Case StudyOnTeleTech Corporation, 1996
...s the capital it used. Economic Profit = (ROC ¨C Hurdle Rate) * Capital Employed where: ROC = Return on Capital = NOPAT/Capital; NOPAT = Net Operating Profit After Taxes The Economic Profit was an important consideration in strategic decision about capital allocation, manager promotion and the awarding of incentive compensation. 3.3 Existing Estimate of Hurdle Rate Currently, the financial rating of Teletech was between AA- and A+. At these ratings, new debt funds might cost Teletech was 7.03% and the after tax cost of debt was 4.22% after a 40% tax rate. With a beta of 1.041, the cost of equity might be about 11.77%. At market-value weights of 18% for debt and 82% for equity, the resulting WACC for the company would be 10.41%. The hurdle rate of 10.41% was then applied to all investment and performance-measurement analyses in the company. 4 Impact of Risk-adjusted Hurdle Rates 4.1 Impact on Performance Evaluation The Economic Profits of the two business segments are calculated according to the formula in Section 3.2 with a constant hurdle rate of 10.41% as follows: Telecom P&S Segment WACC 10.41% Segment ROC / IRR 9.80% 12.00% NOPAT $1.18 billion $480 million Economic Profit -73.08 million 63.72 million Based on Economic Profit calculated for each segment, it is clear that under a constant corporate hurdle rate, a positive Economic Profit of P&S implies it performed better at the business unit level. Therefore, its managers would have a better chance of getting promoted and receiving higher incentive compensation. However, Telecom, which can earn 9.8% on capital, is actually profitable on a risk-adjusted basis, even though is not profitable compared to the corporate hurdle rate. The reverse is true for P&S, which promises to earn 12.0% on capital. Calculation supporting this argument is given in summary of calculations in Section 5.3. 4.2 Impact on Resource Allocation Without the risk-adjusted system of hurdle rates, Telecom will gradually starve for capital, while P&S will be force-fed. It is because Telecom¡¯s return is less than the corporate hurdle rate, while P&S are greater. When risk-adjusted hurdle rates are adopted, each business unit will have its own WACC. Comparing WACC with ROC of each business unit, we can see that the NPV of Telecom turns positive while that of P&S¡¯ turns negative. This suggests projects undertaken by Telecom are in fact bringing in value. Capital allocation should be adjusted to align with this change in value in each segment. 5 Segment WACC Estimation Weighted Average Cost of Capital is calculated as below, WACC = (% of debt ¡Á cost of debt) + (% of equity ¡Á cost of equity) where % of debt + % of equity = 100% To calculate segment WACC, cost of equity, cost of debt and debt-to-equity ratio will be estimated for both Telecom and P&S. Overall WACCTeletech will be equal to (¦ØTel ¡Á WACCTel) + (¦ØP&S ¡Á WACCP&S), where ¦ØTel and ¦ØP&S are Telecom and P&S market value weights (total is 100%). 5.1 Cost of Debt In order to calculate cost of debt, two assumptions will be made. First, Teletech is a big publicly held company, which has 36 analysts publishing reports and forecasts on the firm, therefore, the firm is assumed to be transparent, that is investors can see through the corporate mask and evaluate the activities going on inside. Second, according to investment bankers, the bond rating of Telecom and P&S are given AA and BBB- respectively. Telecom P&S Bond Rating AA BBB- Debt Rate by Rating, 1996 7.00% 7.78% Tax Rate, 1996 40% 40% After-tax Cost of Debt = Debt Rate ¡Á (1-T) 4.20% 4.67% 5.2 Cost of Equity Capital Asset Pricing Model (¡°CAPM¡±) will be used to determine the cost of equity, which is equal to Rf + ¦Â (Rm ¨C Rf). In order to estimate the equity beta for Telecom and P&S, samples of comparable firms¡¯ equity beta are averaged. In year 1996, industrial averages equity beta for Telecommunication and P&S are 0.84 and 1.5 respectively. Lastly, risk free return is based on US long-term bond of 6.04% and risk premium return is assumed at 5.50%. Telecom P&S ¦Â (Equity Beta) 0.84 1.5 Rf (Risk Free) 6.04% Rm-Rf (Risk Premium) 5.50% Cost of Equity (CAPM) = Rf + ¦Â (Rm ¨C Rf) 10.66% 14.29% 5.3 WACC It is assumed that capital structure weights approximately equal to the average of comparable firms. In 1996, average weight of debt and weight of equity in