Importance of Capital Budgeting

Currently Teletech applies their corporate hurdle rate of 10. 41% to all capital projects. The first objective of this case was to determine whether this corporate hurdle rate was appropriate for capital budgeting decisions within its two segments, Telecommunications Services and Products and Systems. In order to make this determination, the Weighted Average Cost of Capital (WACC) will be calculated for each segment of the company. WACCTeletech = (Wdebt Teletech K debt) + (Wequity Teletech K equity)

The WACC reflects the risk of an average project undertaken by the firm.

The WACC is the required rate of return that the firm must pay to generate funds; it becomes a guideline or hurdle rate for measuring profitability of investments. If the project does not clear hurdle the firm will loose money on the project and decrease the value of the company. We began by determining the cost of equity for each segment. The risk free rate (Rf) is given in the case at 6. 04% reflecting the return on a long-term bond.

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The capital projects of the company

This rate is appropriate given the longer nature of the capital projects of the company. The market risk premium (Rm-Rf) is also given in the case. The market risk premium is the premium investors require for bearing the risk of an average stock. Both of these variables were held constant across the segment calculations because they apply to the firm as a whole not its segments. The next variable to be determined is the equity beta. There are various methods for estimating the beta of the two segments.

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We choose the pure play technique.

The pure play technique

The pure play technique is a method of determining segment betas using the data from other publicly traded companies in the same business line. The equity beta for Telecommunications Services segment of Teletech was computed using the data of eighteen comparable firms within the industry found in Exhibit 3 in the case. From this data, the geometric and arithmetic averages of beta were determined to be 0. 83 and 0. 84, respectively (reference Tables 1 and 2 of Appendix). Since there is little difference between the two methods, we chose the arithmetic average of 0.84 for beta.

Using the above variables, the cost of equity using the CAPM approach was 10. 66% CAPM = Rf + i?? (Rm – Rf) The WACC is now computed using the weights of debt and equity and their associated costs to the company. Note that the case provided information that the after-tax cost of debt is 4. 20%. The debt to equity ratio was not given in the case for the individual segments so it had to be estimated. For the Telecommunications Services segment, we used the average market weight of debt for the industry given in Exhibit 3 to determine the weight of debt.

The average market value was used instead of the book value because the market weights represent current conditions of the company and take into account the effects of changing market conditions and the current stock prices. Weight of debt utilized is 22. 8% and the weigh of equity utilized is 77. 8%. With all the WACC components determined, the Telecommunications Services segment WACC was calculated to be 9. 19%. Reference Table 3 of Appendix for a summary of the above. The same process was used to determine the WACC in the Products and Systems segment of Teletech.

The risk free rate and market risk

The risk free rate and market risk premium were the same for the Telecommunications Services segment and the pure play technique was utilized to determine the equity beta. The data of comparable companies namely eight Telecommunications Equipment companies and fourteen Computer and Network Equipment companies, were used to compute the equity beta. That data was also found in Exhibit 3 of the case. Again, the geometric and arithmetic averages of beta were determined to be 1. 49 and 1. 50.

To maintain consistency, the arithmetic average of 1.50 was utilized for beta. Using the above variables, the cost of equity using the CAPM approach was 14. 29%. The WACC is again computed using the market weights of debt and equity and their associated costs to the firm. Note that the case provided information that the after-tax cost of debt is 4. 67%. For the Products and Systems segment, we used the average market weight of debt for the industries (Telecommunications Equipment and Computer and Network) given in Exhibit 3 to determine the weight of debt.

The weight of debt was determined to be 3. 5% and the weight of equity was found to be 96. 5%. Finally, the WACC of the Products and Systems segment was calculated to be 13. 95%. Reference Table 3 of the Appendix for a summary of the calculations. To double-check the validity of our assumptions we computed the WACC of the company using the two segments WACCs. The corporate WACC should equate to the weighted average of the segment WACCs for the segments. The WACC for the company was given in case as 10.

41% using the segment figures the WACC for the company is 10. 38%. The two percentages are very close but not exact due perhaps to estimations of beta. We are confident in the validity of the segment WACCs. The segments WACCs also pass the so-called sniff test. The Telecommunications Services segment is less risky than the overall corporation. We would expect like other telecommunications companies or public utilities it would have a large fairly stable client base, steady revenue, and a large amount of fixed assets.

Two distinct divisions with two distinct levels of risk

Its stability can also be witnessed in its ability to raise capital using debt financing. On the other hand, the Products and Systems segment is much more risky than the overall company. Like other comparable firm the technology the firm uses is ever changing, it has less fixed assets, and its inventory becomes quickly outdated. Teletech is composed of two distinct divisions with two distinct levels of risk. If the company continues to use the corporate hurdle rate of 10. 41% shareholder value will be damaged.

Telecommunications Services will be starved for capital while Products and Systems will have abundant capital, which will lead to good lower risk projects on the Telecommunications side being passed over for higher risk poor projects on the Products and Services side. One way this could be combated would be to compute a project hurdle rate for every project in the company. However, that would be very cumbersome and to time consuming. The more cost effective and timely method would be to use the divisional hurdle rates that were computed above.

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Importance of Capital Budgeting. (2020, Jun 02). Retrieved from https://studymoose.com/capital-budgeting-11383-new-essay

Importance of Capital Budgeting

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