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The Cost of Capital

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Essay title: The Cost of Capital

Case Questions

Case #5 – Marriott Corporation: The Cost of Capital

1. Are the four components of Marriott’s financial strategy consistent with its growth objective?

2. How does Marriott use its estimate of its cost of capital? Does this make sense?

3. What is the weighted average cost of capital for Marriott Corporation?

a. What risk free rate and risk premium did you use to calculate the cost of equity?

b. How did you measure Marriott’s cost of debt?

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?

5. What is the cost of capital for the lodging and restaurant divisions of Marriott?

a. What risk free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers?

b. How did you measure the cost of debt for each division? Should the debt cost differ across divisions? Why?

c. How did you measure the beta of each division?

Case Hints and Suggestions

The primary objective of this case is to show students how the CAPM is used to compute the cost of capital. Students learn to calculate beta based on comparable companies and to lever betas to adjust for capital structure. Students are asked to determine the appropriate risk-less rate and market risk premium. This case also encourages students to focus on the choice of time period to estimate expected returns and the difference between the geometric and the arithmetic average as a measure of expected returns.

The cost of capital for Marriott as a whole

The case provides an ideal opportunity to review the capital asset pricing model and the weighted average cost of capital through calculation of the cost of capital for Marriott as a whole.

To calculate the WACC you will need information on the cost and amount of debt and the cost and amount of equity. Information on the amount and cost of debt is given in Table A. You will need to now the cost above the long-term U.S. government bonds and the rate on 30-fixed government bonds from Table B. You will need to use the CAPM to calculate the cost of equity. It is important to realize that Marriott’s current capital structure is 41% debt, but their target capital structure is 60% debt. So, you need to realize that the current Beta is based upon 41% debt. You must “unlever” this Beta. Then use the unlevered Beta with the 60% debt ratio to calculate a new-levered Beta that reflects the target capital structure. Please see “Leveraged Betas and the Cost of Equity” and/or your class notes for help with this. Besides the beta you will need several other variables to use the CAPM.

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