Marriott Corporation: The Cost of Capital
(Abridged)
Teaching Note
Substantive Issues
This case provides students with the opportunity to explore how a company uses the capital
asset pricing model (CAPM) to compute the cost of capital for the company and for each of its
divisions. The weighted average cost of capital (WACC) formula and the mechanics of applying it
are stressed.
Pedagogical Objectives
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 betas based on comparable companies and to lever betas to
adjust for capital structure. Students are asked to determine the appropriate riskless rate and market
risk premium. This case also encourages students to focus on the choice of time period to estimate
expected returns.
In addition to the cost of capital issues, the case presents an integrated financial system that
relies on the CAPM and modern financial economics. Marriott’s financial strategy emphasizes share
repurchases, hotel syndications, and the aggressive use of debt financing. Each of these strategic
components is consistent so that the strategy can be pursued coherently.
This case is a shorten version of “Marriott Corporation: the Cost of Capital,” HBS No. 298-
101. The unabridged case deals with the choice of arithmetic on geometric averaged for estimating
the expected return on the market. The unabridged version also uses equity betas estimated from
daily data instead of the monthly data that is used in the abridged version.
Opportunities for Student Analysis
Overview Before focusing on computing the cost of capital for Marriott and each of its divisions,
it is worthwhile to examine the central role that the hurdle rate plays in Marriott’s financial strategy.
Marriott is committed to using excess funds to repurchase stock. Since an alternative to any physical
investment is a share repurchase, it is natural for Marriott to use external market-based hurdle rates
as a measure of the opportunity cost of funds.
1
,298-081 Marriott Corporation: The Cost of Capital (Abridged)
Syndication is a key control device for the whole capital budgeting system. Marriott builds
hotels and sells them off in partnerships, maintaining its role as the general partner and hotel
operator. Marriott invests $1 billion in assets each year, and sells off about $1 billion in assets each
year in syndications. Projects face a quicker market test than in the typical industrial firm. Since the
process turns over quickly—one or two years—valuation errors appear quickly. The partnership
syndication market is the important capital market for Marriott. And Marriott’s experience is that
projects with zero NPV just break even at syndication—which gives the corporation great confidence
in the cash flow and discount rate systems.
Students may question the overall efficiency of the syndication market and the information
content of its prices. The syndication market is essentially a private market. It may be less efficient
than a public equity market because of limited information and marketability, and high transaction
costs. As such, the syndication market test may be a poor test of the market value of hotels.
However, as long as Marriott can sell its developed properties in the syndication market, it can
capture some of the benefits of any mispricing that occurs. While the mispricing benefits
shareholders, it could mislead Marriott about the reliability of its capital budgeting system. Since
Marriott holds the assets before syndication, inefficiencies and instability in the syndication market
can have a large impact on Marriott.
One way to show the importance of the hurdle rate is to examine the effect of an error of a
few percentage points on the profitability of Marriott. Figure A in the case shows that a typical hotel
breaks even at about a 10% hurdle rate. At a 12% hurdle rate, Marriott loses 15% of its investment. If
Marriott used a 10% hurdle rate when the actual hurdle rate was 12%, it would lose 15% of its $1
billion in annual development, or $150 million. In contrast, if the rate were actually 8%, Marriott
would enjoy unanticipated gains of about $250 million.
In summary, errors in the hurdle rate can lead to incorrect decisions about the type and
amount of investment, trigger or fail to trigger repurchases, and affect incentive compensation.
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 the calculation of the
cost of capital for Marriott as a whole.
Marriott measured the opportunity cost of capital for investments using the weighted
average cost of capital (WACC) as
WACC = (1 − t)R D (D/V) + R E (E/V)
where D and E are the market value of the debt and equity, R D is the pre-tax cost of debt, R E is the
after-tax cost of equity, V is the value of the firm (V = D+E), and τ is the corporate tax rate. Equity
rates are determined by the CAPM. Therefore, computing the cost of capital using the CAPM and
WACC requires information on the amount of debt, the cost of debt, and the cost of equity.
The cost and amount of debt Information on the amount and cost of debt is given in Table A.
Focusing on Marriott as a whole, the target capital structure is 60% debt, and this debt costs 1.30%
above long-term U.S. government bonds. The 30-year fixed U.S. government rate was 8.95% (Table
B), so the debt cost for Marriott was 10.25%.
