Marriott solutions - notes during class that were on test. PDF

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FIN 320 Spring 2016 Prof. Kadiyala

Solution to Marriott corporation Estimating Divisional Costs of Capital Main Issues a) What risk-free rate and risk premium should be used in estimating the cost of equity? b) How do we measure the cost of debt for each division? Should it differ across divisions? c) How do we estimate divisional betas? 1. The Lodging Division First, estimate unlevered beta using comparable lodging firms from Exhibit 3. For each firm calculate unlevered beta, get the average unlevered beta by weighting each company by sales: Unlevered beta for Hilton = (1-0.14) * 0.76 = 0.654 Similarly unlevered betas for Holiday, LaQuinta, and Ramada =0.284, 0.276 and 0.476 Weighted average asset beta (based on sales) for comparables = 0.41= [0.77/ (0.77+1.66+0.17+0.75) *0.654] + [1.66/(0.77+1.66+0.17+0.75)*0.284] + [0.17/(0.77+1.66+0.17+0.75) *0.276] + [0.75/(0.77+1.66+0.17+0.75) *0.476] Using Marriott’s target D/V of 74% for lodging implies a levered equity beta equal to e = (V/E) (a) = (1/0.26)*(0.41) = 1.58 Because lodging assets are long-term assets, we use the long-term government bond rate of 8.95%. With the market premium of 8.47%, => re = 8.95% + (1.58)(8.47%) = 22.33% Because from table A, we know that debt rate is 1.1% above government rate, we know that the pre-tax cost of debt is 8.95 + 1.1 = 10.05% => WACC = (1-t)rd(D/V) + re(E/V) = (1-0.34)(10.05%)(0.74) + (22.33%)(0.26) = 10.71%

2. The Restaurant Division

Using the same procedures as above, we can calculate that the weighted average unlevered beta for comparable restaurants is 0.83. => e = (V/E) (a) = (1/0.58)(0.83) = 1.43 Because restaurant assets are shorter-term assets, we use the 10-year government bond rate of 8.72% as the risk-free rate and the historical premium of 8.47% yields, => re = 8.72 + 1.43(8.47) = 20.83% => WACC = (1-0.34)(0.42)(10.52) + (0.58)(20.83) = 15.00% 3. The Contract Services Division Main problem: There are no publicly-traded comparable companies. How then do we estimate the division’s beta? One way to handle this is to use the information on the unlevered betas for Marriott as a whole and for the restaurant and lodging divisions to infer the unlevered beta for contract services. M =(wL)L + (wR)R + (wCSM)CS where w is the weight attached to each beta. Ideally, the weights should reflect the fraction of total equity in each division, but since that number is unobservable, we can use the fraction of identifiable assets from each division as given in Exhibit 2. M = 0.65 = (0.61)(0.41) + (0.83)(0.12) + (0.27)CS Unlevered CS = 1.11 => e = (V/E) (a) = (1.11) (1/0.60) = 1.85 Like restaurants, contract service assets have shorter useful lives. Therefore, we use the 10-year government bond yield and the corresponding market risk premium. => re = 8.72 + (1.85)(8.47) = 24.39% => WACC = (1-0.34)(0.40)(8.72+1.40) + (0.60)(24.39) = 16.52%...