Hbs Case “Marriott Corporation the Cost of Capital” free essay sample

HBS case â€Å"Marriott Corporation: The cost of capital† 1)Are the four components of Marriotts financial strategy consistent with its growth objective? In my opinion, the four components of Marriotts financial strategy are consistent with its growth objective. As we find in the case, the four components of Marriotts financial strategy: Manage rather than own hotel assets, Invest in projects that increase shareholder value, Optimize the use of debt in the capital structure, and Repurchase undervalued shares; are aligned with the growth objective. Marriott wants to remain a premier growth company. This means aggressively developing appropriate opportunities within our chosen lines of business—lodging, contract services, and related businesses. In each of these areas, their goal is to be the preferred employer, the preferred provider, and the most profitable company. 2)How does Marriott use its estimate of its cost of capital? Does this make sense? In the case is stated that Marriott required three inputs to determine the opportunity cost of capital: debt capacity, debt cost, and equity cost consistent with the amount of debt. The cost of capital varied across the three divisions because all three of the cost-of-capital inputs could differ for each division. This is the most logical approach due to the fact that the projects related to a particular division should be evaluated using the division’s WACC rather than the corporation’s WACC. 3)What is the Weighted Average Cost of Capital for Marriott Corporation? In order to calculate the WACC for Marriott’s Corporation I’m going to use the following formulas: 1. Weighted Average Cost of Capital: 2. Levered Beta: Marriott’s structure: D= 60% E=40% Marriott’s corporate tax: Tc= 175. 9 / 398. 9 Tc=0. 441 Marriott’s Pre-tax cost of debt: Debt rate premium above government= 1. 30% U. S. Government Securities Interest Rates: Maturity 30 years = 8. 95% Kd = 0. 0895 + 0. 013 Kd= 0. 1025 Marriott’s after tax cost of equity: Leverag. TcAsset BetaEq. Beta MARRIOTT 41%0. 4410. 7991. 11 MARRIOTT 60%0. 4410. 7991. 47 Ke = rf + Beta * (MRP) Rf=8. 95%(U. S. Government Securities Interest Rate) MRP=7. 43%(Exhibit 5) Ke = 8. 95% + 1. 47 * ( 7. 43%) Ke=0. 20 WACC = (1 0. 44) * 0. 1025 * 60% + 0. 2 * 40% WACC=0. 1139 The Weighted Average Cost of Capital for Marriott Corporation is 11. 9% a)What risk free rate and risk premium did you use to calculate the cost of equity? Risk free rate †¢30 years Maturity U. S. Government Interest Rate (8. 95%) Risk Premium †¢Spread between SP 500 Composite returns and long-term U. S. government bond returns between 1926-87 (7. 43%) b)How did you measure Marriotts cost of debt? I calculated Marriotts cost of debt adding Marriott’s debt rate premium above government (1. 30%) to the 30 years Maturity U. S. Government Interest Rates (8. 95%). 4)What type of investments would you value using Marriotts WACC? I will use Marriott’s WACC to evaluate projects that do not refer to a single division. This can be projects that add are related to the whole company and affect each division. In example, a project related with branding that will increase Marriott overall reputation and value 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 overtime? Using a single corporate hurdle rate for evaluating investment opportunities in each of its lines of business will lead to accept bad projects and reject profitable projects. In the case that the IRR of the return was slightly above Marriott WACC you would accept the division’s project although you might be operating bellow the division’s WACC and loosing money. 6)What is the cost of capital for the lodging and restaurant divisions of Marriott? In order to calculate the cost of capital for the lodging and restaurant divisions I will use the same formulas than in question 3. Hotels ReturnEq. BetaLeverageRevenuesAsset Beta HILTON HOTELS CORPORATION13. 