Teaching Note Synopsis and Objecties In October 2005, the chief financial officer (CFO) of a telecommunications company neee to fashion a response to a corporate raier !ho claime that a ma"or business segment of this company shoul ha#e been sol because it !as not earning a satisfactory rate of return$ The case recounts the ebate !ithin the company o#er the use of a single hurle rate to e#aluate all segments of the company #ersus a ris%&a"uste hurle&rate system$ The tas%s for the stuent are to resol#e the ebate, estimate the !eighte&a#erage costs of capital ('(CC) for Teletech)s t!o business segments, an respon to the raier)s assertions$ This case !as prepare to ser#e as part of an introuction on estimating in#estors) re*uire rates of return$ It !oul best follo! one or t!o teaching sessions introucing techni*ues for estimating '(CC$ The re*uire numerical calculations are light, although some of the subtleties about the use of ris%&a"uste hurle rates !ill re*uire time for the no#ice to absorb$ The case can be use to pursue a #ariety of teaching ob"ecti#es, incluing the follo!ing+ ,-ten ris%&return (i$e$, mean&#ariance) analysis to corporate finance$ .ur#ey classic arguments for an against the use of ris%&a"uste hurle&rate systems$ (ssess the assumptions an limitations of ris%&a"uste hurle rates$ ,-ercise the estimation of segment '(CCs$ Consier possible organi/ational barriers to the implementation of ris%&a"uste hurle rates$ This teaching note !as prepare by 0obert F$ 1runer !ith the assistance of .ean 2$ Carr$ The author gratefully ac%no!leges helpful comments from 3rofessor 4arry .hot!ell, an the financial support of the 1atten Institute$ The economic problem an certain *uotations in this case !ere eri#e from an anteceent case, 5(r%ansas 3etroleum6 (78(&F&029:), !ritten by our colleague, 3rofessor 0obert F$ 8anell, to !hose memory this case is eicate$ Copyright ; 2005 The 7ni#ersity of 8irginia 2aren .chool Founation$ (ll rights reser#e$ To order copies, send an e-mail to sales<arenpublishing$com$ No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden Foundation. S!""estions #o$ co%p&e%enta$y cases' 5Ni%e Inc$,6 (case =>) gi#es an introuctory e-ercise in the estimation of the cost of capital$ 5Co%e #s$ 3epsi, 200=,6 (case =9) offers the estimation of '(CCs for t!o competitors an the opportunity to reflect on ho! business ris% ri#es the cost of capital$ S!""ested (!estions #o$ Adance Assi"n%ent This case complements the seminal e-tension of mean&#ariance analysis to corporate finance by ?ar% ,$ 0ubinstein, 5( ?ean&8ariance .ynthesis of Corporate Financial Theory,6 Journal of Finance, @anuary =A:9$ It is not necessary, ho!e#er, that this article be assigne to stuents as collateral reaing !ith the case$ =$ Bo! oes Teletech Corporation currently use the hurle rateC 2$ 3lease estimate the segment '(CCs for Teletech (see the !or%sheet in case ,-hibit =)$ (s you o this, carefully note the points of "ugment in the calculation$ >$ Interpret 0ic% 3hillips)s graph (see Figure 2 in the case)$ Bo! oes the choice of constant #ersus ris%&a"uste hurle rates affect the e#aluation of Teletech)s t!o segmentsC 'hat are the implications for Teletech)s resource&allocation strategyC 9$ 2o you agree that 5all money is green6C 'hat are the implications of that #ie!C 'hat are the arguments in fa#orC 'hat are the arguments against itC 5$ Is Belen 1uono right that management !oul estroy #alue if all the firm)s assets !ere reeploye into only the telecommunications business segmentC 'hy or !hy notC 3lease prepare a numerical e-ample to support your #ie!