6uruJeel e6ebue3 lo ued e 'ulelsaM-qlnos OOOZ O) 'uaql elsurrurle 01 s{8,{\ puouruoJar puu suelqoJd ,(;puepr 01 .luapr -seJd ecl^ Ietcuuug s.uuu eql'SuttUqS uJnB'I poISB aellruuoc eql 'enlu^ fueduoc e,rordrur p1no,r leql suorlseSSns eleru puu ecuuluroJ-red ,{uedruoc elunle^e ol eellruuoc lurceds u pelurodde srol -reJlpJo pJBoq oql 'eroJoJaqJ'suoISIAIp eql Suorue pedole,tep a^Bq suortcr+ pue Suru:ro;red-repun sI {cols s.dgN ]eql surecuoc pesserdxe e^Bq sreploqerer{s lnq '11em ,(lquuosBer pa{ro1r\ sBq ernl -cnrs srqJ 'qcnpord crlspld pue 'elelsa pa5 '3u11qa1 pool(\ 'slcnpord rede4 .1ueua8uuutr41 reqrurJ :suoISIAIp e^U olul pepl^lp st ,(ueduroc eql 'soull lcnpord snorrE^ eqlJo ornlBu eqlJo asnBceg suorleredo eler -edes o,tl se uorlcnpord scrlsuld puu 3ur11rur poo^\ eql sreprsuoc ,(ueduroc aql ',(lryrce; uorlcnpord .e1ql3r13eu eql Jo uollecol cqderEoeB eql pue Suunlcugnuuru scrlsuld go ernleu enbrun eqt Jo esnecag ueeq s8q lcedurr 3q1 'ra^errroH 'ret1lo eql ro; lcnpord euo pelnlrlsqns srerrrolsnc Jr uorsr^rp scrlseld eqt ,(q uorsr,rrp roog poo,/r\ oql uouezrluqruuec yequelod peuJecuoc se^\ ,{11ur1ur 4gg .Burroog lnoqB Jo poozn s.,(uuduoc eql Surseqcrnd ,{1tuer:nc sreruolsnc eleseloq,tr pelo{Jeu ,(1lue:rnc sr lcnpord ot cqeqlu,(s oqJ'seqcleJcs pu€'surnq'8uturuls'Eulpug ol sr lr esnucaq poo^\ ueql;eqfinol luslsrser ,(11en1cu sI 'poo^\ e{tl s{ool lnq Sur;oog ,(tpnb qSrq u ur Surzrlerceds rurg scrl tuqt tcnpord IBJnlBu -se1d u perrnbcu ,(11uecer 'eJoJeJeql 'pw qllBeq c[uouo3e Ilure^o slr suaql8ue;ls uorlBcgrsra^rp lBql seAelleq ,(uuduroc eq1 '3ur33o1 Suturecuoc se:nsserd Ielue(uuoJrlue lueceJ lnoqu peuJecuoo sr pug slcnpo:d poo^\ JoJ puuluop Ieuolluurelur Sursee:cur eql Jo eJp,tlu sl dCN 'sare srql ur se133nr1s ,(ued -IIIoc eql puB 'uJnlu^\op c[uouoce luocer B Surrnp llq preq ,(pulncrlred su,t lueurdole^ep l?rlueprsar 'reuremoll 's8urp1oq olelsa IBar pepuedxe uI petlnsor s0a6l eqt Suunp tueudole,rep ,(tredord InJSSec -cns 'esn luuorluoJcer ele,trrd puu lerluoprseJ JoJ spuullseroJ str ruor; serlredord tuo{ e{BI eruud eql Jo euos Surdolerrep Jo tlnseJ e se elqsa Jeer ur pollo^ur oslu sr ,(ueduroc eqJ 'elquts sr eJoJeJer{l puu 1nd1no sll Jo IIu roJ lellno tuelslsuoc B pedole,rep seq uorlu:edo srql 'Suuoog poo,r\ pue Eurleued secnpord lgql IInu pezrs ,(lelerepotu p se qcns .sosseursnq potulel reqlo lere^es olur pegrsre^rp seq (uedruoc eql srue,( aql re^O 's8urploq puEI slr ruo{ pe^rrep dlnd uror; slcnpord reded reurnsuoc Jo oJnlcBJnuBu eql SureesJe^o puB uorlcnpord JequrlJo seJce uorllru euo JeAo Sur8eueru surBrueJ ,(ueduroc eIilJo sncoJ roluru eq;'uorlurodroc Isuorsrlrprllnur a3rcy e sr 1r ,(11uerrnc puu sele:edo 1t ,(un eql ur sa8uuqc pclppJ luoaJepun ,(uuduroc aql 'suonrpuoc Sur8ueqc o1 esuodser q .spool& qlJoN IBoJD eql ur reqrurl Eo1 o1 sgg81 eril ur peqsrlqBlse sB,!\ (4g5f slcnpord lseJod uroquoN palcerc IetrrdeJ Jo 1so3 spnpor.I lsaroi uraqiloN 06 esBJ C bcneFit the COlllpany l° ■■ ■ ■ ︱ ロ ー ー ー ■ ︱ ︱ １ １ １ １ １ １ １ ①２ｏ。 ﹃ ｏ。ｃ２” 口一 ①鮮 ﹁﹃ ュプ①３ ﹁ｏ﹃ ＯＦ●■５﹃ｏ”Ｚｏ u 識 剛 Ⅲ … ∬替‖鸞蝋騰 ｀ Ind thC usC Of thiS cisiOns fOr funding l diVIS10n nlanagCr だ輩i∬ 為霜 l lon a 4-pcrcCntagc aluatC the prOICCt'S Iビ i「 浦描鴨 山 at 江 any prolCC｀ ThC payback pCriod il‖i撮 !￨‖illi 善 1‖ lulllbCring Opcra● :lililiII 《浦 … ば 霞 1111:ビ 職 ¨ 響 融 … … ‖ Ⅲ は面 jl。 