Marriott Case Study PDF

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MARRIOTT CORPORATION: THE COST OF CAPITAL

BMF 5331 Applied Corporate Finance Marriott Corporation WACC Case Study Yu Anran A0156915X Nicholas Saputra A0220484L Anuj Jain A0220506W Jenhau Lin A0220412A Wu Haolu A0220298E Assumptions:

For divisional WACC calculation, all the key values, calculation and formulas are also shown in the spreadsheet at the appendix of this report. Calculations are based on some assumptions as shown below. a. Tax rate is set for 175.9/398.9 = 44.1%, taken from Marriott’s 1987 financial statement. We assume all companies have the same tax rate. b. Concerning tax rate, we also assume that the tax rate in 1987 would apply for years onwards. c. We use the Hamada Formula to calculate the Unlevered Asset Beta and Relevered Equity Beta, with the purpose of including the effects of tax shield. d. We take 30-year government bond rate as the risk-free rate for Marriott as a whole, because Marriott could be considered as a long-term project. e. Concerning the risk-free rate for 3 divisions inside Marriott, we take the 10-year bond rate as the benchmark, because the investment horizon of these 3 sectors is between short-term and longterm. f. We take Spread between S&P 500 Composite Returns and Long-Term U.S. Government Bond Returns as the MRP (Market Risk Premium) for Marriott as a whole, since Marriott could be considered as a long-term asset. g. We also take Spread between S&P 500 Composite Returns and Long-Term U.S. Government Bond Returns as the MRP (Market Risk Premium) for 3 divisions inside Marriott. h. We use arithmetic mean instead of geometric mean for the Spreads between S&P 500 Composite Returns and Bond Rates (MRP), since arithmetic mean is a better indicator to future performance while geometric mean emphasizes on past performance. In this case study, we are ought to focus on the future performance to determine cost of capital. i. The total asset and the assets of each division are taken from the “identifiable assets” in exhibit 2. j. Assume the CEO of Marriott aims to maintain the target D/V at 60%. Question 1. Cost of Capital I. Cost of capital of Marriott as a whole Cost of Equity: Re= Rf + βe *MRP

MARRIOTT CORPORATION: THE COST OF CAPITAL

βe: Beta equity for Marriot can be attained in Exhibit 3, to be 0.97. However, this equity beta is levered by market leverage of 41%. We need to first unlever it and relever by the target market leverage ratio of 60%. (Pure-play method). βe = 0.97/ (1+(1-t)*(D/E))*(1+(1-t)* 1.5)= 1.28 (Shown in the spreadsheet ） Concerning the Risk-free rate, we use 30-years US Government Bond (shown in Table B) as a benchmark, because Marriott, the whole company, should be considered as a long-term project. Rf=8.95% For MRP (Market Risk Premium), we use the spread between S&P 500 Composite Returns and LongTerm U.S. Government Bond (shown in Exhibit 5). We take the arithmetic average for the MRP. MRP=7.43% Re= 8.95%+1.28*7.43%= 18.46%

Cost of Debt: Rd = Government bond rate + spread = 8.95% + 1.30% = 10.25% WACC of Marriott as a whole: WACC = (1-T)*rd(D/V) + re*(E/V) = (1-.44)(.1025)(.6) + (.1846)(.4) = 10.83% II. Cost of capital for Marriot’s divisions Cost of Debt: Lodging: Rd = 10-year government bond rate + spread = 8.72% + 1.1% = 9.82% Contract Service: Rd = 10-year government bond rate + spread = 8.72% + 1.4% = 10.12% Restaurant: Rd = 10-year government bond rate + spread = 8.72% + 1.8% = 10.52% Cost of Equity: Step 1: Find the unlevered Beta for lodging and restaurant division A. Lodging:

MARRIOTT CORPORATION: THE COST OF CAPITAL

We compare Marriot’s lodging division (ꞵ E = 0.97, D/E = 0.7) with competitors who are running similar businesses, including: Hilton Hotels: ꞵE = 0.88, D/E = 0.16 Holiday Corporation: ꞵE = 1.46, D/E = 3.76 La Quinta Motor Inns: ꞵE = 0.38, D/E = 2.23 Ramada Inns: ꞵE = 0.95, D/E = 1.86. According to the unlevered beta formula ꞵ U = ꞵ E * [1/(1+(1-t)(D/E))], we can get the unlevered Beta for each lodging company: Marriott: ꞵU = 0.70 Hilton Hotels: ꞵU = 0.81 Holiday Corporation: ꞵU = 0.47 La Quinta Motor Inns: ꞵU = 0.17 Ramada Inns: ꞵU = 0.47 The average unlevered beta ꞵU for Lodging (Excluding Marriott) = (0.81+0.48+0.17+0.47) / 4 = 0.48 B. Restaurant: Likewise, we find the companies that have the same business with Marriot’s restaurant division, including: Church’s Fried Chicken: ꞵE = 0.75, D/E = 0.04 Collins Foods International: ꞵE = 0.6, D/E = 0.11 Frisch’s Restaurant: ꞵE = 0.13, D/E = 0.06 Luby’s Cafeteria: ꞵE = 0.64, D/E = 0.01 McDonald’s: ꞵE = 1, D/E = 0.3 Wendy’s International: ꞵE = 1.08, D/E = 0.27 Therefore, unlevered beta ꞵU would be: Church’s Fried Chicken: ꞵU = 0.73 Collins Foods International: ꞵU = 0.56 Frisch’s Restaurant: ꞵU = 0.13 Luby’s Cafeteria: ꞵU = 0.64 McDonald’s: ꞵU = 0.86 Wendy’s International: ꞵU = 0.94 The average unlevered beta ꞵU = (0.73+0.57+0.13+0.64+0.86+0.94) / 6 = 0.64 Step 2: Calculate the levered beta We use the industry unlevered beta as the unlevered beta for Marriot’s different divisions. Therefore, lodging division has a ꞵA = 0.48, while restaurant division has ꞵ A = 0.65. We then relever the beta using the following formula: ꞵE = [1 + ((1-t) * (D/E)] * ꞵA Marriott: ꞵE = [1 + (1-44%) * (60/40)] * 0.72 = 1.28

