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# Marriott Corporation” the Cost of Capital

Paper type: Essay 3 (625 words)
Categories: Corporation, Economics, Finance, Math, Mathematics, Science
 Views: 501

What is the weighted average cost of capital for the Marriott Corporation and cost of capital for each of its divisions?
– What risk-free rate and risk premium did you use to calculate the cost of equity?
– How did you measure the cost of debt?

– How did you measure the beta for each division?

Solution

What risk-free rate and risk premium did you use to calculate the cost of equity?

– Risk-free rate proxy
The risk-free rate is determined using the yields of U.

S. Treasury securities, which are risk-free from default risk. U.S. Treasuries are subject to interest rate risk, therefore, the selected maturity should correspond to an investment horizon.

– Investment horizon
According to the cost-of-capital calculation methodology used by Marriott Corporation, lodging division was treated as long-term, while restaurant and contract services divisions were treated as short-term because those assets had shorter useful lives.

– Expected return proxy
Arithmetic average return is more suitable than geometric mean as it is better in estimating an investment’s expected return over a future horizon based on its past performance (geometric mean is a better description of long-term historical performance of an investment).

– Risk-free interest rate
Taking into account the above, arithmetic average annual returns of long-term U.S. government bonds for the period 1951-1987 (4.88%, see Appendix 1) is considered to be risk-free rate for lodging division. Arithmetic average annual returns of short-term U.S. government bonds for year 1987 (5.46%, see Case Exhibit 4) is considered to be risk-free rate for restaurant and contract services divisions.

– Market proxy
S&P 500 index is selected as a market proxy as it is believed to be close to the true market portfolio. As it is important to use historical returns for the same market index used to calculate beta (which is given), an assumption is made that the given leverage data is calculated based on the same S&P 500 index.

Market risk premium should be calculated for the same horizon as that used for the risk-free interest rate. Thus a spread between S&P 500 composite returns and long-term U.S. government bond returns for the period 1951-1987 (7.88%, see Appendix 2) is a market risk premium for lodging division. A spread between S&P 500 composite returns and short-term U.S. government bond returns for year 1987 (-0.23%, see Case Exhibit 5) is a market risk premium for restaurant and contract services divisions.

How did you measure the cost of debt?

Marriott Corporation and each division are given market value-target leverage ratios and credit spreads as well as U.S. government interest rates as of April 1988 (see Case Tables A and B). According to investment horizons discussed above, the following cost of debt is estimated:

How did you measure the beta for each division?

Ideally, when estimating beta by using past returns, time interval should be consistent with an investment horizon. Betas given in Case Exhibit 3 are estimated over 1986-1987 period. As these are the only betas given, they are assumed to be relevant for both long-term and short-term investment horizons.

Equity betas of each division are calculated from comparable hotel and restaurant companies. Equity betas are then unlevered taking into account financing structure of each company according to the following formula:

[pic], where Tax = 40%

An average of unlevered betas of comparable companies is assumed to be a proxy for unlevered betas of Marriott divisions. For calculations of unlevered betas for each division see Appendix 4.

What is the weighted average cost of capital for the Marriott Corporation and cost of capital for each of its divisions?

WACC is calculated according to the formula given in the case taking into account the tax shield. Cost of equity is calculated according to CAPM model.

## Cite this essay

Marriott Corporation” the Cost of Capital. (2016, Jun 05). Retrieved from https://studymoose.com/marriott-corporation-the-cost-of-capital-2-essay

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