If elmarto-ga is not available question is open to anyone.
This is the long case study questions.
TELETECH CORPORATION, 1996
Raiders Dials Teletech
Wake-up Call Needed Says Investor
New York (AP)---The reclusive billionaire Victor Yossarian has
acquired a 10 percent stake in Teletech Corporation and has
demanded two seats on the firm’s board of directors. The purchase was
revealed yesterday in a filing with the Securities and Exchange
Commission, and separately in a letter to Teletech’s CEO, Maxwell
Harper. “The firm is misusing its resources and not earning an
adequate return,” the letter said, “The company should abandon its
misguided entry into comput-ers, and sell the Product and
Systems Segment. Management must focus on creating value for
shareholders.” Teletech issued a brief statement emphasizing the
virtues of a link between com-puter technology and
telecommunications.
TELETECH CORPORATION, 1996
Margaret Weston, Teletech’s chief financial officer, learned of
Yossarian’s letter late one eveing in early January 1996. Quickly
she organized a team of lawyers and finance staff to assess
the threat. Maxwell Haper, the firm’s CEO, scheduled a
teleconference meeting of the firm’s board of directors the next
afternoon. Harper and Weston agreed that before the meeting they
needed to fash-ion a response to Yossarian’s assertions about
the firms’s returns.
Ironically, returns had been the sub-ject of debate within
the firm’s circle of senior managers in recent months. A
num-ber of issues had been raised about the hur-dle rate used by
the company in evaluating performance, and in setting the
annual capital budget. Since the company was ex-pected to invest
nearly $2 billion in capital
Wall Street Daily News, January 9, 1996
projects in 1996, gaining closure and consensus on these issues had
become an important priority for Margaret Weston. Now, Yossarian’s
letter lent urgency to the discussion. In the short sun, she needed
to respond to Yossarian. In the long run, she needed to assess the
competing viewpoints, and recommend new policies as necessary. What
should be the hurdle rated for Teletech’s two business segments? Was
the Products and Systems segment really paying its way?
The Company
Teletech Corporation, headquartered in Dallas, Texas, defined itself
as a “provider of integrated information movement and management,”
The firm had two main business segments: Telecommunications Services
and Products and Systems, which manufactured computing and
telecommunications equipment. In 1995, Telecommunications Services
had earned a return on capital(ROC) of 9.8 percent; Products and
Systems had earned 12.0 percent. The firm’s current book value of net
assets was $16 billion, consisting of $11.4 billion allocated to
Telecommunications Services, and $4.6 billion allocated to Products
and Systems. An internal analysis suggested that Telecommunications
Services accounted for 75 percent of the market value of Teletech,
while Products and Systems accounted for 25 percent. The current
capital expenditures proposed by Telecommunications Services offered
prospective internal rates of return averaging of 9.8 percent; the IRR
for prospective Products and Systems projects averaged 12.0 percent.
Overall, it appeared that the firm’s prospective return on capital
would be 10.35 percent. Top management applied a hurdle rate of 10.41
percent to all capital projects, and in evaluating the performance of
business units.
Over the past 12 months, the firm’s shares had not kept pace
with the overall stock market indices, or with industry indexes for
telephone, equipment, or computer stocks. See Figure 1.
Securities analysts had remarked on the firm’s lackluster earnings
growth, pointing especially to increasing competition in
telecommunications, as well as disappointing performance in the
Products and Systems segment. A prominent commentator on television
opined that “there was no precedent for hostile takeover of a
telephone company, but in the case of Teletech, there is every reason
to try.”
Teletech’s Telecommunications Services Segment
The Telecommunications Services segment provided long-distance, local
and cellular telephone service to more than 7 million customer lines
throughout the Southwest and Midwest. Revenues in this segment grew
at an average rate of 3 percent over the 1989-95 period. In 1995,
segment revenues, net operating profit after tax (NOPAT), and net
assets were $11 billion, $1.18 billion, and $11.4 billion,
respectively. Since the court-ordered breakup of the Bell System
telephone monopoly in 1983, Teletech had coped with gradual
deregulation of its industry through aggressive expansion into new
services and geographic regions. Most recently, the firm had been a
leading bidder for cellular telephone operations, and for licenses to
offer personal communication services (PCS). In addition, the firm
had purchased a number of telephone operating companies in
privatization auctions in Latin America. Finally, the firm had
invested aggressively in new technology---primarily digital switches
and optical-fiber cables—in an effort to enhance its service quality.
