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…