q 一 鸞Ⅲip¨ radical dCparturC fro Ii::llllilξ :よ ::lll[ 鰍 胴 ‖ 撚 撚 質 鮒 灘 ¨¨¨ 鰤 panyValuiobOrp10 揮獣樅 hcr Strong nlCdiati( Yolanda Trebble(t and thC fOur diViSi( loヽ :: :il lirt∬ mtt」 [:: ￨よ I〔 lil甘 ￨∫ On,_ ctice iS dCpresSing c0111- llili櫛 礁 朧 欝義 苗 i離 l増 》 隠I縦1驚l驚‖ 割精 the grOup ThCtCam Was )d aS lmportanti lct lincヽ Ving qucStiOnS,I Vithin a diViS10n, ach diViS10n,fOr Cach prOdl l Should hurdl or on an lndi 2 HOW ShOuld 3 HOW ShOuld thc Rcal Est ■10rc dCbt il 撚‖徴暴i麟‖ ‖ 獅 lC buSiness a part Of Cengage Learning ◎ 2000 SOuth‐ WeStern′ 16 Eurureel eOeOueC Jo ued e 'urelse^ -qlnos OO0Z O 8ur1ou 'dn req pe{ceq seles uqol 'sseursnq elutse IEaJ eql ur punor8 esol plno,r 4g1q ,e1ur ra,trol e esn sruJg Surleduoc elrq^\ elur elprnq .req8rq e esn ol pecJoJ ere^\ or{s Jr lur{l penS;e aerqnq 'suolsl^rp reqlo s.ddN Jo sseuDISrJ eql Jo llnsor B sB lqep Jo lsoJ IIEre^o s.ddN moleq slurod slseq 9a 'luecJed 97'1 1 ,(1uo pe8ererr.e srotrteduoc Jreqt roJ lqep Jo tsoc xBl-eroJeq eql 's8urre: puoq .stuJu elll?AJesuoc eql uo pesefl'lqep luecrad 09 lnoqu posn sruJu elrlulrasuoc lsou aql ue^e puP lqep luecred gl ol osolJ peSpre^B ,{rlsnpur eletse IBer oqt ur sruJrJ teqt pen8re eqg'pasodo:d s?,e^ lqap luocrcd 7y p ernlsnJls 141duc uuoJlun u lBql lcEJ eql ol uoncelqo Suorls e pecro^ 'uorsr^rc elBlslJ IeeU eql Jo luoplse;d ecrzr. 'eerqnq ,(11e; ',(lqtoorus unr lou plp Surlaeru eql 'sBapr I8rlrur req pelueserd pue Surleeu lsJrJ eql pe11uc ,(11eg ',(e,rrepun .(1ree1c uorle8rlselur Jaq qll1\ 'uorsrcep ral{ JoJ sluerun8ru 3uor1s lueserd lsntu egs lBqt 1l\eul eqs puE IBrsJe^oJluoc aq plnoa suorsrcep eseql luql pezlleer eqs 're^eaoH 'ssoccns Jo ecueqc roq esueJcur plno,^A lueue8euuur Jo sJerleq eql qlr^l luelslsuoc sulr\ lBql qcuorddu eldturs e qltm Surgels 'eJoJeJeqJ 'soter elpJnq eldqynu.r ldeccu o1 lueu -eEeueur Sutpensred eull pJuL{ B o^Bq ol Suro8 ,(pearlu sB,{\ eqs teql peuosuer oqs 'suorlelnclec 11e ur luecred 9€ Jo elur xu1 luut8ruu etels-sn1d-lerapeJ slr puu luacred 0'Zl ]o lqap Jo lsoc xel -aroJoq s6ddN osn ol paprcop osle eqs 'uorsrlrp qcee JoJ ernlcnls 14rduc srqt esn o1 peprcep ,(1p[ -tut ,(11e9 'tqap luecred Z, sI eJnlcnrls Ietrdec purldo s.,(uuduroc eql se^erleq lueure8eue141 esernlculs plrdec 8ur,(re,r lceueJ ol polsnfpe eq slsoc ,(lrnbe luuorsrarp .elerrdordde plnoqs alqep JoJ pesn eq plnoqs etur tseretur teql11 epe^rrep eq ,{eqt plnoqs ,,,roq ^\oH eJe soJnlcnJls lulrdec lueJaJJrp JI aslsoc lqap pue sorntcnJls lqrduc lueleJJrp peu8rsse oq suors -r^rp tuaJeJJrp plnoqs Jo pesn eq a8ere,te elerodroc eql plnoqs '(CCVfvf) plrdec ao tsoc e8urea.e pelqSrerrr eql olur pelurod-rocur eq plnoqs ernlJn4s plrdec /r\oq roprsuoJ 01 pepoou ,(1eg .1xe51 '{srJ s.uorsr^rp eqt uo Surpuedep 'lsoc elurofuoc uro+ sJeJJIp ,(1rnbe;o lsoc s.uorsrlrp qcee lsql eluJlsuoruep ,{1;ea1c plno^\ esrJrexe srql 'luecred Z'rl set xepur gSlN eql uo uJnleJ unr-8uo1 eql pue luecred E.9 sB^\ eler ,{rnsuerl un.r -3uo1 eqt luql peuluuetep oqs '(e1eq eutlenlu1 eqt o1 pesoddo se) uleq pelndruoc eql esn ot petue^\ eqs 'uosuedtuoc;o esod:nd eql rog 'hld173 eql Sursn .(q ,(1rnbe Jo lsoc s.,(ueduroc eql qsrlqelse 1r pe^orleq eqs 'eler elprnq pelsnfpe-1su leuorsr^rp u 3ur11cq eroJeg 'qcu,(1 ol luelrodrur sst\ IIITTaIAI ,(q pelroder se Zl'l puB eur.IenlBn ,(q pegoder se ,0. I Jo Bleq elerodroc s.dCN tsuru8u tr erudruoc pue €leq elerodroc aql elurrrnso ol su1eq luuorsr^rp oseql esn ol potue,&\ ra11o7 ,(ueg ＯＬ ｃ﹂ ①〓ｔＯＺ “ Ｏ①もの上口 あもつＯｏ﹂ 住 ち０﹂ ”﹄二五 ●〓０ srsssv srYuoduoJ do rNslusd ossvg rs}Iuvw vrs g'rvNorsrAr(I oarYnrrJsg obSE ZT'I ObEE 86'0 0b9l ob6 8Z'I z8'0 ob9 ev'l olBtsg IBeu stcnpoJd crlsuld slcnpoJd poo^\ uo[3npord Jeql,url slcnpor4 -rede4 NOrSrAr0 :a1q4 SulirrolloJ eqt ur pelsrl eJe seleq uodn peer8e er{J 'wleq lBuors -rzrrp elerrdordde aql eurujelep ol JolceJlp uorsr^rp qcse qlr^\ 1eu ,(1elewdes eqs uorlBtuJoJur sql qlll6 'xepur eql q1r,r pue suorsr^rp