The cost of equity According to the CAPM, the cost of equity, or equivalently, the expected return
for equity, is determined as
Expected return = r = riskless rate + beta X [risk premium]
2
, Marriott Corporation: The Cost of Capital (Abridged) 298-081
where the risk premium is the difference between the expected return on the market portfolio and the
riskless rate. To compute the expected return, three inputs are needed: beta, the riskless rate, and the
risk premium.
Unlevered asset beta The levered equity beta of 1.11 reported in Exhibit 3 could be used in the
CAPM to determine the cost of equity for Marriott if the target debt ratio matched the actual debt
ratio. Based on data in Exhibit 1, the value of long-term debt was $2,499 in 1987 and the equity value
was $3,564. The actual debt ratio is 41%, which is substantially below the 60% target. The beta has to
be adjusted for the difference between the actual and target debt ratio by unlevering the beta to get
an unlevered asset beta and levering it at the target debt rate.
The formula for unlevering betas is derived by noting that
V=D+E
The returns to the assets of the firm are simply a weighted average of the returns to debt and
equity:
R A= R D(D/V) + R E(E/V)
The asset beta is found by computing the covariance of RA and R M and dividing by the
variance of the market.
Asset beta= cov(RA,RM )/var(RM )
= cov( R D(D/V) + R E(E/V),RM )/var(R M )
= (D/V)βD + (E/V) βE
Assuming that the debt is riskless with a beta of zero, the equation for asset beta simplifies to
βA= asset beta = (E/V) βE
The unlevered asset beta of Marriott should be based on the actual market value leverage
ratio—not on the target ratio. The E/V ratio for unlevering the levered equity beta is 59%:
βM
A = (E/V) βEM
= .59 X 1.11
= .65
After determining the asset beta, the next step is to calculate the levered equity beta
consistent with Marriott’s target of 60% debt financing (Table A). The formula used to calculate the
asset beta is inverted to compute an equity beta from an asset beta:
βEM = (V/E) βM
V
= 2.50 X .65
= 1.63
3
(Abridged)
Teaching Note
Substantive Issues
This case provides students with the opportunity to explore how a company uses the capital
asset pricing model (CAPM) to compute the cost of capital for the company and for each of its
divisions. The weighted average cost of capital (WACC) formula and the mechanics of applying it
are stressed.
Pedagogical Objectives
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 betas based on comparable companies and to lever betas to
adjust for capital structure. Students are asked to determine the appropriate riskless rate and market
risk premium. This case also encourages students to focus on the choice of time period to estimate
expected returns.
In addition to the cost of capital issues, the case presents an integrated financial system that
relies on the CAPM and modern financial economics. Marriott’s financial strategy emphasizes share
repurchases, hotel syndications, and the aggressive use of debt financing. Each of these strategic
components is consistent so that the strategy can be pursued coherently.
This case is a shorten version of “Marriott Corporation: the Cost of Capital,” HBS No. 298-
101. The unabridged case deals with the choice of arithmetic on geometric averaged for estimating
the expected return on the market. The unabridged version also uses equity betas estimated from
daily data instead of the monthly data that is used in the abridged version.
Opportunities for Student Analysis
Overview Before focusing on computing the cost of capital for Marriott and each of its divisions,
it is worthwhile to examine the central role that the hurdle rate plays in Marriott’s financial strategy.
Marriott is committed to using excess funds to repurchase stock. Since an alternative to any physical
investment is a share repurchase, it is natural for Marriott to use external market-based hurdle rates
as a measure of the opportunity cost of funds.
1
,298-081 Marriott Corporation: The Cost of Capital (Abridged)
Syndication is a key control device for the whole capital budgeting system. Marriott builds
hotels and sells them off in partnerships, maintaining its role as the general partner and hotel
operator. Marriott invests $1 billion in assets each year, and sells off about $1 billion in assets each
year in syndications. Projects face a quicker market test than in the typical industrial firm. Since the
process turns over quickly—one or two years—valuation errors appear quickly. The partnership
syndication market is the important capital market for Marriott. And Marriott’s experience is that
projects with zero NPV just break even at syndication—which gives the corporation great confidence
in the cash flow and discount rate systems.
