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.
UCSD IR/PS
Prof. Bruce Lehmann
"Modigliani and Miller and the Irrelevance of Debt Policy" (Jan. 9, 2001)
http://www2-irps.ucsd.edu/faculty/blehmann/study_materials/corporate_finance-1-notes.pdf
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 ...