30. 7614%0. 770. 697 HOLIDAY CORPORATION28. 81. 3579%1. 660. 435 LA QUINTA MOTOR INNS-6. 40. 8969%0. 170. 397 RAMADA INNS, INC. 11. 71. 3665%0. 50. 667 Average0. 549 Restaurants ReturnEq. BetaLeverageRevenuesAsset Beta CHURCH’S FRIED CHICKEN-3. 21. 454%0. 391. 417 COLLINS FOODS INTERNATIONAL20. 31. 4510%0. 571. 365 FRISCH’S RESTAURANTS56. 90. 576%0. 140. 550 LUBY’S CAFETERIAS (Operates cafeterias. ) 15. 10. 761%0. 230. 756 McDONALD’S22. 50. 9423%4. 890. 805 WENDYâ€⠄¢S INTERNA TIONAL4. 61. 3221%1. 051. 149 Average1. 007 LodgingRestaurant D/V50. 0%75. 0% E/V50. 0%25. 0% Tc44%44% Kd10. 05%8. 70% Rf8. 95%6. 90% Rprem1. 10%1. 80% Ke15. 31%29. 74% Eq. Beta0. 8562. 696 Asset Beta0. 5491. 007 Rf8. 95%6. 90% EMRP7. 43%8. 47% Sales % from total41. 00%13. 00% WACC10. 6%11. 08% a)What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers? Risk free rate Lodging division †¢30 years Maturity U. S. Government Interest Rate (8. 95%) †¢Is a long-term investment Risk Premium Lodging division †¢Spread between SP 500 Composite returns and long-term U. S. government bond returns between 1926-87 (7. 43%) †¢Is a long term investment Risk free rate Restaurants’ division †¢1 year Maturity U. S. Government Interest Rate (6. 90%) †¢Is a short-term investment, and the next available option is a 10 years rate which is too long. Risk Premium Restaurants’ division †¢Spread between SP 500 Composite returns and short-term U. S. Treasury bill returns: between 1926-87 (8. 47%) †¢Is a short-term investment, and I used a 1 year Maturity U. S. Government Interest Rate as the risk free rate. b)How did you measure the cost of debt for each division? Should the debt cost differ across divisions? Why? I calculated each division’s cost of debt adding the division’s debt rate premium above government to the U. S. Government Interest Rates that best represented the divisions behave. Risk free rate Lodging division 30 years Maturity U. S. Government Interest Rate (8. 95%) Risk free rate Restaurants’ division †¢1 year Maturity U. S. Government Interest Rate (6. 90%) The debt cost should differ across divisions because each one operate as independent business with different behavior. c)How did you measure the beta of each division? In order to measure the beta of each division, I got the average Asset Beta of the companies that where more similar to the division, and I leverage it with the capital structure of the particular division. 7)What is the cost of capital for Marriotts contract services division? How can you estimate its equity cost of capital without publicly traded comparable companies? In order to calculate the cost of capital for the contract service division I will use most of the formulas I stated on question number three. Additionally, as we do not have data of similar companies that we can use to extract the contract service division’s Asset Beta, I will calculate the WACC for the contract service division using the following formula: Marriott’s Asset Beta = (Lodging Asset Beta * division’s % of total sales) + (Restaurants Asset Beta * division’s % of total sales) + (Contract services Asset Beta * division’s % of total sales) Cleaning the equation in function of the Contract services Asset Beta, you find the Contract services Asset Beta. MarriottLodgingRestaurantContract Services D/V60. 0%50. 0%75. 0%60. 0% E/V40. 0%50. 0%25. 0%40. 0% Tc44%44%44%44% Kd10. 25%10. 05%8. 70%8. 30% Rf8. 95%8. 95%6. 90%6. 90% Rprem1. 30%1. 10%1. 80%1. 40% Ke19. 87%15. 31%29. 74%21. 91% Eq. Beta1. 4700. 8562. 6961. 772 Asset Beta0. 7990. 5491. 0070. 964 Rf8. 95%8. 95%6. 90%6. 90% EMRP7. 43%7. 43%8. 47%8. 47% TA %100. 00%41. 00%13. 00%46. 00% WACC11. 39%10. 46%11. 08%11. 55% The contract service’s WACC is 11. 55%