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Marriott Corporation: The Cost Of Capital

1382 words - 6 pages

Divisional hurdle rates at Marriott have a significant impact on the firm's financial and operating strategies. Marriott measures the opportunity cost of capital for investments of similar risk using the Weighted Average Cost of Capital ("WACC"). The scope of this analysis is to assist Marriott in selecting the appropriate hurdle rate for each division as of April 1988 ("Valuation Date"). As the risk entailed in each division is different, Marriott should discount divisional projects at the division's hurdle rate. In order to select the appropriate hurdle rate, the WACC of each division and of the company as a whole are calculated and used as a proxy for the divisional and corporate hurdle ...view middle of the document...

(2) Market Risk Premium: We used the 1987 Long-Term Equity Spread rate as the market risk premium for our analysis. We believe a longer estimation window is appropriate for the market risk premium as it matches the time horizon of the investment projects for Marriott and its divisions. However, given the volatility of the Long-Term Equity Spread rates from 1975 to 1987 we believe these are not representative of the market risk premium as of the Valuation Date. . Consequently, we chose the 1987 Long-Term Equity Spread rate (even though it is over a shorter window) because the 1987 rate is consistent with the Long-Term Equity Spread rate from 1926-1987, the longest estimation window provided. Also, we believe the market risk premium should be relative to long-term risk free securities due to the long term nature ((3) Tax Rate: The tax rate used for this case was 34% according to the case instructions.(4) Pre-tax Return on Debt Capital: To determine the pre-tax return on debt capital for Marriott and its divisions, we applied the appropriate credit spread for Marriott and its divisions from Table A of the case to the corresponding risk-free rate for Marriott and its divisions as discussed above.(5) For simplicity in modeling, it was assumed that the debt beta equals 0.MarriottIn order to determine the cost of equity of Marriott, we calculated Marriott's unlevered equity beta using the tax rate provided, Marriott's most current market debt to equity ratio , and Marriott's levered equity beta . With the unlevered beta, we calculated Marriott's relevered beta using the target market value debt percentage in capital established in Table A of the case and the tax rate provided. We used the target market value debt percentage in capital instead of the long-term debt percentage to total capital as seen in Exhibit 1 of the case because it represents the capital structure target Marriott and its divisions will use for selecting investment projects during the current period (the period over which the hurdle rates apply). Also, we did not use the market leverage percentage as seen in Exhibit 3 of the case because the long-term debt percentage to total capital uses book values rather than market values for debt and equity and thus the market leverage percentage does not represent the target capital structure that Marriott plans to use. After following the steps described above to determine the cost of capital, the cost of equity is 20.91% and the cost of debt is 6.77%11. Consequently, Marriott's WACC (rounded) is 12.0%.Lodging DivisionTo calculate the cost of equity of the Lodging Division, we used the average unlevered beta of the comparable companies to determine the unlevered beta of the Lodging Division because the division's beta was not provided. We assumed this to be the best proxy for the Lodging Division's unlevered beta and...

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