Question

Teletech Corporation
You are asked to assess Teletech’s cost of capital, specifically the hurdle rate(s) (i.e., discount rates) that Teletech should use to assess projects for its telecommunications and computer divisions. Please answer the questions below In May 1988, at the time of the decision making in the Teletech case, the risk-free interest rate was approximately 8.0%. Assume an equity risk premium of 5.0%.
"Net identifiable assets" in Exhibit 1 represents the book value of equity for each division. Assume that it may be used as a proxy for the market value of equity for each division. (In reality, one would find the market cap of the equity of the entire company - share price times the # of shares outstanding - and attribute a portion of that market cap to each of the two divisions.
However, for the purpose of this case study, we will use the book values instead.) Make any other reasonable assumptions as necessary.
1) How does Teletech currently compute its hurdle rate and how does it evaluate risky projects?
What is wrong with this method?
2) What are the advantages and disadvantages of a divisional hurdle-rate system compared to a single corporate-wide hurdle rate? Which do you recommend and why?
3) Teletech's before-tax cost of debt is 10.13%. What is Teletech's after-tax cost of debt? (Note that the after tax cost of debt mentioned in parentheses near the bottom of page 2 is a typo.)
The statutory corporate tax rate is 34%, but because of various R&D credits the average tax rate for the computer division is 25%. Discuss your choice of tax rates (25% or 34%) for calculating the after-tax cost of debt.
4) What is Teletech's corporate cost of equity? This can be based on Teletech’s equity beta given in the case. What is Teletech's corporate weighted average cost of capital (WACC)?
5) Use the data on the telecommunications industry (top half of Exhibit 2) to estimate the telecommunications division's WACC. The betas presented are equity betas for each firm. For simplicity, assume that the debt of the telecommunications companies (other than Teletech) is risk free (and has a beta of 0).
I suggest the following sequence of steps:
a) For each of the companies in the telecommunications industry, calculate the asset beta.
b) What would you estimate as the asset beta of Teletech's telecommunications division?
c) What is the required return for the business risk (rA) of the telecommunications industry?
d) What is the cost of equity for telecommunications projects?
e) What is the division's WACC?
6) Repeat question 6 for the computer division.
7) What should the relationship be between the two divisional WACCs and the corporate WACC? Does this relationship hold? Explain.

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Teletech Corporation
1) How does Teletech currently compute its hurdle rate and how does it evaluate risky projects? What is wrong with this method?
ANSWER
Teletech currently computes its hurdle rate based on a moving average of the firm’s estimated historical cost of capital over the previous ten years, and applies this rate as a minimum return-on-investment criterion for both operating divisions. The company evaluates risky projects by discounting cash inflows and outflows at the hurdle rate with high risk projects requiring an NPV ratio of 1.5, compared to 1.2 for moderate risk projects and 1.0 for very low risk projects.
The problem with the weighted-average method used by Teletech is that it is backward looking as opposed to forward looking. Companies should base their hurdle rates on...

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