2- Should Rf vary by division? Should it be a long-term or short-term rate? Whic

Question

2- 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. ?

Marriott Cost of Capital Step 1. Calculating asset beta for each division as bridge to find levered beta Step 2. Using asset bela for each division, calculating cost of capital Step 3. Calculating WACC 5 yr Avg Tax Rate 6 Tax Rate Levered Equity Bcta Weight of debt Weight of equity DIE Unlevered Asset Bcta Targct Debt Target Equity Target DVE EN hareholders cquity (1987) 810.8 Long term debt (1987) 2498.8 8 Marriott 41% 0.754 0.40 0.24 74% 11 Hiton 12 Holday 13 La Quinta 14 Ramada 15 Average 0.65 028 028 14% 0.163 3.762 Unlevered Asset Beta 0.422 21% 31% Target DIE Lcvered Equity Bcta 0.89 1.72 7 Restaurants 18 Church's 9 Colins 0 Frisch's 1.39 1.31 0.54 0.75 0.72 Unlevered Asset Beta Target DrE Levered Equity Beta 0.04 0.959 10% 0.06 0.01 3.91 0.76 2 McDonalds 23% 24 Average Unlevered Asset Beta Target DIE Levered Equity Beta 1.405 6 Contract Services 7 Average ldentifiable Assets Assets % Unlevered BetaS Beta Assets 0.422 0.255909649 0.959 0.118733559 1.405 0.379481821 0.754 0.754125029 30 2 Contract Services 3 Marriott 567.6 1237.7 4582 7 Lodging Restaurants Contract Services 1.40% 6 Government interest rati 1.10% 1.80% 8 Cost of debt 39 Risk premium equty 40 Unlevered Asset Bela 1 Levered E 12 Cost of equity 43 Target debt value 44 Target equity value 8.70% 676% 0959 10.35% 7 43% 1.405 5.74 44.01% 10.05% 7,43% 0.422 13.91% 74% 26% 58% 6 WACC 8.52% 18.80% 29.14% WACC - (weight of equity) x (cost of equity) +(weight of debt) x (cost of debt) 48

Explanation / Answer

Risk free rate should vary by division. The rate may be long term or short term depending upon the priod of investment. Hence for the lodging division, the long term rate should be used. This is because the investment will mature only in the long term in a lodging division. It is a long term investment and hence is subject to higher risk. The investment in Restaurants and contract services will be recovered in the short term and hence using the short term risk free rates is more suitable.The current Government interest rate is more suitable for determining the risk free rate. Historical average is not appropriate because

1. The period under consideration becomes debatable.

2. It overestimates the cost of equity of business.

3. The current rate is more determinable and clear parameter.

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