Suouru uorluleuoc Jo 1e,,'e1 q8rq e punoJ pue xepur 00S dTS eql uo sSururee srn-a-srl uorsrlrp qceo ur sSurume 3o ,(1qr1e1oa, eqt pez,(1uue ueql eqs 'seleq Jreql peur -IuBxe puB suoISIAIp ,(uuduroc eqtJo I{me 01 rBlrrurs eJe^\ lBql seruudtuoc papul ,(1c1qnd pele8nse,rur Jelloz '.ISIJ Jo sle^al luoJeJJrp qJns oluq suorsrlrp s,dCN esnuceg 'tuorcgJeoc Blaq qr ,(q pe.rnsueru se,(lrlrtelo^. e^IlBIer s.Icols u,(q',(1e,r,rsnlcxe lou q8noqtlu ged e8rul ur'{su elgurlso srolselur luql lueule8eueru roruos s.ddN pecurluoc puu plrdec ,(lrnbe Jo lsoc sll Jo lueurrurelep ,(e1 eq1 sB ISIJ s.LurIJ eql ees srolselul pelJlsJe^rp-lla,{ ler{l peureldxe oqs 'suorssncsrp pJelas reuv '{srr -JBruJo ldecuoc eql uo sncoJ o1 su,r. ,ftrnbur roq uels o1 eculd olquuosueJ u teqt peprcep Jelloz leI ０ 〓●■ ｏ﹃ ω Ｈ ｚ ｏユ すの﹁コ ﹁Ｏ﹁①∽汁 ﹁ ﹃００ＣＱ Ｆ ¨∪ ■０〇一①Ｑ 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― VhCn calculating hurdlc ratcs lo、 v industl‐ y practice l:or capital structurcヽ ヽ Vhen 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― /ithin thc past qual‐ tcr,thc financial press had reportcd lost carnings ヽ cncing financial dificulties ヽ 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 ucttlrcs、 vas hurdic ratcs OthCrs agrcedヽ vith hCr point,butthe issuc ol'usillg divisional capital stl‐ not rcsolvcd alld nccdCd to be disCusscd l｀ urthcr accountingお r individual pr● CCt lo、 v FoHowing the mecting,Betty dccidcd t()lbcus on Ways ol｀ 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― ienccd opcrating pcrsonncI sitivc to lllarkct and production conditions f()r thc product.The cxpel‐ 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,」 pr(り cct cash llows bascd on post audit results of individual lllanagcr's previous pr(pJects 。hn attusts Vith this ヽ init)rmation in lnind,Betty concludcd that any systcin accounting for individual prQiCCt risk would CVCr,shc belicvcs that risk nccds to bc incor― ncccssarily bc solllcヽ Vhat arbitl・ ary and illlprccise Hoヽ ノ ccts,particularly thosc invol宙 ng cntircly new tcch poratcd into thc analysis br extrcmcly largc pr● 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 cctS,espe bclicvcs that thc costs WOuld outwcigh thc bcnents Ofthcsc approachcs ibrillost pr● r cially in vicw ofthc highly su匈 cct市 e naturc ofthc cstinlalon proccss that WOuld havc to bc usedお the probability data. aH rCqucsts As an alternativc,Betty decided tO rccommcnd thal divisi()nal managcrs classi″ isk prQicctS WOuld bc risk groups High-1・ risk,avcragc risk,and low― for hnding into cithcr high― isional ratci avcragc― risk pr● ectS WOuld bc cvaluatcd at cvttluatcd at a hurdle ratc l l tiincs thc d市 thc di宙 sional ratc;and low― risk prqicctS WOuld be cvaluated at a hurdlc ratc 0 9 timcS thC d市 ′ ヽ hen this was discusscd at thc ncxt group lllccting,thc lllcinbcrs agrecd that thc proce― sional ratc ヽ i― 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 you vノ ci‐ c ablc to spcnd of complcting thc repol‐ t and dcfcnding it beFore the group BCf()rc shc le負 、 vcd Betty's notcs.She lllcn― a day becollling ihnliliar、 vith the capital budgcting situation and rcvicヽ tioncd that shc rcmaincd con宙 nCCd that capital budgcing mustinvolvc iudglncnt as wcll as quanti― /s:(1)Onc hurdlc ratc iS uscd tativc analy scs Currcntly,the capital budgcting proccss iS aS foHoヽ throughout thc cntirc corporation;(2)NPVs,IRRs,MIRRs,and paybacks arc calculatcd:and(3) eCt dOCsお r thcse quantitative data arc used,along with such qualitativc factors as``whatthc pr● acccpt,rclect,or dcた r"dccision Bctty our strategic position in thc