3 Case 90 Northern Forest Products Cost of Capital Directed Northern Forest Products (NFP) was established in the 1800s to log timber in the Great North Woods. In response to changing conditions, the company underwent radical changes in the way it operate

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that hc had rcad an articlc in his pr()た ssionaliOurnal about a divcrscお od company struggling with

thc issue of divisional hurdle ratcs The articlc noted that thc restaurant industry tends to have dcbt

rati()s of about 70 pcrccnt,which arc about twicc that ol:thc othcr maOr di宙 sions Thc coinpany

dccidcd to use a 70 perccnt dcbt ratio for its rcstaurant division,colllparcd to 40 percent f()r its frozcn

f()ods division,so that colnparability、 vith stand― alone compctitOrs could bc achievcd_Thc articlc ibr―

ther pointcd()utthat Zcnith Stccl Corporation's Equipincnt Lcasc Financing Division also has a high

dcbt ratio(abOut 80 pcrccnt dcbt,as opposcd to 42 pcrcent ror its othcr divisions)In bOth Situa―

tions,thc colllpanies indicatcd that thcy could rclllain colnpctitive only il'thcir divislons could ibl―

lo、v industl‐ y practice l:or capital structurcヽ VhCn calculating hurdlc ratcs

Vヽhen John linishcd hiS discussion of dcbt ratios for rcstaurants and cquiplllcnt lcasing,

Yolanda Trcbblc notcd that both thc restaurant and cquipmcnt lcasing industrics havc bccn cxperi―

cncing financial dificulties ヽヽ /ithin thc past qual‐ tcr,thc financial press had reportcd lost carnings

and drops in thc bond ratings for scveral colllpanics in thcsc industrics ShC thcn suggcstcd that

thcir problcmslnight havc becn compoundcd by ovcl・ ―CXpansion rcsulting fronl using unrcalisticaHy

lo、v hurdic ratcs OthCrs agrcedヽ vith hCr point,butthe issuc ol'usillg divisional capital stl‐ ucttlrcs、vas

not rcsolvcd alld nccdCd to be disCusscd l｀urthcr

FoHowing the mecting,Betty dccidcd t()lbcus on Ways ol｀ accountingお r individual pr● CCt

risk Shc nlct、 vith cmployccs in various opcrations of thc Company and discovercd thatlnostindi―

vidual prqiCCtS arc parts oflargcr processcs Also,thc rcsults of a givcn capital pr● ect arc highly scn―

sitivc to lllarkct and production conditions f()r thc product.The cxpel‐ ienccd opcrating pcrsonncI

wcrc nlore conndcnt about the prQicCtCd Cash■ ows for solttC pr● CCtS than for othcrs They nlcn―

ti()ncd that solllC prlDlcctS arc silnply riskicr than othcrs AIso,」 ohn reportcd that solllC Opcrating pcr

sonncl havc bcttcr“ track records"in brecasting cash nows than othcrs Thcrerorc,」 。hn attusts

pr(り cct cash llows bascd on post audit results of individual lllanagcr's previous pr(pJects Vヽith this

init)rmation in lnind,Betty concludcd that any systcin accounting for individual prQiCCt risk would

ncccssarily bc solllcヽ Vhat arbitl・ ary and illlprccise Hoヽ ノCVCr,shc belicvcs that risk nccds to bc incor―

poratcd into thc analysis br extrcmcly largc pr● ccts,particularly thosc invol宙 ng cntircly new tcch

nologics or product lines.In thesc cascs,Bctty thinks that ly10ntc Carlo silnulation or sccnario

analysis should bc uscd to gencrate risk and rcturn characteristics oFthc prqicct HOWCVcr,she

bclicvcs that thc costs WOuld outwcigh thc bcnents Ofthcsc approachcs ibrillost pr● cctS,espe

cially in vicw ofthc highly su匈 cct市 e naturc ofthc cstinlalon proccss that WOuld havc to bc usedお r

the probability data.

