Information on Corporation can be found from Exhibit 1 of Case 15 in Case Studies in Finance: Managing for Corporate Value Creation, 6th edition, by Bruner RF, Eades KM, Schill MJ McGraw Hill, pg 225.
I am using 4.62% for risk-free rate for both Telecommunication Services and Product and Systems segments based on the U.S. Treasury Securities of 30 years. The risk market premium, however, cannot be found from given information. Therefore, we are following the Corporate rate. For equity beta, we are using average for each industry based on Exhibit 3 on page 228. The same follows for weight of debt.
Formula to calculate cost of equity :
Cost of equity for Telecommunication, therefore, can be calculated as follow: Ke = 4.62% + 1.04(5.50%) = 10.34%
While for Product and Services:
Ke = 4.62% + 1.39(5.50%) = 12.27%
Formula for WACC :
WACC for Telecommunication = (3.44% * 27.10%) + (10.34%* 72.90%) = 8.47%
WACC for Products and Services = (4.48% * 7.50%) + (12.27%* 92.50%) = 11.72%
Through the graph, Rick Phillips was trying to say that it was not fair to apply one hurdle rate for all segments within the Teletech Corporation. It was explained that that one hurdle did not regard the risk level the segment was at. For example, although Telecommunications Services’ return is lower than the hurdle rate proposed, it still could be profitable if the risk-adjusted hurdle is considered. The choice of constant versus risk-adjusted hurdle rate did affect the evaluation of each business unit.
Suppose the upcoming project for Telecommunication services would have a return rate of 9.00%, if we used the hurdle rate of the corporate, then we would likely to reject the project. However, if we use the segment’s hurdle rate, we would gladly accept the project. On the other hand, if the rate of return of upcoming project in Product and Services was 9.50%, we would accept the project if we used corporate hurdle rate, but we will reject if we use the segment’s hurdle rate. Teletech’s resource-allocation strategy at the moment was not efficient because it regarded both business unit had the same risk, while in fact, they differed. And this would cause the firm making wrong decision most of the time.
No, we do not agree that “all money is green”. It says that Teletech Corporation is one box. And everything happened in that box should use the same exact hurdle rate, therefore, it does not matter which segments are going for an investment, all the future projects should be valued against one and only hurdle rate. The argument in favor is that we do not finance each business unit separately. The diversification of the company keeps the capital cost down and eases each division to borrow money for improvement. In addition to that, single hurdle rate can result in consistent and understandable performance review. On the other hand, the argument against it is that it is not fair to judge all investment against one hurdle rate as different business unit carries different risk.
Helen Buono is wrong. Investing all the firm’s assets in the telecommunications division would not destroy the value of the company. It will, on the other hand, maximize the value. It is because the WACC of the segment is particularly lower than the ROC rate. “If the Return on Invested Capital of a company exceeds its WACC, then the company created value. If the Return on Invested Capital is less than the WACC, then the company destroyed value” (InvestorWords, 2014)
‘Products and Systems’ has destroyed the company value, as it can be seen from the numerical example provided from number 5. The Real Value if we invested 100% of our capital in P/S will result in only $15.62billions of value, while if we invested 100% of our capital in T/S, we will get $17.24billions. Even though we try to mix both segments, it will still result in lower value than 100% of T/S.
Teletech should say to:
Rick Phillips: He understands exactly the whole point and Teletech should consider the risk rate for both segments and apply different hurdle rates to value the investments each business unit is going to take. Even though it might cause the calculation of NPV to be inconsistent and harder to understand for the stakeholders, but if explained carefully, it would resolve the problem. Helen Buono: She is wrong with her theory that if Teletech invests only on Telecommunication Services, the value will be going down. She is to provide a change within her own segment, try to figure out how to lower down the WACC of the segment. If there is no progress after some time, then Teletech Corporation might have to sell that division in order to maximize value for the stakeholders. In response to Victor Yossarian, Teletech should say that if the hurdle rate of 9.30% to all capital projects are based on to evaluate the business performance regardless of the risk, which also mean Teletech is undervaluing Telecommunication Services and overvaluing Products and Services. Therefore, to create value for shareholders, NPV of each division is needed measuring with different hurdle rates considered by the risk for each business unit. Then, the division which has negative NPV will be eliminated.
1. InvestorWords 2014, ROC, InvestorWords, viewed 11 September 2014, < http://www.investorwords.com/5773/ROC.html>