markct,"in making thc final“ 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 6レ 6uruJee-l a6e6uaC lo ued e 'ulelseM-qlnos 0002 6l s.dgN uo alulrdEc Jo lsoc IIeJe^o eql uo puu uleq erJodJoc 'eull re^o 'eABq slql plno^\ '(e8ereau elBJodJoc IreJJ; 1gq^\;petueqcun sur?rueJ uorsr^rp arD Jo {srJ org lBql Eurunssy eql speesxe ,(lpquelsqns elBr rll^\oJE slr) selur elpJnq rusdluoc eql peecxa sunloJ Jlaql uoIsI^IC slcnpoJd 3IlsBId eIIl esnBJeq Eurpuq;o pe,rrecoJ 1ele1 qErq ,(leluuoqrodordsrp u .aldurexe rog',(uuduroc orllJo ernlcn4s {sIJ eql eEueqc Jr uoddEq plno^\ 13q^\ lnoqB {ulw 'q slrnpoJd tseJod uJeqlJo5l dq pesn ,(pueunc e18J olpJnq alEuls aqt moq ureldxg .onF^ uug lceJJu rrB, (eqr moq puu luuuodtur eJB slueulsnfpe 1sp ,(q,n ureldxg 'u uBO 'suotlsenb Eur,no11o; eql EUIJa^\suB ;o ecueuodtul eqt umldxg '1 ,(q ssecord uorlucolle Su4eEpnq p11duc eqt ur luaulsnfpu lsrr SNOIISSNO 'sonssl lueuodurr eql paJe^ot eABq nof pq1 ams g>pru ol pue stqEnoqt rno{ ernlcnrls dleq o1 suoBsenb Eur,tolo; eql no,( peluur-e ,(1eg .Eurleour eqt lu po}ueserd eq o1 goder eqt erederd lsnlu nol lq31g roq aJoJeq l{Eru eql ^\ou 'uorlerofuoc eJllue eql JoJ peJnsueru lnq 'sJolcBJ eerfl eurus eql 'sruef eeJql lsBI eql JeAo uo pesgq sr so1qncexe elurofuoc Jorues eqlJo uonesueduo, ellluocul eq; pe3ere,re ge,qlrno.rE s8ururee s11 (g) puu'ql,norE selus sll (Z)'gOU s.uoISI^Ip eqt (1) :sro1cel eeJgl uo peseq sr Ie^eI uoIsI^Ip aql 19 uollssuedruoc e^nuecul eql 'suolsl^lp eql puB uorlu-tofuoc eql qloq Jo ecuuugoyed lueceJ oql pue ^(ruouoce eql Jo e1uls eql uo Eutpuedep 'resf ol rea,( ruor; ,(puert ,ftuzr so3eluocred esaql lcols elrluecur Jo sesnuoq se uorlesueduroc pnuuu Jleql Jo JIut{ ,(lapuruorddu e1rereJ sre3uue111 uorswp 'uu1d lueunc eql Jepun 'ue1d luerrnc eq1 Eutureluteur;o SutEuuqc Sutuec -uoc uorlgpueruruocer B eppru puu pe^lolur sanssl eql o1 leeds o1 paruderd erem no,(;r pecu?que eq ppo^\ uolloruord JoJ secuurlc rnof 11e; aqg 'Eurleeru eql le dn tqEnorq eg plno^\ senssl aseql l€ql erns sE^\ ,(neg .uoBesuadruoc rlaql lcudrur plnoc suoBBpueruluocer eql puB Eurlaeru et0 lB eq IIIA\ sre6eueru aqtgo,(uetu erurs 'leuuosred luarue8euuu reddn rog ueld uouesuedtuo, pes?q-eAnuecur s.fuuduroc oql Surzr(1uuu uI pe6lo^ut ,(lrireeq su,tr Eur11rq5 sJnB'I lslll ,neu1 ,(11eg ,(1pulg 000`Sτ I (g3 luututrel +) 3 ∽ｏ﹂ＯＬ Ｃ﹂Φ〓ｔＯＺ ” ０﹂０こ ”〓０ Ｏ①ち ①﹂一 ０ ぁも っＯｏ﹂Ｌ 一 g 000`SS v 000`ι S 9 s 000`Z9 000`09 000`8S L (dn yels) g (ooo`sSZ) I 000`ι シ Z 000`τ S uⅦ Å MO■ こ HSVЭ s.&rolf, qseJ 1ca[or4 'S/t\OU qsec Eurnollo; eql qlr^\ elduruxe ue Sursn ssecord Surle8pnq plrduc s.,(ueduroc eqt.;o selduruxe eJ€d -erd no,( teqt petseEEns eqs 'Sulpun; roJ suolslcep lu?llnseJ eql puu f,f,Vl6. puu ,(1rnbe 3o slsoc eql o1 slue1lllsnlpe {sIJ Jo lcudrur eql urc1dxe no,( dleq o1 'srs,(1eue e,rneltluenb Suruoddns pus senssl eql puqoq uonlnlul eII Jo suolssncstp qldep-ur 01 IIa^l papuodsar dnor8 eql luql peuonueur ,{neg .senssr eseql Jeloc 01 lueuodtur sB^\ lr luql pe^eqaq eqs {sIJ IBuoISIAIp ro3 Suqsnlpe Jo poqlour ,fteruud eql eq plno^\ slqt aculs pue B1eg Suqeunse uI pe^lo^ul senssl olul 8uqoo1 ueoq pug Bpuelo1 .eJnlrnrs pelue^\ oslB eqs 'enP^ lgql pelou eqs lelrdec Sururocuoc pesler sanssl eql eAIosaJ ol no,( うん ０ 〓”﹁︹０ ﹃ ω ” Ｚ Ｏユ すの﹁⊃ ﹁Ｏ﹁①∽汁 ﹁ ﹁ＯＱ⊂０”∽一Ｕ 〓①ｏ汁①Ｑ 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 prcmium to the cost ol'capital. 4. 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. 6 How would your thinking about the capital structure decision be afl'ected if: E,ach division raised its own debt; that is, il the divisions werc sct up as wholly owned a. 