Marriott Corporation - Piazza

B+. 31 – 33. B. 28.5 – 30.5. B-‐. 26 – 28. C+. 23.5 – 25.5. C. 21 – 23. D. 0 – 20.5. F. Mid te rm. 1. Midterm 1 (42 points max). 7. Marriott Corporati...

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TiEYouth  

TiEYouth  

•  Largest Entrepreneurship Conference in the world •  Interact with real entrepreneurs and receive valuable advice •  Learn tricks of the trade in starting your own business

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•  Details   •  Saturday,  May  18  from  2:30-­‐4:45pm   •  Santa  Clara  Conven&on  Center   •  20  &ckets  available  for  $20  each  (usually  $35)   •  Interested?   •  Register  at  h"p://bit.ly/WNTCbp   •  Ques&ons?   •  Contact  Terry  Koh     3

h"p://&econ.org/entrepreneurship/youth  

Bloomberg  Aptitude  Test  

Bloomberg  Aptitude  Test    

Free  2-­‐h  exam  to  assess  an  individual's  aptitude   relevant  to  opportunities  in  business  and  =inance  

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h"p://&econ.org/entrepreneurship/youth  

•  Details   •  Sunday  May  19th  3-­‐5pm  or  Saturday  May  25th   3-­‐5pm   •  Social  Sciences  1  PC  (Room  135)   •  Interested?   •  Register  at  www.takethebat.com  (space  is   limited)   •  Ques&ons?   •  Contact  Jennifer  Pak     5

h"p://about.bloombergins&tute.com/students/  

Midterm  1  

Midterm  1  (42  points  max)  

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Points  

Grade  

41  -­‐  42  

A+  

38.5  –  40.5  

A  

36  –  38  

A-­‐  

33.5  –  35.5  

B+  

31  –  33  

B  

28.5  –  30.5  

B-­‐  

26  –  28  

C+  

Marriott  Corporation  

23.5  –  25.5  

C  

Case  study  

21  –  23  

D  

0  –  20.5  

F  

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1-1

Marrio"  Corpora&on  case  

Marriott  hurdle  rate  

Cost  of  Capital   Week  6  

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•  Cost  of  capital   •  Minimum  expected  return  an  investment  must   offer  to  be  a"rac&ve   •  Opportunity  cost  of  using  capital  for  real  assets   rather  than  financial  assets  of  the  same   systema&c  risk   •  Required  return   •  Hurdle  rate   •  Discount  rate  for  capital  budge&ng  projects  

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Uses  of  the  cost  of  capital   •  Capital  budge&ng  and   valua&on   •  Discount  rate  for   discoun&ng  free  cash   flows  (NPV  calcula&on)  

•  Capital  structure  

Cost  of  capital  

Cost  of  capital  

De=inition  and  synonyms  

•  Pay  bonus  if  return   exceeds  cost  of  capital  

Finding  the  cost  of  capital  

•  Cost  of  capital  associated   with  an  investment   depends  on  its  risk   •  Cost  of  capital  indicates   how  the  market  views  the   risk  of  our  assets  

•  Cost  of  capital  depends   on  the  use  of  capital,   not  its  source  

Cost  of  capital  

•  Return  earned  on  assets   depends  on  the  risk  of   those  assets  

Cost  of  capital  

•  Incen&ve  compensa&on  

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Cost  of  capital  and  risk  

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•  Op&mal/target  capital   structure  minimizes  the   cost  of  capital    

•  Calcula&on  (in  theory)    Real  rate  of  interest   +  Expected  infla&on  premium   =  Nominal  rate  of  interest   +  Risk  premium   =  Cost  of  capital     •  Appropriate  risk  premium  is  hard  to  determine   •  Use  company’s  or  compe&tors’  WACC  instead  

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1-2

Weighted  Average  Cost  of  Capital  (WACC)    

Cost  of  equity  (RE)  

•  Overall  return  the  firm   must  earn  on  its  assets   to  maintain  the  value  of   the  stock   •  Required  return  on  the   firm’s  assets  based  on   the  market’s  percep&on   of  their  risk  

•  =  wERE  +  wDRD(1-­‐TC)  

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•  Required  return  on   equity  

Cost  of  capital  

Cost  of  capital  

•  Cost  of  capital  for  the   firm  as  a  whole  

•  Example   •  Your  company  is  expected  to  pay  a  dividend  of   $1.50  per  share  next  year  and  then  to  increase   dividends  by  5.1%  per  year     •  The  current  stock  price  is  $25   •  RE  =  1.50/25  +  0.051  =  11.1%  

