Solutions to Case Study “Marriott Corporation: Cost of Capital”

Marriott Corporation: The Cost of Capital

Key Profile of the company

• Marriott’s operation was focused in three main business streams: Lodging, Restaurants and Contract Services. In terms of sales turnover, contract services division had the highest contribution into the company’s overall sales performance in 1987 (46%), followed by lodging (41%) and restaurant divisions (13%). In terms of profit generation, lodging services accounted for 51% of company’s total profit comparing to 33% and 16% generated by contract services and restaurant services.

• The company had been remaining high growth rate (sales growth rate was 24% in 1987 and EPS doubled for the past 4 years). The operating strategy was to remain premier growth company, focusing on 3 business lines.

• Divisional hurdle rate was significant to the company. If the hurdle rate increases by 1%, the present value of project inflow will decrease by 1%.

• Marriott’s financial strategy included: managing rather than own hotel assets, investing in projects that increase shareholder value, optimizing the use of debt in the capital structure and repurchasing undervalued shares.

• Marriott’s unsecured debt was A-rated in April 1988.

• The spread between the debt rate above the government bond rate was different in each division. Marriott used long term debt for lodging because hotel had long useful lives and it used short term debt as the cost of debt for its restaurant and contract services divisions as those assets had shorter useful lives.

• Marriott used CAPM to estimate cost of equity

Overall Assumptions

• Risk free rate

For risk free rate, we would consider the following two possibilities: either to use Treasury bill yield in 1987 or 1-year government interest rates as at April 1988. The comparison of those indicators in terms of riskiness is given in the below table.

Risk Treasury Bill Yield (1987) @ 5.46% 1-yr Government Interest rate (April 1988) @6.90%...