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Case 16-Teletech Corporation. You w racall that Teletech comprises two quite different divisions. The Telecom Services (TS) Division is basically a regulated utility. The Products & Systems (P8S) Division operates in much more dynamic and competitive computer markets 1. With regard to calculating an appropriate WACC for each division, what were the two most important factors that clearly required separate consideration for the TS Division as compared to the P&S Division? Explain what approach was used in the case to come up with suitable estimates for each of these two types of factors, and how that could be applied to the task of estimating each Division's WACC. Which division had the lowest WACC & which the highest? 2. What were the basic underlying realities supporting the notion that the WACC should be different between the TS Division and the P&S Division? Draw a graph like the one used in the case and spot in where TS and P&S would fall. Use that construct as a basis to describe the core principles described in the case. What might the eventual overall consequences be to a firm like Teletech if it continues to use a single hurdle rate? 3. As reflected in Teletech's overall WACC, the TS Division was producing lower returns than that required overall average, while the P&S Division was producing returns higher than the overall average requirement. Nonetheless, Victor Yossarian was convinced that, as a combined entity, Teletech was undervalued, and that the overall value of the firm could be increased by selling off the P&S Division and focusing investment activities in the TS Division. What are the underlying premises of Yossarian's position, and how would you support or refute his view? Teletech Corporation, 2005 135 UVA-F-1485 DARDEN BUSINESS PUBLISHING UNIVERSITY, VIRGINIA ROL TELETECH CORPORATION, 2005 Margaret Weston, Teletech Corporation's CFO, learned of Victor Yossarian's letter late one evening in early October 2005. Quickly, she organized a team of lawyers and finance staff to assess the threat. Maxwell Harper, the firm's CEO, scheduled a teleconference meeting of the firm's board of directors for the following afternoon. Harper and Weston agreed that before the meeting they needed to fashion a response to Yossarian's assertions about the firm's returns Raider Dials Teletech "Wake-Up Call Needed," Says Investor New York The reclusive billionaire Victor Yeswaran has acquired a 10 percent stake in Teletech Corporation, large regional telecommunication fire 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 party a letter to Teletech's CEO, Maxwell Harper "The firm is missing is resources and not coming adequate retum," the letter said "The company should bundan its misguided entry into computers, and sell its Product and Systems segment Management must focus on creating value for shareholders." Teletech und rief met emphasizing the virtues of link between computer technology and telecommunications Wall S l y October 15, 2005 Ironically, returns had been the subject of debate within the firm's circle of senior managers in recent months. A number of issues had been raised about the hurdle rate used by the company when evaluating performance and setting the firm's annual capital budget As the company was expected to invest nearly $2 billion in capital projects in the coming year, gaining closure and consensus on those issues had become an important priority for Weston. Now, Yossarian's letter lent urgency to the discussion In the short run, Weston needed to respond to Yossarian. In the long run, she needed to assess the competing viewpoints on Teletech's returns, and she had to recommend new policies as necessary. What should the hurdle rates be for Teletech's two business segments, telecommunications Services and its newer products and systems unit? Was the products and systems segment really paying its way? This case was written by Robert F. Braner with the assistance of San D. Curr. It is dedicated to the memory of Professor Robert F. Vandell, a scholar incorporate finance and Investment analysis and the whee of an d er case upon which the present case draws. Teletech Corporation is a fictional company reflecting the issues facing actual firms, and is used as a basis for class discussion rather than to illustrate effective or ineffective handling of administrative situation. The financial support of the Besten Institute is gully acknowledged Car e 2005 by the University of Virginia Darden School Foundation, Charlottesville, VA All rights reserved. To order copies, and an d to salesidardenbusinesspublishin.com. No part of this publication may be pro s tored in a retrieval sed in a spreadsheet or Braised in my form or by any mean t h at photocopying, recording, or otherwise without the permission of the Darden School Foundation UVA-F-1485 The Company The 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, which provided long-distance, local, and cellular telephone service to business and residential customers, and the products and systems segment, which engaged in the manufacture of computing and telecommunications equipment. In 2004, telecommunications services had earned a return on capital (ROC)' of 9.10%; products and systems had earned 11%. 