Introduction and background We are conducting an analysis of Marriott Corporation for calculating the hurdle rates at each of the

firm's three divisions--lodging division, restaurant division and contract service division. Marriott uses Weighted Average Cost of Capital (WACC) as the hurdle rate, and use it to discount the appropriate cash flows when evaluate an investment project. Our goal is to determine the WACC at every division base on the information that the case has provided. First of all, we will determine the cost of debt, cost of equity and the capital structure for the whole company. Then we will compute for the tax rate, and calculate the WACC for the whole company. After this, we will determine the Risk-free Rates, Risk Premiums and Betas for lodging and restaurant divisions in order to calculate the Cost of Equity for these two divisions. After finding out the cost of debt and the fraction of debt for lodging and restaurant divisions, we will be able to calculate the WACC at each of the two divisions. Using a mathematical method, we will then be able to find out the Beta and determine the cost of debt and the fraction of debt for this division. Finally, we will be able to calculate the WACC for contract service division. Background Marriott Corporation was started in 1972, and its founder is Marriott is J. Willard Marriott. The company became one of the leading lodging and food service companies in the U.S. in 60 years. Marriott had three major lines of business: lodging, contract services and restaurants. Lodging operations included 361 hotels, with more than 100,000 rooms in total. Hotels ranged from the full-service, high-quality Marriott hotels and suites to the moderately priced Fairfield Inn. Contract services provided food and services management to health care and educational institutions and corporations. It also provided airline catering and airline service through its Marriott In-Flite Service and Host International operations. Marriott's restaurants included Bob's Big Boy, Roy Rogers, and Hot Shoppes. When the management of Marriott evaluated an investment project, they used an appropriate hurdle rate to discount the appropriate cash flows. Since the lodging assets had longer useful lives than contract service division and restaurant division, the cost of debt at each division are different. Also, the expected returns at each of the three divisions were different as well. Therefore, the Marriott's management decided to use different hurdle rate for each of the three divisions. The divisional hurdle rate had a significant effect on the firm's financial and operating strategies. If hurdle rates were to increase, the present value of project inflows would be decreased, and the company's growth would be reduced. Marriott also

considered using the hurdle rates to determine incentive compensation. Managers would be more sensitive to Marriott's financial strategy and capital market conditions, if the compensation plan could reflect hurdle rates. In April 1988, Dan Cohrs, the company's vice president of project finance, was preparing his annual recommendations for the hurdle rates at each of the firm's three divisions. Since the hurdle rates would affect the firm's financial and operating strategy, he had to consider all the aspects that related to this analysis, and calculate the rates very carefully. Assumptions In order to present our evaluations and calculations of the hurdle rates, we had to make certain assumptions. These assumptions are described below. Capital Structure The existing capital structure of Marriott was optimal. Questions 1. Are the four components of Marriott's financial strategy consistent with its growth objectives? The company's growth objective is to remain a premier growth company by aggressively developing appropriate opportunities within its lines of business. This indicates that its cost of equity might be higher because the company is using CAMP to measure Re, and investing in higher risk projects will yield higher returns. Strategy #2 conflicts with the company's objective because the company is using hurdle rate to discount cash flows and evaluate potential investments. If Re was higher, then WACC, which is the hurdle rate, would be higher as well. If this was the case, the company's growth would be reduced therefore failing the company's growth objective. If the company's objective is to keep growing by aggressively developing appropriate opportunities, it is best if they do not use their funds to buy back stock shares, even though these shares were undervalued. So strategy #4, which is to repurchase undervalued shares, conflicts with the company's objective. When the company intends to remain a premier growth company, it must aggressively invest in different profitable projects to generate more profit. If Marriott used their funds to buy back stock shares, the available funds for investment would be reduced. This will have a negative effect on the company's growth objective. 2.How does Marriot use its estimate of its cost of capital? Does this make sense?

Marriot use cost of capital as the hurdle rate to discount future cash flows for the investment projects of the firm's three divisions. Hurdle rate is the minimum rate of return that is required in order for the company to accept the investment. Marriot use the hurdle rate to calculate the net present value and net present value over cost to decide for the profit rate. Since cost of the project stays constant, net present value and hurdle rate are used as variable to decide if they should accept the project. The higher the hurdle rate, the lower the net present value because future cash flows are discounting at a higher rate. This also means lower return on the project. However, WACC and net present value of the project should be considered and calculated separately for each division for different investments projects. Therefore figure A could be misleading because it does not separate hurdle rate into different division. For example, NPV is equal to zero when hurdle rate equal to 10% according to figure A. But for a division with lower risk, it could have positive NPV when hurdle rate equal to 10%. Therefore, use a firm wide WACC, they might end up reject good projects for low risk division and accept bad projects for high-risk division. As the case indicates, WACC can only measure investment of similar risk class unless we take into consideration of risk factor of the division or the industry. For the incentive compensation, we agree with the comparison of the divisional return on net assets and market-based divisional hurdle rate to arrive at the appropriate compensation rate. 3. What is the weighted average cost of capital for Marriott Corporation? The weighted average cost of capital for Marriott is 9.53%. The WACC for lodging division is 8.02% and 10.61% for restaurants division. For contract services, it is 7.89%. a. What risk-free rate and risk premium did you use to calculate the cost of equity? We use the short term treasury bill returns from 1926-1987 for restaurants and contract services as the risk-free rate and that is 3.54%. Long term U.S. government bond returns from 1926-1987 for Marriot and Lodging as the risk-free rate and that is 4.58%. The risk premium is the spread between S&P 500 composite returns and short-term treasury bill returns from 1926-1987 and that is 8.47% for restaurants and contract services. The risk premium for Marriot and Lodging is the spread between S&P 500 composite returns and long-term U.S. government bond returns and that is 7.43%. b. How did you measure Marriott's cost of debt? We calculate the cost of debt based on the information provided in table A and table B. The cost of debt for Marriott is the debt rate premium above government plus 30 year government interest rate and it is 10.25%. The cost of debt for Lodging is its

