Using the CAPM, compute the cost of equity capital for the lodging division at the target leverage ratio for the division. Explain why this is higher than the cost of equity capital if Marriott had a zero-debt policy.

Information from 1987:

There is a lot of information missing, I'll try to fill some important blanks:

Marriots's total debt $2,500 million (59% of total capital)

since debt to capital ratio = total debt / (total equity + debt)

then, we can assume equity = $1,737 million (41% of total capital)

the lodging division's number were a little different:

debt to capital 74%

equity = 26%

cost of debt = 1.1% + long term US securities interest rate (8.95%) = 10.05%

cost of equity = risk free rate + (beta x risk premium) =

cost of equity = 5.46% + (1.11 x 7.92%) = 14.25%

Marriot's Lodging division's WACC = (26% x 14.25%) + (74% x 10.05% x (1 - 42% corporate tax rate) = 3.71% + 4.31% = 8.02%

If Marriot had a zero debt policy, its cost of equity would be lower because the business risk would be lower. The cost of debt is lower because interest payments decrease income taxes. But at the same time, you have to earn enough money to pay your interest obligations on time. That extra pressure to make more money, increases the company's risk. As the company's risk increases, investors will demand higher returns for their investment. That is why T-bills yield the lowest returns, simply because they are a extremely safe investment. As risk increases (more interests = more risks), investors will demand a higher rate of return and cost of equity will increase.  

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