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 7 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 company and within each division'l are you with the l.l and 0.9 proiect risk-adiustment t'actors'l Is there theoretical tbundation ibr the sizc ttl'these ad-iustments'l b. Hgw crtrnlbrtable a 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.) 9. 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 overall cost of capital? How long would it take 1br the cff'ects ol these relatively risky investnlcnts to show up in the corporate beta as reported by brokers and investrnent advisory services'l 10. 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 2 percentage points or to 0'? if the additional premium is reduced to Northcrn Frtrest Products uses an incentive-based cclmpensation plan fbr its uppcr mcnagement pcrsonnel. @ 2000 South-Western, a part of Cengage Learning 20 6urureel a6e6ue31o ].ted e 'u.,elseg-Urnog gg9r レ乙 a ①Ｌ Ｏ ¨ ∽一 ０コＯＯ﹂■ “ ∽①﹂〇﹂ Ｃ﹂①〓〓 ＯＺ ” Ｏ①ち ︶ ０ ﹄●五 “〓 ｏ euoRusueduor uo lsedrur uorsr^rp eql ecnpeJ ol JeprsuoJ d,IN plno, suo[do Jeqlo tu[l ! 'c e{Jols s.ddNJo ecrJd eql Eurzrur -IxBur Jo lurodpuuls eql uo.lJ pEq Jo pooE eq suorlcBeJ asoql plno/v[ asuorlBpueuruoceJ .sJoEeu€r.u ecuengur ol uBId uoq?suedr[oc oql lcedxe nof plnol\ ,r\oH 'q s.fileg ol uorlJpal 6uruJE -oJd uonusuedruoc s.,(ueduoc aql qll!\ sualqoJd prydacuoc snorlqo ,(uu ees no,( oC 'B QUESTIONS 28 total question / 4 – 7 questions each. 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 adjustments are important because if they are not used than expectations for projects will be unrealistic. It is necessary to use risk adjustments because you may accept a high risk project that should have been rejected which could affect the firm’s value. This could also cause the firm to improperly budget a project and run out of money before the project before it is finished. Therefore, this could have a negative effect on the firms stock and also cause embarrassment to the company. 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 capital? This will increase the corporate beta, and it will also increase the cost of capital for the corporation. The beta for the Plastic Products Division is higher than the corporation’s beta. This means if they receive a higher level of funding than the cost of equity for the division will increase because they will be investing more in their assets. If the cost of equity increases in a division with a higher beta than they should assume the corporate beta will increase long with cost of capital. 2. Explain the rationale behind using beta as a measure of risk. . Beta is important to use as a measure of risk because it measures the risk that cannot be diversified away. Compute the company’s 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)? The company’s beta calculated in the spreadsheet is 1.06. ValueLine reported the company’s beta at 1.04 while Merrill Lynch reported it at 1.12. The inconsistent reported betas can result from both companies using historical betas. Historical betas are not good measurements of the future riskiness of firms. This is because they use historical returns and do not account for recent market volatility. 3. 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. Cost of equity = 14.65% WACC = 11.77% Hurdle Rate = 15.77% The negative impact of the added premium is that it causes the company to pass up on projects that could benefit the shareholders. But by breaking the hurdle rate down for each division it should help capture these projects. 