debt rate premium above government plus 30 year government interest rate and that is 10.05%. The cost of debt for contract services is its debt rate premium above government plus 1 year government interest rate and it is 8.3%. The cost of debt for restaurant is its debt rate premium above government plus 1 year government interest rate and that is 8.7%. 5. What is the cost of capital for the lodging and restaurant divisions of Marriott? The cost of capital for the lodging and restaurant divisions of Marriott is 8.02% and 10.61% respectively. (Please see detailed calculation in attachment 2) a. What risk-free rate and risk premium did you use to calculate the cost of equity for each division? Why did you choose these numbers? Lodging division Risk-free rate and risk premium that are used to calculate the cost of equity for the lodging division are 4.58% and 7.43% respectively. This risk-free rate is an arithmetic average of long-term U.S. Government bond returns for the year 1926-1987. The risk premium rate is an arithmetic average of spread between S&P 500 composite returns and long-term U.S. Government Bond returns for the year 1926-1987. We decided to use an arithmetic average rather than a geometric average because the first one should provide more exact data than the second one. The arithmetic average return is the sum of the actual annual returns over the time period divided by the number of years in the time interval. In contrast, the geometric average return is the compound average growth rate over the time interval. Thus, it does not provide the exact data about the annual returns over the time period. We believed that the longer the time period of data, the better and the more exact information. Information that is based on the short period might be distorted from such factors as inflation or economic crisis in some period of time. As can be seen from the Exhibit 4 in page 10 of the case, the return rates in each period of time are rather fluctuated. Thus, return rate that is based on the longest period should be the best representative of the rate to be used. Since the lodging assets have long useful lives, our group decided to use the information based on the long-term returns. Moreover, when investors invest in the lodging business, they should realize that it is a long-term investment. Thus, expected return from this business should be compared with the long-term returns. Restaurant division Risk-free rate and risk premium that are used to calculate the cost of equity for

the restaurant division are 3.54% and 8.47% respectively. This risk-free rate is an arithmetic average of short-term Treasury bill returns for the year 1926-1987. The risk premium rate is an arithmetic average of spread between S&P 500 composite returns and short-term Treasury bill returns for the year 1926-1987. The reason we used these rates for the restaurant division are the same with the reason that we used the rates for the lodging division except that we used the information based on the short-term returns. This is because the assets in this division have shorter useful lives. Also, when we invested in this business, we normally expected short-term returns. b. How did you measure Marriott's cost of debt for each division? Should the debt

cost differ across divisions? Marriott's cost of debt for each division was measured by using the U.S. Government interest rates plus debt rate premium above Government. Since the company expected that it would pay more than the government interest rate to lend money from investors. Including debt rate premium in the cost of debt would make the estimated interest rate as correct as the actual rate as possible. The debt cost should differ across divisions due to different risks in each division. Also the nature of business in each division is also different. This makes the debt rate premium for the hotel (as a whole) and for each division differ, as can be seen from Table A in page 4. As stated in question 5a., the lodging division is a long-term investment while the restaurant division is a short-term investment. Thus, interest rates for these two divisions should be different. Our group decided to use the interest rate of 10.05% for the lodging division. This rate comes from the U.S. government interest rate for 30-year maturity of 8.95% plus the debt rate premium of 1.10%. For the restaurant division, the interest rate is 8.70% which comes from the U.S. government interest rate for 1-year maturity of 6.90% plus the debt rate premium of 1.80%. For the contract services division, we should use the same government rate with the restaurant since the assets of this division also have short useful lives. However, the debt rate premium for this division is 1.40%, leading to the interest rate of 8.3%. c. How did you measure the beta for each division?

The beta for each division was measured by calculating the lever beta using an average unlever beta of the proxy firms. First, we chose the companies in the same line of business of each division (lodging and restaurant). Next, we used the equity

beta of those firms to calculate unlever beta. After that, we used total sales of those companies to calculate a weighted average unlever beta of those proxy firms. Finally, we used the average unlever beta to calculate the beta of each division from the formula: Lever beta (L) = x [1+(1-t) D/E]. The proportion of debt and equity was from the market value-target leverage ratios in Table A in page 4. (Please see detailed calculation in attachment 2) 6. What is the cost of capital for Marriott's contract services division? How can you estimate its equity costs without publicly traded comparable companies? The cost of capital for Marriott's contract services division is 7.89%. (Please see detailed calculation in attachment 3) To estimate the equity costs of this division without publicly traded comparable companies, we did the mathematics based on the information we had. Since we had the amount of unlever beta for the hotel as a whole and for the lodging and restaurant divisions, we used this information to solve for the unlever beta of the contract services division. To estimate the amount of beta as correct as possible, we decided to weight the amount of unlever beta we had. Our group decided to use identifiable assets to calculate the ratio for the weighting purpose. The reason is that the company or the division normally uses cost of capital to purchase assets for the operation. Thus, assets should be the best item to weight the unlever beta. After solving the equation for the unlever beta of the contract services division, we used this beta to calculate the lever beta. The process to calculate the cost of capital is the same as what we did for other divisions in question 5c.