Analysis Teletech is a business process outsourcing multinational Organization, founded in 1982 by Kenneth D. Tuchman and headquartered in Englewood, Colorado. Teletech provides services for customer management, transaction-based processing, database marketing services, professional sales and eCommerce. Teletech operates in diverse industries of Automotive, Communications and Media, Financial Services, Government Services, Healthcare Services and Technology. The firm is based in 17 countries with a total of 62 delivery centers.
The company is listed on NASDAQ (National Association of Securities Dealers Automated Quotations) stock exchange, which is the second largest stock exchange after the New York Stock Exchange in terms of market capitalization. The given case analysis presents an argument between the use of a single hurdle rate to evaluate all segments of the company versus the use of multiple hurdle rates corresponding to the risk of the particular segments in the year 2005. The hurdle rate is the minimum rate of return on a project or investment required by an investor.
The riskier is the project, the higher the hurdle rate. Teletech has two main business segments; Telecommunications services whose function is to provide long distance, local and cellular telephone services and the Products and Systems Segment that deals with the manufacturing of computing and telecommunication equipment. The firm’s book value was $16 Billion , comprising of $11. 4Billion in Telecommunication Services and $4. 6Billion allocated to Products and Systems. Telecommunication accounts for 75% of the market value and Products and Systems account for 25%.
The Return on Capital is 9. 10% for Telecommunication services and 11% for Products and Systems. Teletech uses a hurdle rate (or WACC) of 9. 30% to all capital projects. Values are taken from Exhibit 1: Weight of debt = 22. 2% Weight of equity= 77. 8% rWACC = 3. 53 *22. 2 + 10. 95 *77. 8 =9. 30% This hurdle rate is at the company level irrespective of the return on capital of various segments. Value Creation: The main mission of Teletech is creating value by pursuing business activities that earn premium rates of return.
The company creates its value by increasing the securities prices of the organization and by assessing the capital-investment proposals. As Teletech consists of different segments the profitability or the value of the company is calculated by Economic Profit Economic Profit = (ROC-Hurdle Rate) * Capital employed The capital-investment proposals are assessed by discounting the projected cash flows to the present value by using the firm’s hurdle rate. n ? = [Free cash flow t /(1+ Hurdle rate)t ]- Initial Investment t=1 Although the same hurdle rate of 9. 0% (based on the WACC) was applied to all investment and performance-measurement analyses at the firm by calculating the Economic Profitability and Net present values, there was still debate about how the rate should be used within the company in evaluating different projects in various segments. Rick Phillips, executive Vice President of Telecommunication Services was of the view that different rates should be used for the Telecommunication Services and Products and Systems as both the segments varied in nature and the risks faced.
The cost of equity of Telecom Services is lower than Product and System’s Division. The Product and System’s Division profitability and sales growth have been strong but its risk is high. He said that, “The hurdle rate for PS should reflect those higher costs of funds. Without the risk-adjusted system of hurdle rates, TS will gradually starve for capital, while PS will be force-fed. ” Segment WACC’s for Teletech: For Telecommunications Services Industry Ce = Risk free rate + beta (Risk Premium) 4. 62% + 1. 04(5. 5) Ce = 10. 45% (Debt is 27. 1% & Equity is 72. % from Exhibit 3) Wacc=Cd(1-t)*WD +Ce*WE =3. 44*27. 1+10. 45*72. 9 =8. 55% Hurdle rate of 8. 55% should be calculated for Telecommunication segment.
Product and System’s Division: Ce = Risk free rate + beta (Risk Premium) = 4. 62% + 1. 33 (5. 50) =11. 94% (Debt is 5. 3% & Equity is 94. 7% from Exhibit 3) WACC=Cd (1-t)*WD+ Ce*WE =4. 48*5. 3+11. 94*94. 7% WACC = 11. 54% Hurdle rate of 11. 54% should be calculated for Product and System’s Division. Therefore Telecommunication system segment currently earns a ROC of 9. 1% but should earn a ROC of 8. 5% is good performance. Product and System’s Division segment currently earns a ROC of 11% but should earn a ROC of 11. 54% is considered as poor performance. Constant Vs. Risk Adjusted Hurdle Rate For Telecommunication Segment Economic Profit using a common hurdle rate ROC=NOPAT/CAPITAL 9. 1%=$1. 18/CAPITAL CAPITAL = $12. 967 Billion EP= (9. 1% – 9. 3%) (12. 967) EP = – $2. 5934 Billion EP using a risk-adjusted hurdle rate ROC=NOPAT/CAPITAL 9. 1%=$1. 18/CAPITAL CAPITAL = $12. 967 Billion EP= (9. 1% – 8. 55%) (12. 967) EP = $7. 13185 Billion
The figures clearly show that Teletech is under valuing the Telecommunications division by using a common hurdle rate For Product and Systems Divisions EP using a common hurdle rate ROC=NOPAT/CAPITAL 11%=$480/CAPITAL CAPITAL = $4363. 64 Million EP= (11% – 9. 3%)(4363. 64) EP = $7418. 188 Million EP using a risk-adjusted hurdle rate ROC=NOPAT/CAPITAL 11%=$480/CAPITAL CAPITAL = $4363. 64 Million EP= (11% – 11. 54%)(4363. 64) EP = -$2. 3563656 Billion The comparison shows that Teletech is over valuing Product and Systems Division by using a common hurdle rate instead of risk- adjusted hurdle rate.
The figure 2 of constant vs. Risk Adjusted Hurdle Rates shows that the rate of return in Telecomm. Services are below 9. 8% and the returns on Product and Systems are above 11 % but in the greater risk area. Money is green but it can be greener. Teletech can further improve their performance by the use of multiple hurdle rates as it will create more value for the company. Helen Buono’s favourable argument is that diversification helps the company keep the capital costs down and enables the corporation to borrow more in total than the sum of the capabilities of the divisions separately.
Helen Buono’s argument saying that a single hurdle rate may deprive an under profitable division of investments in order to channel more funds into a more profitable division is not quite logical because if several less risky projects although less profitable are undertaken it will benefit the company without any doubt unless in the case of putting away many low risk projects for a single high risk project. I don’t agree with Helen Buono that management would destroy value if all the firm’s assets were redeployed into only the telecomm. usiness segment because it has higher economic profit for a risk adjusted hurdle rate and as it lies in low risk region, I don’t think the management would destroy value of the firm. Products and System has not destroyed value coz Economic Profit on the common hurdle rate is high. That means that although high risk projects were undertaken, the rate of return on them was also quite high. Teletech should tell Victor Yossarian the reason why the returns are dwindling. They should recommend Victor the use use of Multiple hurdle rates which would help create more value to the firm.