Northern Forest Products Case

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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 …show more content…

The inconsistences occur because these two reported measures are based on historical data.

Although beta is a good measurement of a project’s or division’s risk, measuring based on historical data is a drawback that cannot be ignored. Beta must be altered for any reconstruction in portfolio or firm’s capital structure because beta itself does not incorporate up-to-date information. In other words, beta does not take into account recent changes; therefore, it is a poor predictor of the future. Basically, historical betas do not provide good measures of the future riskiness of firms or divisions and NFP shall be right to use their calculated beta instead of those reported betas.

3. Question: 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.
______________________________

According to the case, we have following inputs:

* The long-run Treasury rate was 6.5% illustrating risk-free rate (rRF) * The long-run return on the

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