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Northern Forest Products

JANUARY 23, 2013



Corporate brief history

Northern Forest Products (NFP) is a large multidivisional corporation. The major focus of the company is to manage timber production and oversee the manufacture of consumer paper products from pulp. Over the years, the company has diversified into other businesses, such as paneling and wood flooring production, or real estate. Therefore, the company is divided into five divisions: Timber Management, Paper Products, Wood Milling, Real Estate and Plastic Products. Although this structure has worked reasonably well, but shareholders have expressed concerns that NFPs stock is under-performing and frictions have developed among the divisions.

The major problems of NFP lie in financial planning process. NFP currently does not have a formal procedure for project evaluations and capital allocation. Each division manager is provided a maximum amount of money to fund small projects. NPV, IRR, MIRR are calculated to evaluate the projects, which apply a single corporate rate (4% premium over cost of capital) . Some lower level managers even accept 2% premium and breakeven projects. Besides, NFP also applies 6-year-or-less payback period and an informal risk-adjustment process for riskier divisions. Because of these problems, a team was set up to study the question of risk-adjusted hurdle rates. Betty, the team director, comes up with the idea of applying differential hurdle rates for different divisions, which use the concepts of CAPM and a fixed capital structure to calculate WACC.
So on

Although this idea arises many conflicts among divisions, concerning to the competiveness in different industries, they finally agree to change to new approach, which require divisional managers to classify all requests into either high-risk, averagerisk, or lower-risk projects. Each level will be adjusted with the divisional rate to calculate its own rate.



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 NFPs corporate beta and on the overall cost of capital?

a. Risk adjustments play an important role in the capital budgeting allocation process. In reality, a firm can have various business product lines and be divided into different divisions with different level of risk and capital structure, the divisions WACC should be adjusted to reflect the divisions risk and capital structure, and it can reduce the likelihood of cost overrun before a project is completed as well. Failure in adjusting risk for divisions is a common cause of poor financial management performance, which leads to wrongly estimate the discount rate for each division, which brings about incorrect estimate of the divisions return. For example, if WACC < IRR => the division could be regarded as profitable. Nevertheless, because the firm does not consider the risk adjustment for this division, this return may not enough to compensate the actual risk of the project. The risk adjustment can affect the weighted average cost of capital (WACC). And the WACC will affect the firm value according to this formula:


FCFt (1 + WACC )^t

b. In the case of Northern Forest Products, the single hurdle rate currently used by NFP can drastically change the risk structure of the company. The hurdle rate is the minimum rate of return on a project or division proposal. If the rate of return exceeds the hurdle rate, the project should be invested. A single hurdle rate for all evaluation will fail to reflect the actual risk and return of different divisions, therefore NFP may waste resources for unnecessary projects. If the division with high level of risk receive inappropriate funds, the overall corporate beta could increase over time. As a result, the firm faces higher level of risk ( bp = n 1 bi wi ) and the overall cost of capital increases.

For example: the Plastic products beta is 1.28 > the average corporate beta is 1.06 => if this division received a disproportionately high level of funding because their returns exceed the company hurdle rates, new NFPs corporate beta and the overall cost of capital would increase a lot more than the current ones.


Explain the rationale behind using beta as a measure of risk. Compute the companys 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)?

a. Rationale behind using beta: In finance, the Beta of a security (or portfolio) is used as an indicator of its historical volatility in regards to a benchmark, generally the New York Stock Exchange (NYSE) Composite Index or the S&P 500 Index. Beta is a measure of a stocks systematic, or market, risk, which cannot be eliminated by diversification. Being a reflection of a stocks risk, higher beta illustrates that if the market risk rises 10%, a 1.6 -beta stock would move up 60% correspondently. Beta can also be negative (infrequent but possible), which would mean that the equitys return tends to move in the opposite direction from the markets move. Moreover, there is no upper or lower bound to Beta, although it typically does not stray too far from 1.00. A Beta of zero does not mean the asset is riskfree but that the correlation of that assets return to the markets return is zero. Investors are compensated for non-diversifiable risks, deriving that higher beta is compensated with higher return. b. Computation: Being aware of the investors sensitivity towards risk, Zoller is convinced that cost of equity capital should be based on the beta coefficient. Hence, divisional beta calculation is to estimate divisional risks. The calculation result in a beta of 1.06.

