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• If elmarto-ga is not available question is open to anyone. This is the long case study questions. TELETECH CORPORATION, 1996 Raiders Dials Teletech Wake-up Call Needed Says Investor New York (AP)---The reclusive billionaire Victor Yossarian has acquired a 10 percent stake in Teletech Corporation and has demanded two seats on the firm’s board of directors. The purchase was revealed yesterday in a filing with the Securities and Exchange Commission, and separately in a letter to Teletech’s CEO, Maxwell Harper. “The firm is misusing its resources and not earning an adequate return,” the letter said, “The company should abandon its misguided entry into comput-ers, and sell the Product and Systems Segment. Management must focus on creating value for shareholders.” Teletech issued a brief statement emphasizing the virtues of a link between com-puter technology and telecommunications. TELETECH CORPORATION, 1996 Margaret Weston, Teletech’s chief financial officer, learned of Yossarian’s letter late one eveing in early January 1996. Quickly she organized a team of lawyers and finance staff to assess the threat. Maxwell Haper, the firm’s CEO, scheduled a teleconference meeting of the firm’s board of directors the next afternoon. Harper and Weston agreed that before the meeting they needed to fash-ion a response to Yossarian’s assertions about the firms’s returns. Ironically, returns had been the sub-ject of debate within the firm’s circle of senior managers in recent months. A num-ber of issues had been raised about the hur-dle rate used by the company in evaluating performance, and in setting the annual capital budget. Since the company was ex-pected to invest nearly $2 billion in capital Wall Street Daily News, January 9, 1996 projects in 1996, gaining closure and consensus on these issues had become an important priority for Margaret Weston. Now, Yossarian’s letter lent urgency to the discussion. In the short sun, she needed to respond to Yossarian. In the long run, she needed to assess the competing viewpoints, and recommend new policies as necessary. What should be the hurdle rated for Teletech’s two business segments? Was the Products and Systems segment really paying its way? The Company Teletech Corporation, headquartered in Dallas, Texas, defined itself as a “provider of integrated information movement and management,” The firm had two main business segments: Telecommunications Services and Products and Systems, which manufactured computing and telecommunications equipment. In 1995, Telecommunications Services had earned a return on capital(ROC) of 9.8 percent; Products and Systems had earned 12.0 percent. The firm’s current book value of net assets was $16 billion, consisting of $11.4 billion allocated to Telecommunications Services, and $4.6 billion allocated to Products and Systems. An internal analysis suggested that Telecommunications Services accounted for 75 percent of the market value of Teletech, while Products and Systems accounted for 25 percent. The current capital expenditures proposed by Telecommunications Services offered prospective internal rates of return averaging of 9.8 percent; the IRR for prospective Products and Systems projects averaged 12.0 percent. Overall, it appeared that the firm’s prospective return on capital would be 10.35 percent. Top management applied a hurdle rate of 10.41 percent to all capital projects, and in evaluating the performance of business units. Over the past 12 months, the firm’s shares had not kept pace with the overall stock market indices, or with industry indexes for telephone, equipment, or computer stocks. See Figure 1. Securities analysts had remarked on the firm’s lackluster earnings growth, pointing especially to increasing competition in telecommunications, as well as disappointing performance in the Products and Systems segment. A prominent commentator on television opined that “there was no precedent for hostile takeover of a telephone company, but in the case of Teletech, there is every reason to try.” Teletech’s Telecommunications Services Segment The Telecommunications Services segment provided long-distance, local and cellular telephone service to more than 7 million customer lines throughout the Southwest and Midwest. Revenues in this segment grew at an average rate of 3 percent over the 1989-95 period. In 1995, segment revenues, net operating profit after tax (NOPAT), and net assets were $11 billion, $1.18 billion, and $11.4 billion, respectively. Since the court-ordered breakup of the Bell System telephone monopoly in 1983, Teletech had coped with gradual deregulation of its industry through aggressive expansion into new services and geographic regions. Most recently, the firm had been a leading bidder for cellular telephone operations, and for licenses to offer personal communication services (PCS). In addition, the firm had purchased a number of telephone operating companies in privatization auctions in Latin America. Finally, the firm had invested aggressively in new technology---primarily digital switches and optical-fiber cables—in an effort to enhance its service quality. All of these strategic moves had been costly: the capital budget in this segment had varied