Case 1

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...