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Cost  of  capital  

D (1+ g) D RE = 0 +g= 1 +g P0 P0

Cost  of  capital  

•  Dividend  growth  model   •  SML  or  CAPM  

Example:  Estimating  the  dividend  growth   rate  using  historical  average  

•  Rearrange  the  DGM  to  solve  for  R  

•  Year  Dividend  Percent  Change   1995  1.23   (1.30–1.23)/ 1.23= 1996  1.30       (1.36–1.30)/ 1.30= 1997  1.36       (1.43–1.36)/ 1.36= 1998  1.43       (1.50–1.43)/ 1.43= 1999  1.50     •  Average  =  (5.7  +  4.6  +  5.1  +  4.9)  /  4  =  5.1%  

5.7% 4.6% 5.1% 4.9%

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•  Advantage   •  Easy  to  understand  and  use   •  Disadvantages   •  Only  applicable  to  companies  currently  paying   dividends   •  Not  applicable  if  dividends  aren’t  growing  at  a   reasonably  constant  rate   •  Extremely  sensi&ve  to  the  es&mated  growth  rate  –   an  increase  in  g  of  1%  point  increases  the  cost  of   equity  by  ≥1%  point   •  Does  not  explicitly  consider  risk  

SML/CAPM  approach  

Cost  of  capital  

Advantages  and  disadvantages  of  DGM  

Cost  of  capital  

•  Two  methods  for   determining  RE  

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The  dividend  growth  model  approach  

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•  Return  required  by   equity  investors  given   the  risk  of  the  cash   flows  from  the  firm  

•  Use  CAPM  to  compute  our  cost  of  equity   •  Risk-­‐free  rate,  Rf   •  Market  risk  premium,  E(RM)  –  Rf   •  Systema&c  risk  of  stock,  βE   •  E(RE)  =  Rf  +  βE(E(RM)  –  Rf)   •  Example   •  Your  company  has  a  β=0.58.  Risk-­‐free  rate  is   6.1%.  Expected  market  risk  premium  is  8.6%   •  RE  =  6.1  +  .58(8.6)  =  11.1%  

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1-3

•  Advantages   •  Explicitly  adjusts  for  systema&c  risk   •  Applicable  to  all  companies,  as  long  as  we  can   compute  beta   •  Disadvantages   •  Have  to  es&mate  the  expected  market  risk   premium,  which  varies  over  &me   •  Have  to  es&mate  beta,  which  varies  over  &me   •  Relying  on  the  past  to  predict  future  

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Example:  Cost  of  equity  

Cost  of  capital  

Cost  of  capital  

Advantages  and  disadvantages  of  SML  

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Cost  of  debt  (RD)  

Example:  Cost  of  debt  

•  Focus  on  cost  of  long-­‐ term  debt  or  bonds   •  Best  es&mated  by  the   YTM  on  the  exis&ng  debt     •  May  also  use  es&mates  of   current  rates  based  on   the  bond  ra&ng  we  expect   when  we  issue  new  debt  

•  The  cost  of  debt  is  not   the  coupon  rate  

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Cost  of  capital  

Cost  of  capital  

•  Required  return  on  the   company’s  debt  

Example:  Cost  of  debt  with  multiple  bonds    

•  Take  weighted   average  of  YTMs  

•  Bond  1   •  BV  =  100   •  P  =  95   •  YTM  =  5%  

•  Weights  equal  to   market  value  of  each   issue  

•  Market  value     =  price  in  $  *  #  of  bonds   outstanding   =  price  as  %  of  par  value  *   current  BV  of  issue  

•  Bond  2   Cost  of  capital  

Cost  of  capital  

•  Our  currently  outstanding  bond  issue  has  25  years   lew  to  maturity   •  Coupon  rate  is  9%,  paid  semiannually   •  Bond  is  currently  selling  for  $908.72   •  Solu&on   •  908.75=(45/R)(1-­‐1/(1+R)50)+1000/(1+R)50   •  R  =  5%   •  RD  =  YTM  =  2*R  =  10%  

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Cost  of  debt  with  multiple  bonds   outstanding  

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•  Suppose  our  company  has  a  beta  of  1.5.  The   market  risk  premium  is  9%  and  the  current  risk-­‐ free  rate  is  6%   •  The  market  believes  our  dividends  will  grow  at  6%   p.a.  and  our  last  dividend  was  $2.  Our  stock  is   currently  selling  for  $15.65.  What  is  our  cost  of   equity?   •  SML:  RE  =  6%  +  1.5(9%)  =  19.5%   •  DGM:  RE  =  [2(1.06)  /  15.65]  +  .06  =  19.55%  

•  BV  =  20   •  P  =  90   •  YTM=10%  

•  Market  values   •  MV1  =  95%  *  100  =  95   •  MV2  =  90%  *  20  =  18   •  Total  MV  =  95  +  18  =  113    

