Case 90 Questions Essay

1420 Words Apr 20th, 2015 6 Pages
QUESTIONS
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.
Without the correct risk adjustment the firms stock will lose value by taking on high risk projects. The firm could also be considered uncompetitive if they reject low cost/low risk projects.
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
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Capital structure decision will be affected when each division raises its own debt. Since the divisions are free of the parent company’s structure- permitting each division to set up their target debt ratio close to the industry average. This leads to each division setting a high debt ratio to achieve a lower hurdle rate.
b. Divisions issued their own debt, but the corporation guaranteed the divisional debt?
Capital structure will not be affected when the divisions issue their own debt, but the corporation guaranteed the divisional debt. This is due to the fact that the parent company still carries the risk of each divisions projects.
7. Now assume that projects are identified within divisions as being high risk, average risk, or low risk.
a. What hurdle rates would be assigned to projects in the three risk categories for the company and within each division?
Name
High Risk
Average Risk
Low Risk
Company
17.35%
15.77%
14.20%
Paper Products
17.65%
16.05%
14.44%
Timber Production
16.96%
15.42%
13.88%
Wood Milling
16.18%
14.71%
13.24%
Plastic Products
18.44%
16.76%
15.09%
Real Estate
19.18%
17.43%
15.69%

b. How comfortable are you with the 1.1 and 0.9 project risk-adjustment factors? Is there a theoretical foundation for the size of these adjustments?
We are content with the 1.1 and the 0.9 project risk-adjustment factors because they use both of the minimal acceptable rate of return and associated risk. There is a

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