Name Paper Products Timber Production Wood Milling Plastic Products Real Estate

Assets 38.0% 33.0% 15.0% 9.0% 5.0% 100%

Beta 1.12 0.98 0.82 1.28 1.43 1.0587

The outcome is of substantial difference comparing to that reported by ValueLine (1.04) or Merril Lynch (1.12).

c. The inconsistencies in reported beta: At Value Line, the Beta coefficient is derived from a regression analysis of the relationship between weekly percentage changes in the price of a stock and weekly percentage changes in the NYSE Composite Index over a period of five years.1 Merril Lynch2 and Zoller both based their calculation on S&P 500 Index yet Merril Lynch constructed its calculation regarding the corporate as a whole while Zollerbuilt the calculating from divisional betas. d. Are historical betas good measures of future risk? Though beta is a good measurement of a stocks movement, it providing historical measuring is a drawback that cannot be ignored. Firstly, beta must be altered for any restructure in portfolio or firms assets because beta itself does not incorporate new information. Secondly, historical price movements are poor predictors of the future; in other words, beta reflects little what lies ahead. On balance, beta is of great benefit to short-sellers but is less useful to long-term investors.


Using the computed beta, find the WACC and the hurdle rate for the company. Discuss the negative impact of the added premium to the cost of capital.

a. Computation: rS = rRF+ (rM - rRF)b = 6.5 + (14.2-6.5)(1.06) = 14.67% WACC = wDrD(1-T) + wErS = (0.42)12(1-0.35)+(1-0.42)(14.67) = 11.8% Hurdle rate = WACC+4% = 11.8 + 4 = 15.8% Zoller identified the long-run Treasury rate was 6.5% illustrating an identical risk-free rate, the long-run return on the NYSE index was 14.2% was set as the market rate of return. Furthermore, every division is determined to have similar capital structure of 42% of debt as believed to be the optimal for the corporation. The previous cost of debt of 12% and tax rate of 35% were the remaining fundamental contributing to the calculation. Lastly, NPF requires a minimum of 4% for every project return. b. Negative impact of added premium: There is controversy along with the assembled 42% debt as divisional managers held that divisional capital structure should follow industry practice. When it comes to calculating hurdle rates, Zoller recommended divisional managers classify funds to high-, average-, and low-risk projects and multiple the bases of 4% with 1.1, 1.0, and 0.9 respectively for alternating. The hurdle rate includes an additional premium leading to significantly higher cut-off rate approval of a project.
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Compute the cost of equity for each of the companys divisions. Then, compute the WACC and the hurdle rate for each division, assuming that all divisions use a 42 percent debt ratio.
Answer Division Paper Products Timber Production Wood Products Plastic Products Real Estate Beta -----1.12 0.98 0.82 1.28 1.43 Cost Equity -----15.12% 14.05% 12.81% 16.36% 17.51% WACC -----12.05% 11.42% 10.71% 12.76% 13.43% Hurdle Rate -----16.05% 15.42% 14.71% 16.76% 17.43%


Do you agree with Betty concerning the capital structure issue? Discuss several arguments that Betty can use to help justify using the company rather than divisional capital structure to determine WACC.

We agree with Betty concerning the capital structure issue that is how capital structure should be incorporated into the weighted average cost of capital (WACC). Management believes the companys optimal capital structure is 42 percent debt and Betty initially decided to use this capital structure for each division. She also decided to use NFPs before-tax cost of debt of 12.0 percent and its federal -plus-state marginal tax rate of 35 percent in all calculations. However she met some objections from some members of board of directors. Kelly Dubree, vice president of the Real Estate Division indicated that firms in real estate industry averaged close to 75 percent debt and even the most conservative firms used about 60 percent debt. She argued that the company would lose ground in the real estate business if she were forced to use a higher hurdle rate than competing firms. John Sales, corporate capital budgeting director, backed her up. He brought out an example about Zenith Steel Corporations Equipment Lease Financing Division with high debt ratio (80 percent debt, as opposed to 42 percent for its other divisions). His point in this protest is the company could remain competitive only if its divisions could follow industry practice for capital structure when calculating hurdle rates. Although these objections were reasonable but with some strong arguments, Betty still could convince management to accept multiple hurdle rates.

Firstly, some company which used divisional capital structure such as Zenith Steel Corporation have been experiencing financial difficulties, such as lost earnings and drops in bond ratings which were reported in financial press within the past quarter. Their problems might have been compounded by over-expansion resulting from using unrealistically low hurdle rates. Secondly, using corporate average is a simple approach that was consistent with beliefs of management. Therefore, it could help avoiding mistakes while calculating cost of debt for different divisions. Finally, using company capital structure instead of divisional structure would help company reach its optimal capital structure. As it was indicated before, higher-risk division like Plastic Products Division have had disproportionately more funding affected negatively on overall risk of the company. Hence, the idea of different hurdle rates for different divisions should be considered and this could be performed only by utilizing optimal capital structure.