•  Cost  of  debt   RD  =  95/113  *  5%   +            18/113  *  10%     =  5.8%  

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1-4

Cost  of  preferred  stock  

Capital  structure  weights  

•  Preferred  stock  is  a   perpetuity  

•  Example  

Cost  of  capital  

Cost  of  capital  

•  Preferred  stock  generally   pays  a  constant  dividend   every  period  forever   •  RP  =  D  /  P0   •  Your  company  has   preferred  stock  that  has   an  annual  dividend  of  $3.   Current  price  is  $25   •  RP  =  3  /  25  =  12%  

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Debt  and  taxes   •  We  are  concerned  with   awer-­‐tax  cash  flows   •  Interest  expense   reduces  our  tax  liability  

•  Your  MV  of  equity  is  $500  million  and  the  MV  of   debt  is  $475  million   •  V  =  500  million  +  475  million  =  975  million   •  Weights  are  determined  by  how  much  of  each   type  of  financing  we  use   •  wE  =  E/V  =  500  /  975  =  .5128  =  51.28%   •  wD  =  D/V  =  475  /  975  =  .4872  =  48.72%   •  wP  =  P/V  =  0  /  975  =  0%  

Cost  of  capital  

Cost  of  capital  

Example:  Capital  structure  weights  

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•  Dividends  are  not  tax   deduc&ble,  so  the  cost   of  equity  is  unaffected   by  tax  

-­‐  Interest   =  Taxable  income  

Weighted  Average  Cost  of  Capital:   WACC  =  wERE  +  wPRP  +  wDRD(1-­‐TC)  

$400m  of  bonds   $100   -­‐   $100  

EBIT  

$100  

-­‐  Interest  (5%)  

$20  

=  Taxable  income  

$80  

-­‐  Taxes  (25%)  

$25  

-­‐  Taxes  (25%)  

$20  

=  Net  income  

$75  

=  Net  income  

$60  

•  Before-­‐tax  cost  of  debt  is  $20  (=  5%  *  400)   •  Awer-­‐tax  cost  of  debt  is  $20  -­‐  5  =  $15   •  $15/$400  =  3.75%   •  3.75%  =  5%  (1  -­‐  25%)  

Cost  of  capital  

No  debt   EBIT  

Cost  of  capital  

•  Reduced  taxes  reduce  our   cost  of  debt   •  Awer-­‐tax  cost  of  debt     =  RD(1-­‐TC)  

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Example:  after-­‐tax  cost  of  debt  

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•  Nota&on   •  E  =  MV  of  equity  =   #  outstanding  shares  *    price  per  share   •  D  =  MV  of  debt  =     #  outstanding  bonds  *    bond  price   •  V  =  MV  of  the  firm  =  D  +  E   •  Capital  structure  weights   •  wE  =  E/V  =  percent  financed  with  equity   •  wD  =  D/V  =  percent  financed  with  debt  

•  Weights  are   determined  by  how   much  of  each  type  of   financing  we  want  to   use   •  Weights  should  reflect   target  ra&os,  not   current  ones  

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1-5

Example:  WACC  

•  50  million  shares   •  $80  per  share   •  Beta  =  1.15   •  Market  risk  premium  =   9%   •  Risk-­‐free  rate  =  5%  

•  Debt  Informa&on   •  1  million  bonds   outstanding   •  $1,000  face  value   •  Current  quote  =  110   •  Coupon  rate  =  9%,   semiannual  coupons   •  15  years  to  maturity  

•  Tax  rate  =  40%  

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Cost  of  capital  

Cost  of  capital  

•  Equity  Informa&on  

Example:  WACC  

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•  Capital  structure  weights   •  E  =  50  million  (80)  =  4  billion   •  D  =  1  million  *  1,000  *  1.10  =  1.1  billion   •  V  =  4  +  1.1  =  5.1  billion   •  wE  =  E/V  =  4  /  5.1  =  .7843   •  wD  =  D/V  =  1.1  /  5.1  =  .2157   •  WACC   =  .7843  (15.35%)  +  .2157  (4.712%)     =  13.06%  

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Divisional  and  project  costs  of  capital  

Cost  of  capital  

Cost  of  capital  

Example:  WACC  

•  WACC  is  only  appropriate   as  our  discount  rate  for   projects  that  are  the  same   risk  as  the  firm’s  current   opera&ons   •  If  the  project  is  more  or   less  risky  than  the  firm  as   a  whole,  we  need  to   determine  the   appropriate  discount  rate   for  that  project   •  Divisions  also  owen   require  separate   discount  rates  (e.g.,  GE)  

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•  What  would  happen  if  we  use  the  WACC  for  all   projects  regardless  of  risk?   •  WACC  =  15%   •  Project  Required  Return  IRR   •  A  20%  17%   •  B  15%  18%   •  C  10%  12%  

