The Teletech Corporation operated in two business segments: Telecommunications Services (TS), and Products and Systems (P&S). Though Teletech was a dominant service provider in the area, the company has been experiencing a downtrend of earning growth and stock prices due to keener competition and worse performance in certain segment.
Teletech has been using economic profit as a measure of value creation at the segment and business-unit level and net present value as a measure of value creation at the project level; and both these values were calculated using the hurdle rate. The main problem faced by Teletech was that the company leaders had to decide what hurdle rate(s) should be used for evaluating performance and budgeting of each segment; and what would be the future of the P&S unit, having in mind the accusatory letter of the new 10% stakeholder, Victor Yossarian.
By October 2005 only one corporate hurdle rate of 9.30% was used for performance assessment, and the rate was based on the Teletech’s WACC as a representation of the opportunity cost of money. There was an ongoing debate if one common corporate hurdle rate should continue be used for valuation, or different hurdle rates which take into account the associated with the investments risk should be implemented.
There was a doubt that the returns of the P&S segment were relatively high because they were compared to the not risk-adjusted corporate hurdle rate, and that in fact the P&S segment was reducing the shareholders’ value. Victor Yossarian’s opinion was that Teletech had to get rid of the P&S segment as it was not providing adequate return.
Hurdle rates recommendation
We recommend that Teletech should use two different hurdle rates for both segments.
First, using WACC as a corporate hurdle rate is not appropriate since different segments have different investment risks. The Products and Systems segment (with the beta of 1.36) clearly had higher risk than Telecommunication services (with the beta of 1.04). Thus, instead of using one hurdle rate calculated based on the corporate beta of 1.15, using two rates will allow the returns of the segments to be compared to more suitable risk-adjusted rates. (See Exhibit 1)
Second, our calculation shows that using two hurdle rates would result in higher economic profits of each segment as well as in total (See Exhibit 3). Higher profit would make company more attractive to investors.
Third, using different hurdle rates also would help the assessment of capital-investment proposals more accurate. Since different segment has different risk, when evaluating a project, the firm should classify the project into each segment and use an appropriate hurdle rate of the corresponding segment to calculate NPV of the project. That would make the NPV of the project more precise. For example, the Telecommunications services had lower risk, lower beta, thus it had lower cost of capital. So, if everything else equals, the NPV of a project in the TS segment should be higher than that of the P&S segment. This should be reflected in a lower hurdle rate for TS and a higher hurdle rate for P&S.
We recommend forming P&S as separate entity (financially) , considering possible unit reorganization or sale. Our reasoning is:
• The P&S segment does not provide satisfactory return, although it is shown as profitable when compared to the corporate hurdle rate of 9.30% (or even with a P&S segment hurdle rate - see detailed calculation in Exhibit 1 and returns-hurdle rates comparison in Exhibit 2), or in terms of Economic profit (see Exhibit 3). However, the reported high returns are mainly because P&S is able to receive low-interest debt based on the higher aggregate corporate rating. However, if the P&S segment is organized as a separate entity (with assumed BB rating), then it will need at least 86% equity financing to be break even, assuming that P&S 11%...