As an alternativc,Betty decided tO rccommcnd thal divisi()nal managcrs classi″ aH rCqucsts

for hnding into cithcr high― risk,avcragc risk,and low― risk groups High-1・ isk prQicctS WOuld bc

cvttluatcd at a hurdle ratc l l tiincs thc d市 isional ratci avcragc― risk pr● ectS WOuld bc cvaluatcd at

thc di宙 sional ratc;and low― risk prqicctS WOuld be cvaluated at a hurdlc ratc 0 9 timcS thC d市 i―

sional ratc ヽヽ′hen this was discusscd at thc ncxt group lllccting,thc lllcinbcrs agrecd that thc proce―

durc、vas arbitrary but rcasonablc,and most of thc group felt that gcncral risk grouping、 /as bcttcr

than thc currcnt proccdure

Just bcf()rc hcr final rcport、 vas duc,Betty、 vas reassigned to an emcrgcncy situation rcgard―

ing thc loss ofthc company's mlor cuStOmcrin Japan You have bcen aSSigncd lo takc ovcrthc task

of complcting thc repol‐t and dcfcnding it beFore the group BCf()rc shc le負 、 you vノ ci‐c ablc to spcnd

a day becollling ihnliliar、 vith the capital budgcting situation and rcvicヽ vcd Betty's notcs.She lllcn―

tioncd that shc rcmaincd con宙 nCCd that capital budgcing mustinvolvc iudglncnt as wcll as quanti―

tativc analy scs Currcntly,the capital budgcting proccss iS aS foHoヽ /s:(1)Onc hurdlc ratc iS uscd

throughout thc cntirc corporation;(2)NPVs,IRRs,MIRRs,and paybacks arc calculatcd:and(3)

thcse quantitative data arc used,along with such qualitativc factors as``whatthc pr● eCt dOCsお r

our strategic position in thc markct,"in making thc final“ acccpt,rclect,or dcた r"dccision Bctty

clllphasizcd that this gcncral proccdurc should be rctaincd,but that the quantitative inputs uscd in thc

final dccision would be bcttCr if difた rential nsk― acllustcd discount ratcs wcre uscd Shc wanted t()

makc surc that you cxplaincd thc nccd for differcntial nsk aliustmCnts and how thCy impact llrm

@ 2OOO South-Western, a part of Cengage Learning

18

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Explarn the rationale behind using beta as a rneasure of risk. Compute thc citmpany's beta

basecl on thc divisional bctas and colnpare it with that provided by Valucline and Merrill Lynch. Explain some of the inconsistencies that can be ftrund in reportcd betas. Do historical betas provide good measures of the future riskiness of flrlrs (or divisions)'/

Using the cornputed beta, ijnd the cost of equity, the weighted averagc cost of capital (WACC), and thc hurdle rate lor the cornpany. Discuss the negativc irnpact of the added prc-

mium to the cost ol'capital.

Compute the cost of ecluity ttrr each of the company's divisions. Then. c()lnpute the WACC ancl the hurdle rates fbr each division, assurning that all divisions use a 42 percent dcbt ratitl.

Do you agree with Betty concerning the capital structure issue'l Discuss several arguments that Betty can use to help.justily using the cornpany rather than divisional capital structure to determinc WACC.

How would your thinking about the capital structure decision be afl'ected if: a. E,ach division raised its own debt; that is, il the divisions werc sct up as wholly owned

subsidiaries. which then issued their own debt'l (ln tact. Northern Forcst Products raises dcbt capital at the corporate level, and headquarters then makes lunds available to the

various divisions). b. Divisions issued their own debt, but the corporation guaranteed the divisional debt'l

Now assume that proiects are identified within divisions as being high risk, average risk. or low risk. a. What hurdle rates would bc assigned [o proiects in the three risk categories tbr the com-

pany and within each division'l b. Hgw crtrnlbrtable are you with the l.l and 0.9 proiect risk-adiustment t'actors'l Is there a

theoretical tbundation ibr the sizc ttl'these ad-iustments'l

Bctty's analysis requires estimated betas fbr NFP's five divisions. Suppose she did not lbel comfbrtable with beta analysis. Could divisional (and project) hurdle rates be established using total risk analysis? Il'so, describe how this rnight be done. (Hint: The risk of divisions (and projects) can be viewed on a stand-alone basis or on a within-firrn basis. which treats the firm as a portfblio of assets.)

Supposethat.dcspitethehighercostof capitaltbrriskyprojects(l.l timesdivisionalcost), the Plastic Products Division rnade relatively heavf investt.nents in prtr.iects deemed to be more risky than average. What ettbct would this have on the firrn's corporate beta and over- all cost of capital? How long would it take 1br the cff'ects ol these relatively risky invest- nlcnts to show up in the corporate beta as reported by brokers and investrnent advisory

services'l

Compute the Payback, IRR, MIRR. and NPV fbr the example cash flows. Discuss how the risk adjustments attect the acceptability of the pro.ic'ct.

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

Northcrn Frtrest Products uses an incentive-based cclmpensation plan fbr its uppcr mcnage- ment pcrsonnel.

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@ 2000 South-Western, a part of Cengage Learning

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