between $1.5 and $2 billion in each of the previous 10 years. Unfortunately, profit margins in the telecommunication segment had been under pressure for several years. Government regulators had been slow to provide rate relief to Teletech for its capital investments. Other leading telecommunications providers had expanded into Teletech’s geographic markets and invested in new technology and quality enhancing assets. Teletech’s management noted that large cable TV companies might enter the telecommunications market and continue the pressure on margins. On the other hand, Teletech was dominant service provider in its geographic markets and product segments. Customer surveys revealed that the company was the leader in product quality and customer satisfaction. Teletech’s management was confident that the company could command premium prices, however the industry might evolve. Teletech’s Products and Systems Segment Before 1990, telecommunications had been the company’s core business, supplemented by an equipment-manufacturing division that produced telecommunication components. In 1990, the company acquired a leading computer workstation manufacturer with the goal of applying state-of-the-art computing technology to the design of telecommunications equipment. The explosive growth in the microcomputer market and the increased use of telephone lines to connect home- and office-based computers with mainframes convinced Teletech management of the potential value of marrying telecommunications equipment and computing technology. Using Teletech’s capital base, borrowing ability, and distribution network to catapult growth, the Products and Systems segment increased its sales by nearly 40 percent in 1995. This segment’s 1995 NOPAT and net assets were $480 million and $4.6 billion, respectively. Products and Systems was acknowledged to be a technology leader in the industry. While this accounted for its rapid growth and pricing power, maintenance of the leadership position required sizable investments in R&D and fixed assets. The rate of technological change was increasing, as witnessed by sudden major write-offs by Teletech on products that until recently management had thought were still competitive. Major computer manufacturers were entering into the telecommunication-equipment industry. Foreign manufacturers were proving to be competitors in bidding on major supply contract. FOCUS ON VALUE AT TELETECH Teletech’s mission statement said in part, We will create value by pursing business activities that earn premium rates of return. Translating that statement into practice had been a challenge for Margaret Weston. First, it had been necessary to help managers of the segments and business units understand what “create value” meant for them. Because the segments and smaller business units did not issue securities into the capital market, the only objective measures of value were the securities prices of the whole corporation—but the activities of any particular manager might not be significant enough to drive Teletech’s securities prices. Therefore, the company had adopted a measure of value creation for use at the segment and business unit level that would provide a proxy for the way investors would view each unit’s performance. This measure, called “economic profit,” multiplied the excess rate of return of the business unit time the capital it used: Economic Profit = (ROC --- Hurdle rate) x Capital employed Where: NOPAT ROC = Return on capital = ----------- Capital NOPAT = Net operating profit after taxes Each year, the segment and business unit executives were measured on the basis of economic profit. This measure was an important consideration in strategic decisions about capital allocation, manager promotion, and the awarding of incentive compensation. A second way in which the value creation perspective influenced managers was in the assessment of capital-investment proposals. For each investment, projected cash flows were discounted to the present using the firm’s hurdle rate to give a measure of the net present value (or NPV) of each project. A positive (negative) NPV indicated the amount by which the value of the firm would increase (decrease) if the project were undertaken. The following equation shows who the hurdle rate was used in the familiar NPV equation: n Free cash flowt Net present value = å [ ----------------- ] - Initial investment t = 1 ( 1 + hurdle rate)1 HURDLE RATES How the rate should be used within the company in evaluating projects was another point of debate. Given the different natures of the two businesses and the risks each one faced, differences of opinion arose at the segment level over the appropriateness of measuring all projects against the corporate hurdle rate of 10.41 percent. The chief advocate of multiple rates was Rick Phillips, executive vice president of Telecommunications Services, who presented his views as follows: Each phase of our business is different, must compete differently, and must draw on capital differently. Until recently, telecommunications was a regulated industry, and the return on our total capital highly certain, given the stable nature of the industry. Because of the recognized safety of the investment, many telecommunications companies can