All of these strategic moves had been costly: the capital budget in
this segment had varied between $1.5 and $2 billion in each of the
previous 10 years.
Unfortunately, profit margins in the telecommunication segment
had been under pressure for several years. Government regulators had
been slow to provide rate relief to Teletech for its capital
investments. Other leading telecommunications providers had expanded
into Teletech’s geographic markets and invested in new technology and
quality enhancing assets. Teletech’s management noted that large
cable TV companies might enter the telecommunications market and
continue the pressure on margins.
On the other hand, Teletech was dominant service provider in
its geographic markets and product segments. Customer surveys
revealed that the company was the leader in product quality and
customer satisfaction. Teletech’s management was confident that the
company could command premium prices, however the industry might
evolve.
Teletech’s Products and Systems Segment
Before 1990, telecommunications had been the company’s core business,
supplemented by an equipment-manufacturing division that produced
telecommunication components. In 1990, the company acquired a leading
computer workstation manufacturer with the goal of applying
state-of-the-art computing technology to the design of
telecommunications equipment. The explosive growth in the
microcomputer market and the increased use of telephone lines to
connect home- and office-based computers with mainframes convinced
Teletech management of the potential value of marrying
telecommunications equipment and computing technology. Using
Teletech’s capital base, borrowing ability, and distribution network
to catapult growth, the Products and Systems segment increased its
sales by nearly 40 percent in 1995. This segment’s 1995 NOPAT and net
assets were $480 million and $4.6 billion, respectively.
Products and Systems was acknowledged to be a technology
leader in the industry. While this accounted for its rapid growth and
pricing power, maintenance of the leadership position required sizable
investments in R&D and fixed assets. The rate of technological change
was increasing, as witnessed by sudden major write-offs by Teletech on
products that until recently management had thought were still
competitive. Major computer manufacturers were entering into the
telecommunication-equipment industry. Foreign manufacturers were
proving to be competitors in bidding on major supply contract.
FOCUS ON VALUE AT TELETECH
Teletech’s mission statement said in part,
We will create value by pursing business activities that earn
premium rates of return.
Translating that statement into practice had been a challenge
for Margaret Weston. First, it had been necessary to help managers of
the segments and business units understand what “create value” meant
for them. Because the segments and smaller business units did not
issue securities into the capital market, the only objective measures
of value were the securities prices of the whole corporation—but the
activities of any particular manager might not be significant enough
to drive Teletech’s securities prices. Therefore, the company had
adopted a measure of value creation for use at the segment and
business unit level that would provide a proxy for the way investors
would view each unit’s performance. This measure, called “economic
profit,” multiplied the excess rate of return of the business unit
time the capital it used:
Economic Profit = (ROC --- Hurdle rate) x Capital employed
Where:
NOPAT
ROC = Return on capital = -----------
Capital
NOPAT = Net operating profit after taxes
Each year, the segment and business unit executives were measured on
the basis of economic profit. This measure was an important
consideration in strategic decisions about capital allocation, manager
promotion, and the awarding of incentive compensation.
A second way in which the value creation perspective
influenced managers was in the assessment of capital-investment
proposals. For each investment, projected cash flows were discounted
to the present using the firm’s hurdle rate to give a measure of the
net present value (or NPV) of each project. A positive
(negative) NPV indicated the amount by which the value of the firm
would increase (decrease) if the project were undertaken. The
following equation shows who the hurdle rate was used in the familiar
NPV equation:
n Free
cash flowt
Net present value = ĺ [ ----------------- ] - Initial
investment
t = 1 ( 1
+ hurdle rate)1
HURDLE RATES
How the rate should be used within the company in evaluating projects
was another point of debate. Given the different natures of the two
businesses and the risks each one faced, differences of opinion arose
at the segment level over the appropriateness of measuring all
projects against the corporate hurdle rate of 10.41 percent. The
chief advocate of multiple rates was Rick Phillips, executive vice
president of Telecommunications Services, who presented his views as
follows:
Each phase of our business is different, must compete differently, and
must draw on capital differently. Until recently, telecommunications
was a regulated industry, and the return on our total capital highly
certain, given the stable nature of the industry. Because of the
recognized safety of the investment, many telecommunications companies
can raise large quantities of capital from the debt markets. In
operations comparable to Telecommunications Services, 75 percent of
the necessary capital is raised in the debt markets at interest rates
reflecting solid AA quality, on average—this is better than the
corporate bond rating of AA-/A+. Moreover, I have to believe that the
cost of equity of Telecommunications Services is lower than for
Products and Systems. I contrast this with the Products and Systems
segment where, although sales growth and profitability are strong,
risks are high. Independent equipment manufacturers are financed by
higher yield BBB-rated debt and more equity with higher expected total
returns.
