The major difference between a case analysis and problems we do in class is that compared to the latter that often has “standard” answers, the former generally does not. As such it requires you to make choices on which parameters to choose as the input for your analysis, and can have multiple answers. This is natural because in realities we often face choices. The key to write a good case report is to utilize what you learned in this course to justify your choices. So your grade in the case report will not necessarily depend on whether your answer matches the “correct” one, but more on whether your analysis reflects the thinking and skills that this course is trying to deliver.
In this case, you will use the CAPM model and comparable firms to estimate the weighted average cost of capital (WACC) for a whole company and for each of its divisions. As a starting point, I suggest you to review the PowerPoint lecture slides for Session 4, especially the last example on estimating the WACC for several divisions of a firm. The techniques used in both that example and this case are similar, except that the latter is more complicated and, rather than being directly provided with the inputs needed in your analysis as in the slides example, you will need to find the inputs on your own in the case material.
Your report should clearly show the hurdle rates (another name for WACC, also called required rate of return) that you would recommend for Marriott as a whole, and for each of its three divisions.
You should clearly state your choice of parameters (there are quite a few) in the course of analysis and provide brief justifications. Aside from explaining the underlying reasons for your answer to the questions below (mostly estimation issues), your write-up should also contain a brief discussion about the role that “hurdle rate” plays in Marriott’s financial strategy. In particular, discuss the danger of directly applying the hurdle rate of the firm as a whole to its divisions.
I do not expect you to produce a full business report for this case analysis. Instead, the exercise is meant to capture, through a practical example, some fundamental points that this course tries to deliver. As such, you should limit yourself to produce reports of two to five pages of text. You can include as many exhibits as you need in an appendix (as long as they are referred to in the text).
You should NOT simply attempt to answer these hint questions as all the content of your final report.):
• You may use 34% as the corporate tax rate (applicable during the time of the case).
• Estimation of Equity Beta
o We mentioned in class that we need to use target debt ratio in the estimation of the cost of capital. Given this, did Marriott as a whole reach its target ratio at the time of decision making? If not, what should we do to estimate the equity beta?
o How/where do we get Rb? Note that the case description mentions the credit spread, which is the premium for Marriott debt above the current (riskfree) government rates. In choosing which riskfree rate, Rf, to use, you should note that as we discussed in class, for best practice we should match the maturity of Rf with the expected life of the project. According to the case, is there any difference between the expected life of Marriott and its three divisions?
o What is βb? Should Rb and βb be different for Marriott as a whole and for each of its divisions? Justify.
o For Marriott’s contract service division, there are no data on publicly traded comparable firms. However, the case says that the asset beta for Marriott as a whole equals a weighted average of the asset betas of lodging, restaurant, and contract service. What are reasonable weights to use?
o Feel free to lever/unlever using βb = 0 (although one can do better by estimating a more precise βb).
• Weighted Average Cost of Capital
o Should the risk premium, Rm – Rf, be a spot (i.e., current) rate or a historical average? Should it be a long-term or short-term rate? In other words, should the risk premium be relative to T-bills (maturities of one year or less) or Tbonds (maturities of ten years or longer)? Justify.
o Should 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) government interest rate or the historical average? Justify your answers.
o Should Rm – Rf vary by division?