$ D$ Bas 3roucts an .ystems (3E.) estroye #alueC 'hat e#ience or illustrations can you gi#e to support your opinionC :$ 'hat shoul Teletech say in response to 8ictor FossarianC Sp$eads)eet *i&es The spreasheet file, CaseG=5$-ls, supports stuent preparation of the case an contains case ,-hibits =, >, an 9$ ( separate file, TNG=5$-ls, supports the instructor)s class preparation$ 3lease o not share the instructor)s spreasheet file !ith the stuents$ Hypot)etica& Teac)in" P&an The follo!ing *uestions affor a possible outline for a A0&minute iscussion of the case$ . !hat are "ic# $hillips%s arguments for the use of the ris#-ad&usted hurdle-rate system' !hat are (uono%s arguments against the system' ( *uic% sur#ey of arguments on either sie of the *uestion sets the stage for calculations an for a #ote at the en of class$ 2$ !hat are the implications of $hillips%s graph for capital allocation at Teletech )Figure * in the case+' !ould allocating capital on the basis of the ris#-ad&usted hurdle-rate system create or destroy value' Figure 2 suggests ramatically iffering resource&allocation strategies uner the t!o hurle&rate schemes$ The instructor might aim to !al% stuents through the figure, an to prepare to offer an illustration of ho! the firm)s security prices might change if its resource allocation change$ .ee E+)ibit TN2 for an e-ample$ >$ !hat are the !,--s of the two segments' .as $roducts and /ystems destroyed value' !hat about Telecommunications /ervices' In getting the stuents) estimates on the boar, the instructor shoul anticipate some #ariation in results ue to the ini#iual stuent)s choices about peer firms ra!n from case ,-hibit >$ 9$ Do you have any other concerns about Teletech%s possible implementation of a ris#- ad&usted hurdle-rate system' If time permits, the instructor coul in#ite stuents to consier a range of implementation issues an then ta%e a #ote of the class$ 5$ !hat should Teletech say to $hillips' !hat should the company say to (uono' !hat about to 0ossarian' The instructor coul close the iscussion !ith a brief re#ie! of the assumptions an ifficulties of implementing a ris%&a"uste hurle&rate system$ The %ey notion is that this system emboies the #ery mean&#ariance logic of in#estors an therefore probably con#eys better signals to the managers of a firm than oes a single company&!ie hurle rate$ The instructor coul also note that ignorance of in#estors) !ishes ultimately in#ites capital& mar%et iscipline (for e-ample, in the form of Fossarian)$ Case Ana&ysis Ris,-adj!sted e$s!s constant .ACC )!$d&e $ates The case presents generic arguments for an against the use of a ris%&a"uste hurle&rate system$ Those arguments !ill not be repeate here$ Bo!e#er, the ris%&return graph in the case (Figure 2) brings the comparison of the t!o systems to a point+ The allocation of resources implie by the t!o systems !oul be iametrically oppose$ The constant '(CC system currently in use !oul fee the 3E. segment an star#e Telecommunications .er#icesH a ris%&a"uste system !oul o the re#erse$ 1ecause Teletech)s financial results uner the constant '(CC system are alreay %no!n (for e-ample, the lo! 3I, multiple, the threatene attac% by a corporate raier), the instructor coul as% stuents to consier the effect of implementing the ris%& a"uste system$ 7sually the harest step for stuents to absorb is reali/ing that the firm)s '(CC !ill a"ust in response to changes in the ris% of the firm)s business$ /isc!ssion 0!estions 1 and 2 E+)ibit TN1 gi#es a rough illustration of the potential change in Teletech)s mar%et #alue uner a ris%&a"uste system (an the ensuing change in capital allocation that it !oul trigger)$ Three scenarios are presente+ the current state (:5I25J mi- of the t!o segments) an the t!o polar e-tremes, !here all the firm)s capital is allocate e-clusi#ely to one segment$ The bottom line is the #alue of the enterprise, !hich is estimate as the firm)s net operating profit after ta- (NO3(T) capitali/e by the !eighte&a#erage cost of capital ('(CC)$ 7ner scenario (, !here all resources are allocate to the Telecommunications .er#ices segment, the firm)s return on capital is A$=0J$ 1ecause this is higher than the '(CC for Telecommunications .er#ices (at K$9AJ), the firm)s mar%et #alue, at L=:$=5 billion, is higher than its in#estment base of L=D billion$ .tuents may fin that concept ifficult to grasp initially$ The %ey is in obser#ing that because resources ha#e been completely allocate to the lo!er ris% segment, the firm)s '(CC !ill ecline to a le#el consistent !ith Telecommunications .er#ices$ Bence in scenario (, #alue has been