Teletech uses the WACC/hurdle rate to make capital budgeting decisions. Other smaller segments in the company may not issue securities in the open market. Therefore, the company was forced to develop some type of yardstick for these other smaller segments. Teletech uses an economic profit model. The model measures whether a segment’s returns are enough to cover the costs of capital. The second objective of this case was to determine whether the Products and Systems segment is under performing as Yossarian claims.
The Telecommunications Services and the Products and Systems segments’ economic profit was comparatively analyzed using the corporate hurdle rate and each segment’s individual hurdle rates. A summary of the results can be found in Table 4 of the Appendix. In 1995, the Telecommunications Services segment had net operating profit after tax of $1. 18 billion and a Return on Capital of 9. 8%. Therefore, the capital was calculated to be approximately $12 billion. Utilizing the corporate hurdle rate of 10. 41%, the economic profit was calculated to be approximately ($73. 5 billion).
This would lead one to believe that the segment is under performing and measures should be taken to rectify the situation. However, utilizing the segment’s individual hurdle rate of 9. 19% provides an economic profit value of approximately $73. 5 billion. This is a great contrast to the value calculated with the corporate hurdle rate. This also makes the case even stronger for using the individual segment hurdle rates. The Return on Capital for this segment is definitely lower than that of the Products and Systems segment however as we have previously calculated the cost of capital for the Products and Systems segment is much higher.
The Products and Systems segment in 1995 had net operating profit after tax of $480 million and a Return on Capital of 12%. The capital calculated with this information was approximately $4 billion. Utilizing the corporate hurdle rate of 10. 41%, the economic profit was calculated to be approximately $63. 6 million. This indicates that the segment is profitable and is providing value to the corporation. However utilizing the segment’s individual hurdle rate of 13. 95% provides an economic profit value of approximately ($78 million). Again, there is a great contrast in these numbers.
Using the segment WACCs forces the Products and Systems segment to increase its Return on Capital to at least 13. 96%. If the segment is not able to achieve that hurdle, it will remain unprofitable. The corporate hurdle rate cannot be utilized for all projects within all segments of the company. By doing so, in this case one undervalues the profitable segment of the company and hides the fact that the other segment is under performing and unprofitable. The next step for Margaret and her finance team at Teletech is to determine what if anything can be done with the Products and Systems division.
A question that she needs to answer is whether both departments in that segment the one that manufactures telecommunications components and the one that manufacturers computer workstations hold any value for the company. The case didn’t provide individual NOPAT’s for the departments so an economic profit analysis could not be completed. If the outcome of that analysis finds that the Products and Segments segment is important to the bottom line profitability of the company NOPAT needs to be increased.
Teletech would need to find ways to increase sales perhaps by bundling long distance, Internet access, and computer rentals. They would also have to work at cutting operational costs and capital expenditures. The company should also make a close evaluation of their growth plans for the segment because of the past large expenditures on R;D. Given the current economic conditions and the competition that Products and Systems segment is facing they may not be able to increase the NOPAT. In that situation, they should sell the segment and cut their losses. Ms.
Weston should first consult the legal council for Teletech to help outline what she should and shouldn’t say to Yossarian. After she has an approved plan she should set-up a face to face meeting with him. Obviously, in the short-time frame, she wouldn’t be able to have resolved all the issues facing the company, but she should have a workable plan to implement the segment hurdle rates and the reasons for the implementation and probable outcomes from the changes. Ms. Weston also needs to develop a plan to deal with the under performing Products and Systems segment with a defined time frame.
If Teletech decides not to sell the division, they must establish a deadline date and a realistic goal for improvement, for example, an increase in NOPAT of 1% in 12 months. This goal would not make the segment profitable but it would show the potential for profitability. Yossarian may not approve of the plans for improvement but he may be satisfied that Teletech management has recognized the profitability problems and has an action plan. Most importantly, Ms Weston and the board have to keep the shareholders of the company in mind all the time. They are obligated to act in the best interest of the shareholders.