telecommunication industry are 22.80% and 77.20%, and in telecommunications and computing equipment industries, they are 3.45% and 96.55%. Telecom P&S Cost of Debt 4.20% 4.67% Weight of Debt 22.80% 3.45% Cost of Equity 10.66% 14.29% Weight of Equity 77.20% 96.55% Segment WACC = (% of debt ¡Á cost of debt) + (% of equity ¡Á cost of equity) 9.19% 13.96% 6 Value Consideration 6.1 Ensure Positive NPV in future A company can use the hurdle rate to discount the project¡¯s future cash flows to a present value, and then subtract the initial investment from it to derive the NPV. We can also compare the project IRR directly with hurdle rate. In future, Teletech should follow the capital budgeting policy that if the IRR is greater than the WACC, (NPV will be positive) then the project is considered worthy to be accepted. If IRR is smaller than the WACC, NPV will be negative and the project should be rejected. In this way, it will ensure projects accepted will bring in net cash inflow and therefore will add value to the company. In addition, rating projects with higher NPV with priority during the capital allocation process aids to achieve the objective to maximize the net cash inflow, thus the shareholders¡¯ wealth and value of the company. 6.2 Economic Profit By using risk adjusted hurdle rate: Telecom P&S Segment WACC 9.19% 13.96% Segment ROC / IRR 9.80% 12.00% NPV (IRR vs WACC) Positive (+) Negative (-) NOPAT $1.18 billion $480 million Capital Employed $12.04 billion $4 billion Economic Profit $73.8 million - $78.32 million 6.3 Is P&S destroying value? If Teletech uses risk-adjust hurdle rate, in future, they would accept more telecommunications projects at the expenses of rejecting some P&S projects assuming the average ROCs of the segments remain similar to the previous year. Since more capital resources will be allocated to Telecom, which has a higher segment economic profit, the overall economic profit will be increased. Using risk adjusted hurdle rate will NOT destroy value, instead the policy change will bring Teletech better earning per share and market value. Since segment WACC of Product & Systems is 13.96%, which is greater than ROC of 12%, so NPV and economic profit is negative. Under the existing project selection policy based on a constant corporate hurdle rate, P&S had been underperformed and destroyed Teletech¡¯s market value. 7 Constant or Risk Adjusted Hurdle Rates? The central idea of the risk-adjusted hurdle rate system is that required returns should be driven by risk, i.e. higher return is required to compensate for a higher risk. To aid a better assessment on the return on investment and thus resources allocations, risk-adjusted hurdle rates system is recommended to reflect the underlying risk correctly. In addition, the use of risk-adjusted hurdle rates as a base for performance evaluation is fairer because each segment¡¯s return on capital is evaluated against its respective cost of funding. However, whether the two segments are able to have its own risk-adjusted hurdle rate relies heavily on the assumption that TeleTech¡¯s operation is transparent to investors. In other words, investors must be perfectly informed the financial information of each segment in order to be able to access the risk of different business segments. Looking back to the WACC calculations, it¡¯s not difficult to find that the reason why the WACC of Telecom is lower than that of the P&S is the debt to equity ratio. When we look at the debt to equity ratio of the comparable firms in Telecom, the average debt to equity ratio is 31.1%. That means Telecom can be financed with about 23.7% of debt and 76.3% of equity, compared to the average of about 3.7% debt and 96.3% equity in P&S. Should TeleTech not able to communicate with the investors about the purpose of raising debt, it is not possible to raise adequate debt to finance its Telecom projects. Thus, the estimated WACC for Telecom will not be practical. On the other hand, if the adoption of the risk-adjusted hurdle rate system is communicated to the investor effectively, Teletech¡¯s value will be re-evaluated. Since then the projects performed by each segment should gain a return higher than the respectively weighted cost of capital, the overall value of Teletech would increase. 8 Barriers & Considerations Although risk-adjusted hurdle rate system is identified to be a good policy for Teletech, some b...