create$ 7ner scenario C, !here all resources are allocate to 3E., the return on capital is ==J an the '(CC is ==$:>J$ .ince the firm in this scenario earns less than the cost of capital, its mar%et #alue of L=5 billion is smaller than its in#este base of L=D billion$ Bence in scenario C, #alue has been estroye$ O#erall, it appears that in#esting in the lo!er absolute&return, but the higher relati#e& return, Telecommunications .er#ices segment !ill create #alue for Teletech)s in#estors, much as the corporate raier in the case suggests$ The %ey presumption here is that in#estors !ill obser#e the changes in the ris%iness of the firm)s assets, an they !ill a"ust their re*uire returns accoringly$ .ecurity prices a"ust as !ell$ The ability of in#estors to obser#e changes in ris%iness epens importantly on the transparency of the firm$ The graph in case Figure 2 can be use to emphasi/e some of the potential !ea%nesses in the constant hurle&rate system$ First, constant hurle&rates can result in the acceptance of ba in#estments (3E. falls in this area on the graph)$ .econ, constant rates can result in the re"ection of goo in#estments (Telecommunications .er#ices falls in this area on the graph)$ (n thir, if in#estment opportunities roughly form an up!ar&sloping clou in ris%&return space, constant hurle rates can result in nai#e ris% shifting (i$e$, to the right on the graph) in the pursuit of higher& return in#estments$ Esti%atin" se"%ent .ACCs The graph in Figure 2 is merely 3hillips)s o!n abstract representation$ 'hether this is reality or not epens upon estimating the '(CCs of the t!o segments$ E+)ibit TN2 completes the !or%sheet sho!n in case ,-hibit =$ Note that some stuent "ugment is re*uire here$ .tuents !ill iffer on the betas an the capital&structure !eights to be applie, although their tenency !ill be to use the segment a#erages from case ,-hibit > (as !as one in E+)ibit TN2)$ The beta an !eights for 3E. ra! on the a#erages of the telecommunications&e*uipment an computer&e*uipment segment a#erages in case ,-hibit >$ = The instructor shoul emphasi/e the importance of internal consistency bet!een beta an capital&structure assumptions$ The use of inustry a#erages for beta an capital&structure ratios accomplishes that internal consistency$ 1ut if stuents aim to use betas from some firms an capital structures from others, the only proper course is to unle#er the betas an rele#er them to reflect the other capital structures$ E+)ibit TN2 re#eals that the '(CC for 3E. is ==$:>J, !hile the '(CC for Telecommunications .er#ices is K$9AJ$ (t prospecti#e returns of ==$0J, 3E. is, inee, not paying its !ay, as Fossarian suggests$ ?ean!hile, Telecommunications .er#ices is profitable to in#estors, !ith a return of A$=0J$ The numbers seem fairly consistent !ith the ris%&return graph in the case$ The note in E+)ibit TN2 iscusses the computation neee to sho! #alue aiti#ity in the '(CC, !hich is iscusse in case ,-hibit 2$ It is not suggeste that e#ery instructor try to emphasi/e that point !ith all the stuents$ For most stuents, simply getting appro-imate ans!ers !ill be sufficient to lea#e an impression of #alue aiti#ity an of the application of the mean& #ariance theory to corporate finance$ = .tuents !ill stri#e to fin the 5scientific6 measures of the !eights, often out to three or more ecimal places, base on the ata in case ,-hibit >$ Instea, !e li%e to emphasi/e that the !eights must be chosen as a matter of &udgment, informe by the information on peer firms$ For instance, regaring the ebt !eight for the Telecommunications .er#ices segment, !e use 2:$=J, !hich is simply the a#erage of the peers in case ,-hibit >$ For 3E., the calculation in E+)ibit TN2 uses :$5J, !hich is a rough abstraction from the 5$KJ a#erage !eight of the computer an net!or% peers, an from the =D$DJ a#erage !eight of the telecommunications&e*uipment peers$ Our use of :$5J is not the correct assumption, although it is certainly reasonable$ ?any stuents !ill focus on the 5$KJ a#erage !eight for the computer an net!or% segment, but this is inconsistent !ith the clear escription in the case of 3E. as a manufacturer of telecommunications e*uipment and computing e*uipment$ The learning point for stuents is that their assumptions must be consistent !ith the funamentals of the business they are analy/ing$ The instructor)s spreasheet moel !ill permit one to try other reasonable !eights as !ell$ ?argaret 'eston)s ilemma in the case remains robust to #ariations in stuent assumptions about ebt !eights, as long as they remain in a reasonable range, in comparison, to a sample of peer firms$ /isc!ssion 0!estion 1 I%p&e%entation iss!es .