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Case 15 Version 2.

Teletech Corporation, 1996


Teaching Note

Synopsis and Objectives

In January 1996, the chief financial officer of this Suggestions for complementary cases:
telecommunications company must fashion a response to Nike Inc. (case 13) gives an introductory
a raider who claims that a major business segment of this exercise in the estimation of the cost of
company should be sold because it is not earning a capital. Coke vs. Pepsi, 2001 (case 14)
offers the estimation of WACCs for two
satisfactory rate of return. The case recounts the debate competitors and opportunities to reflect upon
within the company over the use of a single hurdle rate how business risk drives cost of capital.
to evaluate all segments of the company versus a risk- Phon-Tech Corp. (UVA-F-1161) is a
adjusted hurdle-rate system. The tasks for the student simplified version of Teletech Corporation,
are to resolve the debate, estimate weighted average 1996 (case 15), excluding consideration of
levered beta and segment capital structures.
costs of capital (WACCs) for the two business segments,
and respond to the raider.

The case was prepared to serve as part of an introduction to estimating investors required
rates of return. It would best follow one or two class sessions introducing techniques for
estimating WACC. The numerical calculations required are light, though some of the subtleties
about the use of risk-adjusted hurdle rates will require time for the novice to absorb.

The case can be used to pursue a variety of teaching objectives, including the following:

Extend risk-return (i.e., mean-variance) analysis to corporate finance


Survey classic arguments for and against the use of risk-adjusted hurdle rate systems
Assess the assumptions and limitations of risk-adjusted hurdle rates
Exercise the estimation of segment WACCs

This teaching note was prepared by Professor Robert F. Bruner. Casey Opitz assisted in the preparation of the case.
The author gratefully acknowledges helpful comments from Professor Larry Shotwell, and the financial support of
the Batten Institute. The economic problem and certain quotations in the case were derived from an antecedent case,
Arkansas Petroleum (UVA-F-0247), written by Professor Robert F. Vandell, to whose memory the case is
dedicated. Copyright 1997 by the University of Virginia Darden School Foundation, Charlottesville, VA. All
rights reserved. To order copies, send an e-mail to dardencases@virginia.edu. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means
electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School
Foundation. Rev. 12/01.

181
182 Case 15 Teletech Corporation, 1996

Consider possible organizational barriers to the implementation of risk-adjusted hurdle


rates

Suggested Questions for Advance Assignment

This case complements the seminal extension of mean-variance analysis to corporate


finance by Mark E. Rubinstein (A Mean-Variance Synthesis of Corporate Financial Theory,
Journal of Finance, January 1974). However, it is not necessary that this article be assigned as
collateral reading with the case.

1. How does Teletech currently use the hurdle rate?

2. Please estimate segment WACCs for Teletech (see the worksheet in case Exhibit 1). As
you do this, make careful note of points of judgment in the calculation.

3. Interpret Rick Phillipss graph (Figure 2 in the case). How does the choice of constant
versus risk-adjusted hurdle rates affect the evaluation of Teletechs two segments? What
are the implications for Teletechs resource-allocation strategy?

4. Do you agree that all money is green? What are the implications of this view? What
are the arguments in favor? Opposed?

5. Is Helen Buono right that management would destroy value if all of the firms assets
were redeployed into only the telecommunications business segment? Why or why not?
Please prepare a numerical example to support your view.

6. Has Products and Systems destroyed value? What evidence or illustration can you give
to support your opinion?

7. What should Teletech say in response to Victor Yossarian?

Spreadsheet Files

A spreadsheet file, UVA-S-F-1152.XLS, supports student preparation of the case and


contains case Exhibits 1 and 3. A separate file, UVA-S-F-1152TN.XLS, supports instructor
preparation. Please do not share the instructors file with students.

Hypothetical Teaching Plan

The following questions afford a possible outline for a 90-minute discussion of the case:
Case 15 Teletech Corporation, 1996 183

1. What are the arguments by Rick Phillips for the use of a risk-adjusted hurdle-rate
system? The arguments of Helen Buono against?