Students may question the overall efficiency of the syndication market and the information
content of its prices. The syndication market is essentially a private market. It may be less efficient
than a public equity market because of limited information and marketability, and high transaction
costs. As such, the syndication market test may be a poor test of the market value of hotels.
However, as long as Marriott can sell its developed properties in the syndication market, it can
capture some of the benefits of any mispricing that occurs. While the mispricing benefits
shareholders, it could mislead Marriott about the reliability of its capital budgeting system. Since
Marriott holds the assets before syndication, inefficiencies and instability in the syndication market
can have a large impact on Marriott.
One way to show the importance of the hurdle rate is to examine the effect of an error of a
few percentage points on the profitability of Marriott. Figure A in the case shows that a typical hotel
breaks even at about a 10% hurdle rate. At a 12% hurdle rate, Marriott loses 15% of its investment. If
Marriott used a 10% hurdle rate when the actual hurdle rate was 12%, it would lose 15% of its $1
billion in annual development, or $150 million. In contrast, if the rate were actually 8%, Marriott
would enjoy unanticipated gains of about $250 million.
In summary, errors in the hurdle rate can lead to incorrect decisions about the type and
amount of investment, trigger or fail to trigger repurchases, and affect incentive compensation.
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 the calculation of the
cost of capital for Marriott as a whole.
Marriott measured the opportunity cost of capital for investments using the weighted
average cost of capital (WACC) as
WACC = (1 − t)R D (D/V) + R E (E/V)
where D and E are the market value of the debt and equity, R D is the pre-tax cost of debt, R E is the
after-tax cost of equity, V is the value of the firm (V = D+E), and τ is the corporate tax rate. Equity
rates are determined by the CAPM. Therefore, computing the cost of capital using the CAPM and
WACC requires information on the amount of debt, the cost of debt, and the cost of equity.
The cost and amount of debt Information on the amount and cost of debt is given in Table A.
Focusing on Marriott as a whole, the target capital structure is 60% debt, and this debt costs 1.30%
above long-term U.S. government bonds. The 30-year fixed U.S. government rate was 8.95% (Table
B), so the debt cost for Marriott was 10.25%.
The cost of equity According to the CAPM, the cost of equity, or equivalently, the expected return
for equity, is determined as
Expected return = r = riskless rate + beta X [risk premium]
2
, Marriott Corporation: The Cost of Capital (Abridged) 298-081
where the risk premium is the difference between the expected return on the market portfolio and the
riskless rate. To compute the expected return, three inputs are needed: beta, the riskless rate, and the
risk premium.
Unlevered asset beta The levered equity beta of 1.11 reported in Exhibit 3 could be used in the
CAPM to determine the cost of equity for Marriott if the target debt ratio matched the actual debt
ratio. Based on data in Exhibit 1, the value of long-term debt was $2,499 in 1987 and the equity value
was $3,564. The actual debt ratio is 41%, which is substantially below the 60% target. The beta has to
be adjusted for the difference between the actual and target debt ratio by unlevering the beta to get
an unlevered asset beta and levering it at the target debt rate.
The formula for unlevering betas is derived by noting that
V=D+E
The returns to the assets of the firm are simply a weighted average of the returns to debt and
equity:
R A= R D(D/V) + R E(E/V)
The asset beta is found by computing the covariance of RA and R M and dividing by the
variance of the market.
Asset beta= cov(RA,RM )/var(RM )
= cov( R D(D/V) + R E(E/V),RM )/var(R M )
= (D/V)βD + (E/V) βE
Assuming that the debt is riskless with a beta of zero, the equation for asset beta simplifies to
βA= asset beta = (E/V) βE
The unlevered asset beta of Marriott should be based on the actual market value leverage
ratio—not on the target ratio. The E/V ratio for unlevering the levered equity beta is 59%:
βM
A = (E/V) βEM
= .59 X 1.11
= .65
After determining the asset beta, the next step is to calculate the levered equity beta
consistent with Marriott’s target of 60% debt financing (Table A). The formula used to calculate the
asset beta is inverted to compute an equity beta from an asset beta:
βEM = (V/E) βM
V
= 2.50 X .65
= 1.63
3
