Teletech Corporation, 2005 Case Solution

Empirical studies have given immense importance tothe concept of risk and returns. With the increased risk, the shareholders would be compensated more in terms of returns and vice versa, whereas the use of constant hurdle rate does not take into account the correlation between the risk and returns of the individual segments. It can be seen that every individual segment has anon-diversifiable risk associated with it, which is higher for the Product and System segment of Teletech Corporation. Currently, the company is considering a capital budgeting project that requires an investment of $2 billion, which is quite a significant amount that strongly requires that the company should come up with the optimal hurdle rate so that the shareholder’s interest in the company could be maintained. The current situations are yielding just the opposite results; Telecommunication service segment is yielding low return as compared with the cost of capital, whereas the other segment is yielding high return because of improper division of the hurdle rates.

 The firm is not currently assessing its future accurately;Telecommunication Services are returning capital below the corporate hurdle rate and the Products & Systems are above the rate, but the firm is not factoring in riskiness of the segments individually.

In order to do so, the cost of capital for the individual segments is computed in order to come up with some conclusions. The first and the foremost components is the cost of equity capital that is computed with the help of capital assets pricing model, which considers the risk adjustments in the form of beta. With the help of the data of the comparable companies, the equity beta for the two segments are computed which is then converted to the asset beta with the tax rate of 40% and the value of debt/equity ratio, which is also computed by the data of comparable companies. The risk free rate as well as the market risk premium is assumed to be similar for both the segments. The costs of equity for the two segments are 10.36% for the Telecommunication Services segment and 12.11% for the Products and System segment. The increased cost in the second segment depicts the increased risk associated in the overall business.

With the help of the comparable company’s data, the weights are assigned to the two funds providers for the two segments, which later yield to the cost of capital. It can be seen that the cost of capital for Telecommunication Services department is 8.49%, which is much lower than the original hurdle rate used by the company. On the other hand, Products and System segment yields the WACC of about 11.41%, which is much higher than originally used. With the help of these data, the new WACC of the company is computed by assigning 75% weight to the computed WACC of the first segment and 25% to the other one. The new WACC for the overall corporation is lower as compared to the originally used WACC,which is about 9.22%. The overall computations are performed in the exhibits given below………………

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