Teletech Corporation case study. Corporate raider has taken a 10% stake in the firm, management must assess their valuation and financing approach to two different business divisions. Current methodology employs a singular assessment of WACC to arrive at a hurdle rate inappropriate to either division's risk profile and market.
Teletech WACC analysis
Teletech Corporation 2005
Teletech is a regional telecommunications firm serving over 7 million customers of the Midwest and South regions of the United States (pg. 218). The industry is undergoing a transformational change, in which new competitors are entering the marketplace as the service products of previously unrelated firms, cable television firms, begin overlap (pg. 219).
Teletech has achieved a market dominant position by investing heavily in their capital equipment. The dividend of their 10-year capital expenditures is the delivery of a superior product and high levels of customer satisfaction (pg. 219).
Although the firm appears to maintain a secure place in its market, the competitive landscape is changing. The entry of new competitors and channels of communications, cell phones over landlines, compelled the firm to recently acquire a new business line that is aimed at developing new technology integrating computers with the firm's strength in telecommunications. While the newly acquired 'Products and Systems' division has achieved impressive revenue growth of 40% for 2004, the firm's share performance lags behind industry benchmarks in each of the segments it operates, telephone, equipment, and computers, as well as the S&P 100 overall (pg. 219).
The underperformance of the firm to both competitors and the market has attracted the investment of a corporate raider aiming to alter the course of management and sell the Products and Services division (pg. 217). The entry of the corporate has compelled the firm to reconsider its management approach and decision making models. At issue is the appropriateness of gauging various investment projects using a single hurdle rate of 9.30% for the two divisions of the firm (pg. 218). The current hurdle rate approximately represents the firm's overall weighted average cost of capital.[footnoteRef:1] [1: Wacc=Kdebt (1-tax rate) x D% + Kequity x E%. 5.88*(1-.4)*.22 + 10.95*.78 = 9.317%]
Two Hurdles Analysis
The telecommunications division is comprised of its telephone services and communications equipment operations. The telecommunications division is a very stable utility business that has maintained a steady 3% growth from 2000-2004 (pg. 218). The stability of a utility business entails a low risk profile, which contrasts the more volatile computer industry that is the Products and Systems division. According to the theoretical analysis of investment management, the two divisions represent very different risk profiles and should not be held to the same hurdle rate (pg. 226). The error of applying the same hurdle rate is that capital would be improperly allocated to the riskier Products and Systems division over Telecommunications, thereby undervaluing the risks of the former for the safety of the latter.
Applying a hurdle rate to each division yields two measures that reflect the inherent risks to each division if it were separate. The cost of equity for the telecommunications division is calculated at 10.34% using the average beta for the industry.[footnoteRef:2] The weighted average cost of capital for the telecommunications division yields a hurdle rate, appropriate to the risk inherent to the business line, of 8.841%.[footnoteRef:3] [2: Telecommunications cost of equity = risk free + (beta*risk premium). 4.62 + (1.04*5.5) = 10.34] [3: Telecomm Wacc=Kdebt (1-tax rate) x D% + Kequity x E%. 5.88*.6*.22 + 10.34*.78 = 8.841%]
The Products and Services hurdle rate is calculated using an average beta of 1.36, between both the equipment and computer industries (pg. 228). A cost of equity for the division results in a rate of 12.1%.[footnoteRef:4] The higher costs of equity more accurately reflects the nature of the business environment, in which products thought to be competitive are found obsolete and required write downs (pg. 220). The division weighted average cost of capital is found to be 10.214%.[footnoteRef:5] [4: Product+Services equity cost = risk free + (beta * risk premium). 4.62 + (1.36*5.5) = 12.1%] [5: Products&Services Wacc = Kdebt (1-tax rate) x D% + Kequity x E%. 5.88*.6*.22 + 12.1*.78 = 10.214]
As the investment theory of financial management notes, the separated division hurdle rates should still support the combined overall rate (pg. 226). Combining the two rates supports yields a weighted average cost of capital for the overall firm of 9.184%.[footnoteRef:6] The disparity is attributable to rounding and activities of corporate treasury activities (pg. 227). [6: Combined Wacc = .25*10.214 + .75*8.841 = 9.184]
Division Valuation
The case ultimately must address the economic value that each division delivers to the firm. If it is found that Products and Services is not delivering returns reflective of its associated risks, then it is wise to sell the division if it is not strategically necessary. Similarly, if it is found to be building value, then the management has the basis to maneuver to keep it.
Utilizing the single hurdle rate of the firm yields a valuation for the telecommunications division of -2.5934 billion,[footnoteRef:7] and the products and services delivers economic profits of 7.418 billion.[footnoteRef:8] The single hurdle approach rewards the risky division with an inflated valuation that reflects the capital structure of the utility, while punishing the telecommunications division with measures reflecting an industry with higher betas and risk rewards. The result is a skewed view of the firm and inefficiencies that would present arbitrage opportunities for a savvy raider to take advantage of. [7: Single Hurdle rate telecomm= 1.18 billion / 9.1% = 12.967. Economic profits: (9.1%- 9.3%)*(12.967) = -2.5934 billion.] [8: Single Hurdle rate products and services = 480 million / 11% = 4.363 billion. Economic profits: (11%- 9.3%)*(4.363) = 7.418 billion.]
Separating the firm's measurement to reflect the appropriate risk profile illustrates a more even valuation of the economic profits. The economic profits of the telecommunications division are found to be 3.358 billion,[footnoteRef:9] and the Products and Services division yields economic profits of 3.429 billion.[footnoteRef:10] [9: Telecommunications capitalization = 1.18 billion / 9.1% = 12.967. Economic profits: (9.1%- 8.841%)*(12.967) = 3.358 billion.] [10: Products&Services capitalization = 480 million / .11 = 4.363 billion. Economic profits (11%- 10.214%)*(4.363) = 3.429 billion.]
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