In my book, the hurdle rate for Products and Systems should
reflect these higher costs of funds. Without the risk-adjusted system
of hurdle rates, Telecommunications Services will gradually starve for
capital, while Products and Systems will be force-fed—that’s because
our returns are less than the corporate hurdle rate, and theirs are
greater. Telecommunications Services lowers the risk of the whole
corporation, and should not be penalized.
Here’s a rough graph of what I think is going on.
Telecommunications Services, which can earn 9.8 percent on capital, is
actually profitable on a risk-adjusted basis, even though it is not
profitable compared compared to the corporate hurdle rate. The
triangle shape on the drawing shows about where Telecommunications
Services is located. My hunch is that the reverse is true for
Products and Systems, which promises to earn 12.0 percent on capital,
P + S is located on the graph near the little circle.
In deciding how much to loan us, lenders will consider the
compositions of risks. If money flows into safer investment, over
time the cost of their loans to us will decrease.
Our stockholders are just as much concerned with risk. If they
perceive our business as being more risky than other companies, they
will not pay as high a price for our earning. Perhaps this is why our
price/earnings ratio is below the industry average most of the time.
It is not a question of whether we adjust for risk—we already do
informally. The only question in my mind is whether we make these
adjustments systematically or not.
While multiple hurdle rates may not reflect capital-structure
changes on a say-to-day basis, over time they will reflect prospects
more realistically. At the moment, as I understand it, our real
problem is an inadequate and very costly supple of equity funds. If
we are really rationing equity capital, then we should be striving for
the best returns on equity for the risk. Multiple hurdle rates
achieve this objective.
Implicit in Phillip’s argument, as Weston understood
it, was the notion that if each segment in the company had a different
hurdle rate, the costs of the various forms of capital world remain
the same. However, the mix of capital used would change in the
calculation. Low-risk operations would use leverage more extensively,
while the high-risk divisions would have little or no debt funds.
This lower-risk segment would have a lower hurdle rate.
Opposition to Risk-Adjusted Hurdle Rates
Phillips’s views were supported by several others within Teletech;
opposition was just as strong, however, particularly within the
Products and Systems segment. Helen Buono, executive vice president
for the segment, expressed her opinion as follows:
All money is green. Investors can’t know as much about our operations
as we do. To them the firm is an opaque box: they hire us to take
care of what is inside the box, and judge us by the dividends coming
out of the box. We can’t say that one part of the box has a different
hurdle rate than another part of the box, if our investors don’t think
that way. Like I say, all money is green: all investments at
Teletech should be judged against one hurdle rate.
Multiple hurdle rates are illogical. Suppose that the furled
rate for Telecommunications Services was much lower than the
corporatewide hurdle rate. If we undertook investments that met the
segment hurdle rate, we would be destroying shareholder value because
we weren’t meeting the corporate hurdle rate.
Our job as managers should be to put our money where the
returns are best. A single hurdle rate may deprive an underprofitable
division of investments in order to channel more funds into a more
profitable division, but isn’t that the aim of the process? Our
challenge today is simple: we must earn the highest absolute rates of
return we can get.
In reality, we don’t finance each division separately. The
corporation raises capital based on its overall prospects and record.
The diversification of the company probably helps keep our capital
costs down and enables us to borrow more in total than the sum of the
capabilities of the divisions separately. As a result, developing
separate hurdle rates is both unrealistic and misleading. All our
stock holders want is for us to invest our funds wisely in order to
increase the value of their stock. This happens when we pick the most
promising projects, irrespective of their source.
MARGARET WESTON’S CONCERNS
As she listened to these arguments, presented over the course of
several months, Weston became increasingly concerned with several
related considerations. First, the corporate strategy directed the
company toward integrating the two divisions. One effect of using
multiple hurdle rates would be to make justifying high-technology
research and application proposals more difficult, as the required
rate of return would be increased. Perhaps, she thought, multiple
hurdle rates were the right idea, but the notion that they should be
based on capital costs rather than strategic considerations might be
wrong. On the other hand, perhaps multiple rates based on capital
costs should be used, but in allocating funds, some qualitative
adjustments should be made for unquantifiable strategic
considerations. In Weston’s mind, theory was certainly not clear on
how to achieve strategic objectives when allocating capital.