4. Compute the cost of equity for each of the company’s divisions. Then, compute the WACC and the hurdle rates for each division, assuming that all divisions use a 42 percent debt ratio. Division Beta Equity WACC Hurdle rate Paper product 1.12 15.12% 12.05% 16.05% Timber product 0.98 14.05% 11.42% 15.42% Wood product 0.82 12.81% 10.71% 14.71% Plastic products 1.28 16.36% 12.76% 16.76% Real estate 1.43 17.51% 13.43% 17.43% 5. 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. Yes, I agree with the capital structure. She could point out that using the expanding to quickly could spread them too thin which would result in drops in bond ratings and lost earnings because they would have unrealistic low hurdle rates. Using corporate average is simple and it would avoid mistakes in calculation of debt for all divisions. The capital structure would help the company achieve its optimal capital structure instead of using different hurdle rates for different divisions. 6. 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? (In fact, Northern Forest Products raises debt capital at the corporate level, and headquarters then makes funds available to the various divisions). b. Divisions issued their own debt, but the corporation guaranteed the divisional debt? 7. 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? High risk Average risk Low risk Company 17.35% 15.77% 14.20% Paper product 17.65% 16.05% 14.44% Timber product 16.96% 15.42% 13.88% Wood mill 16.18% 14.71% 13.24% Plastic products 18.44% 16.76% 15.09% Real estate 19.18% 17.43% 15.69% 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? These numbers are fine. There is no completely right number higher or lower to set this factor. Current procedures would lead to a 4 percent premium to cost of capital and would include a formal risk adjustment process. 8. 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? Yes. 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.) Hurdle rates can be estimated for stand-alone risk using sensitivity analysis, scenario analysis, or the Monte Carlo Simulation. They can also be estimated for within firm risk by considering the affect the project or division has on the returns of the corporation as a whole with all of its assets or projects. 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? 10. Compute the: Payback, IRR, MIRR, and NPV for the example cash flows. Discuss how the risk adjustments affect the acceptability of the project. 11. How do the Payback, IRR, MIRR, and NPV change if the additional premium is reduced to 2 percentage points or to 0? 2% 0% Payback 4.76 – Unchanged 4.76 - Unchanged IRR 16.34% - Unchanged 16.34% - Unchanged MIRR 15.14% - Decreased 14.23% - Decreased NPV $22,478 - Increased $43,248 – Increased 12. Northern Forest Products uses an incentive-based compensation plan for its upper management personnel. a. Do you see any obvious conceptual problems with the company’s compensation program? The effectiveness of Senior Managers is measured by their ability to create return on equity, increase sales and increase growth. These are good targets for increasing intrinsic value sense they lead to higher capital gains and or dividend ratios. However, these measures and the incentives gained by targeting them may cause Senior Management to accept projects that may otherwise be deemed too risky and thus jeopardize intrinsic value. b. How would you expect the compensation plan to influence managers’ reaction to Betty’s recommendations? Since managers’ compensation is tied to ROE, sales and growth