raise large quantities of capital from the debt markets. In operations comparable to Telecommunications Services, 75 percent of the necessary capital is raised in the debt markets at interest rates reflecting solid AA quality, on average—this is better than the corporate bond rating of AA-/A+. Moreover, I have to believe that the cost of equity of Telecommunications Services is lower than for Products and Systems. I contrast this with the Products and Systems segment where, although sales growth and profitability are strong, risks are high. Independent equipment manufacturers are financed by higher yield BBB-rated debt and more equity with higher expected total returns. In my book, the hurdle rate for Products and Systems should reflect these higher costs of funds. Without the risk-adjusted system of hurdle rates, Telecommunications Services will gradually starve for capital, while Products and Systems will be force-fed—that’s because our returns are less than the corporate hurdle rate, and theirs are greater. Telecommunications Services lowers the risk of the whole corporation, and should not be penalized. Here’s a rough graph of what I think is going on. Telecommunications Services, which can earn 9.8 percent on capital, is actually profitable on a risk-adjusted basis, even though it is not profitable compared compared to the corporate hurdle rate. The triangle shape on the drawing shows about where Telecommunications Services is located. My hunch is that the reverse is true for Products and Systems, which promises to earn 12.0 percent on capital, P + S is located on the graph near the little circle. In deciding how much to loan us, lenders will consider the compositions of risks. If money flows into safer investment, over time the cost of their loans to us will decrease. Our stockholders are just as much concerned with risk. If they perceive our business as being more risky than other companies, they will not pay as high a price for our earning. Perhaps this is why our price/earnings ratio is below the industry average most of the time. It is not a question of whether we adjust for risk—we already do informally. The only question in my mind is whether we make these adjustments systematically or not. While multiple hurdle rates may not reflect capital-structure changes on a say-to-day basis, over time they will reflect prospects more realistically. At the moment, as I understand it, our real problem is an inadequate and very costly supple of equity funds. If we are really rationing equity capital, then we should be striving for the best returns on equity for the risk. Multiple hurdle rates achieve this objective. Implicit in Phillip’s argument, as Weston understood it, was the notion that if each segment in the company had a different hurdle rate, the costs of the various forms of capital world remain the same. However, the mix of capital used would change in the calculation. Low-risk operations would use leverage more extensively, while the high-risk divisions would have little or no debt funds. This lower-risk segment would have a lower hurdle rate. Opposition to Risk-Adjusted Hurdle Rates Phillips’s views were supported by several others within Teletech; opposition was just as strong, however, particularly within the Products and Systems segment. Helen Buono, executive vice president for the segment, expressed her opinion as follows: All money is green. Investors can’t know as much about our operations as we do. To them the firm is an opaque box: they hire us to take care of what is inside the box, and judge us by the dividends coming out of the box. We can’t say that one part of the box has a different hurdle rate than another part of the box, if our investors don’t think that way. Like I say, all money is green: all investments at Teletech should be judged against one hurdle rate. Multiple hurdle rates are illogical. Suppose that the furled rate for Telecommunications Services was much lower than the corporatewide hurdle rate. If we undertook investments that met the segment hurdle rate, we would be destroying shareholder value because we weren’t meeting the corporate hurdle rate. Our job as managers should be to put our money where the returns are best. A single hurdle rate may deprive an underprofitable division of investments in order to channel more funds into a more profitable division, but isn’t that the aim of the process? Our challenge today is simple: we must earn the highest absolute rates of return we can get. In reality, we don’t finance each division separately. The corporation raises capital based on its overall prospects and record. The diversification of the company probably helps keep our capital costs down and enables us to borrow more in total than the sum of the capabilities of the divisions separately. As a result, developing separate hurdle rates is both unrealistic and misleading. All our stock holders want is for us to invest our funds wisely in order to increase the value of their stock. This happens when we pick the most promising projects, irrespective of their source. MARGARET WESTON’S CONCERNS As she listened to these arguments, presented over the course of several months, Weston became increasingly concerned with several related considerations. First, the