The first procedure we took in evaluating the financial position of Teletech was to estimate the Weighted Average Cost of Capital (WACC) for both its Telecommunications segment and its Products and Systems segment and then compare that to the firms corporate WACC. The WACC assesses the amount the risk that an average capital project undertaken by the firm contains. It is also the required rate of return the firm must end up paying in order to later generate funds, which can then be used as a benchmark to determine how profitable an investment is or may be.
In order to begin calculating WACC we first must calculate the cost of equity for each segment. By comparing Teletech to that of other publically traded companies in the same industry we determined that a beta of 1. 04 was appropriate for the Telecommunications segment, and a beta or 1. 36 for the Products and Systems segment. Using the CAPM approach, we took the segments betas as well as our calculated market risk premium of 5. 5% (See section 1 of Calculations) and were able to determine the cost of equity for the Telecommunications segment to be 10. 34% and the Products and Systems segment to be 12. 1%.
Continuing further we applied each segments after-tax cost of debt along with the firm’s percentage weights of debt and equity, 22. 2% and 77. 8% respectively and were able to determine that the Telecommunications segment had a WACC of 8. 8% while the Products and Systems segment had a WACC of 10. 4%. Teletech currently uses a hurdle rate (or WACC) to help develop decisions surrounding its capital spending. Although, because Teletech is a segmented corporation they needed to find a way to assess the financial position or profitability of their individual segments and how those segments in return affect the entire corporation.
To do so, they use an Economic Profitability (EP) measure (See section 2 of Calculations). Additionally, Teletech is debating whether or not they should continue to use a constant corporate hurdle rate, or if they should begin to use a risk-adjusted hurdle rate. In order to determine which method is more justified for Teletech we needed to calculate the EP’s of both segments using the constant hurdle rate, and then compare that to the segment calculated EP’s using separate risk-adjusted hurdle rates.
We began first with the Telecommunications segment; we knew it had a net operating profit after-tax (NOPAT) of $1. 18 billion and a return of capital (ROC) of 9. 1%. We were able to calculate the EP of Telecommunications to be $-25. 9 million, ultimately not economically profitable. Taking the same procedure for the Products and Systems segment, with a NOPAT of $480 million and a ROC of 11% we found its EP to be roughly $74. 1 million. This was quite a surprised, considering Victor Yossarian wants to drop the P & S segment and place all assets into the Telecommunications Segment.
Next, we calculated each segments EP using a risk-adjusted approach. We simply took the segment’s WACC calculated earlier and applied that as the hurdle rate. Telecommunications EP became positive at $38. 9 million and Products and Systems fell to $26. 17 million. The implications of using a risk-adjusted hurdle rate are clear just by reviewing the four EP’s. By choosing to use a constant hurdle rate that does not compensate for risk, Teletech is undervaluing its profitable segment and overvaluing or even masking the profitability (unprofitability) of its telecommunications department.
Additionally, this has not only a negative affect on the internal aspects of the corporation, but it also has a huge negative impact on its external investors and possibly implies neglect by management toward shareholders. We believe that Teletech is actually hurting itself by using a common constant hurdle rate. Using a corporate hurdle rate is completely inappropriate due to the fact that Teletech is segmented; each segment of the business is likely to have different levels of risk, in fact we know this just by looking at each segments equity beta found earlier.
Telecommunications had a beta of 1. 04 while Products and Systems had a beta of 1. 36, meaning the P & S segment is carrying more investment risk than the Telecomm segment and therefore should be evaluated on with a different standard. After estimating the financial position of each of Teletech’s segments we have determined that Mrs. Bruno is correct in her assessment that value would be destroyed if Teletech were to remove their Products and Systems segment.
Just by reviewing the numbers from our economic profit calculations we can see that the P & S segment is actually more economically profitable than the Telecomm segment, which (using a constant hurdle rate) in fact is actually currently very unprofitable. Looking further we see that the Telecomm segment consists of roughly 75% of Teletech’s assets, while P & S consists of just 25% of assets and is more successful. Does it make sense to remove your assets that are creating profit out of that segment and dump them into your unprofitable segment?
In our opinion, no; removing the P & S segment has a huge affect on the companies R&D, and since the Telecommunications industry relies so heavily on the influx of new technologies (cables/wires, electronic switches, among others) it would seem a poor long-term decision to negatively impact that. Yossarian’s plan may benefit shareholders in the short term, but over the long term Teletech would begin to lose a grasp on its hold of the market share and fall behind its competitors doing virtually nothing different for its shareholders.
Victor Yossarian is a venture capitalist that believes Teletech needs to restructure in order to stay successful in the telecommunications market. We believe Yossarian acquired a 10% stake in the firm because he sees a potential to profit using a new business plan. By creating a greater value for shareholders, he would be able to raise the firm’s stock price and sell the firm in the near future. The two seats on the board will allow him to have power in the boardroom and persuade the board to carry out his strategy. What bothers Yossarian is that Teletech is not realizing an adequate return for a company of its stature.
Teletech was the dominant service provider in the Southwest and Midwest markets and customer surveys routinely determined that the firm was the leader in both product quality and customer satisfaction. The Products and Services segment was known as a technology leader in the industry, and this accounted for its rapid growth and pricing power. By abandoning its entry into computers and focusing on its Product and Systems segment, Yossarian believed high profit margins would soon be realized, thus allowing him to create value for the compan