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Teaching Note
Synopsis and Objecties
In October 2005, the chief financial officer (CFO)
of a telecommunications company neee to fashion a
response to a corporate raier !ho claime that a ma"or
business segment of this company shoul ha#e been sol
because it !as not earning a satisfactory rate of return$
The case recounts the ebate !ithin the company o#er the
use of a single hurle rate to e#aluate all segments of the
company #ersus a ris%&a"uste hurle&rate system$ The tas%s for the stuent are to resol#e the
ebate, estimate the !eighte&a#erage costs of capital ('(CC) for Teletech)s t!o business
segments, an respon to the raier)s assertions$
This case !as prepare to ser#e as part of an introuction on estimating in#estors)
re*uire rates of return$ It !oul best follo! one or t!o teaching sessions introucing techni*ues
for estimating '(CC$ The re*uire numerical calculations are light, although some of the
subtleties about the use of ris%&a"uste hurle rates !ill re*uire time for the no#ice to absorb$
The case can be use to pursue a #ariety of teaching ob"ecti#es, incluing the follo!ing+
,-ten ris%&return (i$e$, mean&#ariance) analysis to corporate finance$
.ur#ey classic arguments for an against the use of ris%&a"uste hurle&rate systems$
(ssess the assumptions an limitations of ris%&a"uste hurle rates$
,-ercise the estimation of segment '(CCs$
Consier possible organi/ational barriers to the implementation of ris%&a"uste hurle
This teaching note !as prepare by 0obert F$ 1runer !ith the assistance of .ean 2$ Carr$ The author gratefully
ac%no!leges helpful comments from 3rofessor 4arry .hot!ell, an the financial support of the 1atten Institute$
The economic problem an certain *uotations in this case !ere eri#e from an anteceent case, 5(r%ansas
3etroleum6 (78(&F&029:), !ritten by our colleague, 3rofessor 0obert F$ 8anell, to !hose memory this case is
eicate$ Copyright ; 2005 The 7ni#ersity of 8irginia 2aren .chool Founation$ (ll rights reser#e$ To order
copies, send an e-mail to sales<arenpublishing$com$ 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 meanselectronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Darden Foundation.
S!""estions #o$ co%p&e%enta$y cases'
5Ni%e Inc$,6 (case =>) gi#es an introuctory
e-ercise in the estimation of the cost of
capital$ 5Co%e #s$ 3epsi, 200=,6 (case =9)
offers the estimation of '(CCs for t!o
competitors an the opportunity to reflect on
ho! business ris% ri#es the cost of capital$
S!""ested (!estions #o$ Adance Assi"n%ent
This case complements the seminal e-tension of mean&#ariance analysis to corporate
finance by ?ar% ,$ 0ubinstein, 5( ?ean&8ariance .ynthesis of Corporate Financial Theory,6
Journal of Finance, @anuary =A:9$ It is not necessary, ho!e#er, that this article be assigne to
stuents as collateral reaing !ith the case$
=$ Bo! oes Teletech Corporation currently use the hurle rateC
2$ 3lease estimate the segment '(CCs for Teletech (see the !or%sheet in case ,-hibit =)$ (s
you o this, carefully note the points of "ugment in the calculation$
>$ Interpret 0ic% 3hillips)s graph (see Figure 2 in the case)$ Bo! oes the choice of constant
#ersus ris%&a"uste hurle rates affect the e#aluation of Teletech)s t!o segmentsC 'hat
are the implications for Teletech)s resource&allocation strategyC
9$ 2o you agree that 5all money is green6C 'hat are the implications of that #ie!C 'hat are
the arguments in fa#orC 'hat are the arguments against itC
5$ Is Belen 1uono right that management !oul estroy #alue if all the firm)s assets !ere
reeploye into only the telecommunications business segmentC 'hy or !hy notC 3lease
prepare a numerical e-ample to support your #ie!$
D$ Bas 3roucts an .ystems (3E.) estroye #alueC 'hat e#ience or illustrations can you
gi#e to support your opinionC
:$ 'hat shoul Teletech say in response to 8ictor FossarianC
Sp$eads)eet *i&es
The spreasheet file, CaseG=5$-ls, supports stuent preparation of the case an contains
case ,-hibits =, >, an 9$ ( separate file, TNG=5$-ls, supports the instructor)s class preparation$