A quick survey of arguments on either side of the question sets the stage for calculations
and for a vote at the end of class.

2. What are the implications for capital allocation at Teletech of Rick Phillipss graph
(Figure 2 in the case)? Would allocating capital on the basis of the risk-adjusted hurdle-
rate system create or destroy value?

Figure 2 suggests dramatically differing resource-allocation strategies under the two


hurdle-rate schemes. The instructor might aim to walk students through the figure, and
prepare to offer an illustration of how the firms security prices might change if its
resource allocation changes. See Exhibit TN2 for an example.

3. What are the WACCs of the two segments? Has Products and Systems destroyed value?
What about Telecommunications Services?

In getting student estimates on the board, the instructor should anticipate some variation
in results due to student choices about peer firms drawn from case Exhibit 3.

4. Do you have any other concerns about Teletechs possible implementation of a risk-
adjusted hurdle-rate system?

If time permits, the instructor could invite students to consider a range of


implementational issues and then take a vote of the class.

5. What should Teletech say to Rick Phillips? To Helen Buono? To Victor Yossarian?

The instructor could close the discussion with a brief review of the assumptions and
difficulties of implementing a risk-adjusted hurdle-rate system. The key notion is that
this system embodies the very mean-variance logic of investors and therefore probably
conveys better signals to the managers of a firm than does a single company-wide hurdle
rate. The instructor could also note that ignorance of investors wishes ultimately invites
capital-market discipline (e.g., in the form of Victor Yossarian).

Case Analysis

Risk-adjusted versus constant WACC hurdle rates


Discussion
The case presents generic arguments for and against the use of a risk- Questions
adjusted hurdle-rate systemthese will not be repeated here. However, the risk- 1 and 2
184 Case 15 Teletech Corporation, 1996

return graph in the case (Figure 2) brings the comparison of the two systems to a point: the
allocation of resources implied by the two systems would be diametrically opposed. The
constant WACC system currently in use would feed the Products and Systems (P+S) segment
and starve Telecommunications Services; the risk-adjusted system would do the reverse.
Because Teletechs financial results under the constant WACC system are already known (e.g.,
low P/E multiple, threatened attack by a raider), the instructor could ask students to consider the
effect of implementing the risk-adjusted system. Usually the hardest step for students to absorb
is that the firms WACC will adjust in response to changes in the risk of the firms business.

Exhibit TN1 gives a rough illustration of the potential change in Teletechs market value
under a risk-adjusted system (and the ensuing change in capital allocation that it would trigger),
Three scenarios are presented: the current state (75/25 percent mix of the two segments) and the
two polar extremes, where all of the firms capital is allocated exclusively to one segment. The
bottom line is the value of the enterprise, which is estimated as the firms net operating profit
after tax (NOPAT) capitalized by the weighted average cost of capital (WACC).

Under Scenario A, where all resources are allocated to Telecommunications Services, the
firms return on capital falls to 9.8 percent. But because this is higher than WACC (9.17
percent), the firms market value ($17.09 billion) rises higher than its investment base ($16
billion). Students may find this hard to grasp initially. The key is in observing that because
resources have been allocated totally to the lower risk segment, the firms WACC will decline to
a level consistent with Telecommunications Services. In this scenario, value has been created.

Under Scenario C, where all resources are allocated to Products and Systems, the return
on capital rises to 12 percent; the WACC rises to 14.11 percent. Because the firm in this
scenario earns less than the cost of capital, its market value is smaller than its invested base.
Value has been destroyed.

Overall, it appears that investing in the lower-absolute-return (but higher-relative-return)


Telecommunications Services segment will create value for Teletechs investors, much as the
raider in the case suggests. The key presumption here is that investors will observe changes in
the riskiness of the firms assets, and adjust their required returns accordingly. Security prices
adjust as well. The ability of investors to observe changes in riskiness depends importantly on
the concept of transparency of the firm.

