Reference no: EM13332083 , Length: 1300 Words
Case 1 (Marriott Case) Assignment
Reading:
Read the Case 1 (Marriott Case). 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. Students also learn to calculate betas based on comparable companies and to lever betas to adjust for capital structure.
Risk-free rate and risk-premium
The CAPM is a one-period model. Multi-period applications of the CAPM rely on the assumption that the CAPM holds in each period. And the theoretically correct way to use CAPM is to recompute an expected return in each period, using a different riskless rate, beta, and risk-premium. For many long-tem projects, it is reasonable to assume that beta and risk-premium are stable over the life of the project, and the yield on a long-term riskless bond is used. In this case, the 30-year U.S government interest rate in April 1988) is used to proxy for the riskless rate. And the spread between S& P Composite returns and long-term U.S. government bonds for 1926-1987 period, 7.43%, is used to reflect the risk-premium.
Unlevered Asset Beta and Levered Equity Beta
The following equation shows the relationship between levered-equity beta (ßE) and unlevered asset beta (ßU):
ßE = ßu*[1 + (1-t)(D/E)],
D/E = (D/V)/(E/V) = (D/V)/(1-D/V), V= D+E. Leverage = D/V,
Therefore, ßE = ßU*[1 + (1-t)(D/E)] = ßU*[1 + (1-t)*leverage/(1-leverage)]
Or ßU = ßE / [1 + (1-t)(D/E)].
Where t is the tax rate, D is market value of debt and E is market value of equity. Therefore, firm value = D+E, assuming the firm use only debt and equity to finance its capital.ßU is unlevered beta, also named asset beta. Asset beta is the beta of a debt-free company. It is also called beta of assets.ßE is equity beta, the beta of equity when debt is used.
We use the effective tax rate in 1987 to proxy for the tax rate, which is equal to income taxes in 1987 divided by taxable income in 1987, that is 175.9/398.9 = 0.44 = 44%.
Note that when Marriott's market leverage is 41%, its equity beta is 1.11. Leverage = D/(D+E) = D/V = 0.41, that is D = 0.41V, so E = V - D = 0.59V, D/E = 0.41V/0.59V = 0.69,
So the unlevered beta of Marriott = 1.11/[1 + (1-0.44)*0.69] = 0.80.
Given the unlevered equity beta of Marriot is 0.80, When leverage is 0.60, the levered equity beta = 0.80 * [1 + (1-0.44)*(0.6/0.4)] = 1.47
Then you may apply the CAPM to find out the cost of equity for Marriott under target leverage level of 0.60. The cost of debt for Marriott is equal to Marriott's debt rate premium above government plus 30-year government interest rate = 1.30% + 8.95% = 10.25%. Eventually you will apply the WACC formula to find Marrott's WACC.
When you calculate the cost of capital for Marriott's divisions, note that each division will have different equity beta and cost of debt.
Your write-up should begin with an opening paragraph that synopsizes the case, and answer all the following questions:
Would you invest in Marriott Corporation for the next 1 year? Why or Why not?