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Cost of capital for the lodging and restaurant divisions

In April 1988, the vice president of project finance at the Hilton Corporation , Christopher Nassetta, was preparing recommendations for discount rates that should be used to evaluate each of the firm's three divisions. Hilton had three major lines of business: lodging (61% of total assets), contract services (27%), and restaurants (12%). The target leverage ratio is 74% for lodging, 40% for contract services, and 42% for restaurants. The target leverage ratio for the Hilton Corporation is 60%. Hilton's existing leverage ratio is 41%. Hilton's beta, calculated using daily returns from 1986 and 1987, was 0.97.

Hilton's current debts are high-quality. Therefore there is only a small spread above the current government bond rates. But since each division has its own risk, each division pays a different premium above government bonds rates. The spreads for Hilton as a whole and for each of the three divisions (lodging, contract services, and restaurants) respectively are: 1.3%, 1.1%, 1.4% and 1.8%. Note that Hilton uses long-term debt for its lodging business (since lodging assets such as hotels had long asset lives) and shorter-term debt for its restaurant and contract services division.

The government interest rates in April 1988 were 8.95% for a 30-year bond and 8.72% for a 10-year bond. The historical market risk premium measured by the difference between S&P 500 and long-term government bond is 7.43%. There are some comparable companies in the lodging and restaurant businesses that have similar business risks as the divisions of Hilton. Dan found that the equity beta of Marriott Hotels and that of Holiday Corp are respectively .88 and 1.46. The market leverage of Marriott and that of Holiday are respectively 14% and 79%. The two companies have similar market capitalizations. There are two restaurant chains that operate similarly to Hilton's restaurant division: McDonald's and Wendy's. The equity betas of the two restaurants are respectively: 1 and 1.08. The market leverages of the two restaurants are: 23% and 21%. McDonalds' market share is about four times of Wendy's. Currently Hilton's marginal tax rate is 34%.

Questions:

1. What is the overall weighted cost of capital for the Hilton Corporation?

A. What risk-free rate did you use to calculate the cost of equity?

B. Be careful to distinguish between actual debt/value ratios and target debt/value ratios, and decide which one to use in the weight cost of capital calculations. Be careful to lever or unlever your equity beta appropriately.

(To keep it simple, ignore debt and taxes for the purpose of levering and unlevering beta. Use the formula: Beta Assets = ( (Equity) / (Debt + Equity) x Beta Equity)

2. What is the cost of capital for the lodging and restaurant divisions of Hilton?

A. What risk-free rate did you use in calculating the cost of equity for each division?

B. How did you measure the beta of each division?

3. What is the cost of capital for Hilton's contract services division? How can you estimate its equity costs without publicly traded comparable companies?

4. If Hilton used a single single corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time?

Solution Preview

In April 1988, the vice president of project finance at the Hilton Corporation , Christopher Nassetta, was preparing recommendations for discount rates that should be used to evaluate each of the firm's three divisions. Hilton had three major lines of business: lodging (61% of total assets), contract services (27%), and restaurants (12%). The target leverage ratio is 74% for lodging, 40% for contract services, and 42% for restaurants. The target leverage ratio for the Hilton Corporation is 60%. Hilton's existing leverage ratio is 41%. Hilton's beta, calculated using daily returns from 1986 and 1987, was 0.97.

Hilton's current debts are high-quality. Therefore there is only a small spread above the current government bond rates. But since each division has its own risk, each division pays a different premium above government bonds rates. The spreads for Hilton as a whole and for each of the three divisions (lodging, contract services, and restaurants) respectively are: 1.3%, 1.1%, 1.4% and 1.8%. Note that Hilton uses long-term debt for its lodging business (since lodging assets such as hotels had long asset lives) and shorter-term debt for its restaurant and contract services division.

The government interest rates in April 1988 were 8.95% for a 30-year bond and 8.72% for a 10-year bond. The historical market risk premium measured by the difference between S&P 500 and long-term government bond is 7.43%. There are some comparable companies in the lodging and restaurant businesses that have similar business risks as the divisions of Hilton. Dan found that the equity beta of Marriott Hotels and that of Holiday Corp are respectively .88 and 1.46. The market leverage of Marriott and that of Holiday are respectively 14% and 79%. ...

Solution Summary

Solution provides assistance in computing cost of capital for the lodging and restaurant divisions of Hilton

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