The graph in case Figure 2 can be used to emphasize some of the potential weaknesses of
the constant-hurdle-rate system. First, constant hurdle rates can result in the acceptance of bad
investments (P+S falls in this area on the graph). Second, constant rates can result in the
rejection of good investments (Telecomm falls in this area on the graph). And third, if
investment opportunities roughly form an upward-sloping cloud in risk-return space, constant
hurdle rates can result in naive risk shifting (i.e., to the right on the graph) in pursuit of higher-
return investments.
Case 15 Teletech Corporation, 1996 185

Estimating segment WACCs

The graph in Figure 2 is merely Rick Phillipss abstract representation. Discussion


Whether this is reality depends on estimating the WACCs of the two segments. Question 3
Exhibit TN2 completes the worksheet given in case Exhibit 1. Note that some
student judgment is required here: students will differ on the betas and capital-
structure weights to be applied, though their tendency will be to use segment averages in case
Exhibit 3 (as was done in Exhibit TN2). The beta and weights for P+S draw upon averages of
the telecommunications-equipment and computer-equipment segment averages in case Exhibit
3.1 The instructor should emphasize the importance of internal consistency between beta and
capital-structure assumptions, which the use of industry averages for beta and capital-structure
ratios accomplishes. But if students aim to use betas from some firms and capital structures from
others, the only proper course is to unlever the betas and relever them to reflect the other capital
structures.

Exhibit TN2 reveals that the WACC for P+S is 14.11 percent. For Telecommunications
Services, it is 9.17 percent. At prospective returns of 12.0 percent, P+S is indeed not paying its
way, as Victor Yossarian suggests. Meanwhile, Telecommunications Services is profitable to
investors, with a return of 9.8 percent. The numbers seem fairly consistent with the risk-return
graph in the case.

The note in Exhibit TN2 discusses the computation needed to show value additivity in
WACC, which is discussed in case Exhibit 2. It is not suggested that every instructor try to
emphasize that point with all students. For most students, simply getting close-enough
numbers will be sufficient to leave an impression of the application of mean-variance theory to
corporate finance and of value additivity.

1
Students will strive to take scientific measures of the weights, often out to three or more decimal places,
based on the data in case Exhibit 3. We like to emphasize instead that the weights must be chosen as a matter of
judgment, informed by the information on peers. For instance, regarding the debt weight for the
Telecommunications segment, we use 23 percent, which simply rounds up from the 22.8 percent average of peers in
Exhibit 3. For P+S, the calculation in Exhibit TN2 uses 3.0 percent, which is a rough abstraction from the 4.7
percent average weight of the computer and network peers, and from the 2.0 percent average weight of the
telecommunications-equipment peers. Our use of 3.0 percent is not the correct assumption, though it is certainly
reasonable. Many students will focus on the 4.7 percent average weight for the computer and network segment
but this is inconsistent with the clear description in the case of P+S as a manufacturer of telecommunications
equipment and computing equipment. The learning point for students is that their assumptions must be consistent
with the fundamentals of the business they are analyzing. The instructors spreadsheet model will permit one to try
other reasonable weights as well. The dilemma of Margaret Weston in the case remains robust to variations in
student assumptions about debt weights, as long as they remain in a reasonable range, in comparison to a sample of
peer firms.
186 Case 15 Teletech Corporation, 1996

Implementational Issues

Skeptics in the class may ask, If risk-adjusted hurdle rates are so good, Discussion
why dont all firms use them? Outside of indolence and ignorance, the Question 4
following kinds of issues prove to be barriers to implementation:

Politics: Margaret Weston can count on stiff opposition because the change in hurdle-
rate systems creates winners and losers within the firm. Politics may be a severe barrier.
Advocating the risk-adjusted system will be no easy matter. Smart opponents will point
to the numerous assumptions underlying the system, and may attempt to confuse issues
with less-confident listeners. On the other side, implementation of the risk-adjusted
system will lead to a higher value of the firm (about 6 percent, according to Exhibit
TN1). This should serve the interests of shareholders (and Victor Yossarian). Whether
organizational politics can be surmounted to serve shareholder interests, however, will
hinge on the effectiveness of Teletechs shareholder governance. This may explain why
Yossarian has requested two board seats.