3lease o not share the instructor)s spreasheet file !ith the stuents$
Hypot)etica& Teac)in" P&an
The follo!ing *uestions affor a possible outline for a A0&minute iscussion of the case$
. !hat are "ic# $hillips%s arguments for the use of the ris#-ad&usted hurdle-rate system'
!hat are (uono%s arguments against the system'
( *uic% sur#ey of arguments on either sie of the *uestion sets the stage for calculations
an for a #ote at the en of class$
2$ !hat are the implications of $hillips%s graph for capital allocation at Teletech )Figure *
in the case+' !ould allocating capital on the basis of the ris#-ad&usted hurdle-rate
system create or destroy value'
Figure 2 suggests ramatically iffering resource&allocation strategies uner the t!o
hurle&rate schemes$ The instructor might aim to !al% stuents through the figure, an to
prepare to offer an illustration of ho! the firm)s security prices might change if its
resource allocation change$ .ee E+)ibit TN2 for an e-ample$
>$ !hat are the !,--s of the two segments' .as $roducts and /ystems destroyed value'
!hat about Telecommunications /ervices'
In getting the stuents) estimates on the boar, the instructor shoul anticipate some
#ariation in results ue to the ini#iual stuent)s choices about peer firms ra!n from
case ,-hibit >$
9$ Do you have any other concerns about Teletech%s possible implementation of a ris#-
ad&usted hurdle-rate system'
If time permits, the instructor coul in#ite stuents to consier a range of implementation
issues an then ta%e a #ote of the class$
5$ !hat should Teletech say to $hillips' !hat should the company say to (uono' !hat
about to 0ossarian'
The instructor coul close the iscussion !ith a brief re#ie! of the assumptions an
ifficulties of implementing a ris%&a"uste hurle&rate system$ The %ey notion is that this
system emboies the #ery mean&#ariance logic of in#estors an therefore probably con#eys
better signals to the managers of a firm than oes a single company&!ie hurle rate$ The
instructor coul also note that ignorance of in#estors) !ishes ultimately in#ites capital&
mar%et iscipline (for e-ample, in the form of Fossarian)$
Case Ana&ysis
Ris,-adj!sted e$s!s constant .ACC )!$d&e $ates
The case presents generic arguments for an against the use of a ris%&a"uste hurle&rate
system$ Those arguments !ill not be repeate here$ Bo!e#er, the ris%&return graph in the case
(Figure 2) brings the comparison of the t!o systems to a point+ The allocation of resources
implie by the t!o systems !oul be iametrically oppose$ The constant '(CC system currently
in use !oul fee the 3E. segment an star#e Telecommunications .er#icesH a ris%&a"uste
system !oul o the re#erse$ 1ecause Teletech)s financial results uner the constant '(CC
system are alreay %no!n (for e-ample, the lo! 3I, multiple, the threatene attac% by a
corporate raier), the instructor coul as% stuents to consier the effect of implementing the ris%&
a"uste system$ 7sually the harest step for stuents to absorb is reali/ing that the firm)s '(CC
!ill a"ust in response to changes in the ris% of the firm)s business$
1 and 2
E+)ibit TN1 gi#es a rough illustration of the potential change in Teletech)s mar%et #alue
uner a ris%&a"uste system (an the ensuing change in capital allocation that it !oul trigger)$
Three scenarios are presente+ the current state (:5I25J mi- of the t!o segments) an the t!o
polar e-tremes, !here all the firm)s capital is allocate e-clusi#ely to one segment$ The bottom
line is the #alue of the enterprise, !hich is estimate as the firm)s net operating profit after ta-
(NO3(T) capitali/e by the !eighte&a#erage cost of capital ('(CC)$
7ner scenario (, !here all resources are allocate to the Telecommunications .er#ices
segment, the firm)s return on capital is A$=0J$ 1ecause this is higher than the '(CC for
Telecommunications .er#ices (at K$9AJ), the firm)s mar%et #alue, at L=:$=5 billion, is higher than
its in#estment base of L=D billion$ .tuents may fin that concept ifficult to grasp initially$ The
%ey is in obser#ing that because resources ha#e been completely allocate to the lo!er ris%
segment, the firm)s '(CC !ill ecline to a le#el consistent !ith Telecommunications .er#ices$
