Case 2

Finance Project

Syed Emmad Ali Shah 15110071 Yawar Hayat 15110097 Yaseen Khan Mohmand Zeeshan Aqleem Paras Saleem Irtiza Bukhari 15110125 15110121 15110080 15110020

Teletech Corporation

Q1) Teletech Corporation is using the WACC as the hurdle rate. There are no separate hurdle rates for
the two segments of the Teletech Corporation. This hurdle rate is applied to all investment and performance measurement analysis in the firm. WAAC is being calculated by finding out what the cost of debt and equity is , and then multiplying them with their appropriate weightages in the business mix. This comes out to be equal to 10.41 %. Any project offering return below this rate is currently rejected by Teletech.

Q2) Teletech Corporation (Both Segments)

Pre-Tax Cost of Debt = 7.00% Tax rate = 40% After Tax cost of debt = 4.2% Cost of Equity = 11.77% (from Exhibit 1) Weight of Debt = 18% Weight of Equity =82% WACC = 0.18(4.2) +0.82(11.77%) =10.4074%

Case 2

Telecommunication Services Pre-Tax Cost of Debt = 7 % Tax rate = 40% After Tax cost of debt = 4.2% Cost of Equity = (Beta for services industry according to exhibit 3 is 0.84. Now, using CAPM model, Rm-Rf will remain the same for the equation, that is Rm-Rf= 5.50 % and Rf= 6.04 %. Therefore, the cost of equity equals to 6.04+0.84(5.5))) == 10.66 % Weight of debt and equity which is optimum for these rates is given in exhibit 3 . These are as follows Weight of Debt: 22.8 % Weight of Equity: 77.2 % WACC = .228(4.2) +.772(10.66) = 9.18712 %

Products and Systems

Pre-Tax Cost of Debt = 7.78% Tax rate = 40% After Tax cost of debt = 4.67% Cost of Equity = (Beta for Products and Systems industry has been taken as the average Telecommunications Equipment Industry And computer And network Equipment Industry, which is ( 1.45+1.55)/2 = 1.50 according to exhibit 3. Now, using CAPM model, Rm-Rf will remain the same for the equation, that is Rm-Rf= 5.50 % and Rf= 6.04 %. Therefore, the cost of equity equals to 6.04+1.5(5.5))) == 14.29 % Weight of debt and equity which is optimum for these rates is given in exhibit 3. These are as follows Weight of Debt: 3.45 % (Again , an average of the two industries , that is (2.2 % + 4.7 % )/ 2 ) Weight of Equity: 96.55 % WACC = .0345(4.67)+.9655(14.29)

Case 2 =13.958

Q3) Services segment is not profitable in case of constant hurdle rates as here it provide returns less
than the required return of Teletech Corporation single hurdle rates. It is providing 9.8 %, as compared to the required 10.41 %. However, in the case of risk adjusted hurdle rate, we can observe that this segment is offering a return ( 9.8 % ), which is higher than the risk adjusted hurdle rate for this segment ( 9.18 % ) . Product and systems Segment is profitable in case of constant hurdle rates as here it provide returns more than the required return of Teletech Corporation single hurdle rates. ( Offering 12% in contrast to hurdle rate of 10.41% only. ) However, in the case of risk adjusted hurdle rate, we can observe that the return it is offering, that is 12 %, is much lower than what it should earn for its risk , that is 13.958 %.

Implications for Resource Allocation:

The implications of using a constant hurdle rate are not beneficial to the companys policy of creating value for the shareholder. As explained above, if constant hurdle rates are used, more resources and funds would be allocated to that segment which is making more returns. However, in case of constant hurdle rates, a segment providing more returns does not necessarily means that it is better than the other segment. The reason for this is that even because a project is earning more than the constant hurdle rate, its return is not adjusted enough for its risk. In this case, at the constant hurdle rate, Teletech Corporation would allocate more resources to the Products and Systems Division because on the surface, it is making much higher returns when compared to the hurdle rate of 10.41 %. Company would be rejecting positive NPV projects for the services segment, just on the basis because the segment was earning less return. But if the risk adjusted hurdle rate would have been used, we could have observed that the project that was rejected before, would be accepted now, thus increasing the value of the firm.

