Determine the cost of capital and risk free rate, Financial Accounting

Instructions:

  • The case should be done in your assigned groups.
  • Hand in a brief write-up not exceeding two pages explaining what was done.

 

In April 1988, the vice president of project finance at the Marriott Corp. , Dan Cohrs, was preparing recommendations for discount rates that should be used to evaluate each of the firm's three divisions. Marriott had three major lines of business: lodging (61% of total assets), contract services (27%), and restaurants (12%). The target leverage ratio is 74% for lodging, 40% for contract services, and 42% for restaurants. The target leverage ratio for the Marriott Corp is 60%. Marriott's existing leverage ratio is 41%. Marriott's beta, calculated using daily returns from 1986 and 1987, was 0.97.

Marriott's current debts are high-quality. Therefore there is only a small spread above the current government bond rates. But since each division has its own risk, each division pays a different premium above government bonds rates. The spreads for Marriott as a whole and for each of the three divisions (lodging, contract services, and restaurants) respectively are: 1.3%, 1.1%, 1.4% and 1.8%. Note that Marriott uses long-term debt for its lodging business (since lodging assets such as hotels had long asset lives) and shorter-term debt for its restaurant and contract services division.

The government interest rates in April 1988 were 8.95% for a 30-year bond and 8.72% for a 10-year bond. The historical market risk premium measured by the difference between S&P 500 and long-term government bond is 7.43%. There are some comparable companies in the lodging and restaurant businesses that have similar business risks as the divisions of Marriott. Dan found that the equity beta of Hilton Hotels and that of Holiday Corp are respectively .88 and 1.46. The market leverage of Hilton and that of Holiday are respectively 14% and 79%. The two companies have similar market capitalizations. There are two restaurant chains that operate similarly to Marriott's restaurant division: McDonald's and Wendy's.  The equity betas of the two restaurants are respectively: 1 and 1.08.  The market leverages of the two restaurants are: 23% and 21%. McDonalds' market share is about four times of Wendy's. Currently Marriott's marginal tax rate is 34%.

Questions for the Marriott Case

Please structure your case report around the following questions:

1) What is the overall weighted average cost of capital for the Marriott Corporation?

a) What risk-free rate did you use to calculate the cost of equity?

b) Be careful to distinguish between actual debt / value ratios and target debt /value ratios, and decide which one to use in the wacc calculations. Be careful to lever or unlever your equity beta appropriately.

(To keep it simple, ignore debt and taxes for the purpose of levering and unlevering beta. Use the formula:                          

βAssets  = E/D+E * βE

2) What is the cost of capital for the lodging and restaurant divisions of Marriott?

a) What risk-free rate did you use in calculating the cost of equity for each division?

b) How did you measure the beta of each division?

3) What is the cost of capital for Marriott's contract services division? How can you estimate its equity costs without publicly traded comparable companies?

4) 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 over time?

Posted Date: 3/4/2013 7:07:06 AM | Location : United States







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