Marriott Corporation: The Cost of Capital - Assignment Example

The cost of capital Are the four components of Marriott’s financial strategy consistent with its growth objective? a) It is advisable to manage than to own as it is consistent with the growth strategy. In this manner, mar riot can attract additional capital that gives it an opportunity to even invest more in the future, share the risks with limited partners. The partnership can be of great benefit as it is a good way of saving on taxes. b) The decision to invest in projects increases the shareholders value of the company. This is consistent with the growth and from the NPV criteria, positive NPV of projects increases the shareholders value. c) Optimization of the capital structure is also consistent with the growth of the company. The optimal capital structure should obviously be higher than the shareholders value. This helps in the control of default risks. d) The repurchase of the undervalued assets in this case can lead to the directing of cash flows out of the projects with positive NPV that is a significant impediment to the growth of the company. 2. How does Marriott use its estimate of its cost of capital? Does this make sense? a) Discounted cash flows from the projects by the suitable division of a hurdle rate to get the net present value which financially makes sense since risks among different divisions do vary. b) Another method is through incorporation of the hurdle rate in the compensation policy which in sense does not make sense since the rate does reflect risks of different activities and not managers performance. 3. What is the weighted average cost of capital for Marriott Corporation? Marriot Corporation measures the opportunity cost of the cost of capital for the investments using the weighted average cost of capital for similar investments that have the same risk. The WACC for the corporation is 11.89%. a) What risk-free rate and the risk premium did you use to calculate the cost of equity? For the purposes of risk premium consistency, the arithmetic average was most applicable to the historic US government bonds of 4.58% for the longest period because of its accurate estimate. The risk premium used is 7.43% though it seems to be high, low free rate compensates it. For the calculation of equity, beta is a necessity because there is no comparison that matches its operational profile. Beta 1.17 ke = (4.58%+1.17) = 13.27% b) How did you measure Marriott’s cost of debt? I simply summed up premium according to company’s rating to a ten year US government interest rate. Kd = 8.72%+1.3% = 10.02%. a high company rating leads to a little default risk and the difference in the estimated debt cost is 0.4*13.27%+10.02%*0.6*(1-0.42) = 8.795% c) Did you use arithmetic or geometric averages to measure rates of return? Why? The SBBI show was both arithmetic and geometric means data. Arithmetic mean is just a simple average rate of return yearly. The Geometric mean is less than the arithmetic mean. The arithmetic mean is preferred as investors use it in making expectations about the future returns on their investments. 4. What type of investments would you value using Marriot WAAC? The WACC can be used in the measurement of lodging investments, restaurants, and contract services because they have similar characteristics. 5. If Marriott used a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time? The WACC for Marriott, lodging, restaurant and contract divisions are 11.89%, 9.63%, 15.65% and 16.39% respectively. The corporation will be using a single corporate hurdle which is 11.89% of the whole company. By using such rate, any project arising from lodging division will be shut down as the cost of capital will be 9.63% 6. What is the cost of capital for the lodging and restaurant divisions of Marriott? Lodging cost of capital Cost of debt = government interest rate (8.72%) + debt premium (1.80%) = (8.72+1.80) % = 10.52% Tax rate is 44% WACC = {1-T) (D/V) Kd + (E/V) Ke = {1-0.44) (0.74)*(10.05) % + (0.26) (21.02) % = 4.16% + 5.14% = 9.63% Restaurant cost of capital Cost of debt kd= government interest rate + debt premium = 8.72% + 1.80% =10.52% Cost of equity = government interest rate (8.72%) + risk premium equity (8.47%) * levered equity (1.65) = (8.72+8.47)*1.65 = 17.58% WACC = (1-T) (D/V) kd + (E/V) ke = (1-0.44) (0.42) (10.52) % + (0.58) (17.58) % = 15.65% of the cost capital of restaurant a) What risk-free rate and the risk premium did your use in calculating the cost of Equity for each division? Why did you choose these numbers? I used a risk-free rate of 8.95% for the lodging since it the long-term division, and I assume it will get a more than 30 years economic life. Contract services and restaurant divisions have shorter economic life of about ten years thus why I used 8.72%. I used 7.43 % risk premium for lodging because it has long-term rates and 8.72% for restaurant and contract services because they have short-term rates. b) How did you measure the cost of debt for each division? Should the debt Cost differs from divisions? Why? The cost of debt for lodging was computed as 30-year risk free rate added to premium risk that equals to (8.95+1.10)% = 10.05% this before the tax on the cost of debt. In restaurant division, I used a 10-year risk free rate and the risk premium which equals to (8.72+1.80) % = 10.52%. The assumption made was that lodging had a useful life of 30 years while restaurant had ten years, so they needed different debt costs across the divisions. c) How did you measure the beta of each division? Beta for lodging From exhibit 3 The unlevered asset beta is 0.42 The targeted debt/value is 0.74 this from table A Levered equity beta = {V/Et)*BA = {1/0.26)* 0.42 = 3.85 * 0.42 = 1.6240 The levered equity beta is 1.62 Beta for restaurant From exhibit 3 Unlevered asset beta is 0.96 The targeted debt/value is 0.42 this from table A The levered equity beta = {V/Et)*BA = {1/0.58)*0.96 = 1.72*0.96 = 1.6528 The levered equity beta for restaurant is 1.6228 7. What is the cost of capital for Marriott’s contract services division? How can you Estimate its equity costs without publicly traded comparable companies? The Beta asset for contract services Dollar Percentage Asset beta Lodging $2777.4 60.6% 0.43 Restaurants $1237.7 27% 0.96 Contract services $567.6 12.4% 1.05 Marriot $4582.7 100% 0.65 Unlevered asset beta is 1.05. The targeted debt value is 0.40 from table A. The levered equity beta = {V/Et)*BA = (1/0.60)*1.05 = 1.67*1.05 = 1.75% The equity cost of restaurant K E = r F+ β E x RP M = {8.872%+1.75}*8.74 from exhibit 5 = 23.54% WACC = (1-T) (D/V) kd + (E/V) ke = (1-0.44) (0.40) (10.12%) + (0.60) (23.54%) = (2.266 + 10.362) = 16.39% Read More