Q4)

I agree with the statement that all money is green. At the utmost level, investors are interested in the amount of return that they can earn on their investments. The implications of this method are that any activity of the entity, which increases the value of the firm, must be taken by the firm to increase the investors and shareholders value. Regarding this case, concept falls to the discussion of

whether it would be better for the firm to use a single hurdle rate, or several risk adjust hurdle rates. The arguments in favor of this statement are those given by Helen Buono, who states that if single rate is used, it would be more beneficial, as the Product and Systems division is earning higher returns than the corporate hurdle rate. The firms total value is increasing and shareholders value is being increased. Also, the calculation of figures such as NPV depends

Case 2

upon the usage of a single hurdle rate. NPV becomes very difficult to interpret if several hurdle rates are employed. The arguments for opposing of this statement are those given by Rick Philips, who argues that the single rate concept is hurting the telecommunication services division, which is then not able to earn returns to increase the total value of the firm. He argues that the low risk services division lowers the total hurdle risk , therefore it should not be penalized by setting a high constant hurdle rate which is due to the risky high equity cost of the products division.
Concluding, A corporations basic aim is to maximize shareholders equity the question here really is whether that maximization is in the short period, or it is done keeping in mind future economic benefits. In case of accepting the statement , the only factor of interest to shareholders is the gain in value of the firm , which the company can achieve by making use of multiple risk adjusted hurdle rates.

Q4) A corporations basic aim is to maximize shareholders equity the question here really is whether that maximization is for a short period followed by a roll up of the company or it is done keeping in mind future economic benefits. I do not agree that all money is green. Separate hurdle rates do matter, investors are not interested in the current returns alone they also want to know how reliable the returns are. If telecommunications hurdle rate is low right now it is not because it cannot be as profitable as the Supply and Product department. Apart from the low risk involved in this sector of the corporation, a lot of capital is also being re invested into Research and development which imply high future gains. And if not that, atleast steady gains. The high investment in R&D also means that the company has not yet run out of ideas in this sector of the business which gives a positive signal to young investors looking for capital returns later on in their life. If a single hurdle rate is used to compare the benefits of different sectors in a business regardless of positive NPV should be rejected if its hurdle rate is below the corporations hurdle rate. One of arguments in support of the statement all money is green comes from the statement survival of the fittest. If the hurdle rate is seen as the only indicator of a sectors well-being, then any project that fails to produce the required returns in a given period should be halted.

Q5) Bruno is not correct when he says that the company would reduce its value if it all the firms assets
were redeployed into the telecommunication services segment. This can be explained by two concepts. First is that as calculated above, the WAAC for this division is 9.18 %. However, the division is earning 9.8 % annually. This means that the division would be making more than its hurdle rate, therefore, increasing the firms value Mathematically, the concept of Economic Profit can be used to support our above answer. Economic Profit = (ROC Hurdle Rate) Capital Employed = (9.8 % - 9.18 %) 16 Billion $

Case 2 = 6.2 % * 16 Billion = 0.992 Billion Dollar (Increased total value of firm)

Q6) Yes, the products and services segment of the company has destroyed firms value. The calculated
WACC of the segment is 13.958 %. (Calculated in Q2). Product Segment has been showing returns of 12 %. Since the returns from the segment are lesser than the required return of 12 % , it is evident that the segment has been contributing to firms overall decrease in value. This can also be explained by using the concept of economic Profits. Economic Profit = (ROC Hurdle Rate) Capital Employed = (12 % - 13.958 %) 4.6 Billion $ = -1.958% * 4.6 Billion = -0.09 Billion Dollar (decreased total value of firm)

Q7) Teletechs response to Victor Yossarian should be that it understands the problem that the
company is facing due to its using of a single constant hurdle rate and how it is making the value of firm decrease by 0.09 billion dollars annually. However, the company is undertaking several evaluations to reconsider the use of multiple adjusted hurdle rates. Also, the response should include the companys decision to close down the Products and Systems division, based solely on the concept that it is making losses. By applying these suggestions, the company could fulfill its mission to create value for the shareholders.