Objective: 1) Calculate the divisional and the company cost of capital and explain the calculation. 2) Evaluate Marriott's use of company cost-of-capital rate for the individual divisions. Cost of Capital for Lodging Division can be expressed as CC = We*Ce + Wd*Cd.
For the weights of debt and equity (We and Wd), the 1988 target-schedule rates of debt-to-assets and debt-to-equity were used as the only measures available in the case.
Cost of Equity (Ce) was calculated based on the CAPM formula. 30-year T-bond was used as a long-term risk-free security to get the risk-free rate, since Marriott used the cost of long-term debt for its lodging cost-of-capital calculations. The market premium 8.47 was the arithmetic-average spread between the S&P 500 returns and the short-term US T-bills between 1926-1987. This market premium is consistent with the current academic suggestions and it was used in all calculations of this exercise.
The leveraged Beta (Bl) of the lodging division, needed for CAPM, was derived from the following equation: Bl=Bu(1+D/E), where Bu is the unleveraged Beta. Bu was in turn derived from the weighted-average of the Bu's of the lodging businesses given in the case. The weighted-average method rather than a simple arithmetic-average method was used to allow a more accurate Bu of the overall industry.
Cost of Debt (Cd) is defined as (risk-free rate)+the premium (Table A of the case). Once again, the 30 T-bond rate was used for the risk-free rate. Cost of Capital for Lodging is 13.24%.
The WA Bu of today's lodging industry is slightly higher than that in 1987, indicating a slight increase in the business risk associated with the industry.
Cost of Capital for Restaurant Division was calculated in the same manner. The 1-year T-bill was used as a usual shorter-term security to obtain the risk-free rate. The unleveraged Beta, used to obtain the leveraged Beta for the CAPM, was once again the weighed-average of the unleveraged B's of the restaurant industry representatives given in the case. However, the restaurants given for the calculation were mostly fast-food chains while Marriott operates rather middle-level restaurants. Today's WA Bu of the middle-class and upper-class restaurants appeared to be slightly higher indicating that the overall cost of capital for Marriott's restaurant division should be slightly higher. The cost of capital for the restaurant division is 14.85%.
Cost of Capital for Contracting Services Division was also calculated through the above methods. However, the unleveraged Beta could not be calculated in the same way as for the two other divisions due to the absence of the comparable businesses from which the unleveraged Betas (Bu) could be obtained. Consequently, the Bu was back-factored from the relationship between the divisional Bu's (or Buc - contracting, Bul - lodging, and Bur - restaunrants ) and the company Bu (or Bum - Marriott) expressed in the following formula:
Bum = Wl*Bul + Wr*Bur + Wc*Buc
where W's are the respective weight factors of each divisional Bu. The Bu is by definition a measure of risk associated with equity alone. The company equity can be viewed as a portfolio in which the divisional equities are individual investments. The contribution of each investment's Beta to the portfolio Beta is based on the portion of that investment in the whole portfolio which in this case is the portion of a divisional equity in the company equity (Ed/Ec).
The cost of capital for the contract services is 14.29%.
Marriott's WACC is 13.73%. It is the weighted average of the cost of company debt and the cost of company equity - which is mathematically the same as the weighted-average of the divisional costs of capital weighted based on net identifiable assets.
Marriott's WACC can be used to discount the multi-divisional projects that are impossible to evaluate by discounting their divisional components separately. However, the divisional WACC should be used for divisional projects. If the company WACC is used to discount divisional projects, both Restaurant and Contracting divisions may accept projects with returns below their WACC, thus resulting in losses; while the lodging division will use a higher-than-divisional WACC rate to discount its projects thus rejecting profitable projects and hampering its growth.