MARRIOTT CORPORATION: THE COST OF CAPITAL

Lodging: ꞵE = [1 + (1-44%) * (74/26)] * 0.48 = 1.25 Restaurant: ꞵE = [1 + (1-44%) * (42/58)] * 0.65 = 0.91 (Also shown in the spreadsheet, marked by red) We take Marriot’s whole equity beta as the weighted average of the equity beta of three divisions, i.e. ꞵ E of Marriot = ꞵ E of lodging * (lodging asset / total asset) + ꞵ E of (restaurant asset / total asset) + ꞵ E of contract * (contract asset / total asset) 1.28 = 1.25 * (2777.4 / 4582.7) + 0.91 * (567.6 / 4582.7) + ꞵE of contract * (1237.7 / 4582.7) Solve the equation and we get ꞵE of contract service = 1.54 Step 3: Calculate Cost of Equity for 3 Divisions Lodging: 8.72% + 1.32 * 7.43% = 17.93% Restaurant: 8.72% + 0.91 * 7.43% = 15.43% Contract: 8.72% + 1.54 * 7.43% = 20.19% Step 4: Calculate WACC WACC for lodging division: 74% * 9.82% * (1-44%) + 26% * 17.93% = 8.73% WACC for restaurant division: 42% * 8.7% * (1-44%) + 58% * 15.37% = 11.42% WACC for contract division: 40% * 8.3% * (1-44%) + 60% * 25.59% = 14.38%

Question 2. Single Overall WACC or Divisional WACC? Marriott corporation has three divisions: Lodging, Restaurant and Contract services. Not all 3 divisions carry the same kind of risk and returns. After calculating the WACC for the whole corporation and the three divisions, it shows that the variation is significant. The cost of capital for contract is 14.38% whereas the cost of capital for restaurant and lodging are 11.42% and 8.73% respectively and the composite WACC is 10.83%. The level of variation shows that if a single cost of capital is used, it is likely that the company passes on the low-risk projects and takes up high risk projects. Therefore, it is advisable for Marriott to use multiple costs of capital to efficiently evaluate their investment opportunities. Question 3. Comments on the Marriott Case Study We think the difficulty for this case study will be 8. Although WACC calculation methods and modelling techniques were taught in class and were easy to master and apply, we still spent a lot of time reading through the case and filtering out the useful information that helps us answer the question. Besides, we were struggling to make key assumptions to supplement the missing information of the missing material, including risk-free rate, market risk premium, tax rate, assets for 3 divisions, arithmetic mean for MRP and so on. Last but not least, the most complicated part was to find the equity beta for each division. Since betas available in the reading materials, we had to unlever beta for these divisions first, and then relever betas with the target D/V ratio to get the equity betas for lodging, contract and restaurant sectors. The technique we applied here is so-called ‘pure-play’ method. To conclude, although the knowledge about WACC is simple, it is hard to find useful information and apply ‘pure-play’ method. Therefore, we grade the project with 8, a difficult one.

MARRIOTT CORPORATION: THE COST OF CAPITAL

Marriot Hotel Industry Hilton Holiday La Quinta Ramana Retrausrant Industry Church Collins Frisch Luby Mcdonald's Wendy

Lodging Restaurant Contract

Equity Market Beta Leverage 0.97 0.88 1.46 0.38 0.95

0.75 0.6 0.13 0.64 1 1.08

Target Market Leverage

0.41 0.14 0.79 0.69 0.65

Tax Unlevered D/E Ratio Rate Asset Beta 0.69 0.60 0.44 0.70 0.74 0.16 0.44 0.81 3.76 0.44 0.47 2.23 0.44 0.17 1.86 0.44 0.47 Average Unlevered Asset Beta for Hotel Industry 0.48

0.42 0.04 0.04 0.44 0.1 0.11 0.44 0.06 0.06 0.44 0.01 0.01 0.44 0.23 0.30 0.44 0.21 0.27 0.44 Average Unlevered Asset Beta for Restraurant Industry

Total Assets Assets of different division 2777.4 567.6 4582.7 1237.7

Relevered Beta Marriot Relevered Beta Contract

0.73 0.56 0.13 0.64 0.86 0.94 0.64

Relevered equity Beta 1.28

1.24

0.90

1.28 [1.28 - 1.25 * (2777.4 / 4582.7) - 0.91 * (567.6 / 4582.7)] / (1237.7 / 4582.7). =1.54

MARRIOTT CORPORATION: THE COST OF CAPITAL

WACC Calculation for 3 Sectors MRP

7.43%

Spread between Market and 10-yr bond rate

Risk Free Rate

8.72%

10 yr Bond rate

Lodging Debt Rate Premium

1.10%

Given

Contract Debt Rate Premium

1.40%

Given

1.80% Lodgin g 17.93% 9.82% 0.26 0.74 0.44

Given

Contract 20.19% 10.12% 0.6 0.4 0.44

Restraurant 15.43% 10.52% 0.58 0.42 0.44

8.73%

14.38%

11.42%

Restraurant Debt Rate Premium

Cost of Equity Cost of Debt Weight of Equity Weight of Debt Tax Rate

WACC...