Essay About Ideal Situation And Corporate Finance

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This is a classic cost-of-capital and capital allocation case. There
are lots of questions that can be asked but the core issues are:
•
does debt change the potential value of the firm? This is the
implicit argument that the Rick Phillips, Exec VP of
Telecommunications Services, makes in his brief when he says “if money
flows into safer investment, over time the cost of their loans to us
will decrease.”
•
is there a different cost-of-capital for the 2 business units of
Teletech? There are no comparable equity betas for the two business
units, but we do have operating profits and debt information to help
make a judgment.
Prof. Bruce Lehmanns lecture notes from his introduction to corporate
finance lay out some of the principals of the Nobel-Prize winning work
of Franco Modigliani and Merton Miller. The most-relevant comments
start on page 5, noting what some of the implications are:
Managers should always maximize net present value (NPV)
There are problems when firms near bankruptcy or their inability to
produce positive cash flow
There are inevitable battles over capital structure between cash
cows and growing business units.
4. Measurement of project risk continues to be a problem.
UCSD IR/PS
Prof. Bruce Lehmann
“Modigliani and Miller and the Irrelevance of Debt Policy” (Jan. 9, 2001)
Merton Miller, in his attempt to explain the irrelevance of borrowing
in the capital structure, uses the example, “Say you have a pizza, and
it is divided into four slices. If you cut it into eight slices, you
still have the same amount of pizza. We proved that! Rigorously!”
Arnold Kling — AP Economics
“Corporate Finance: Leverage and the Modigliani-Miller Theorem” (undated)
So the first conclusion is that NPV — using a risk-adjusted
cost-of-capital — should be the sole determinant of decisions to
invest or not invest. And, of course, projects with the highest
potential return should get priority — though funding should be
sought for any investment with a positive NPV.
The question is: do the two business units have different costs-of-capital?
THE MARKETS FOR TS AND P&S
The ideal situation is to find several competing companies and judge
the beta or capital market risk for them. Considered to be the best
way to judge company-related risk, this is still an imperfect process.
Even taking two closely-competitive semiconductor companies such as
Intel (NASDAQ: INTC) and Advanced Micro Devices (NYSE: AMD), youll
find many things are the same (percent of R&D spending; gross margins
on major product lines; percent of sales & marketing spending). — and
youll find many things different (share of microprocessor markets;
markets for new product development; customers; capital structure).
Bernard Ingles memo to CFO Margaret Weston in the Teletech case makes
mention of this in his last point but really makes no mention of what
companies would provide likely comparisons — or if the companies are
publicly-traded.
In terms of equity, we know only that the company has a low aggregate
beta of 1.04. However, we do have a good idea of what debt risks are
— and the portion of capitalization thats allocated to
Telecommunications Services (TS) and Products & Services (P&S):
Debt: 18%
Equity: 82%
TS Capital: 75% ($1.18 billion)
P&S Capital: 25% ($4.1 billion)
TS cost of debt: 7.00%
Corporate cost of debt: 7.03%
Knowing the weighted averages, we know too that:
P&S cost of debt: 7.12% (as its 25% of the portfolio).
Returns being required by the bond holders allow us to calculate a
beta on the debt:
QuickMBA
“Analysis for Financial Management,” Robert Higgens
“Corporate Finance — Cost of Capital”
rD = rF + Bd * (rM-rF)
where,
rD: return required by market
rF: the risk-free