Nothern Forest Product Case Study

Case 1 Fin400 Analysis

CASE 90: Northern Forest Products |

Topic: Cost of Capital |

Instructor: Dr. BILICI and Dr. Tran Phi Long |

GROUP 11:

Nguyễn Diệp An

Hoàng Tiến Nhật Anh

Phạm Nguyên Hạnh

Đỗ Quang Huy

Nguyễn Hoàng Long

Nguyễn Phương Thủy

Phạm Anh Thư

Phan Thị Thu Trang

Nguyễn Đức Trung

Vũ Thị Minh Tú

NOTHERN FOREST PRODUCT CASE STUDY

Question 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 adjustment is of importance since evaluation of a project would not be appropriate if the hurdle rate is only based on the company risk. In determining the cost of capital for the project, risk must be accounted on the process of allocating capital and resources. The lack of risk adjustment in considering the proportion amount of capital invested in each project would result in the misallocation of resources. By adjusting the firm’s overall hurdle rate, the company can review the divisional risk before taking capital allocation and investment decision.

Without risk adjustment, the firm’s stock value would be affected for taking in and allocating large proportion of resource in project with high risk which may result in loss. Besides, when the firm rejects acceptable project with low risk or allocate small amount of capital in the project, it may lose its competitiveness over other firms. To conclude, the improper risk adjustment leads to misallocation of resources which will bring about lower 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 capital?

The single hurdle rate currently used by Northern Forest Products can change the risk structure of the company since the divisional beta of 1.28 is higher than the company beta of 1.06. The overall cost of capital would rise once there is more investment in this division. When the company use single hurdle rate instead of risk adjustment, the higher return with higher risk project would be chosen over lower return and lower risk project. The resource would be misallocated and increase the proportion of asset of the high risk project which would in turn increase the weighted corporate beta. As the result, the overall cost of capital of the corporate would rise.

Question 2:

Explain the rationale behind using beta as a measure of risk. Compute the company's beta based on 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 riskiness of firms (or divisions)?

To investors, beta is an effective measure of risk since this is the risk that cannot be diversified. Hence, in valuation process, corporate beta will be used considering the CAPM. NFP’s beta can be calculated based on the divisional beta as follow:

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β = ∑wi βi = 38% x 1.12 + 33% x 0.98 + 15% x 0.82 + 9% x 1.28 + 5% x 1.43

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= 1.058

There has been difference detected in the reported beta and the previously computed beta. Valueline and Meryl Lynch reported the corporate beta as 1.04 and 1.12 whereas the previous calculation shows the result of 1.06. Those two reported beta are measured using historical beta which is based on a regression of past return against the market. When using historical data to predict the future value, it cannot be as precise and useful as predicted data for it does not involve the changes in capital structure and market volatility. Moreover, the assumption that the future risk resembles future risk is not applicable for firms that are not stable whose asset structure is enduring significant changes. Therefore, using historical beta to predict future risk is not an efficient method and should be adjusted when being measured.

Question 3:

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

Cost of equity

Applying CAPM, Cost of equity can be computed as follow:

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rs=rRF+ rM-rRF × β

In which:

rRF=6.5%

rM=14.2%

β (the weighted average of divisional betas) = 1.06

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rs = 6.5% + (14.2% - 6.5%) 1.6 = 14.65%

NFP’s cost of capital includes cost of debt and cost of equity as its component. WACC is calculated by taking the weighted average of the after-tax cost of debt and cost of equity:

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WACC= wd×rd+ 1-T×ws×rs

In which:

wdweight of debt=42%

wsweight of equity=100%-42%=58%

rd(cost of debt)=12%

T(tax rate)=35%

Rs (computed cost of equity) = 14.65%

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WACC = 0.42 (12%)(1-35%) + 0.58 (14.65%) = 11.77%

Finally, in order to calculate Hurdle Rate, required premium of 4% would be added to the cost of capital.

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Hurdle Rate=WACC+Required Premium

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= 11.7% + 4% = 15.77%

The addition of 4% premium to the cost of capital has negative impact on the company value. The premium leads to the decision of refusing the potential project that would not be able to cover the additional required premium. Hence, the additional required premium of 4% should be reduced so that the firm can accept the project that has higher return that its adjusted risk would increase the firm’s value. The required premium prevents the firm from maximizing its value