%eptics in the class may as%, 5If ris%&a"uste hurle rates are so goo, !hy on)t all firms use themC6 Outsie of inolence an ignorance, the follo!ing issues ha#e pro#en to be barriers to the implementation of ris%&a"uste hurle rates+ $olitics+ 'eston can count on stiff opposition because the change in hurle&rate systems creates !inners an losers !ithin the firm$ 3olitics may be a se#ere barrier$ (#ocating the ris%&a"uste system !ill be no easy matter$ .mart opponents !ill point to the numerous assumptions unerlying the system, an may attempt to confuse the issues !ith less& confient listeners$ On the other sie, implementation of the ris%&a"uste system !ill lea to a higher #aluation of the firm (about :J, accoring to E+)ibit TN1)$ This shoul ser#e the interests of shareholers (an Fossarian)$ 'hether organi/ational politics can be surmounte to ser#e shareholer interests, ho!e#er, !ill hinge on the effecti#eness of Teletech)s shareholer go#ernance$ This may e-plain !hy Fossarian has re*ueste t!o boar seats$ 1stimation+ The case presents a simplifie problem in estimating segment '(CCs$ The simplifying assumptions inclue+ (=) inepenence of the t!o segments, an (2) no ris% management through corporate treasury operations$ 0ealistically, Teletech)s t!o segments are not inepenent, although ho! much business they o !ith each other is not state in the case$ 0ela-ing the assumptions of inepenence an treasury consierably complicates the tas% of estimating segment '(CCs, the treatment of !hich is beyon the scope of iscussion in this case an note$ .ome e-ecuti#es !oul choose to ma%e simplifying assumptions in the belief that operating managers shoul be charge a cost of capital that reflects their o!n narro! span of influence$ Other e-ecuti#es !oul gi#e up the ris%& a"uste system in frustration in the belief that it shoul be 5one right or not at all6 an that oing it right is too complicate$ 2rgani3ational change+ .ystems of ris%&a"uste hurle rates probably ma%e sense in the conte-t of a larger effort to transform a culture to!ar a more in#estor&oriente point of #ie!$ ?easurement systems are only one a#enue of change$ Other a#enues shoul inclue internal an e-ternal communications, training, compensation, an changes in organi/ation$ ?any e-ecuti#es !ill recogni/e thisH but only a fe! !ill ha#e the energy for it$ 2iscussion of issues such as these !ill help sensiti/e stuents to the challenges of implementing mean&#ariance logic an #alue aiti#ity in a corporate setting$ /isc!ssion 0!estion 2 ,-hibit TN= TELETECH CORPORATION, 2005 Illustration of the 3otential ("ustment in ,nterprise 8alues (ccoring to Changes in the ?i- of .egments .ource+ Case !riter analysis$ ,-hibit TN2 TELETECH CORPORATION, 2005 ,stimation of .egment '(CCs+ Completion of Case ,-hibit = Note+ This elegant result of #alue aiti#ity, (i$e$ !here the '(CC, compute 5#ertically6 e*uals the '(CC compute 5hori/ontally6) is obtaine e-actly only if special care is ta%en in computing the !eighte a#erage beta an costs of ebt$ .ome analysts might prouce an e*uity beta that simply uses the :5I25 asset !eighting for segment betas (li%e!ise !ith the cost of ebt)$ The typical result is gi#en in the column to the right of the bo- abo#e, !here 5hori/ontal6 an 5#ertical6 isagree$ 1ut this simple !eighting is incorrect since the t!o segments ha#e ifferent mi-es of ebt an e*uity$ The correct approach is to account for these iffering mi-es$ For instance, the !eighte a#erage cost of ebt (5$KKJ abo#e) is compute as+ .ource+ Case !riter analysis$