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Weighted Average Cost of Capital and Wide Hurdle Rate Essay

1) How does Teletech currently compute its hurdle rate and how does it evaluate risky projects? What is wrong with this method? Teletech computes it’s hurdle rate by averaging the past 10 years annual weighted average cost of capital (WACC) rates, and then “massaging” the result into a round percentage. This is not an ideal way to calculate the hurdle rate as it reflects rates of financing from the past when borrowing rates were in different ranges. Teletech evaluates risky projects by determining if the present value ratio is greater than 1 (PV inflows/PV outflows). Projects that had a ratio of greater than 1 are given further consideration but those that fall below 1 are summarily dismissed. The firms used a NPV ratio of 1 for very low risk projects, 1.2 for moderate risk projects, and 1.5 for high risk projects.

2) What are the merits of a divisional, as opposed to corporate-wide, hurdle rate system? Which do you recommend and why? * the merits of a divisional rather than corporate wide hurdle rate system reflect the different risks unique to the different market segments – there may be risks that one division encounters that should not be reflected when evaluating a project for the other division. Teletech corporation is divided into two main segments: Telecommunications Services and Products and Systems and both segments can be viewed as wholly different industries that are uncorrelated. It would be advisable to have two separate divisional hurdle rates with which to evaluate projects for the two different segments since each segment will have unique criteria to accepting and declining projects. * I would recommend a divisional for this reason.

3) How does Teletech currently adjust for inflation in its capital budgeting process? What changes, if any, would you make? (This requires a careful reading of the paragraph on page 3.) * Adjustment for inflation in its capital budgeting project – 1. Estimates for inflation are determined/supplied by the firms economics department and plugged into future cash flows. 2. Net cash flows in future years were deflated by an estimate of the cost of living index in order to convert them into current terms. 3. Common dollar cash flows discounted at the hurdle rate to determine the NPV ratio for the project.

* in analysis, England said that the cost of capital had fallen to reflect investors’ view of inflation, in essence, double-counting the inflation effect. * My recommendation would be to complete an analysis on the cost of capital to ensure that it is sufficiently reduced due to the effects of inflation and then use net cash flows that have not been deflated by the cost of living index. There seems to be a confusion as to what figures are nominal and what are real and it is important to clearly define the distinction so that the cash flows are discounted.

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