debt costs
  1.30 8.72 10.02 (See Tables AB)
• We will ignore the difference between floating
  rate vs. fixed coupon rate debts here
• The floating rate debt will be studied in
  Investments elective

6
The Cost of Equity for Marriott Corp.

• The cost of equity is based on the CAPM
• The risk free rate was 8.72.
• Note there is a debate whether we should use
  long-term or short-term government bond rate as
  the risk-free benchmark. However, it is typical
  to use the 10-year rate in the corporate setting,
  as practiced by McKinsey other consulting
  firms.
• The equity risk premium was 7.43.
• However, based on the most recent data, it should
  be around 6.5.
• There are some ambiguities about the magnitude of
  the equity risk premium.

7
The Cost of Equity (continued)

• The historical equity beta was 1.11 (see Exhibit
  3)
• Can we use this beta directly?
• If the target and the historical debt ratios are
  similar, we could. Otherwise, we have to adjust
  the beta.
• The beta was estimated as 1.11 at the time when
  the debt/total capital ratio was 0.497 (based on
  the average between 83-87). However, the target
  debt ratio was 60, see Table A.
• The adjustment can be done by first finding the
  un-levered beta for Marriott, and then adjust for
  the target debt capital ratio. In doing so, we
  need to assume that the beta of debt is zero, or
  you could find the beta of debt by regression.

8
Cost of Equity for Marriott as a Whole

• The formula
• The beta of debt is typically small. Without any
  further information, lets assume it is zero.
  Thus, the assets beta is 0.5031.110.558
• After adjusting for the target debt ratio, the
  beta of equity for Marriott should be 0.558/0.4
  1.396

9
WACC for Marriott as a Whole

• Choosing t 44, the effective tax rate from
  1983-88 based on Exhibit 1,
• However, using a single hurdle rate imposes a
  systematic bias on project selection. Risky
  projects appear more profitable, and less risky
  projects appear less profitable.
• For the calculation of the WACC for lodging
  division, see the spreadsheet.

10
Some Practical Considerations for Calculating the
Cost of Capital

• Estimating the costs for many sources of capital
  is not very precise. In practice, we often make
  simplifying assumptions.
• Non-interest-bearing liabilities, such as
  accounts payable, are excluded from calculation
  of WACC to avoid inconsistencies and simplify the
  valuation.
• There are other long-term liabilities (such as
  pension funds liabilities), which are often too
  complicated to infer the required rate of return.
  There is no definitive answer to the question.