corporate strategy directed the company toward integrating the two divisions. One effect of using multiple hurdle rates would be to make justifying high-technology research and application proposals more difficult, as the required rate of return would be increased. Perhaps, she thought, multiple hurdle rates were the right idea, but the notion that they should be based on capital costs rather than strategic considerations might be wrong. On the other hand, perhaps multiple rates based on capital costs should be used, but in allocating funds, some qualitative adjustments should be made for unquantifiable strategic considerations. In Weston’s mind, theory was certainly not clear on how to achieve strategic objectives when allocating capital. Second, using a single measure of the cost of money (the hurdle rate or discount factor) made the net present value results consistent, at least in economic terms. If Teletech adopted multiple rates for discounting cash flows, Weston was afraid the NPV and economic profit calculations would lose their meaning and comparability across business segments. To her, a performance criterion had to be consistent and understandable, or it would not be useful. In addition, Weston was concerned with the problem of attributing capital structures to divisions. In Telecommunications Services, a major new switching station might be financed by mortgage bonds. But in Products and Systems, it was not possible for the division to borrow directly; indeed, any financing was feasible only because the corporation guaranteed the debt. Such projects were considered highly risky—perhaps, at best, warranting only a minimal debt structure. Also, Weston considered the debt-capacity decision difficult enough to make for the corporation as a whole, let alone for each division. Judgments could only be very crude. In further discussions with those in the organization about the use of multiple hurdle rates, Weston ran across two predominant trains of thought. One argument held that the investment decision should never be mixed with the financing decision. A firm should decide what its investments should be and then how to fiancé them most efficiently. Adding leverage to a present-value calculation would distort the results. Use of multiple hurdle rates was simply a way of mixing financing with investment analysis. This argument also held that a single rate left the risk decision clear-cut: management could simply adjust its standard (NPV or economic profit) as risks increased. The contrasting line of reasoning noted that the weighted-average cost of capital tended to represent an average market reaction to a mixture of risks. Lower-than-average-risk projects should probably be accepted even though they did not meet weighted-average criterion. Higher-than-normal-risk projects should provide a return premium. While the multiple-hurdle-rate system was a crude way of achieving this end, it at least was a step in the right direction. Moreover, some argued that Teletech’s objective should be to maximize return on equity funds, and because equity funds were and would remain a comparatively scarce resource, a multiple-rate system would tend to maximize returns to stockholders better than a single-rate system. To help resolve these questions, Weston asked her assistant, Bernard Ingles, to summarize academic thinking about multiple hurdle rates. His memorandum is given in Exhibit2. She also requested that he draw samples of comparable firms for Telecommunications Services and Products and Systems that might be used in deriving segment WACCs. The summary of data is given in Exhibit 3. Information on capital-market conditions in January 1996 is given in Exhibit 4. CONCLUSION Weston could not realistically hope that all the issues before her would be resolved in time to influence Victor Yossarian’s attack on management. But the attack did dictate the need for an objective assessment of the performance of Teletech’s two segments—the choice of hurdle rates would be very important in this analysis. However, she did want in institute a pragmatic system of appropriate hurdle rates (or one rate) that would facilitate judgments in the changing circumstances Teletech faced. What were the appropriate hurdle rates for the two segments? Was Products and Systems underperforming as Yossarian suggested? How should Teletech respond to the raider? EXHIBIT 2 Theoretical Overview of Multiple Hurdle Rates To: Margaret Weston From: Bernard Ingles Subject: Theory of Segment Cost of Capital Date: January 1996 You requested an overview of theories about multiple hurdle rates. Without getting into minutiae, the theories boil down to the following points: 1. The central idea is that required returns should be drive by risk. This is the dominant view in the field of investment management, and is based on a mountain of theory and empirical research stretching over several decades. The extension of this idea from investment management to corporate decision making is straightforward, at least in theory. 