How would your thinking about the capital structure decision be affected if: a. Each division raised its own debt; that is, if the divisions were set up as wholly owned subsidiaries, which then issued their own debt? b. Divisions issued their own debt, but the corporation guaranteed the divisional debt?

a. When each division has its own right to issue their own debt, by nature, each division will make different decision, which aim to meet the optimal capital structure of the industry. For example, in the NFPs circumstances, Real Estate Division may raise the debt portion up to 60-70%, which meets the industrys standard. It may arise the conflict between the divisions and corporations optimal capital structure. b. When the division still issues its own debt, but under the guarantee of corporation, it is obvious that decision of individual division will be affected at the corporation level. The situation allows NFP to put the capital structure under control, reducing the conflict among divisions. Moreover, the guarantee of corporation will help to reassure the behavior of investors when deciding to buy division debts. QUESTION 07

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?

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?

a. Risk-adjusted hurdle rates:

Name COMPANY Paper Products Timber Production Wood Milling Plastic Products Real Estate High Risk -----17.35% 17.65% 16.96% 16.18% 18.44% 19.18% Avg. Risk -----15.77% 16.05% 15.42% 14.71% 16.76% 17.43% Low Risk -----14.20% 14.44% 13.88% 13.24% 15.09% 15.69%

b. In my opinion, the risk-adjustment factors (1.1 and 0.9) are arbitrary, but reasonable, comparing to the current procedures which add up a premium of 4% to the cost of capital. At least, this approach introduces a formal riskadjustment process. However, there is no completely satisfactory way to specify exactly how much higher and lower we should set out for this factor.


Bettys analysis requires estimated betas for NFPs five divisions. Suppose she did not feel comfortable with beta analysis. Could divisional (and project) hurdle rates be established using total risk analysis? If so, describe how this might be done. (Hint: the risk of divisions (and projects) can be viewed on a stand-alone basis or on the within-firm basis, which treats the firm as a portfolio of assets)

In the case the financial manager do not feel comfortable with the beta analysis, she could calculate the divisional (and project) hurdle rates by using total risk analysis. Since the risk of divisions (and projects) can be viewed on a stand-alone basis or on a withinfirm basis. To be more specific, we could refer a division as a portfolio of projects assets and a firm as a bigger portfolio of divisions assets. Thus, our analysis will be calculated on hierarchy levels, which means the figure calculated for divisions risk based on projects will be used in firms risk calculation. In general knowledge, using total risk analysis means calculating the standard deviation of expected return on a project as a risk measurement. There should be two methods to calculate the hurdle rate by total risk analysis: using historical data and using statistics for future estimation.

Using historical data, the realized rate of return could be calculated using the formula: =1 =

Next, the standard deviation of a sample of returns can be estimated using this formula:
= =
2 =1( ) 1

Using statistics for future estimation, a probability distribution table is needed for calculation. In detail, we estimate a probability of each expected return. For example:
Probability 0.3 0.4 0.3 Expected Return $400,000 $150,000 ($100,000)

Then, the calculation will be based on these steps:

1. Calculate the expected rate of return of the project:


2. Calculate the standard deviation based on the formula:

= = ( )2

The calculation will be repeated until we have all the standard deviation of the projects, divisions and firms. These standard deviation could be used as hurdle rates for evaluate future projects.


Suppose that, despite the higher cost of capital for risky projects (1.1 times divisional cost), the plastic products division made relatively heavy investments in projects deemed to be more risky than average. What effect would this have on the firms corporate beta and overall cost of capital? How long would it take for the effects of these relatively risky investments to show up in the corporate beta as reported by brokers and investment advisory services?

A firm could be referred as a big portfolio of assets. Thus, beta coefficient of a firm could be calculated as similar as one of a portfolio, which means a weighted average

of betas of individual assets. Since these logic thinking are relevant, if a firm has significant proportion of its capital to more than average risk projects, consequently, its corporate beta will rise. The WACC of the firm will also increase as the result of the higher level cost of capital components because the firm is taking more risk in the eyes of investors. Assume that the market is efficient, which is a highly possible assumption in the case of United States market, then the effects of these relatively risky investments will reflects as soon as they become aware to the public. In reality, as some research and discussions suggested 3 , considering the speed of market adjustment relies on many factors including trading volume and liquidity of the company's stock, number of analysts/specialists following the stock and the quality of the information disseminated, the market could take up to 48 hours after the publication of the information to react to the optimum position.