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% of the market value (MV) of Teletech, while products and systems accounted for 25%. Overall, it appeared that the firm's prospective ROC would be 9.58%. Top management applied a hurdle rate of 9.30% to all capital projects and in the evaluation of the performance of business units. Teletech Share Prices vs. Market and Industry Indeses Y Over the past 12 months, Tele- tech's shares had not kept pace with the overall stock market or with industry indexes for telephone, equipment, or computer stocks. Securities analysts had remarked on the firm's lackluster earnings growth, pointing especially to increasing competition in telecommuni- cations, as well as disappointing per- formance in the Products and Systems segment. A prominent commentator on TV opined, "There's no precedent for a hostile takeover in this sector, but, in the case of Teletech, there is every reason to Now. Du MAN M ASO 04 Telecommunications services 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% during 2000-04. In 2004, 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 the gradual deregulation of its industry through aggressive expansion Return on capital was calculated as the ratio of net operating profits after tax (NOPAT) to capital. UVA-F-1485 into new services and geographical regions. Most recently, the firm had been a leading bidder for cellular telephone operations and for licenses to offer personal communications services (PCS), In addition, the firm had purchased a number of telephone operating companies through 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 those strategic moves had been costly: the capital budget in this segment had varied between $1.5 billion and $2 billion in each of the previous 10 years. Unfortunately, profit margins in the telecommunications 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 geographical markets and invested in new technology and quality enhancing assets. Teletech's management noted that large cable-TV companies had aggressively entered the telecommunications market and continued the pressure on profit margins. Nevertheless, Teletech was the dominant service provider in its geographical markets and product segments. Customer surveys revealed that the company was the leader in product quality and customer satisfaction. Its management was confident that the company could command premium prices no matter how the industry might evolve. Products and systems Before 2000, telecommunications had been the company's core business, supplemented by an equipment manufacturing division that produced telecommunications components. In 2000, 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 usage of telephone lines to connect home and office-based computers with mainframes convinced Teletech's management of the potential value of marrying telecommunications equipment with 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% in 2004. This segment's 2004 NOPAT and net assets were $480 million and S4.6 billion, respectively. The products and systems segment was acknowledged as a technology leader in the industry. While this accounted for its rapid growth and pricing power, maintenance of that leadership position required sizable investments in research and development (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 the telecommunications-equipment industry, Foreign manufacturers were proving to be stiff competition for bidding on major supply contracts. UVA-F-1485 Focus on Value at Teletech We will create value by pursuing business activities that earn premium rates of return -Teletech Corporation mission statement (excerpt) Translating Teletech's mission 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 creating value meant. Because the segments and smaller business units did not issue securities in the capital markets, the only objective measure of value was 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 by the capital it used: Economic profil - (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 evaluated based on economic profit. This measure was an important consideration in strategic decisions about capital allocation, manager promotion, and incentive compensation. The second way in which the value-creation perspective influenced managers was in the assessment of capital investment proposals. For each investment, proje discounted to the present using the firm's hurdle rate to give a measure of the net present value (NPV) of each project. A positive (or negative) NPV indicated the amount by which the value of the firm would increase or decrease) if the project were undertaken. The following shows how the hurdle rate was used in the familiar NPV equation: Net present value Free cash flow, (1 + Hurdle rate - Initial investment UVA-F-1485 Hurdle Rates The hurdle rate used in the assessments of economic profit and NPV had been the focus of considerable debate in recent months. This rate was based on an estimate of Teletech's weighted average cost of capital (WACC). Management was completely satisfied with the intellectual relevance of a hurdle rate as an expression of the opportunity cost of money. The notion that the WACC represented this opportunity cost had been hotly debuted within the company, and while its measurement had never been considered wholly scientific, it was generally accepted. Teletech was "split-rated between A- and BBB+. An investment banker recently suggested that, at those ratings, new debt funds might cost Teletech 5.88% (about 3.53% after a 40% tax rate). With a beta of 1.15, the cost of equity might be about 10.95%. At market value weights of 22% for debt and 78% for equity, the resulting WACC would be 9.30%. Exhibit summarizes the calculation. The hurdle rate of 9.30% was applied to all investment and performance measurement analyses at the firm. Arguments for risk-adjusted hurdle rates How the rate should be used within the company in evaluating projects was another point of debate. Given the