🏨 Case Study: Marriott Corporation - The Cost of Capital
📋 Case Overview
| Attribute | Detail |
|---|---|
| Company | Marriott Corporation |
| Founded | 1927 |
| Key People | J.W. Marriott, Jr., Dan Cohrs (VP of Project Finance) |
| Theme | Hurdle rates, divisional cost of capital, capital structure optimization |
| Outcome | Established the standard academic and practitioner approach to calculating WACC for multi-divisional firms. |
📖 Background
In 1988, Marriott Corporation was a rapidly growing hospitality empire comprised of three distinct divisions:
- Lodging (Hotels): Capital intensive, heavy real estate.
- Contract Services: Providing food/services to schools and hospitals; asset-light, stable cash flows.
- Restaurants: Fast-food chains and family dining; highly competitive, economically sensitive.
Historically, corporations used a single, company-wide Weighted Average Cost of Capital (WACC) to evaluate all potential projects. However, Dan Cohrs, Marriott’s VP of Project Finance, realized that using a single “hurdle rate” was fundamentally flawed. It punished low-risk projects (which were rejected because they couldn’t beat the artificially high company WACC) and rewarded high-risk projects (which were accepted easily but didn’t adequately compensate for their specific risk). Marriott needed a sophisticated methodology to calculate a distinct cost of capital for each division.
🎯 Central Problems
1. The Divisional Hurdle Rate Problem
How do you calculate a discrete WACC for a division that is not public? Because Contract Services doesn’t trade on the stock market, you cannot simply look up its stock beta on Bloomberg.
2. Unlevering and Relevering Beta
Different divisions can support different levels of debt. Lodging has hard real estate assets and can support 74% debt. Contract services has no hard collateral and can only support 40% debt. The financial challenge was stripping the effect of debt out of comparable companies, and reapplying Marriott’s targeted debt capacity.
3. The Risk-Free Rate Selection
Should the company use a short-term Treasury bill or a long-term Treasury bond as the risk-free rate when calculating the Cost of Equity via the Capital Asset Pricing Model (CAPM)?
🔬 Strategic Analysis
Framework Application 1: WACC Calculation Methodology
Marriott’s methodology became the gold standard for project finance:
| Step | Action | Business Logic |
|---|---|---|
| 1. Identify Comps | Find pure-play public companies that operate only in the specific division’s industry (e.g., Hilton for Lodging, McDonald’s for Restaurants). | You must use market proxy data since the division has no standalone stock price. |
| 2. Unlever Beta | Calculate the unlevered beta (asset beta) for all comps using the formula: . | This strips away the financial risk (leverage) of the peers, leaving only the pure business risk. |
| 3. Average & Relever | Take the average unlevered beta of the comps, and relever it using Marriott’s target debt capacity for that specific division. | Reattaches Marriott’s unique financial structure to the industry’s base business risk. |
| 4. Apply CAPM | Plug the new divisional beta into CAPM. | Yields the precise Cost of Equity for that division. |
Framework Application 2: Capital Structure Optimization
Marriott strategically mismatched its debt to its assets. They utilized massive amounts of cheap debt to build hotels, but then pursued an “originate-and-sell” model where they sold the real estate to investors and kept the lucrative, high-margin management contracts.
📈 Key Metrics (Marriott 1988)
| Metric | Lodging | Contract Services | Restaurants | Corporate |
|---|---|---|---|---|
| Target Debt Ratio (D/V) | 74% | 40% | 42% | 60% |
| Estimated Division Beta | ~1.15 | ~0.75 | ~1.05 | ~1.11 |
| Final WACC | ~8.5-9.0% | ~10-10.5% | ~10.5-11% | ~9.5% |
(Note: Data variations exist based on risk premium assumptions used by students).
📝 Key Lessons
- Risk Dictates the Hurdle Rate: Never use a corporate-wide WACC for a multi-business firm. Low-risk divisions will stagnate, and high-risk divisions will consume all capital and destroy value.
- Debt Capacity is Derived from Asset Quality: The Lodging division could safely target 74% leverage because physical real estate provides collateral and stable cash flows. Restaurants cannot support that leverage.
- Pure-Play Comparables are Essential: Finding the true cost of equity requires stripping the leverage out of fundamentally similar public peers to isolate the pure business risk.
- Match Debt Duration to Asset Life: Marriott matched short-term corporate debt with short-term projects, and 10-30 year long-term Treasury rates against long-lived hotel assets.
- WACC is an Estimate, Not a Fact: Small shifts in the assumed Equity Risk Premium (ERP) or the chosen risk-free rate drastically alter the WACC. Valuation requires judgment, not just algebraic precision.
❓ Discussion Questions
- If Marriott’s corporate overall WACC is 9.5%, and the Lodging division evaluates a project at 9.0%, why is it a massive strategic error to reject it for “failing to beat the corporate average”?
- Should Marriott use a 1-year Treasury rate, a 10-year Treasury rate, or a 30-year Treasury rate as the risk-free rate () in the CAPM formula? Why?
- Why is it necessary to use the targeted future capital structure (debt-to-equity ratio) rather than the company’s historical or current capital structure when calculating WACC?
- How do you measure the cost of debt () for a division when the division doesn’t issue its own bonds to the public market?
- The “originate-and-sell” hotel strategy is highly lucrative. How does this strategy impact Marriott’s beta and overall risk profile over time?
🔗 Connected Concepts
- WACC: The absolute focal point of the case—learning how to synthesize debt and equity costs to find a minimum hurdle rate.
- CAPM: The Capital Asset Pricing Model used to calculate the Cost of Equity () for the various divisions.
- Beta and Systematic Risk: Explains why the restaurant division and the lodging division have inherently different sensitivities to macroeconomic shocks.
- Capital Structure: Driven by the realization that different assets dictate entirely different theoretical debt capacities.
- DCF Valuation: WACC is the denominator required to discount the future cash flows of Marriott’s new hotel projects.
- Comparable Company Analysis: The technique used to identify pure-play competitors to extract proxy beta numbers.
- Risk-Free Rate: A core debate in the case regarding which duration of government bonds correctly anchors the CAPM equation.
- Agency Theory: The underlying reason a division manager might advocate using the “wrong” WACC if it helps their specific bonus structure.