My recommendation for Teletech Corporation is to change from a constant hurdle rate to the use of two risk-adjusted hurdle rates, one for each segment.
Teletech’s performance is evaluated based on economic profit calculations. Through this measure, the risk-adjusted hurdle rates return a higher amount of profit compared to a single corporate hurdle rate. Currently, the firm has been using 9. 30% as their hurdle rate, and as a result the firm’s share prices are sluggish. Their price-to-earnings ratio is also below investor’s expectation in comparison to the company’s risk.With nearly $2 billion being invested in upcoming capital projects, the discount rate to be used within the firm (1) needs to be more accurate, (2) account for risk, and (3) not destroy shareholder’s value. The hurdle rate set at 9. 3% is derived from using the WACC.
In 2004, Telecommunications Services has returned less than the hurdle rate at 9. 1%, while Products & Systems returned 11%. The concern lies in Teletech’s share prices, which are not keeping up with market or industry indexes.With two different hurdle rates, the firm can evaluate projects on two different assessments of risks. The firm should take any project that would beat the corporate hurdle rate and not account for risk. The telecommunications services industry is stable according to the equity beta average of nine different firms (1. 04).
This is used to calculate a risk-adjusted hurdle rate for this segment. Currently, it’s outperforming its risk-adjusted hurdle rate and is also more stable in comparison to Products & Systems.Similarly, I calculated the Products & Systems segment with the exact same assumption of equal weights. I came up with an equity beta of 1.
36, and a WACC of 10. 41%. Despite having a return on capital higher than the WACC, the firm is destroying value by investing in projects that are only beating the 9. 3% hurdle rate. With a risk-adjusted hurdle rate, the firm can better evaluate projects as well as predict how they will finance each one.
Telecommunication Services only needs to achieve an 8. 1% return or higher to beat the hurdle rate, while the Products & Systems segment has to return 10. 41%. Products & Systems is a higher risk segment than Telecommunication Services and these hurdle rates reveal that. Currently, they’re destroying value for the firm, and the Products & Systems segment needs to be reevaluated. One of the measures of success the firm employs to evaluate performance is economic profit. In 2004, the firm employed $17. 3 billion in capital and returned 9.
58%, resulting in $4. 85 billion in economic profit.If the company simulated a model situation of using their actual returns on capital of each segment and their new hurdle rates of 8. 81% and 10. 41%, the company will see a drastic change.
Taking into consideration the company employs the same amount of money within each segment; Telecommunications Services would have an ending economic profit of $3. 77 billion and Products & Systems would return $2. 57 billion.
From this, we can see that the Products & Systems segment has a fair amount of risk associated with it, which in turn increases its cost of capital. A combined total of $6. 4 billion when using two separate risk-adjusted hurdle rates compared to an actual $4.
85 billion when using a single constant hurdle rate. Even though this is just a simulation, the firm can see that project evaluation is a key to the operations. The company wants to see higher share prices and price to earning ratios that are above the industry standards so they would be more attractive to investors. According to the prices to earnings ratio, the risk doesn’t match the reward and investors are aware.
Currently the firm is not accurately assessing their future.Telecommunications Services is returning capital below the corporate hurdle rate and Products & Systems is above the rate, but the firm is not factoring in riskiness of the segments individually. The relationship between risk and return is important to take into consideration. The constant hurdle rate results in a flat line and doesn’t correlate risk with return. The latter is the risk-adjusted hurdle rate that reveals a positive relationship. This paints a better picture for the firm can also help with forecasting future projects.
The firm should still utilize the Products & Systems segment, but for future calculations, the firm needs to evaluate projects using a risk-adjusted hurdle rate. Individual risk-adjusted hurdle rates will be a more accurate depiction of the composition of risks each segment takes on. Risk-adjusted hurdle rates are more precise in measuring project returns, cost of capital, and assess each segment’s risks.
Forward-looking, the firm will have a better assessment of where they will be in their future forecast, which is great for investors and shareholders alike.