Compute the Payback, IRR, MIRR, and NPV for the example cash flows. Discuss how the risk adjustments affect the acceptability of the project.
Answer Cost Capital Hurdle Rate (Cost Capital + Req.Premium) 25.43% 21.43%

Project Cash Flows

Year 0 (start up) 1 2 3 4 5 6 7 8 (+ terminal CF) Cash flow (255,000) 47,000 52,000 55,000 57,000 58,000 60,000 62,000 125,000 Cumulative CF (255,000) (208,000) (156,000) (101,000) (44,000) 14,000 74,000 136,000 261,000

Payback = 4 + (44,000/58,000) = 4.76 years

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Project IRR Project MIRR

16.34% 18.80%

Using IRR and MIRR function in excel: IRR = IRR(CF0:CF8, WACC) MIRR = MIRR(CF0:CF8,WACC, WACC)
Project NPV Name COMPANY Paper Products Timber Production Wood Milling Plastic Products Real Estate High Risk $261,000 $261,000 $261,000 $261,000 $261,000 $261,000 Avg. Risk ($66,394) $132,748 ($129,716) ($129,716) ($129,716) $373,192 Low Risk ($50,884) $143,355 ($116,949) ($116,949) ($116,949) $360,521

How the risk adjustments affect the acceptability of the project: The company required payback period is six years or less. Projects with paybacks more than six years are rejected. Projects with paybacks in the five to six year range are considered marginal and accepted or rejected depending on managements confidence in the cash flow forecasts and on the projects long-run, strategic effects on the firm. Projects with positive NPV are accepted; otherwise, projects with negative NPV are rejected. The company requires IRR and MIRR to exceed the hurdle rate. If a project has IRR and MIRR less than its hurdle rate, it will be rejected. The risk adjustments make the requirement of acceptability of the project higher. In this calculation, the risk adjustment is 4% and it makes NPV lower than the result that has not risk adjustment.


How do the Payback, IRR, MIRR, and NPV change if the additional premium is reduced to 2 percentage points or to 0?

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If the additional premium is reduced to 2% points or to 0, the Payback, IRR remain the same because these outputs are calculated with WACC, not hurdle rate.

Additional Premium MIRR NPV

4% 16.07% $5,329

2% 15.14% $25,574

0 14.23% $48,340


Northern Forest Products uses an incentive-based compensation plan for its upper management personnel. a. Do you see any obvious conceptual problems with the companys compensation program? b. How would you expect the compensation plan to influence managers reaction to Bettys recommendation? Would these reactions be good or bad from the standpoint of maximizing the price of NFPs stock? c. What other options could NFP consider to reduce the division impact on compensation?

a. There are some obvious flaws that can be easily recognized from the companys current incentive-based compensation plan: The first problem with the compensation plan is that it seems to be unfair for the division managers. To senior executive managers of NFP, incentive compensation is based on the performance of the entire corporation and it is fine. But to division managers, using those three factors (ROE, sales growth and earnings growth) at division level is unfair as those ratios varies across industries and might be out of the managers control. For example, the industry of Plastic goods and Real estate usually provide higher growth rate than other industry; therefore, even managers in Wood and Timber products division do their jobs equal or better than their Plastic and Real estate counterparts, their compensation still might be lower than them. As a result, the factors might not reflect the division managers real performance. The second problem of the compensation plan is that the compensation only takes into account how profitable of each division regardless of risk. As only focus on profit, this current compensation plan encourage division managers to take risk as the higher the risk of the project, the higher the profit the project offers. The entire corporation might suffer if all the risky projects perform negatively. Finally, the factors used to evaluate compensation are averaged over the last three years. This method of evaluation might not fully reflect recent performance of each manager. If the division performs well at the first two years but receives loss in the last year, and the average of the three is still positive, the managers of the division still receive bonus for the final years.
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b. To each division managers, the reaction to Betty recommendations might be different. The managers that have the favors from the compensation plan like Plastic and Real estate might dislike the new change but the others might be like it. The first recommendation of Betty is to use divisional hurdle rate. Lately, the corporation uses single rate. As each industry has different characteristic, many risky projects in high return industry will be more easily to be accepted instead of the one in safe but low return industries. With the use of divisional hurdle rate, safer divisions will have more opportunities therefore; the managers of them will have positive reaction when riskier divisions will have opposite reaction. Next recommendation is applying uniform capital structure. The uniform capital structure might be optimal for the whole corporation, but it will lead to disadvantages to some division that need higher debt ratio to be competitive like Real estate division As a result, the manager in those divisions will likely to reject this recommendation. For the reaction for the first recommendation, the negative reaction is bad to the standpoint of maximizing the NFPs stock price as the recommendation offers more competition between divisions inside the corporation. However, for the recommendation of applying uniform capital structure, negative reaction might be reasonable as it will decrease the competitiveness of the higher debt ratio required division.

c. To reduce the division impact on compensation, there are other options that NFP can consider: One option is to base the incentive compensation of each division on the comparison to other corporation in the same industry. The ratio compared to the ratio outcomes in the industry is fairer than making unequal comparisons across different industries. Also, instead of using quantitative data to measure the performance of division, qualitative measurements can be used to evaluate contribution of managers. Finally, the 3-year averaged measurement can be replaced by the annual method so that it will encourage managers to do their best every year.

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