1. The top management of Teletech Corporation was applying 9.30% as a hurdle rate to all capital projects and as a performance evaluation, regardless of the business units.
Products and Systems
MV asset weights
A- / BBB+
Pretax cost of debt
After-tax cost of debt
Rm - Rf
Cost of equity
Weight of debt
Weight of equity
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.
4. 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.
5. 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...
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