Cost of Equity

Cost of Equity

Introduction

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 rates.

WACC Analysis

General Considerations

The following steps were taken to calculate the WACC of each of the divisions and for Marriott:

1) We used the Capital Asset Pricing Model (“CAPM”) to calculate the cost of equity.

2) The cost of debt was determined by adjusting the pre-tax return on debt capital for the tax benefit associated with the deductibility of interest on debt

3) The appropriate market value weights for debt and equity as a percentage of the market value of invested capital were applied to the cost of equity and the cost of debt to determine the corresponding WACC.

The rationale for some inputs was common:

(1) Risk Free Rate: We believe the most appropriate risk free rate to use for the cost of capital of Marriott and its divisions is the rate that corresponds with the expected economic life of each project. Since Marriott and the Lodging Division both have projects with economic lives longer than 10 years, we used the 30 yr. U.S. government interest rate as of the Valuation Date. Because the other divisions (contract services and restaurant) have project lives around ten years, we used the 10 yr. U.S Government Rate as of the Valuation Date accordingly. It was assumed that the most accurate expected risk free rate is the last available rate rather than a historical average of previous rates.

(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 (<10 years) of the investment projects of Marriott and its divisions.

(3) Tax Rate: The tax rate used for this case was 34% according to the case ...