DUKE UNIVERSITYFuqua School of Business

FINANCE 251F/351Hint Sheet: Marriott Corporation

Prof. Simon Gervais Spring 2010 – Term 1

In this case, you will use the CAPM model to compute the cost of capital for a whole companyand for each of its divisions. To properly use WACC as a measure for the overall cost of capital,you need to consider the following issues.

• You may use 34% as the corporate tax rate (after the 1986 Tax Reform Act).

• CAPM.

◦ Market risk premium (rm − rf ):

– Which estimate of rm should we use? Justify.

– Should the rf be a historical average or a spot (i.e., current) rate? Should it be along-term or short-term rate? In other words, should the risk premium be relativeto T-bills (maturities of one year or less) or T-bonds (maturities of ten years orlonger)? Justify.

– Should the market risk premium vary by division?

◦ Leading rf (i.e., riskfree part of CAPM formula):

– Marriott’s restaurant and contract service divisions can be thought of as havingproject lives of around ten years, its lodging division and Marriott as a whole havelonger economic lives.

– Should the leading rf vary by division? Should it be a long-term or short-term rate?Which is the more appropriate riskfree rate to use, the current (spot) governmentinterest rate or the historical average? Justify your choices.

– Does your answer (between short-term and long-term) depend on whether the higherreturn on the long-term government rate can be attributed to liquidity vs. risk?

• Weighted average cost of capital.

◦ There are three measures of D/V for Marriott available in this case: 58.8% in Exhibit 1,41% in Exhibit 3, and 60% in Table A. Which is the correct one to use and why?

◦ How/where do we get rD? Should the riskfree part be affected by maturity? What isβD (if we want to do the analysis in betas, as is often done in practice)? Should rD andβD be different for Marriott as a whole and for each of its divisions? Justify.

◦ Cost of equity or equity betas.

– The equity beta values in Exhibit 3 are based on the capital structure in place in1987.

– How would you proceed to estimate the equity beta for Marriott as a whole, and foreach of its divisions? How are the comparable firms used? Which are used? Howare they weighted?

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– For Marriott’s contract service division, there are no data on publicly traded com-parable firms. However, the case says that the asset beta for Marriott as a wholeequals a weighted average of the asset betas of lodging, restaurant, and contractservice. What are reasonable weights to use?

– Feel free to lever/unlever using βD = 0 (although one can do better for Marriott asa whole).

• Assume that the credit spread (the premium for Marriott debt above the current governmentrates) already reflects any adjustment for the presence of floating rate debt, i.e., don’t worrytoo much about the presence of floating rate debt in your report (although we may talk aboutit in class).

• Your report should clearly show the hurdle rates that you would recommend for Marriott asa whole, and for each of its three divisions.

• You should clearly state your choice of parameters (there are quite a few) in the course ofanalysis and provide brief justification. Aside from explaining the underlying reasons for youranswer to the above questions (mostly estimation issues), your write-up should also containa brief discussion about the role that “hurdle rate” plays in Marriott’s financial strategy.

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