Group Member:

1.
2.
3.
4.
5.

Anil Kumar (MP13009)

Avishekh Kumar Singh (MP13020)
Chandra Shekhar Mishra (MP13023)
Joydeep Bagchi (MP13028)
Manoj Kumar (MP13033)

Marriot Corporation : Cost of Capital

Dan Cohrs, VP Project Finance, Marriot Corporation, faced with making recommendations
for the hurdle rates at Marriott Corporation and its three divisions utilizing CAPM and
WACC.
It is important that Cohrs makes an appropriate recommendation for each division because
hurdle rates influence project investment decisions. Cohrs is faced with 1) deciding which
data he will use to calculate the rates and 2) calculating the weighted average cost of capital
(WACC) with the little information given about the contract division and Marriott
Corporation altogether.
Investing in projects that increase shareholder value enhances the probability of growth in the
market value of the firm. Optimizing the debt used in the firm's capital structure would
typically result in a decrease in the firm's average cost of capital. Repurchasing the
undervalue shares may result in a strong return on investment.
The first step would be to determine the appropriate tax rate. The average of the tax rates for
1926 thru 1987 can be used as the tax rate for the corporation and its divisions. Each year's
tax rate can be calculated using the tax amount divided by each year's income before tax.
Note the following table in order to compute the Tax Rate calculations:

Income
before
income
taxes
Income
taxes
TaxRate

197
8

197
9

198
0

198
1

198
2

198
3

198
4

198
5

198
6

198
7

Avg

83.5

105.
6

103.
5

121.
3

133.
7

185.
1

35.4
42.4
0

43.8
41.4
8

40.6
39.2
3

45.2
37.2
6

50.2
37.5
5

76.7
41.4
4

236.
1
100.
8
42.6
9

295.
7
128.
3
43.3
9

360.
2
168.
5
46.7
8

398.
9
175.
9
44.1
0

41.6
3

In this case, use the effective tax rate in 1987 rather than the average tax rate in order to
proxy for the tax rate, which is equal to income taxes in 1987 divided by taxable income in
1987, which is 175.9/398.9, or 0.44. The effective tax rate is 44 percent. Then, the second
step would be to determine the cost of debt by summing the 1988 government interest rates
and the debt rate premium above government. It would be best to use the 30 year government
rate for the Marriott Corporation considering it has been established for more than 30 years.

The third step would then be to determine the cost of equity by using CAPM. It would be best
to use the arithmetic average of the spread between the S&P 500 Return to calculate the risk
premium. Note the following calculations that exhibit that the WACC for Marriott
Corporation is 6.32 percent:
CAPM = Risk Free Rate + (Risk Adjusted Beta * Risk Premium)
= 4.58 + (1.50 * 7.43)
= 15.73
WACC = (1-T) * (D/V) * (Cost of Debt) + (E/V) * (Cost of Equity)
= (1-.44) * (.6) * (.013 + .0895) + (.4) * (15.73)
= (.56) * (.6) * (.1025) + (.4) * (15.73)
= .03 + 6.29
= 6.32%

If Marriott (or any corporation for that matter) only used a single corporate hurdle rate for
evaluating investment opportunities for its individual business lines, they would introduce
error into their accept/reject decisions for new projects within each line of business since
specific projects or divisions have significantly different risk than the firm's or division's
average risk. While calculating a risk-appropriate WACC for every new project under
consideration isn't usually feasible for large corporations like Marriot, calculating a divisional
WACC would lead to less error in accept/reject decisions. Using a firm-wide WACC in
evaluating new projects without using the divisional approach would tend to give advantage
to projects riskier than the firm's average beta and disadvantage to safer, less risky projects.
Overall, Marriott's bottom line would suffer if they used a firm-wide inappropriate
benchmark, which could be avoided by calculating different divisions proxy for different
average project risk levels, then using the divisional approach to calculate separate WACC's
for each division. This will result in fewer errors and an improved bottom line as well as
better pipeline for viable new opportunities. Failure to do so over time will result in Marriott
making large investment mistakes, overfunding risky divisions and projects while
underfunding or rejecting projects that should have been accepted. After making error after
error in their investment choices, working capital would be diminished to such a point, and
shareholders so unhappy, feasibly the company would not be able to continue operations
without a complete overhaul of their investment evaluation technique.
Marriott historically used the CAPM technique to find different costs of capital for each of
their divisions, and the hurdle rate assigned to a specific project was wisely based on market
interest rates, project risk, and estimates of risk premiums. This was mitigated by using
standard company-wide assumptions in cash flow forecasts for consistency across projects,
while maintaining divisional manager control over unit-specific assumptions. Assigning a
single corporate hurdle rate would not improve upon their historical method of evaluating
opportunities within divisions and across them, but rather would result in investing in projects
that decrease shareholder wealth instead.
Using an objective approach to calculating divisional WACC's is more precise so we must
start by computing the average beta per division, using these figures in the CAPM formula to
calculate iE for each division, then using divisional estimates if iE to construct divisional
WACC's.