2. An underlying assumption is that the firm is transparent (i.e., that investors can see through the corporate veil and evaluate the activities going on inside). No one believes firms are completely transparent, or that investors are perfectly informed. But financial accounting standards have evolved toward making the firm more transparent. And the investment community has grown tougher and sharper in its analysis: Teletech now has 36 analysts publishing reports and forecasts on the firm. The reality is that for big publicly held firms, transparency is not a bad assumption. 3. Another underlying assumption is that the value of the whole enterprise is simply the sum of its parts—this is the concept of Value Additivity. We can define “parts” as either the business segments (on the left-hand side of the balance sheet) or the layers of the capital structure (on the right-hand side of the balance sheet). Market values (MVs) have to balance. MVTeletech = (MVTelecommunications + MVProducts+Systems) = ( MVDebts + MVEquity) If these equalities did not hold, then a raider could come along and exploit the inequality by buying or selling the whole or the parts. This is “arbitrage.” By buying or selling, the actions of the raider would drive the MVs back into balance. 4. Investment theory tells us that the only risk that matters is nondiversifiable risk, which is measured by “beta.” Beta indicates the risk that an asset will add to a portfolio. Because the investor is assumed to be diversified, she is assumed to seek a return for only that risk that she cannot shed, the nondiversifiable risk. Now, the important point here is that the beta of a portfolio is equal to a weighted average of the betas of the portfolio components. Extending this to the corporate environment, the “asset beta” for the firm will equal a weighted average of the components of the firm—again, the components of the firm can be defined in terms of either the right-hand side or the left-hand side of the balance sheet. bTeletech Assets = (Wtel.Serv. bTel.Serv. + WP+S bP+S) = (Wdebt + Wequitybequity) where: w = Percentage weights based on market value. bTel.Serv.bP+S = Asset betas for business segments. bdebt = b for the firm’s debt securities. bequity = b of firm’s common stock (given by Bloomberg, etc.) This is a very handy way to model the risk of the firm, for it means that we can use the Capital Asset Pricing Model to estimate the cost of capital for a segment (i.e., using segment asset betas). 5. Given all the previous points, it follows that the weighted average of the various costs of capital (k) for the firm (WACC), which is the theoretically correct hurdle rate, is simply a weighted average of segment WACCs: WACC teletech = (Wtel.serv. WACCtel.serv.) + (Wp+s WACC p+s) Where: Wtel.serv. Wp+s = market value weights WACCtel.serv. = (Wdebt,tel.serv Kdebt, tel.serv.) + (Wequity,tel.serv.Kequity,tel.serv.) WACCp+s = (Wdebt,p+sKdebt,p+s) + (Wequity,p+sKequity,p+s) 6. The notion in point 5 may not hold exactly in practice. First, most of the components in the WACC formula are estimated with some error, Second, because to taxes, information asymmetries, or other market imperfections, assets may not be priced strictly in line with the model—for a company like Teletech, it is reasonable to assume that any mispricings are just temporary. Third, the simple two-segment characterization ignores a hidden third segment: the corporate treasury department that hedges and aims to finance the whole corporation optimally—this acts as a “shock absorber” for the financial policies of the segments. Modeling the WACC of the corporate treasury department is quite difficult. Most companies assume that the impact of corporate treasury isn’t very large, and simply assume it away. As a first cut, we could do this too, though it is an issue we should revisit. Conclusions · In theory, the corporate WACC for Teletech is appropriate only for evaluating an asset having the same risk as the whole company. It is not appropriate for assets having different risks than the whole company. · Segment WACCs are computed similarly to corporate WACCs · In concept, the corporate WACC is a weighted average of the segment WACCs. In practice, the weighted average concept may not hold, due to imperfections in the market and/or estimation errors. · If we start computing segment WACCs, we must use the cost of debt, cost of equity, and weights appropriate to that segment. We need a lot of information to do this correctly, or else we really need to stretch to make assumptions. EXHIBIT 1 Summary of WACC Calculation for Teletech Corporation, and Segment Worksheet Corporate Telecommunications Services MV asset weights 100% 75% Bond rating AA-/A+ AA Pre-tax cost of debt 7.03% 7.00% Tax rate 40% 40% After-tax cost of debt 4.22% 4.20% Equity beta 1.04 Rf 6.04% Rm-Rf 5.50% Cost equity 11.77% Weight of debt 18.00% Weight of equity 82.00% WACC 10.41% EXHIBIT 4 Debt Capital Market Conditions, January 1996 Corporate Bond Yields, by Rating U.S. Treasury Securities Industrials: AAA 6.50% Short-term bills 5.20% AA 7.00 Intermediate-term notes 5.43 A 7.64 Long-term bonds 6.04 BBB 7.78% BB 8.93 B 10.49 Utilities AA 6.53% A 7.94 BBB 8.06 Thanks, Jimmy5

• Answer:

  Jimmy5 -- This is a classic cost-of-capital and capital allocation case. There are lots of questions that can be asked but the core issues are: ? does debt change the potential value of the firm? This is the implicit argument that the Rick Phillips, Exec VP of Telecommunications Services, makes in his brief when he says "if money flows into safer investment, over time the cost of their loans to us will decrease." ? is there a different cost-of-capital for the 2 business units of Teletech? There are no comparable equity betas for the two business units, but we do have operating profits and debt information to help make a judgment. Prof. Bruce Lehmann's lecture notes from his introduction to corporate finance lay out some of the principals of the Nobel-Prize winning work of Franco Modigliani and Merton Miller. The most-relevant comments start on page 5, noting what some of the implications are: 1. Managers should always maximize net present value (NPV) 2. There are problems when firms near bankruptcy or their inability to produce positive cash flow 3. There are inevitable battles over capital structure between cash cows and growing business units. 4. Measurement of project risk continues to be a problem. UCSD IR/PS Prof. Bruce Lehmann "Modigliani and Miller and the Irrelevance of Debt Policy" (Jan. 9, 2001) http://www2-irps.ucsd.edu/faculty/blehmann/study_materials/corporate_finance-1-notes.pdf Merton Miller, in his attempt to explain the irrelevance of borrowing in the capital structure, uses the example, "Say you have a pizza, and it is divided into four slices. If you cut it into eight slices, you still have the same amount of pizza. We proved that! Rigorously!" Arnold Kling -- AP Economics "Corporate Finance: Leverage and the Modigliani-Miller Theorem" (undated) http://arnoldkling.com/econ/saving/corpfin.html So the first conclusion is that NPV -- using a risk-adjusted cost-of-capital -- should be the sole determinant of decisions to invest or not invest. And, of course, projects with the highest potential return should get priority -- though funding should be sought for any investment with a positive NPV. The question is: do the two business units have different costs-of-capital? THE MARKETS FOR TS AND P&S --------------------------------------------- The ideal situation is to find several competing companies and judge the beta or capital market risk for them. Considered to be the best way to judge company-related risk, this is still an imperfect process. Even taking two closely-competitive semiconductor companies such as Intel (NASDAQ: INTC) and Advanced Micro Devices (NYSE: AMD), you'll find many things are the same (percent of R&D spending; gross margins on major product lines; percent of sales & marketing spending). -- and you'll find many things different (share of microprocessor markets; markets for new product development; customers; capital structure). Bernard Ingles' memo to CFO Margaret Weston in the Teletech case makes mention of this in his last point but really makes no mention of what companies would provide likely comparisons -- or if the companies are publicly-traded. In terms of equity, we know only that the company has a low aggregate beta of 1.04. However, we do have a good idea of what debt risks are -- and the portion of capitalization that's allocated to Telecommunications Services (TS) and Products & Services (P&S): Debt: 18% Equity: 82% TS Capital: 75% ($1.18 billion) P&S Capital: 25% ($4.1 billion) TS cost of debt: 7.00% Corporate cost of debt: 7.03% Knowing the weighted averages, we know too that: P&S cost of debt: 7.12% (as it's 25% of the portfolio). Returns being required by the bond holders allow us to calculate a beta on the debt: QuickMBA "Analysis for Financial Management," Robert Higgens "Corporate Finance -- Cost of Capital" http://www.quickmba.com/finance/cf/ rD = rF + Bd * (rM-rF) where, rD: return required by market rF: the risk-free or T-bill rate Bd: beta for the debt rM-rF: Teletech's bond premium So, the bond beta, Bd, for Telecom Services (TS) is: 7.0 = 6.04 + Bd * (5.5) Bd = .17 And the bond beta, Bd, for Products & Services (P&S) is: 7.12 = 6.04 + Bd*(5.5) Bd = .20 Neither beta is particularly risky, indicating the believe that debt coverage is very adequate for both units -- though a little riskier in the case of P&S. No assumptions about variance or risk in stock prices can be made from the debt beta. What's important to note here is that debt coverage with 18% is considered by the market to be highly adequate -- leaving room for additional debt on the balance sheet. WACC ----- Lacking the appropriate tools to separate beta or risk variance for equity, we'll assume that the company's overall cost-of-capital can be used to determine a weighted-average cost-of-capital (WACC) for each of the business units. It's important to note that WACC mixes the impact of debt and equity -- and provides larger equity returns in percentages, at the expense of increasing risk by diverting cash flow to the bondholders. Thus, the use of debt to increase operating returns is often termed "leverage" because of it's ability to increase profitability. WACC = rE (E/VL) + rD(1-t)(D/VL) where, rE: return on equity E/VL: proportion of equity in total firm value rD: bond returns (which are slightly different for the two divisions) t: tax rate (expressed as a decimal; 40% = 0.40) D/VL: proportion of debt in total firm value We can figure two WACC's for each division, inasmuch as the assumptions are that each share the 