differing 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 9.30%. The chief advocate for multiple rates was Rick Phillips, executive vice president of telecommunications services, who presented his views as follows: Each phase of our business is different. They must compete differently and must draw on capital differently. Given the historically stable nature of this industry. many telecommunications companies can raise large quantities of capital from the debt markets. In operations comparable to telecommunications services, 50% of the necessary capital is raised in the debt markets at interest rates reflecting solid A quality, on average. This is better than Teletech's corporate bond rating of A-/BBB. I also have to believe that the cost of equity for telecommunications services is lower than it is for products and systems. Although the products and systems segment's sales growth and profitability have been strong, its risks are high. Independent equipment manufacturers are financed with higher-yielding BB-rated debt and a greater proportion of equity. In my book, the hurdle rate for products and systems should reflect those 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-fedthat's because our returns are less than the corporate hurdle rate, and theirs are greater. Telecommunications services lowers the risk of UVA-F-1485 the whole corporation, and should not be penalized. Here's a rough graph of what I think is going on (Figure 2): Figure 2. Rick Phillips's assessment of constant versus risk-adjusted hurdle rates. 18.00% 16.00% Products and Systems Teletech Counde ATS O Products cons Services Rikre Low Telech Con R Level Telecommunications services, which can earn 9.10% on capital, is actually profitable on a risk-adjusted basis, even though it is not profitable 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 (P&S), which promises to earn 11.0% on capital. P&S is located on the graph near the little circle. In deciding how much to loan us, lenders will consider the composition of risks. If money flows into safer investments, over time the cost of their loans to us will decrease. Our stockholders are equally as concerned with risk. If they perceive our business as being more risky than other companies are, they will not pay as high a price for our earnings. Perhaps this is why our price-to-camings 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 those adjustments systematically or not. -9 UVA-F-1485 projects should provide a return premium. While the multiple-hurdle-rate system was a crude way to achieve this end, at least it 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 would To help resolve these issues, Weston asked her assistant, Bernard Ingles, to summarize the scholarly thought regarding multiple hurdle rates. His memorandum is given in Exhibit 2. She also requested that Ingles obtain samples of firms comparable with the telecommunications services segment and the products and systems unit that might be used in deriving segment WACCs. A summary of the data is given in Exhibit 3. Information on capital market conditions in October 2005 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 the analysis. She did want to institute a pragmatic system of appropriate hurdle rates (or one rate), however, that would facilitate judgments in the changing circumstances faced by Teletech. What were the appropriate hurdle rates for the two segments? Was the products and systems segment underperforming, as suggested by Yossarian? How should Teletech respond to the raider? -10- UVA-F-1485 Exhibit 1 TELETECH CORPORATION, 2005 Summary of the WACC Calculation for Teletech Corporation and Segment Worksheet Telecommunications Services 75% MV asset weights Bond rating Pretax cost of debt Tax rate After-tax cost of debt Corporate 100% A-/BBB+ 5.88% 40% 3.53% Products and Systems 25.00% BB 7.47% 40% 4.48% 5.74% 40% 3.44% Equity beta RM RM-R Cost of equity 1.15 4.62% 10.12% 5.50% 10.95% Weight of debt Weight of equity WACC 22.2% 77.8% 9.30% Data source: Bloomberg LP, S&P Research Insight, and case writer analysis. UVA-F-1485 Exhibit 2 TELETECH CORPORATION, 2005 Theoretical Overview of Multiple Hurdle Rates To: From: Subject: Date: Margaret Weston Bernard Ingles Segment cost-of-capital theory October 2005 You requested an overview of the theories on multiple hurdle rates. Without getting into the minutiae, the theories boil down to the following points: 1. The central idea is that required returns should be driven 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, at least in theory, straightforward 2. An underlying assumption is that the firm is transparent (ie, 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 both 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 have to balance MV (MV S + MV Protest.) -( M MV) If those equalities did not hold, then a raider could come along and exploit the inequality by buying or selling the whole and the parts. This is arbitrage. By buying and selling, the actions of the raider would drive the MVs back into balance. UVA-F-1485 Exhibit 3 TELETECH CORPORATION, 2005 Samples of Comparable Firms 2004 Reves Equity Beta B VL Bed De l Rating Capital Mit Val Mit Val Piero Debe Debt Book Capital Equity Price Earnings Company Name Teletech Corporation 16,000 LISA -BBB+ 46% 22% 29% 12.3 1:19 24 BB+ $0.9% 30.1% 57.7% 29.7% 154 2.4) 16.7 133 BB Telecommunication Services Industry Ahel Corp 8.246 100 ATAT Corp 30 537 LID Both Corp 20.350 100 Centaryel Corp 24111.05 Ciens Communications Co. 2.193 100 IDT Corp 2.217 10S SBC Communications Inc 40.787 105 Spre Corp 27428 119 Verico Communications Inc 71.23 100 Average 104