only, they might not agree with the recommendation to establish divisional hurdle rates since projects in some of the riskier divisions may not be approved that would have otherwise been approved had they gone by the corporate hurdle rate as previously done. Would these reactions be good or bad from the standpoint of maximizing the price of NFP’s stock? These reactions could be bad regarding NFP’s stock price since projects too risky could lead to negative growth. However, in a company that is well diversified, the risk might be offset by other divisions and could have a minimal impact on the price of their stock. c. What other options could NFP consider to reduce the division impact on compensation? NFP could use Market and Economic Value Added as a measure of manager effectiveness. CASE 90: Northern Forest Products | Topic: Cost of Capital | 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 of the division remains unchanged, what effect would this have, over time, on NFP’s corporate beta and on the overall cost of capital? The single hurdle rate currently used by Northern Forest Products can change the risk structure of the company since the divisional beta of 1.28 is higher than the company beta of 1.06. The overall cost of capital would rise once there is more investment in this division. When the company use single hurdle rate instead of risk adjustment, the higher return with higher risk project would be chosen over lower return and lower risk project. The resource would be misallocated and increase the proportion of asset of the high risk project which would in turn increase the weighted corporate beta. As the result, the overall cost of capital of the corporate would rise. Question 2: Explain the rationale behind using beta as a measure of risk. Compute the company's beta based on 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 riskiness of firms (or divisions)? To investors, beta is an effective measure of risk since this is the risk that cannot be diversified. Hence, in valuation process, corporate beta will be used considering the CAPM. NFP’s beta can be calculated based on the divisional beta as follow: ------------------------------------------------β = ∑wi βi = 38% x 1.12 + 33% x 0.98 + 15% x 0.82 + 9% x 1.28 + 5% x 1.43 ------------------------------------------------= 1.058 There has been difference detected in the reported beta and the previously computed beta. Valueline and Meryl Lynch reported the corporate beta as 1.04 and 1.12 whereas the previous calculation shows the result of 1.06. Those two reported beta are measured using historical beta which is based on a regression of past return against the market. When using historical data to predict the future value, it cannot be as precise and useful as predicted data for it does not involve the changes in capital structure and market volatility. Moreover, the assumption that the future risk resembles future risk is not applicable for firms that are not stable whose asset structure is enduring significant changes. Therefore, using historical beta to predict future risk is not an efficient method and should be adjusted when being measured. Question 3: Using computed beta, find the cost of equity, the weighted average cost of capital (WACC), and the hurdle rate of the company. Discuss the negative impact of the added premium to the cost of capital. Cost of equity Applying CAPM, Cost of equity can be computed as follow: ------------------------------------------------rs=rRF+ rM-rRF × β In which: rRF=6.5% rM=14.2% β (the weighted