Teletech Corporation, 2005

Estimating the Cost of Capital

Wake-up Call Needed - Investors

Reclusive Billionaire Victor Yossarian acquired 10%
stake in Telectech in October 2005.
His Demands are:
Two Seats on the Board of Directors.
Sell Product and System segment.
Focus on creating value for Shareholders.

Teletech Corporation
A large regional telecommunication firm headquartered in Dallas,
Texas.
Provider of Integrated
information
movement and management.
Business
Segments
Telecommunication Services
Long-distance, local, and
cellular telephone service.
Business and residential
customers.

Product and Systems

Manufacturer of computing and
telecommunication equipment.

Executives
Maxwell Harper, CEO
Margaret Weston,
CFO
Helen Buono, VP
(Product and System)

Rick Phillips, VP
(Telecommunication)

Telecommunication Services
Merits:
Purchase of few telephone-operating companies through auctions in Latin America.
Has invested aggressively in new technology (digital switches and optical fiber
cables).
Leading service provider in geographical market and product segments.
Leader in Customer satisfaction and Product quality.

Demerits:
Lack of rate relief from Government regulators.
Market penetration by competitors.
Pressure on profit margins.
Strategic decisions for investments are costly in this segment.

Product and systems

Merits:
Explosive growth in microcomputer market and increase usage of telephone lines.
Sales increased by nearly 40% in 2004.
Investments in R&D and Fixed assets.
Can utilize Teletechs capital base, borrowing ability, and distribution network to
increase growth.

Demerits:

Sudden major write-offs of obsolete products.

Competition from Domestic and Foreign major computer manufacturers.

Key figures & Performance

Product and Systems

Telecommunication
Return on Capital
(9.58%)

9.10%

11%

Current Book Value

($16B)

$11.4B

$4.6B

Current Market Value (?)

75%

25%

Telecommunication Product and Systems

Revenue growth [2000-04]

3%

40%

Revenue

$11B

NOPAT

$1.18B

$480m

Net Assets

$11.4B

$4.6B

Current Issues:
Response to activist investor.
Debate over hurdle rate used in assessment of Economic profit and NPV.
Share performance declining relative to industry index over the last 12 months.
Securities Analysts observed
lackluster earnings growth due to increasing competition.
disappointing performance in Product and Systems segment.

Possibility of hostile takeover.

Share performance relative to industry index

Possibility of hostile takeover?

Rick Phillip VP
(Telecommunication)
Both segments have different nature of risks.
Telecommunication has lower risk than Product and Systems segments.
Telecommunication can raise large capital from debt market with solid A rating.
Product and Systems segment should be financed with high yielding (BB-) debt.
Multiple Hurdle Rate to get best return on equity and to reduce cost of equity
funds.
Stockholders are equally concerned with risk.
Comparatively higher debt funding for lower risk segment.

Rick Phillips assessment

Opposition Helena Buono (VP

P&S)
All Money is green and Firm is a black box for investors.
Constant hurdle rate is better than multiple hurdle rate.
Multiple hurdle rate are misleading and could destroy shareholders value.
Unbalanced channeling of funds across segments.
Capital should be raised based on overall prospects and records.

Protagonist- Margaret Westons

concerns
Corporate strategy is toward Integration of two segments.
R&D and application projects seem difficult with multiple hurdle rate.
Multiple hurdle rates are right based on capital costs not based on strategic cost.
Lack of clarity to achieve strategic objective when allocating funds.
Constant hurdle rate make NPV results consistent.
Impossible to borrow debt for product and systems segment separately for high risk

projects.
Investment decisions should not be mixed with financial decisions.
Response to activist investor.

Capital Structure (Market)

No Preferred Shares

Market WACC - Telecommunication

Cost of equity = Risk free rate + Equity Beta (Risk Premium)
Equity Beta = Industry Beta = 1.04 (Exhibit 3)
Risk free rate = 4.62% (Exhibit 4)
Risk Premium = 5.50% (Exhibit 1)
Cost of equity = 4.62% + 1.04 (5.50%) = 10.34%
After-tax cost of debt = 3.44% (Exhibit 3)

Market WACC = 3.44% (22.2%) + 10.34% (77.8%) = 8.8081%

Market WACC Product and Systems

Cost of equity = Risk free rate + Equity Beta (Risk Premium)
Equity Beta = Industry Beta = 1.39 (Exhibit 3)
Risk free rate = 4.39% (Exhibit 4)
Risk Premium = 5.50% (Exhibit 1)
Cost of equity = 4.39% + 1.36 (5.50%) = 11.87%
After-tax cost of debt = 4.48% (Exhibit 3)

Market WACC = 4.48% (22.2%) + 11.87% (77.8%) = 10.228%

Average Beta of Telecommunication Equipment and Computer and Network Equipment Industry.

Focus on value?
Capital
Employed
=(NOPAT/ROC)

Economic Profit
(Single
HR=9.30%)

Economic Profit
(Multiple HR)

$1.18 B

$12.967 B

$-2.5934 B

$3.890 B

$480 m

$4.367 B

$7.4239 B

$3.372 B

ROC

NOPAT

Telecommunicatio
n

9.10%

Product and
Systems

11%

Economic profit = (ROC Hurdle Rate) * Capital Employed

Hurdle Rate for Telecommunication = 8.8081%
Hurdle Rate for Product and Systems = 10.228%

Why Multiple Hurdle Rate?

WACC reflects average of market reaction to a mix of
risks.
Low risk projects low premium - more acceptance.
High risk projects high premium.
Maximize return on equity funds.
Helps to maximize return to shareholders.

Alternatives
To Increase IRR they could sell telecommunications equipment to leasing companies to lower the capital costs.
They could separate the business entirely into separate companies through a spin-off adjusting capitalization to
meet the percentages generally used by competitors.
If these two companies were completely unrelated business lines I would say that they would need to sell one of
the companies because its nearly impossible to manage completely different product lines as proven over and
over again during the 1970s and 1980s when companies were looking to diversify into unrelated product lines.
Overall, I like the idea of having both companies within the corporate structure. The main reason is Teletech
can use these two companies to develop interrelationship brands, which will enable the company to realize
economies or scale and capacity utilization with the company. I think that there needs to be a continued
investment into the separate product lines at separate hurdle rates as a form of diversification to the company
to ultimately bring a higher NPV back to the shareholder.
WACC for Telecommunications: 75% Debt Telecommunications = 11.77*(0.25) + 7.00*(0.6)*(0.75) = 2.94 + 3.15
= 6.09% competition in this industry is extremely competitive. The fact is there have been extensive
buyouts and only a few competitors now dominate the industry. My guess is Victor Yossarian would be looking
to flip this investment to a dominant player in the industry such as Verizon. Weston could lower the WACC
by purchasing Yossarian's shares. If debt was used to purchase the shares, the new debt to equity ratio would be
28% debt and 72% equity. The new WACC for Telecommunications = 11.77*(0.72) +7.00*(0.6)*(0.28) = 8.47% +
1.18% = 9.65%

Westons response to Victor

Yossarian

Questions?
Why Market vs Book WACC?
Why 10 vs 30 year risk free rate?
What does the capital structure look like in both
segments?
Should we sell Product and Systems segment and if not
then why?
Should we use market industry beta? If yes then why?
Why should we use same market risk premium for all
WACC calculation?
Should we make our decision based on Economic profit?

Questions?
Should two segments have different WACC if yes then
what are the assumption and implication of decisions?
Why Exhibit 2 is so important?
Why should we look for similar companies in Exhibit 3?

Questions?

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