Teletech has two business segments, Telecommunications Services and Products and Systems unit, for the last couple of months senior management at Teletech Corporation had been discussing returns. However, only until they received the letter from Victor Yossarian did they decide to spin into action and review the company’s returns, the hurdle rate that was being used company wise and not by business segments, the annual capital budget situation, the review of new possible policies, and finally they needed to do a concrete assessment of the Products and Systems segment to know if it was profitable on its own.
This situation becomes even more critical when taking in consideration that the company plans to invest about $2 Billion in the next year on capital projects. Top management set up the hurdle rate at 9.30%, this rate is applied to all capital projects and it is use in the evaluation of the business units. Exhibit A breaks downs a partial financial status of each business segment; according to top management the firms prospective Return on Capital should be 9.58%.
| Telecommunications Service| Products and Systems|
ROC| 9.10%| 11.0%|
Book Value| $11.4 Billion| $4.6 Billion|
Market Value| 75%| 25%|
Growth| Revenue grew 3% in last 4 years| Sales grew 40% last year |
The approach to a long-term solution for Teletech Corporation required a new WACC calculation of each business segment and a final determination when it comes to using the current hurdle rate or a risk-adjusted hurdle rate. Also a review of Teletech’s value creation formula of economic profit used to make strategic decision about manager promotions, capital allocation, and incentive compensation. In addition to a review of the second value creation formula used for the review of capital investment proposals where the future investment is discounted to the net present value using the hurdle rate of 9.30%. In order to calculate the WACC or hurdle rate for each business segment, the Beta used is the average for the industry. Exhibit B demonstrates the Cost of Equity calculations and WACC calculations for each segment of the company while Exhibit C gives a chart comparing the final results. Exhibit B
Expected Return for Telecommunications ServicesRs = Rf + Bs * (Rm-Rf)Rs = 4.62 * 1.04 (10.12 – 4.62) = 10.34%| Expected Return for Product and SystemsRs = Rf + Bs * (Rm-Rf)Rs = 4.62 * 1.36 (10.12 – 4.62) = 12.10%| WACC for Telecommunications ServicesWACC = [S/S+B]*RS + [B/B+S]*(1-T)*RB WACC = 22.2% (3.44) + 77.8% (10.34%)WACC =0.763 + 8.04WACC = 8.80%| WACC for Product and SystemsWACC = [S/S+B]*RS + [B/B+S]*(1-T)*RB WACC = 22.2% (4.48) + 77.8% (12.10%)WACC = 0.99 + 9.4138WACC = 10.40%|
| Corporate| Telecommunications Services | Product and Systems | Equity Beta| 1.15| 1.04| 1.36|
Rf| 4.62%| 4.62%| 4.62%|
Rm| 10.12%| 10.12%| 10.12%|
Rm-Rf| 5.50%| 5.50%| 5.50%|
Cost of Equity| 10.95%| 10.34%| 12.10%|
After tax cost of debt| 3.53| 3.44| 4.48|
| | | |
Weight of Debt| 22.2%| 22.2%| 22.2%|
Weight of Capital| 77.8%| 77.8%| 77.8%|
WACC| 9.30%| 8.80%| 10.40%|
As the numbers show, the telecommunications service area has a lower hurdle rate at 8.80%, this tells us that this segment of company is underperforming therefore capital projects investment and net present value calculations for these projects should be calculated using the 8.80% since the risk if higher. Knowing this information, it would be deceiving to stockholders and stakeholders if the company decided to use the 9.30% corporate hurdle rate. Additionally, using a risk-adjusted hurdle will better positioned the company to make investment decisions that can benefit this area and look for opportunities to improve the return on investments. Also, knowing and utilizing this information gives senior executives more leverage when it comes to promotions and compensations since currently the 9.30% hurdle rate is being used in the economic profit model that determines manager promotions, capital allocation, and incentive compensation.
The WACC for the Products and Service segment is at 10.40%, this segment of the company is less risky and it should be adjusted and calculated as such. This information also gives management the opportunity to exploit this segment of the company. The Products and Service segment increased sales by 40% in 2004. This was an opportunity for the company to anticipate the growth of this industry and take advantage of the changes in this market. This new hurdle rate should be use to determine the economic profit model and the net present value for future investments since it is a more accurate approach. In conclusion, Margaret Weston’s response to Victor Yossarian’s letter should include this analysis especially since Mr. Yossarian suggested selling the Products and Systems segment of the company and as the calculations show, this is the segment that has the greater return and there is growth opportunity for the company.