Estimation: The case presents a simplified problem in estimating segment WACCs. The
simplifying assumptions include (1) independence of the two segments and (2) no risk
management through corporate treasury operations. Realistically, Teletechs two
segments are not independent, though how much business they do with each other is not
stated in the case. Relaxing the assumptions of independence and treasury considerably
complicates the task of estimating segment WACCs, the treatment of which is beyond the
scope of discussion in this case and note. Some executives would choose to make the
simplifying assumptions, in the belief that operating managers should be charged a cost
of capital that reflects their own narrow span of influence. Other executives would give
up the risk-adjusted system in frustration in the belief that it should be done right or not
at all and that doing it right is too complicated.

Organizational change: Systems of risk-adjusted hurdle rates probably make sense in the
context of a larger effort to transform a culture toward a more investor-oriented point of
view. Measurement systems are only one avenue of change. Other avenues should
include internal and external communications, training, compensation, and changes in
organization. Many executives will recognize this; only some will have the energy for it.

Discussion of issues such as these will help sensitize students to the challenges of
implementing mean-variance logic and value additivity in a corporate setting.
Case 15 Teletech Corporation, 1996 187

Exhibit TN1

TELETECH CORPORATION, 1996

Illustration of the Potential Adjustment in Enterprise Values


According to Changes in the Mix of Segments

Scenarios
A B C Notes
(currently)
Mix of segments:
%Telecomm. 100% 75% 0%
% P+S 0% 25% 100%

Invested capital $ 16.00 $ 16.00 $ 16.00 Given in case


Avg. return on capital 9.80% 10.35% 12.00% Given in case
NOPAT $ 1.57 $ 1.66 $ 1.92 = ROC * Capital
WACC 9.17% 10.41% 14.11% See Exh. TN2

Value of enterprise $ 17.09 $ 15.91 $ 13.61 = NOPAT/WACC

N.B.: WACCs for segments are estimated in Exhibit TN2.

Source: Casewriter analysis.


188 Case 15 Teletech Corporation, 1996

Exhibit TN2
TELETECH CORPORATION, 1996
Estimation of Segment WACCs: Completion of Case Exhibit 1

Telecommunications Products and


Corporate Services Systems Corporate
MV asset weights 100% 75% 25% (Incorrect)
Bond rating AA+/A- AA BBB-
Pretax cost of debt 7.03% 7.00% 7.78% 7.20%
Tax rate 40% 40% 40% 40.00%
After-tax cost of debt 4.22% 4.20% 4.67% 4.32%

Equity beta 1.041 0.84 1.52 101.00%


Rf 6.04% 6.04% 6.04% 6.04%
RM-Rf 5.50% 5.50% 5.50% 5.50%
Cost of equity 11.77% 10.66% 14.40% 11.60%

Weight of debt 18.00% 23.00% 3.00% 18.00%


Weight of equity 82.00% 77.00% 97.00% 82.00%
WACC ("horizontal") 10.41% 9.17% 14.11% 10.41%
WACC ("vertical") 10.41% 10.28%

Note: This elegant result of value additivity (i.e., where the WACC computed vertically equals the WACC
computed horizontally) obtains exactly only if special care is taken in computing the weighted average beta and
costs of debt. Some analysts might produce an equity beta and cost of debt based on the 75/25 asset weighting. The
typical result is given in the column to the right of the box above, where horizontal and vertical disagree. But
this simple weighting is incorrect because the two segments have different mixes of debt and equity. The correct
approach is to account for these differing mixes. For instance, the weighted average cost of debt (7.03 percent,
above) is computed as:

Telecomm. cost of debt 7.00% a


Telecomm. segment debt/segment capital 23.00%
Telecomm. segment debt/total debt 95.83% b

P+S cost of debt 7.78% c


P+S segment debt/segment capital 3.00%
P+S segment debt/total debt 4.17% d

Weighted average cost of debt 7.03% = (a*b)+(c*d)

Source: Casewriter analysis.