Choosing  the  right  discount  rate  

Cost  of  capital  

Example:  Using  WACC  for  all  projects  

Cost  of  capital  

•  Cost  of  equity   •  RE  =  5  +  1.15(9)  =  15.35%   •  Cost  of  debt   •  1100=(45/R)(1-­‐1/(1+R)30)+1000/(1+R)30   •  R  =  3.9268   •  RD  =  3.927(2)  =  7.854%   •  Awer-­‐tax  cost  of  debt   •  RD(1-­‐TC)  =  7.854(1-­‐.4)  =  4.712%  

•  If  project  has  the  same  riskiness  as  the  firm  overall   and  the  firm  has  traded  stock,  use  the  firm’s  own   WACC   •  Applies  to  any  scale-­‐extending  project   •  Does  not  apply  to  scope-­‐extending  projects   •  Otherwise,  use  (in  descending  order  of  preference)   •  Pure  play  approach   •  Find  relevant,  specialized  compe&tors   •  Use  the  average  of  their  costs  of  debt  and  equity  

•  Subjec&ve  approach   •  Use  your  own  WACC  and  adjust  it  subjec&vely  

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1-6

Pure  play  approach  

Beta  and  leverage  

•  Find  the  equity  beta  for  each   company   •  Unlever  each  beta  to  get  the   asset  beta   •  Take  an  average  of  asset  betas   •  Relever  the  average  asset  beta  

•  Use  that  beta  with  the  CAPM   to  find  the  appropriate  cost   of  equity  for  the  product   •  Difficult  to  find  pure  play   firms  

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Cost  of  capital  

Cost  of  capital  

•  Find  companies  that   specialize  in  the  product  we   are  considering  (pure  plays)  

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•  Unlever  beta  for  each  pure  play  compe&tor   •  Observe  βE  for  each  compe&tor   •  Calculate  βA=  E/V  βE     •  Use  compe&tors‘  actual  capital  structures   •  Take  average  of  asset  betas   •  Relever  average  asset  beta  (calculate  βE)  for  firm’s   or  project’s  financial  risk  (leverage)   •  βE  =  βA  V/E   •  Use  firm’s  (or  division’s)  target  capital  structure     •  Use  βE  in  CAPM  to  get  cost  of  equity  

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Cost  of  capital  

Cost  of  capital  

•  Pure  play  2  

•  Take  average  of  asset   betas  

•  Our  firm  

•  Relever  average  asset   beta  

•  E/Vactual  =  55%   •  E/Vtarget  =  50%  

•  Market  

•  RF  =  2%   •  MRP  =  8%  

•  βA,1=  60%  *  1.2  =  0.72   •  βA,2=  80%  *  1.5  =  1.2  

•  βA  =  (0.72  +1.2)/2  =  0.96   •  βE    =  βA  V/E   •     =  0.96  *  1/50%  =  1.92  

•  Use  βE  in  CAPM  

•  RE  =  2%  +  1.92  *  8%   •     =  17.4%  

V  =  E+D  

Example:  Subjective  approach  

•  Consider  the  project’s  risk   rela&ve  to  the  firm  overall  

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•  Unlever  betas  

•  E/V  =  80%   •  βE  =  1.5  

Subjective  approach  

•  You  may  s&ll  make  wrong   decisions,  but  your  error   rate  should  be  lower  

•  Pure  play  1   •  E/V  =  60%   •  βE  =  1.2  

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•  If  the  project  is  more  risky   than  the  firm,  use  a  discount   rate  greater  than  the  WACC   •  If  the  project  is  less  risky   than  the  firm,  use  a  discount   rate  less  than  the  WACC  

V  =  D  +  E  

Example:  Unlevering  and  relevering  beta  

Cost  of  capital  

Cost  of  capital  

Unlevering  and  relevering  beta  

•  β  increases  in  the  systema&c  components  of  business  risk   and  financial  risk   •  Relevant  pure  plays  have  the  same  business  risk,  but   different  levels  of  financial  risk   •  Need  to  adjust  for  different  financial  leverage   •  Asset  (or  firm)  beta  =  βA  =  βunlevered   •  Reflects  business  risk  of  asset   •  Unaffected  by  capital  structure   •  Beta  of  por{olio  of  debt  and  equity  =  weighted  avg.  of   betas   •  βA=  E/V  βE  +  D/V  βD     •  Assuming  the  debt  is  riskless  (βD=0):     βA=  E/V  βE  

Risk  Level

Discount  Rate

Very  Low  Risk

WACC  –  8%

Low  Risk

WACC  –  3%

Same  Risk  as  Firm

WACC

High  Risk

WACC  +  5%

Very  High  Risk

WACC  +  10%

44

1-7