Case 90 Questions
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 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?
The company’s beta (1.06) is lower than the divisional beta (1.28). As a result of this, more investment in the division will increase the company’s beta and cost of capital. The firms cost of capital is increased due to the cost of equity increasing, while the firm is investing in more assets.
2. 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 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)?
Beta is used as a measure of risk because it affectively measures market risk. (Market risk is the most important to investors). Company beta is equal to 1.06. Valueline’s beta is equal to 1.04 and Meryl Lynch’s beta is equal to 1.02. An inconsistency is the company’s beta is based on the divisional betas, while Valueline and Meryl Lynch are based on historical betas. Historical beta’s are not a
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 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?
The company’s beta (1.06) is lower than the divisional beta (1.28). As a result of this, more investment in the division will increase the company’s beta and cost of capital. The firms cost of capital is increased due to the cost of equity increasing, while the firm is investing in more assets.
2. 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 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)?
Beta is used as a measure of risk because it affectively measures market risk. (Market risk is the most important to investors). Company beta is equal to 1.06. Valueline’s beta is equal to 1.04 and Meryl Lynch’s beta is equal to 1.02. An inconsistency is the company’s beta is based on the divisional betas, while Valueline and Meryl Lynch are based on historical betas. Historical beta’s are not a