Bence in scenario (, #alue has been create$
7ner scenario C, !here all resources are allocate to 3E., the return on capital is ==J
an the '(CC is ==$:>J$ .ince the firm in this scenario earns less than the cost of capital, its
mar%et #alue of L=5 billion is smaller than its in#este base of L=D billion$ Bence in scenario C,
#alue has been estroye$
O#erall, it appears that in#esting in the lo!er absolute&return, but the higher relati#e&
return, Telecommunications .er#ices segment !ill create #alue for Teletech)s in#estors, much as
the corporate raier in the case suggests$ The %ey presumption here is that in#estors !ill obser#e
the changes in the ris%iness of the firm)s assets, an they !ill a"ust their re*uire returns
accoringly$ .ecurity prices a"ust as !ell$ The ability of in#estors to obser#e changes in ris%iness
epens importantly on the transparency of the firm$
The graph in case Figure 2 can be use to emphasi/e some of the potential !ea%nesses in
the constant hurle&rate system$ First, constant hurle&rates can result in the acceptance of ba
in#estments (3E. falls in this area on the graph)$ .econ, constant rates can result in the re"ection
of goo in#estments (Telecommunications .er#ices falls in this area on the graph)$ (n thir, if
in#estment opportunities roughly form an up!ar&sloping clou in ris%&return space, constant
hurle rates can result in nai#e ris% shifting (i$e$, to the right on the graph) in the pursuit of higher&
return in#estments$
Esti%atin" se"%ent .ACCs
The graph in Figure 2 is merely 3hillips)s o!n abstract representation$ 'hether this is
reality or not epens upon estimating the '(CCs of the t!o segments$ E+)ibit TN2 completes
the !or%sheet sho!n in case ,-hibit =$ Note that some stuent "ugment is re*uire here$
.tuents !ill iffer on the betas an the capital&structure !eights to be applie, although their
tenency !ill be to use the segment a#erages from case ,-hibit > (as !as one in E+)ibit TN2)$
The beta an !eights for 3E. ra! on the a#erages of the telecommunications&e*uipment an
computer&e*uipment segment a#erages in case ,-hibit >$
The instructor shoul emphasi/e the
importance of internal consistency bet!een beta an capital&structure assumptions$ The use of
inustry a#erages for beta an capital&structure ratios accomplishes that internal consistency$ 1ut
if stuents aim to use betas from some firms an capital structures from others, the only proper
course is to unle#er the betas an rele#er them to reflect the other capital structures$
E+)ibit TN2 re#eals that the '(CC for 3E. is ==$:>J, !hile the '(CC for
Telecommunications .er#ices is K$9AJ$ (t prospecti#e returns of ==$0J, 3E. is, inee, not
paying its !ay, as Fossarian suggests$ ?ean!hile, Telecommunications .er#ices is profitable to
in#estors, !ith a return of A$=0J$ The numbers seem fairly consistent !ith the ris%&return graph in
the case$
The note in E+)ibit TN2 iscusses the computation neee to sho! #alue aiti#ity in the
'(CC, !hich is iscusse in case ,-hibit 2$ It is not suggeste that e#ery instructor try to
emphasi/e that point !ith all the stuents$ For most stuents, simply getting appro-imate ans!ers
!ill be sufficient to lea#e an impression of #alue aiti#ity an of the application of the mean&
#ariance theory to corporate finance$
= .tuents !ill stri#e to fin the 5scientific6 measures of the !eights, often out to three or more ecimal
places, base on the ata in case ,-hibit >$ Instea, !e li%e to emphasi/e that the !eights must be chosen as a
matter of &udgment, informe by the information on peer firms$ For instance, regaring the ebt !eight for the
Telecommunications .er#ices segment, !e use 2:$=J, !hich is simply the a#erage of the peers in case ,-hibit >$
For 3E., the calculation in E+)ibit TN2 uses :$5J, !hich is a rough abstraction from the 5$KJ a#erage !eight of
the computer an net!or% peers, an from the =D$DJ a#erage !eight of the telecommunications&e*uipment peers$
Our use of :$5J is not the correct assumption, although it is certainly reasonable$ ?any stuents !ill focus on the
5$KJ a#erage !eight for the computer an net!or% segment, but this is inconsistent !ith the clear escription in
