Wacc

The calculation of WACC

Dan Chors has to prepare his annual recommendations for the costs of capital of the three divisions and the whole company. The most common method of getting a company’s cost of capital is to calculate its weighted average cost of capital. This method can also be used to calculate the cost of capital for specific project or division.

The WACC can be expressed as the following expressions:

WACC=1-t*rD*DV+rE*EV (1)

Where D and E are the market value of the debt and equity, respectively. rD is the cost of debt, rE is the after-tax cost of equity, and t is the corporate tax rate.

rD can be calculated by adding a debt rate premium to an appropriate government rate.

rE can be calculated through Capital Asset Pricing Model (CAPM). According to CAPM:

rE=riskless rate+β*risk premium (2)

where β is the equity beta, and the risk premium is the difference between the expected return on the market portfolio and the riskless rate.

When we want to get a division’s beta, we need to adjust the beta from a comparable company for the company’s leverage (unlever it) and adjust it (re-lever it) based on the financial structure of the company evaluating the division. This method can be described by the following expressions:

βu=β*11+(1-t)DE (3)

βd=βu*1+(1-t)DE (4)

Where βu is the unlevered beta, and βd is the division’s beta.

1. The whole company’s WACC.

According to the information in the case, the β is 1.1 when the market leverage is 49% (D/V).

The tax rate in 1987 is 175.9/398.9=0.44

βu =1.1/[1+(1-0.44)*0.49/0.51]=o.715

The target debt-to- equity ratio is 0.6/0.4=1.5.

βd =0.715*(1+0.56*1.5)=1.32

Now we use this new beta to calculate the WACC of Marriot as a whole. When calculating the cost of equity, we use the risk-free rate that is equal to 10-year US Government bond rate, which is 8.72%. Besides, we set the market premium as the difference between the S&P 500 and the long-term US Government bond rate, which is given as...