Marriot Corporation the Cost of Capital - Free Essay Example

Sample details Pages: 3 Words: 861 Downloads: 2 Date added: 2017/09/20 Category Business Essay Type Analytical essay Did you like this example? Marriot Corporation : the Cost of Capital. In front of Dan Chores is the issue of recommending three hurdle rates for each of Marriott Corporations three divisions, which have significant effect on the firms financial and operating strategies as well as its incentive compensation. Marriott Corporation had three major lines of business: lodging, contract services and restaurants. Also Marriott had its growth objective, to remain a premier growth company. The four components of Marriotts financial strategy are consistent with its growth objective. Managing hotel assets multiplied the total worth of hotels than otherwise owned by it, thus increased EPS. Optimizing the use of debt in the capital structure, based on a coverage target instead of a target debt-to-equity ratio, also increased EPS by reducing the amount of equity at the maximum level. Repurchasing undervalued shares functioned similarly via replacing part of its shares by cheaper debt financing. Only investing in p rojects that would increase shareholder value required that projects meet the hurdle rates and be audited through their lives. Marriott used WACC to measure the opportunity cost, i. . the hurdle rate, for the corporation as a whole and for each division. In both circumstances, three inputs, debt capacity, debt cost and equity cost are needed. At the firm level, we get the debt capacity of 60% from Table A. The cost of debt is weighted average cost of its overall loan interest rate. Short-term debt for its restaurant and contract services divisions and long-term for its lodging division. Lodging accounted for 51% of its profits, therefore it can be estimated that lodging division used about 51% of its whole capital. Same with contract services of 33% and with restaurant division of 16%. Thus, the overall cost of debt =51%*74%/57. 66 %*( 8. 72%+1. 10%)+33%*40%/57. 66 %*( 6. 90%+1. 40%)+16%*42%/57. 66 %*( 6. 90%+1. 60%) =9. 34%. The cost of equity is the expected return of the equit y. We compute that by using CAPM model. Expected return = Risk free rate + ? *(market return – risk free rate). The risk premium should be calculated by using holding-period returns, as 9. 90%-3. 48%= 6. 42%. Then we can compute the cost of equity is 3. 48%+0. 97*(6. 42%) =9. 71%. According to Exhibit1, 1987, we calculate the tax rate by dividing income tax over EBIT. $175. /$398. 9=44%. Then we can calculate the firm’s WACC = (1-44%)*(9. 34%)*60%+9. 71%*40%=7. 02%. Therefore, projects with expected return below 7. 02% should be rejected if we only recommend a single and solitary hurdle rate. If doing so, we would ignore the difference between business line and probably accept projects with too higher risk relative to its comparable or reject projects with appropriate risk in its business. For each division, the calculation of hurdle rates needs specific debt capacities, cost of debt and cost of equity consistent with the amount of debt. We get debt percentage, 74%, 40% and 42% in capital in Table A. The cost of debt for each division is the government interest rate plus rate premium: lodging: 8. 72%+1. 1%=9. 82%(long-term), contract Services: 6. 9%+1. 4% =8. 3%(short-term) and restaurant: 6. 9%+ 1. 8%=8. 7% (short-term). To estimate the cost of equity, we need to compute the beta of equity for each division using comparable companies. As the betas of debt were not provided, we made 2 assumptions: a. same business lines have the same beta of debt; b. Expected return of debt = Rf + ? *[E(Rm) – Rf*(1-T)] (Rf: risk free rate, E(Rm): expected return of equity market, T: tax rate). Here Rf is the interest rate of T-bill in 1987, E(Rm) is the geomantic average of S;P 500 return from 1926 to 1987, T is as same as the tax rate used by Marriott. ?b of lodging: -0. 077, ? b of restaurants and contract services: -0. 0246. We chose La Quinta Motor Inns (pure lodging business) to compute ? 0 of Marriott’s lodging division. We chose the averag e of Collins Foods International, Luby’s Cafeterias, McDonald’s and Wendy’s International’s ? 0 as ? of Marriott’s restaurant division (these four corporations all operated pure restaurant business). The formula to compute the beta of equity is: ? s=? 0+1-TBS[? 0-? b]. After computed the beta of equity for lodging (l): 0. 126 and restaurants(r) divisions: 0. 747, we can use the whole corporation beta of equity, that is . 97, and the weight for three divisions to get the beta of equity for contract services (CS). ?s(CS)=[? s(Marriott)-? l s(l)-? r s(r)]/? cs. The weights for lodging, contract services and restaurants are the same as computing the cost of debt. The result is ? s (CS)=1. 924. To use CAPM to calculate the cost of equity for each division, the market premium should be decided. For lodging, the geometric average of the spread between S;P500 and T-bill rates is used because the compounding effect should be considered when the time inte rval is large. For restaurant ; contract services, because only 1-yr returns of equity and debt are considered, arithmetic average of the spread between S;P500 and T-bill rates is used to avoid underestimated bias. Below are the WACC for the three divisions. The costs of debt are from previous discussion. | lodging| Restaurant| Contract| | Market Premium for equity| 6. 42%| 8. 47%| 8. 47%| | Cost of equity| 8. 354%| 14. 44%| 20. 92%| | Cost of Debt| 9. 82%| 8. 70%| 8. 30%| | Cost of capital| 6. 241%| 10. 423%| 14. 410%| | The costs of capital are lower than 24% in all of divisions, indicated the growth of Marriott can fulfill all the required return from both creditors and stockholders. Though there could be the bias we added in when calculated the beta of debt and equity. Don’t waste time! Our writers will create an original "Marriot Corporation : the Cost of Capital" essay for you Create order