the case of 3E. as a manufacturer of telecommunications e*uipment and computing e*uipment$ The learning point
for stuents is that their assumptions must be consistent !ith the funamentals of the business they are analy/ing$
The instructor)s spreasheet moel !ill permit one to try other reasonable !eights as !ell$ ?argaret 'eston)s
ilemma in the case remains robust to #ariations in stuent assumptions about ebt !eights, as long as they remain
in a reasonable range, in comparison, to a sample of peer firms$
0!estion 1
I%p&e%entation iss!es
.%eptics in the class may as%, 5If ris%&a"uste hurle rates are so goo, !hy on)t all
firms use themC6 Outsie of inolence an ignorance, the follo!ing issues ha#e pro#en to be
barriers to the implementation of ris%&a"uste hurle rates+
$olitics+ 'eston can count on stiff opposition because the change in hurle&rate systems
creates !inners an losers !ithin the firm$ 3olitics may be a se#ere barrier$ (#ocating the
ris%&a"uste system !ill be no easy matter$ .mart opponents !ill point to the numerous
assumptions unerlying the system, an may attempt to confuse the issues !ith less&
confient listeners$ On the other sie, implementation of the ris%&a"uste system !ill lea
to a higher #aluation of the firm (about :J, accoring to E+)ibit TN1)$ This shoul ser#e
the interests of shareholers (an Fossarian)$ 'hether organi/ational politics can be
surmounte to ser#e shareholer interests, ho!e#er, !ill hinge on the effecti#eness of
Teletech)s shareholer go#ernance$ This may e-plain !hy Fossarian has re*ueste t!o
boar seats$
1stimation+ The case presents a simplifie problem in estimating segment '(CCs$ The
simplifying assumptions inclue+ (=) inepenence of the t!o segments, an (2) no ris%
management through corporate treasury operations$ 0ealistically, Teletech)s t!o segments
are not inepenent, although ho! much business they o !ith each other is not state in
the case$ 0ela-ing the assumptions of inepenence an treasury consierably complicates
the tas% of estimating segment '(CCs, the treatment of !hich is beyon the scope of
iscussion in this case an note$ .ome e-ecuti#es !oul choose to ma%e simplifying
assumptions in the belief that operating managers shoul be charge a cost of capital that
reflects their o!n narro! span of influence$ Other e-ecuti#es !oul gi#e up the ris%&
a"uste system in frustration in the belief that it shoul be 5one right or not at all6 an
that oing it right is too complicate$
2rgani3ational change+ .ystems of ris%&a"uste hurle rates probably ma%e sense in the
conte-t of a larger effort to transform a culture to!ar a more in#estor&oriente point of
#ie!$ ?easurement systems are only one a#enue of change$ Other a#enues shoul inclue
internal an e-ternal communications, training, compensation, an changes in
organi/ation$ ?any e-ecuti#es !ill recogni/e thisH but only a fe! !ill ha#e the energy for
2iscussion of issues such as these !ill help sensiti/e stuents to the challenges of implementing
mean&#ariance logic an #alue aiti#ity in a corporate setting$
0!estion 2
,-hibit TN=
Illustration of the 3otential ("ustment in ,nterprise 8alues
(ccoring to Changes in the ?i- of .egments
.ource+ Case !riter analysis$
,-hibit TN2
,stimation of .egment '(CCs+ Completion of Case ,-hibit =
Note+ This elegant result of #alue aiti#ity, (i$e$ !here the '(CC, compute 5#ertically6 e*uals the '(CC
compute 5hori/ontally6) is obtaine e-actly only if special care is ta%en in computing the !eighte a#erage beta
an costs of ebt$ .ome analysts might prouce an e*uity beta that simply uses the :5I25 asset !eighting for
segment betas (li%e!ise !ith the cost of ebt)$ The typical result is gi#en in the column to the right of the bo-
abo#e, !here 5hori/ontal6 an 5#ertical6 isagree$ 1ut this simple !eighting is incorrect since the t!o segments
ha#e ifferent mi-es of ebt an e*uity$ The correct approach is to account for these iffering mi-es$ For instance,
the !eighte a#erage cost of ebt (5$KKJ abo#e) is compute as+
.ource+ Case !riter analysis$

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