Second, using a single measure of the cost of money (the hurdle rate
or discount factor) made the net present value results consistent, at
least in economic terms. If Teletech adopted multiple rates for
discounting cash flows, Weston was afraid the NPV and economic profit
calculations would lose their meaning and comparability across
business segments. To her, a performance criterion had to be
consistent and understandable, or it would not be useful.
In addition, Weston was concerned with the problem of attributing
capital structures to divisions. In Telecommunications Services, a
major new switching station might be financed by mortgage bonds. But
in Products and Systems, it was not possible for the division to
borrow directly; indeed, any financing was feasible only because the
corporation guaranteed the debt. Such projects were considered highly
risky—perhaps, at best, warranting only a minimal debt structure.
Also, Weston considered the debt-capacity decision difficult enough to
make for the corporation as a whole, let alone for each division.
Judgments could only be very crude.
In further discussions with those in the organization about the use of
multiple hurdle rates, Weston ran across two predominant trains of
thought. One argument held that the investment decision should never
be mixed with the financing decision. A firm should decide what its
investments should be and then how to fiancé them most efficiently.
Adding leverage to a present-value calculation would distort the
results. Use of multiple hurdle rates was simply a way of mixing
financing with investment analysis. This argument also held that a
single rate left the risk decision clear-cut: management could simply
adjust its standard (NPV or economic profit) as risks increased.
The contrasting line of reasoning noted that the weighted-average cost
of capital tended to represent an average market reaction to a mixture
of risks. Lower-than-average-risk projects should probably be
accepted even though they did not meet weighted-average criterion.
Higher-than-normal-risk projects should provide a return premium.
While the multiple-hurdle-rate system was a crude way of achieving
this end, it at least was a step in the right direction. Moreover,
some argued that Teletech’s objective should be to maximize return on
equity funds, and because equity funds were and would remain a
comparatively scarce resource, a multiple-rate system would tend to
maximize returns to stockholders better than a single-rate system.
To help resolve these questions, Weston asked her assistant, Bernard
Ingles, to summarize academic thinking about multiple hurdle rates.
His memorandum is given in Exhibit2. She also requested that he draw
samples of comparable firms for Telecommunications Services and
Products and Systems that might be used in deriving segment WACCs.
The summary of data is given in Exhibit 3. Information on
capital-market conditions in January 1996 is given in Exhibit 4.
CONCLUSION
Weston could not realistically hope that all the issues before her
would be resolved in time to influence Victor Yossarian’s attack on
management. But the attack did dictate the need for an objective
assessment of the performance of Teletech’s two segments—the choice of
hurdle rates would be very important in this analysis. However, she
did want in institute a pragmatic system of appropriate hurdle rates
(or one rate) that would facilitate judgments in the changing
circumstances Teletech faced. What were the appropriate hurdle rates
for the two segments? Was Products and Systems underperforming as
Yossarian suggested? How should Teletech respond to the raider?
EXHIBIT 2
Theoretical Overview of Multiple Hurdle Rates
To: Margaret Weston
From: Bernard Ingles
Subject: Theory of Segment Cost of Capital
Date: January 1996
You requested an overview of theories about multiple hurdle rates.
Without getting into minutiae, the theories boil down to the following
points:
1. The central idea is that required returns should be drive by risk.
This is the dominant view in the field of investment management, and
is based on a mountain of theory and empirical research stretching
over several decades. The extension of this idea from investment
management to corporate decision making is straightforward, at least
in theory.
2. An underlying assumption is that the firm is transparent (i.e.,
that investors can see through the corporate veil and evaluate the
activities going on inside). No one believes firms are completely
transparent, or that investors are perfectly informed. But financial
accounting standards have evolved toward making the firm more
transparent. And the investment community has grown tougher and
sharper in its analysis: Teletech now has 36 analysts publishing
reports and forecasts on the firm. The reality is that for big
publicly held firms, transparency is not a bad assumption.
3. Another underlying assumption is that the value of the whole
enterprise is simply the sum of its parts—this is the concept of Value
Additivity. We can define “parts” as either the business segments (on
the left-hand side of the balance sheet) or the layers of the capital
structure (on the right-hand side of the balance sheet). Market
values (MVs) have to balance.
