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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 Lehmann's 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:

1. Managers should always maximize net present value (NPV)

2. There are problems when firms near bankruptcy or their inability to

produce positive cash flow

3. There are inevitable battles over capital structure between cash

cows and growing business units.

4. Measurement of project risk continues to be a problem.


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 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), you'll

find many things are the same (percent of R&D spending; gross margins

on major product lines; percent of sales & marketing spending). -- and

you'll 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


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 that's 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 it's 25% of the portfolio).

Returns being required by the bond holders allow us to calculate a

beta on the debt:


"Analysis for Financial Management," Robert Higgens

"Corporate Finance -- Cost of Capital"

rD = rF + Bd * (rM-rF)


rD: return required by market

rF: the risk-free



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