Analysis Teletech 2005
WACC and Hurdle Rate: Risk drives required returns and is a fundamental concept when determining whether or not a company is providing appropriate returns to its shareholders. Teletech’s policy was to use a uniform hurdle rate across segments. This policy works well if each potential investment has the same risk. Unfortunately for Teletech, investments differ in their level of risk and therefore in their required rates of return. To adequately assess potential investments, Teletech should implement a hurdle rate for each segment and potentially risk-adjust these hurdle rates for projects within each segment.
As Teletech’s EVP of Telecommunications Services points out in his graph, a single hurdle rate for varying risk segments can be misleading and cause severe financial damage. Specifically it can lead to profitable projects being rejected and unprofitable projects being approved. In either case, shareholder value is not maximized. Exhibit 1 shows our WACC calculation for the Telecommunications Services (TS) and Product and Systems (PS) segments to be 8.5% and 11.7% respectively. Under Teletech’s single hurdle rate philosophy, projects in the TS segment would be rejected if ROC is projected to be below 9.3% even though they would be adding value if above 8.5%. Possibly even more detrimental, projects in the PS segment would be approved if ROC is above 9.3% even though they would be destroying value if below 11.7%. Additionally, the single rate philosophy will lead to more and more of Teletech’s resources being allocated to the PS segment. As these resources shift, many other components used to calculate Teletech’s WACC (hurdle rate) will shift as well. For example, more equity funding will be used changing the capital structure, beta will change to be more based on PS’s industry as will market risk. Fewer and fewer TS