MVTeletech = (MVTelecommunications +
MVProducts+Systems) = ( MVDebts + MVEquity)
If these equalities did not hold, then a raider could come along and
exploit the inequality by buying or selling the whole
or the parts. This is “arbitrage.” By buying or selling, the actions
of the raider would drive the MVs back into balance.
4. Investment theory tells us that the only risk that matters is
nondiversifiable risk, which is measured by “beta.” Beta indicates
the risk that an asset will add to a portfolio. Because the investor
is assumed to be diversified, she is assumed to seek a return for only
that risk that she cannot shed, the nondiversifiable risk. Now, the
important point here is that the beta of a portfolio is equal to a
weighted average of the betas of the portfolio components. Extending
this to the corporate environment, the “asset beta” for the firm will
equal a weighted average of the components of the firm—again, the
components of the firm can be defined in terms of either the
right-hand side or the left-hand side of the balance sheet.
bTeletech Assets = (Wtel.Serv. bTel.Serv. + WP+S bP+S)
= (Wdebt + Wequitybequity)
where: w = Percentage weights based on market value.
bTel.Serv.bP+S = Asset betas for business segments.
bdebt = b for the firm’s debt securities.
bequity = b of firm’s common stock (given
by Bloomberg, etc.)
This is a very handy way to model the risk of the firm, for it means
that we can use the Capital Asset Pricing Model to estimate the cost
of capital for a segment (i.e., using segment asset betas).
5. Given all the previous points, it follows that the weighted average
of the various costs of capital (k) for the firm (WACC), which is the
theoretically correct hurdle rate, is simply a weighted average of
segment WACCs:
WACC teletech = (Wtel.serv. WACCtel.serv.) + (Wp+s WACC p+s)
Where:
Wtel.serv. Wp+s = market value weights
WACCtel.serv. = (Wdebt,tel.serv Kdebt, tel.serv.)
+ (Wequity,tel.serv.Kequity,tel.serv.)
WACCp+s = (Wdebt,p+sKdebt,p+s) +
(Wequity,p+sKequity,p+s)
6. The notion in point 5 may not hold exactly in practice. First,
most of the components in the WACC formula are estimated with some
error, Second, because to taxes, information asymmetries, or other
market imperfections, assets may not be priced strictly in line with
the model—for a company like Teletech, it is reasonable to assume that
any mispricings are just temporary. Third, the simple two-segment
characterization ignores a hidden third segment: the corporate
treasury department that hedges and aims to finance the whole
corporation optimally—this acts as a “shock absorber” for the
financial policies of the segments. Modeling the WACC of the
corporate treasury department is quite difficult. Most companies
assume that the impact of corporate treasury isn’t very large, and
simply assume it away. As a first cut, we could do this too, though
it is an issue we should revisit.
Conclusions
ˇ In theory, the corporate WACC for Teletech is appropriate only for
evaluating an asset having the same risk as the whole company. It is
not appropriate for assets having different risks than the whole
company.
ˇ Segment WACCs are computed similarly to corporate WACCs
ˇ In concept, the corporate WACC is a weighted average of the segment
WACCs. In practice, the weighted average concept may not hold, due to
imperfections in the market and/or estimation errors.
ˇ If we start computing segment WACCs, we must use the cost of debt,
cost of equity, and weights appropriate to that segment. We need a
lot of information to do this correctly, or else we really need to
stretch to make assumptions.
EXHIBIT 1
Summary of WACC Calculation for Teletech Corporation, and Segment
Worksheet
Corporate Telecommunications Services
MV asset weights 100% 75%
Bond rating AA-/A+ AA
Pre-tax cost of debt 7.03% 7.00%
Tax rate 40% 40%
After-tax cost of debt 4.22% 4.20%
Equity beta 1.04
Rf 6.04%
Rm-Rf 5.50%
Cost equity 11.77%
Weight of debt 18.00%
Weight of equity 82.00%
WACC 10.41%
EXHIBIT 4
Debt Capital Market Conditions, January 1996
Corporate Bond Yields, by Rating U.S. Treasury Securities
Industrials:
AAA 6.50% Short-term bills 5.20%
AA 7.00 Intermediate-term notes 5.43
A 7.64 Long-term bonds 6.04
BBB 7.78%
BB 8.93
B 10.49
Utilities
AA 6.53%
A 7.94
BBB 8.06
Thanks,
Jimmy5 |
