Teletech
Table of Contents
Should all projects (and management performance measures) use a corporate-wide WACC?
- Manager pay is tied to the hurdle rate though the EVA calculation. This makes managers argue for their vested interests.
- The effect of using the wrong hurdle rate is misallocation of resources—poor capital budgeting decisions.
1. Discussion
- The effects of being a conglomerate on financial analysis.
- Investment decision is independent of the financing decision.
- "A single hurdle rate may deprive an unprofitable division….." (page 223)
- The human element: pay tied to the hurdle rate.
2. Weighted-Average Cost of Capital (WACC)
2.1. Cost of Equity for Divisions
Divisions of a firm can't offer equity, so how can we get the divisions beta coefficient? We can look for publicly-traded pure plays and use their cost of equity.
2.2. Cost of Debt for Divisions
Divisions of a firm may or may not be able to issue their own debt. If they do, and we can get a market price, we can use that as firm cost of debt.
Otherwise we can get an estimate (from a bank or by looking at a similar pure play) of the debt's rating, and use the cost of debt for that rating.
3. Thought Experiment
Say there is a company with two divisions.
- The first division is a risky new social network. It has a 20% cost of capital. Higher expected return.
- The second is a very safe railroad, which has a 5% cost of capital. Lower expected return.
Both division are the same size, so the total firm cost of capital is 12.5%.
Now, say each division is considering a new project. If each division uses the corporate-wide hurdle rate, which division is more likely to accept the project? Which is more likely to reject?
Consider what happens in the limit as each division considers more projects. What will the firm ultimately become?
4. WACC Calcultion
- What is each divisions capital structure?
- What is each divisions beta?