18/82 debt-to-equity ration: WACC TS = 11.77*(0.82) + 7.00*(0.6)*(0.18) = 10.41 WACC P&S = 11.77*(0.82) + 7.12*(0.6)*(0.18) = 10.42 Thus, absent any comparable betas for firms in the Telecommunications Services or Product & Services areas, the Weighted-Average Cost-of-Capital for the two operations is so close as to be indistinguishable. Thus, Rick Phillips should be concerned more trying to establish a market risk for his division and the sister division. From an operating standpoint, knowing that each division is a bundle of projects -- some of which could have quite high risks -- it is actually in both he and Helen Buono's interest to understand the risks of their investments. Some may be comparatively low (buying a factory or producing equipment for lease) and could be handled differently; some may be comparatively high (new product development) and also could be managed differently (development options; joint ventures, etc.) HOW'S TELETECH DOING? ---------------------- Teletech's investment model, using a 10.41% hurdle rate and evaluating projects by NPV is a good one. It could be perfected by establishing a better idea of project risks within the types of programs examined for investment each year, as mentioned earlier. With earnings of $1.18 billion, Telecommunications Services is returning 10.35% on assets and 12% on an equity valuation of $9.83 billion. With earnings of $480 million, Products & Services is doing slightly better with a 10.43% return on assets and a 14.66% return on equity. Both divisions are returning investments close to the expected returns, though hardly outstanding. Most consultants would try to see how to boost returns through better selectivity on proejcts. Any positive NPV projects should be funded, according to the academic arguments on adding to shareholder value, as the capital-asset pricing model already has risk built-in. However, Telecommunications Services' projects in 9.8 percent range won't make the cut under the current capital structure. WHY IS TELETECH UNDER ATTACK? ------------------------------ Victor Yossarian has chosen an investment in Teletech because he's aware that the company's conservative debt-to-equity ratio is making it a prime target for restructuring. Presumably Yossarian learned something from Milken, Boesky, Kohlberg, Kravis, Roberts, et al during the 1980's LBO era. As Rick Phillips has argued, competitors are able to raise up to 75% of their capital using debt -- lowering their weighted-average cost of money or WACC. If Teletech were structured this way, the 7% money would like produce a WACC that meet his 9.8% threshold: WACC for TS: Assuming 75% Debt WACC TS = 11.77*(0.25) + 7.00*(0.6)*(0.75) = 2.94 + 3.15 = 6.09% This assumes that neither the risk premium for the stock nor the risk premium for the debt will rise substantially, assumptions that CFO Margaret Weston would be wise to check in detail. It is also possible that the company's competitive landscape has changed. The case leaves room for the interpretation of the Products & Services division facing much more intense competition in the future. Inasmuch as investors are judging future returns, it may be that the perception of Teletech is that this unit will not be able to perform competitively in the future. WHAT ARE TELETECH'S OPTIONS? ----------------------------- The options for a company such as Teletech are varied and would probably depend on factors outside this case. If company control were solidly in the hands of a family or trust, the company might choose to do nothing and let Yossarian sit on his $1.3 billion investment. Company managers should know the synergies of having the two units together and have a much more detailed understanding of their markets and opportunities than an outsider. For an arbitrageur to be forced to sit on an investment this large would be painful, costly -- and embarrassing -- even with interest rates in the 6% to 7% range. However, Weston could use the Yossarian opportunity to lower the WACC by purchasing Yossarian's shares. A purchase price of $1.6 billion would provide the investor with a return of at least 23% (assuming a $1.3 billion investment) and retire shares in the company. The new capital structure, assuming that debt was used to purchase the shares, would be 28% debt and 72% equity. This would result in a new WACC for TS = TS = 11.77*(0.72) + 7.00*(0.6)*(0.28) = 8.47% + 1.18% = 9.65% Undoubtedly the firm could consider other options, including: ? aggressive use of sales of telecommunications equipment to leasing companies to lower the capital costs ? separation of the company into two companies, adjusting capitalization to meet the percentages generally used by competitors Google search strategy: You can find the common questions about this finance case using: Yossarian + Teletech The basic theory in the case is covered by the following searches. Using the Nobel Prize winners' names helps restrict the search to more relevant articles: "Modigliani-Miller" + "capital allocation" "cost of capital" + "Modigliani-Miller" It's also helpful to use the Google Glossary, which is still under development, for the common search terms, such as "cost of capital": Google Glossary http://labs.google.com/glossary Best regards, Omnivorous-GA