To find the WACC for the lodging division of Marriot, computed the average equity beta
for the lodging division as follows:
Hotels:
HILTON HOTELS CORPORATION
HOLIDAY CORPORATION
LA QUINTA MOTOR INNS
.89
RAMADA INNS, INC.
Average Equity Beta for lodging division:

Equity Beta
.76
1.35
1.36
1.09

Since lodging assets, like hotels, have long useful lives, Marriot used the cost of long term
debt for its lodging cost-of-capital calculation. Using the average beta for the lodging
division in the CAPM model we must solve the following equation:
CAPM = Risk Free Rate + (Risk Adjusted Beta * Risk Premium)
Cost of Debt = Risk Free Rate + Debt Rate Premium Above Government
Cost of Debt = 8.95% + 1.10% = 10.05%
Weight Equity is calculated by subtracting Debt Percentages from 1. Thus Weight Equity for
the restaurant is equal to (1-0.74), or 26 percent.
Cost Equity = Risk Free Rate + Equity Beta (Market Risk Premium)
Cost of Equity = 8.95% + 1.09(7.43%) = 17.05 percent.
WACC for the lodging division of Marriott:
WACC = (1-T) * (D/V) * (Cost of Debt) + (E/V) * (Cost of Equity)
WACC = 74%(1-0.44) * 10.05% + 26% * 17.05%
WACC = .0859772 or 8.6%
To find the WACC for the Restaurant division of Marriot, computed the average equity
beta for the restaurant division as follows:
Restaurants:

Equity Beta

CHURCH'S FRIED CHICKEN

1.45

COLLINS FOODS INTERNATIONAL

1.45

FRISCH'S RESTAURANTS

.57

LUBY'S CAFETERIAS

.76

McDONALD'S

.94

WENDY'S INTERNATIONAL

1.32

Average Beta for restaurant division:

1.07

Cost of Debt = 8.95% + 1.80% = 10.75%

Cost of Equity = 8.95% + 1.07(7.43%) = 16.9%
WACC = 42%(1-0.44) * 10.75% + 58% * 16.9%
WACC = 12.33%
The WACC for the restaurant division is 12.33 percent.

The weight debt for contract services is given in Table A of the case study as 40 percent. The
given Tax rate for the company is 44 percent.
Cost of Debt = 8.95% + 1.4% = 10.35%
The weight equity is equal to 1 Debt percentage, which is given for contract services as 40
percent. 1-40% = 60%.
Cost Equity is equal to the Risk Free Rate + Equity Beta (Market Risk Premium). Risk Free
Rate and Market Risk Premium are given in the case. Contract services have no available
comparable information. However, the asset beta of the entire company is the weighted
average of all the divisions. After knowing the beta of the company as a whole, and the
weighted betas of the other divisions, the asset beta of the contract services division can be
calculated by:
1.11 = 2,777.4/4582.7 * 1.09 + 467/4582.7 * 1.07 + 1237.7/4582.7 * CSAB
1.11 = .6606 + .1019 + .27 (CSAB)
Asset beta of contract services = 1.287
The cost of equity can then be calculated as:
8.95% + 1.287 (7.43%) = 18.512%
All information needed to compute WACC is resolved and can now be entered into the
weighted-average cost of capital formula:
WACC = Weight Debt (1-Tax rate) Cost Debt + Weight Equity * Cost Equity

WACC= .4(1-.44) * .1035 + .6 * 18.512

WACC = .11113 or 11.13%
The WACC for the contract services division is 11.13 percent.
CONCLUSION
The weighted-average cost of capital for each division varies from each other, and the
company as a whole. This finding is expected because of the differences in debt, equity, and
risk involved in each division. The differences in WACC serve as reinforcement of the
Marriott's decision to create different hurdle rates for different divisions. The closer look at
the divisional hurdle rates will help Marriott achieve one of its goals of increasing
shareholder value by allowing each division to make decisions based on their own
circumstances. Since Marriot Corporation uses some project specific inputs in calculating
WACC as well as some inputs consistent with firm wide values used in calculating the firm
wide WACC, each of Marriot's divisions; lodging, restaurants, and contract services, they
have minimized making false accept/reject decisions for new projects that could occur if they
were to use one single company-wide hurdle rate.