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 …show more content…
Betty’s analysis requires estimated betas for NFP’s 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 a within-firm basis, which treats the firm as a portfolio of assets.)
In the stated scenario, Betty must adjust the beta’s to more accurately reflect the division risk. The beta is needed in order to come up with the cost of equity, which translates to the WACC, as well as the hurdle rate.
9. 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 firm’s 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? The cost of capital and the corporate beta will increase because the firm is more risky as a whole. The aftermath on all of the statements would be almost instantaneous.
10. Compute the Payback, IRR, MIRR, and NPV for the example cash flows. Discuss how the risk adjustments affect the acceptability of the project.
When the risk decreases the NPV