Profit and Corporate Hurdle Rate
Currently, Teletech Corp. is using a single corporate hurdle rate to evaluate its investment decisions in its products and systems segment as well as its telecommunications segment. Using only one hurdle rate doesn’t take into account the risk that the company faces within each segment. Investors demand higher returns for riskier investments. Victor Yossarian is concerned about the low returns for the high risk in the products and systems segment, this is why he wants to abandon this segment.
Using two hurdle rates adjusts for the risk in each industry allows the company to adequately value each segment. Our analysis will show that by using two hurdle rates it will lower the cost of equity and WACC for the less risky telecommunications segment, while raising the cost of equity and WACC for the more risky products and systems segment. Lastly, our calculation of the economic profitability for each industry using the segmented hurdle rates will show that Teletech may be overvaluing its products and systems segment while undervaluing its telecommunications segment.
This implies that Teletech should reallocate its capital in order to increase economic profitability . Introduction We will conduct an industry comparison analysis to show how the the company’s cost of borrowing and beta compares to its competitors. Next, we will explain why it is more beneficial for the company to use segmented hurdles rates rather than the corporate hurdle rate currently being used. We will then calculate a new hurdle rate and the economic profit for each division. Then, we will explain how capital restructuring can increase our profits for each segment.
Lastly, we will address the concerns with the company’s recent performance and the future direction of the company. Industry Comparable Analysis Prior to any action, we will examine Teletech Corp’s market debt to capital and market debt to equity in comparison with a few selected competitors. In Exhibit One, all three comparable companies have a beta lower than 1. 05, which allows them to raise capital at a lower the cost of equity. However, when you compare market debt to equity, it is lower than the industry average showing that more equity can be issued.
They also have a market debt to capital of 22%, which is below the industry average as well. The mean for this section is 28. 10%, which gives us an idea of where the ratio should be in comparison with Teletechs’ top competitors. Based off industry average, Teletech can increase their margins by becoming more levered. Now we will compare the products and systems segment using the same base of measurement with more focus towards the beta. Displayed on Exhibit One, the mean of the three companies is 1. 30, which is a substantially higher beta than Teletech corporate beta of 1.
It is likely that the company can choose to raise capital from the wrong source; which shows’ when you compare its’ corporate debt to equity of 29% to an industry average of 9. 2%. This leads to the assumption that the capital structure that management has in place is inadequate in terms of risk and reward. Due to several outliers in this segment, we believe the industry average should be a little higher. Our assumption is that the the market debt to equity for the new segmented P&S should be somewhere in between.
This is discussed in the capital restructuring section of this analysis, where we assume a 15% weight of debt to calculate the new WACC. Telecommunication Services In order to calculate the new hurdle rate for the telecommunications segment we first had to calculate the cost of equity using the capital asset pricing model. We used the corporate risk free rate and market risk premium and the average beta for the telecommunications segment to make this calculation. As demonstrated in Exhibit Two, the cost of equity is lower than the corporate rate.
Next, we calculated the WACC using the new cost of equity and the average market value of debt in the telecommunications segment. Exhibit Two shows that the WACC is lowered when using the market value of debt and new cost of equity. This means that shareholders will require a lower return on their investments and will cost the company less while raising equity, and issuing debt at a lower rate than the 9. 3% corporate rate currently being used. The segmented hurdle rates allow for lower cost of debt than the corporate hurdle rate.
Lastly, we calculated the economic profitability using both the corporate hurdle rate and the segmented hurdle rate. Using the corporate hurdle rate, we calculated an economic profit that was negative, which can be shown in Exhibit Three. However, when we use the segmented hurdle rate the economic profitability is positive, which is shown in Exhibit Three. This shows that we are undervaluing the telecommunications segment when we use the corporate hurdle rate. Products and System Segment Our next objective was to determine what was the weighted average cost of capital for the products and systems segment.
First, we needed to calculate the cost of equity for this segment. The risk free rate and risk premium were given to us and we calculated the beta by taking industry averages in the telecommunication equipment industry and the computer and network equipment industry. In Exhibit Four, the calculation can be shown and the result is a cost of equity for this segment of 12. 1%. The next step was to determine the overall weighted average cost of capital for this segment. We were given the after-tax cost of debt, but we had to determine a suitable weight of debt for this segment.
The weight of debt was determined by calculating the average market value of debt to capital in the telecommunications equipment industry and computer and network equipment industry. We determined a suitable weight of debt of 9. 2% and a weight of equity of 90. 8% based off the average market value of debt to capital for the telecommunication equipment firms and computer and network equipment firms. This segment is riskier than the telecommunication services segment, so less debt is issued in this segment.
In Exhibit Four, the calculation for the WACC is shown resulting in 11. 4% cost of capital for this segment. We decided to determine what the economic profitability of this segment was using the new segmented WACC. First, we had to calculate the capital employed in order to correctly figure out the profitability. We were given the return on capital for the segment of 11% and the net operating profit after taxes of $480 million. We calculated the capital employed and by using the newly determined capital employed, we plugged the new hurdle of 11. 4% and the given return on capital into the economic profitability formula. Exhibit Five shows the calculations for both the capital employed and the new economic profitability using the new segmented hurdle rate resulting in an economic profitability of $-17. 41 million. We wanted to do a comparison analysis using the corporate hurdle rate and the segmented hurdle rates for each segment. We used the same capital employed that we calculated above and just plugged in the corporate hurdle rate instead of the segmented hurdle rate.
Exhibit Five shows the calculation using the corporate hurdle rate resulting in economic profitability of $78. 19 million. Capital Restructuring After calculating economic profitability for both the telecommunications services segment and products and systems segment using both the newly calculated segmented hurdle rates and also using the corporate hurdle rate, we decided to do a comparison. Exhibit Six shows the economic profitability for each segment. However, the products and systems segment is still underperforming and has negative economic profitability.
The segmented hurdle rate shows that the capital structure of the firm does not properly allocate the optimal capital that could result in much larger economic profits than using a single corporate hurdle rate. The telecommunications services segment has strong performance and low risk, so we determined that we could issue more debt in this segment and decided a weight of debt of 40% was suitable based on performance and comparable firms. Exhibit Seven shows the new WACC with a 40% weight of debt and 60% weight of equity resulting in a lower WACC then using the 27. 1% industry average debt weight.
The products and systems segment is struggling to make economic profit, but we believe that even with the riskier characteristics of this segment that slightly raising the weight of debt above the industry average was a suitable option. The average weight of debt for the industry was 9. 2%, but this resulted in negative economic profit. So, we decided to push the weight of debt to 15% in order to just make this segment profitable without creating major debt risk. We decided to issue more debt because Teletech is a more diversified company that allows the risk to be separate out between the two segments instead of just one industry.
Exhibit Seven shows the calculation for the products and systems segment using the newly determined weight of debt of 15% and weight of equity of 85% resulting in a factorial decrease in the WACC to 10. 96%. Exhibit Eight shows the new comparison analysis using the new WACC from the capital restructuring and shows that both segments are profitable. Conclusion After determining separate WACCs, we calculated economic profit for each segment discovering that products and systems was underperforming.
Using comparable firms, it was evident that there was an opportunity to issue further debt. With the new debt weight, products and systems segment became profitable without significantly impacting this segment’s debt risk. The new debt structure and positive economic profitability would provide increased value for shareholders including Victor Yossarian. We believe that products and systems segment improves the horizontal diversification of Teletech and allows the debt risk to be more separate out with more segments.