Marriott Corporation: The Cost of Capital

Marriott Corporation: The Cost of Capital

Problem Analysis

Capital Asset Pricing Model (CAPM)

As did Marriott in the case study, we will use the Capital Asset Pricing Model (CAPM) for help in determining the cost of equity - the return we expect from the company and each of its divisions.

Our goal is to calculate the Weighted Average Cost of Capital (WACC) for Marriott on the whole and each of its three divisions - Lodging, Contract Services, and Restaurants. To do that, we must first calculate the two major components of WACC, cost of debt (rdebt) and return on equity (requity).

Cost of Debt (rdebt)

The cost of debt, rdebt, is the yield on the company's debt, which we get largely from Table A and Table B from the case study. Because Marriott has an excellent debt rating, it gets an additional premium beyond the usual bond rate. This premium is different for the company and each of its divisions, as shown in Table A of the case study. To assist in determining the base rate, three U.S. government interest rates were provided in Table B. The case implied that the cost of long-term debt was most appropriate for the Lodging division, so there we employed the 30-year maturity rate of 8.95%. It further stated that for the Contract Services and Restaurant businesses a shorter-term debt was a good model, so there we used the 1-year maturity rate of 6.90%. It was not clear to us which long-term debt interest rate was most appropriate for the overall company, so for this we used the average of the two, or 7.93%. We then used these assumptions to calculate the Cost of Debt, rdebt, for Marriott and each of its divisions in Exhibit A.

Exhibit A. Cost of Debt Calculations

Interest rate x ( Premium + 100.00% ) = rdebt

Marriott 7.93% x ( 1.30% + 100.00% ) = 8.03%

…lodging 8.95% x ( 1.10% + 100.00% ) = 9.05%

...contract services 6.90% x ( 1.80% + 100.00% ) = 7.02%

...restaurants 6.90% x ( 1.40% + 100.00% ) = 7.00%

Return on Equity (requity)

The second major component of WACC is return on equity, requity. The return on equity model takes into account three values which we must calculate - a risk-free rate (rf), risk premium rate (rm - rf), and Beta Value (в). We intend to hold the risk-free rate and risk premium rate constant throughout the return on equity analysis, whether considering the overall company or divisions, because it primarily reflects conditions of the overall market and is not specific to the company or division within the company. The Beta Value, however, can be and is different for the company and each of the divisions within the company, and so will be estimated separately for each.

Risk-Free Rate (rf)

The risk-free rate, rf, is defined as the expected return on an investment that in theory carries no risk whatsoever. In Exhibit 4 of the case study we are provided returns for various securities and indices. The lowest risk investment listed is in United States Short-term Treasury bills, which are generally considered to carry a very minimal risk and are frequently used as the basis for risk-free rates in financial analyses. Thus, in our analyses we have set our risk-free rate, rf, equal to 5.46%, the figure from 1987 that was the most recent data available as of the time of the case study.

As an aside, when one examines the distribution of Short-term Treasury bills returns over time there is a lot of variability present. For instance, during the period 1981 through 1985 the return was 10.32%, nearly double the number we are using in our analyses for the risk-free rate. Despite this variation, we feel comfortable using the lower number (5.46%) from 1987 because it is a more conservative estimate, more recent, and more closely approximates the long-term average return on Short-term Treasury bills (an average of 3.54% from 1926-1987) than the temporarily elevated numbers recorded during the last decade.

Risk Premium Rate (rm - rf)

The market return rate, rm, a component of the risk premium rate, is meant to represent the overall return on the market. The risk premium rate is calculated as the difference between the market return rate and the risk-free premium, (rm - rf).

As mentioned previously, Exhibit 4 of the case study provides historical data on returns for various securities and market indices. Specifically, we are provided returns for the Standard & Poors 500 Composite Stock Index (S&P 500), which is useful because the S&P 500 index