Case 15: Teletech Corporation, 2005
Case Study 3: Estimating the Cost of Capital
1. Currently Teletech Corporation (TC) uses a single hurdle rate for both their Telecommunications Services (TS) and Products and Services (P&S) divisions. This hurdle rate obtained by an estimate of TC Weighted Average Cost of Capital (WACC), which is calculated at 9.3%. When analyzing critically at this point, TS is underperforming with a return on capital (ROC) of 9.1%, whereas, P&S segment is well over the required rate of return as it is gaining a ROC of 11.0%. As a result, the firm’ share price is inactive. Their price-to-earning is far below investor’s expectation in comparison to the firm’s risk. The use of a single constant hurdle rate brings about an uncorrelation between risk and return. With an approx. $2 billion being invested in the upcoming years, the discount rate is significantly important in order to make investment decision on profitable projects, that will increase shareholder’s value.
2. Estimate the segment WACCs for Teletech:
Corporate
TS
P&S
Explanation
MV asset weights
100%
75%
25.00%
Bond rating
A-/BBB+
A
BB
Pretax cost of debt (Kd)
5.88%
5.74%
7.47%
Tax rate (t)
40%
40%
40%
After-tax cost of debt
3.53%
3.44%
4.48%
Kd(1-t)
Equity beta (β)
1.15
1.04
1.36
Industry Average
Rf
4.62%
4.62%
4.62%
30-year U.S Treasury Securities
RM
10.12%
10.12%
10.12%
Source: Bloomberg
RM-Rf
5.50%
5.50%
5.50%
Cost of equity (Ke)
10.95%
10.34%
12.11%
Ke=Rf + β(RM-Rf)
Weight of debt
22.19%
22.19%
22.19%
Assume that it stays the same as
Weight of equity
77.81%
77.81%
77.81%
Teletech
WACC
9.30%
8.81%
10.41%
WACC=Wd *Kd(1-t) + We*Ke
3. It seems that TS is actually profitable on a risk-adjusted basic, even though it is underperforming compared with the firm hurdle rate. The reason behind is the current use of constant hurdle rate does not mirror the higher cost of debt required for P&S, and shows
1. Currently Teletech Corporation (TC) uses a single hurdle rate for both their Telecommunications Services (TS) and Products and Services (P&S) divisions. This hurdle rate obtained by an estimate of TC Weighted Average Cost of Capital (WACC), which is calculated at 9.3%. When analyzing critically at this point, TS is underperforming with a return on capital (ROC) of 9.1%, whereas, P&S segment is well over the required rate of return as it is gaining a ROC of 11.0%. As a result, the firm’ share price is inactive. Their price-to-earning is far below investor’s expectation in comparison to the firm’s risk. The use of a single constant hurdle rate brings about an uncorrelation between risk and return. With an approx. $2 billion being invested in the upcoming years, the discount rate is significantly important in order to make investment decision on profitable projects, that will increase shareholder’s value.
2. Estimate the segment WACCs for Teletech:
Corporate
TS
P&S
Explanation
MV asset weights
100%
75%
25.00%
Bond rating
A-/BBB+
A
BB
Pretax cost of debt (Kd)
5.88%
5.74%
7.47%
Tax rate (t)
40%
40%
40%
After-tax cost of debt
3.53%
3.44%
4.48%
Kd(1-t)
Equity beta (β)
1.15
1.04
1.36
Industry Average
Rf
4.62%
4.62%
4.62%
30-year U.S Treasury Securities
RM
10.12%
10.12%
10.12%
Source: Bloomberg
RM-Rf
5.50%
5.50%
5.50%
Cost of equity (Ke)
10.95%
10.34%
12.11%
Ke=Rf + β(RM-Rf)
Weight of debt
22.19%
22.19%
22.19%
Assume that it stays the same as
Weight of equity
77.81%
77.81%
77.81%
Teletech
WACC
9.30%
8.81%
10.41%
WACC=Wd *Kd(1-t) + We*Ke
3. It seems that TS is actually profitable on a risk-adjusted basic, even though it is underperforming compared with the firm hurdle rate. The reason behind is the current use of constant hurdle rate does not mirror the higher cost of debt required for P&S, and shows