Northern Forest Products Case

1103 Words Jan 24th, 2015 5 Pages
1. Question: 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.
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
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NFP will face an increase in the level of risk as well as the overall cost of capital.

Now supposing Plastic Products Division received a disproportionately high level of funding because their returns exceed the company hurdle rates. Unfortunately, the division’s beta is 1.28, larger than the corporate beta reported by ValueLine (1.04) and Merrill Lynch (1.12). As NFP invests more in riskier division and the division’s beta remains unchanged, NFP’s new beta and the overall cost of capital would gradually increase a lot more than the current one, which later poses a threat to the company itself.

2. Question: Explain the rationale behind using beta as a measure of risk. Compute the company’s beta based on the divisional betas and compare it with that provided by Value Line 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)?
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Beta is an effective measure of risk. Unlike standard deviation, beta is a measure of a stock’s systematic, or market risk, which cannot be diversified away. To investors, it is considered to be the most important measure.

Now we are about to take a closer look at NFC’s beta.

According to Northern Forest Products case, we have the following data table:

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