QUESTIONS

28 total question / 4 – 7 questions each.

1. Explain the importance of risk adjustment in the capital budgeting allocation process by answering the following questions.
a. Explain why risk adjustments are important and how they can affect firm value.

Risk adjustments are important because if they are not used than expectations for projects will be unrealistic. It is necessary to use risk adjustments because you may accept a high risk project that should have been rejected which could affect the firm’s value. This could also cause the firm to improperly budget a project and run out of money before the project before it is finished. Therefore, this could have a negative effect on the firms stock and also cause embarrassment to the company.

b. Explain how the single hurdle rate currently used by Northern Forest Products can change the risk structure of the company. For example, think about what would happen if the Plastic Products Division received a disproportionately high level of funding because their returns exceed the company hurdle rates (its growth rate substantially exceeds the corporate average). Assuming that the risk of the division remains unchanged, what effect would this have, over time, on NFP’s corporate beta and on the overall cost of capital?

This will increase the corporate beta, and it will also increase the cost of capital for the corporation. The beta for the Plastic Products Division is higher than the corporation’s beta. This means if they receive a higher level of funding than the cost of equity for the division will increase because they will be investing more in their assets. If the cost of equity increases in a division with a higher beta than they should assume the corporate beta will increase long with cost of capital.

2. Explain the rationale behind using beta as a measure of risk. .

Beta is important to use as a measure of risk because it measures the risk that cannot be diversified away.

Compute the company’s beta based on the divisional betas and compare it with that provided by ValueLine and Merrill Lynch. Explain some of the inconsistencies that can be found in reported betas. Do historical betas provide good measures of the future riskiness of firms (or divisions)?

The company’s beta calculated in the spreadsheet is 1.06. ValueLine reported the company’s beta at 1.04 while Merrill Lynch reported it at 1.12. The inconsistent reported betas can result from both companies using historical betas. Historical betas are not good measurements of the future riskiness of firms. This is because they use historical returns and do not account for recent market volatility.

3. Using the computed beta, find the cost of equity, the weighted average cost of capital
(WACC), and the hurdle rate for the company. Discuss the negative impact of the added premium to the cost of capital.

Cost of equity = 14.65%
WACC = 11.77%
Hurdle Rate = 15.77%

The negative impact of the added premium is that it causes the company to pass up on projects that could benefit the shareholders. But by breaking the hurdle rate down for each division it should help capture these projects.

4. Compute the cost of equity for each of the company’s divisions.

Then, compute the WACC and the hurdle rates for each division, assuming that all divisions use a 42 percent debt ratio.

Division
Beta
Equity
WACC
Hurdle rate
Paper product
1.12
15.12%
12.05%
16.05%
Timber product
0.98
14.05%
11.42%
15.42%
Wood product
0.82
12.81%
10.71%
14.71%
Plastic products
1.28
16.36%
12.76%
16.76%
Real estate
1.43
17.51%
13.43%
17.43%

5. Do you agree with Betty concerning the capital structure issue?

Discuss several arguments that Betty can use to help justify using the company rather than divisional capital structure to determine WACC.

Yes, I agree with the capital structure. She could point out that using the expanding to quickly could spread them too thin which would result in drops in bond ratings and lost earnings because