average of divisional betas) = 1.06 ------------------------------------------------rs = 6.5% + (14.2% - 6.5%) 1.6 = 14.65% NFP’s cost of capital includes cost of debt and cost of equity as its component. WACC is calculated by taking the weighted average of the after-tax cost of debt and cost of equity: ------------------------------------------------WACC= wd×rd+ 1-T×ws×rs In which: wdweight of debt=42% wsweight of equity=100%-42%=58% rd(cost of debt)=12% T(tax rate)=35% Rs (computed cost of equity) = 14.65% ------------------------------------------------WACC = 0.42 (12%)(1-35%) + 0.58 (14.65%) = 11.77% Finally, in order to calculate Hurdle Rate, required premium of 4% would be added to the cost of capital. ------------------------------------------------Hurdle Rate=WACC+Required Premium ------------------------------------------------= 11.7% + 4% = 15.77% The addition of 4% premium to the cost of capital has negative impact on the company value. The premium leads to the decision of refusing the potential project that would not be able to cover the additional required premium. Hence, the additional required premium of 4% should be reduced so that the firm can accept the project that has higher return that its adjusted risk would increase the firm’s value. The required premium prevents the firm from maximizing its value Question 4: Compute the cost of equity for each of the company's divisions. Then, compute the WACC and the hurdle rates for each division, assume that all divisions use a 42 percent debt ratio. Cost of equity Applying CAPM, we have the equation of Cost of equity as below: ------------------------------------------------- rs=rRF+ rM-rRF × β In which: rRF=6.5% rM=14.2% Table 4.1 - Cost of equity for each division of NFP Division | Beta ( β) | Cost Equity ( rs ) | Paper Products | 1.12 | 15.12% | Timber Production | 0.98 | 14.05% | Wood Products | 0.82 | 12.81% | Plastic Products | 1.28 | 16.36% | Real Estate | 1.43 | 17.51% | WACC We all know that Cost of capital includes 3 components: Debt, Preferred stock, and Common Equity (Retained Earnings and Common Stock). However, in this case, there are only Debt and Common Equity that influenced NFP's cost of capital. The equation of WACC is as followed: ------------------------------------------------WACC= wd×rd+ 1-T×ws×rs In which: As assumption, 42-percent-debt capital structure was decided to use for all divisions and NFP's before tax cost of debt of 12% and federal-plus-state marginal tax rate of 35 % were used in all calculations as well . So: wd=42% → ws=100%-42%=58% rd=12% T=35% We have: Table 4.2. WACC for each division of NFP Division | Cost Equity ( rs ) | WACC | Paper Products | 15.12% | 12.05% | Timber Production | 14.05% | 11.42% | Wood Products | 12.81% | 10.71% | Plastic Products | 16.36% | 12.76% | Real Estate | 17.51% | 13.43% | Hurdle Rate Finally, to calculate Hurdle Rate, we just have to plus required premium of 4% to the WACC of each division like what we have done for the Hurdle Rate of whole company. ------------------------------------------------Hurdle Rate=WACC+Required Premium ( =4% ) Table 4.3. Hurdle Rate for each division of NFP Division | WACC | Hurdle Rate | Paper Products | 12.05% | 16.05% | Timber Production | 11.42% | 15.42% | Wood Products | 10.71% | 14.71% | Plastic Products | 12.76% | 16.76% | Real Estate | 13.43% | 17.43% | Question 5: a. Do you agree with Betty concerning the capital structure issue? In terms of the structure issue, we disagree with Betty because: Theoretically, in order to set a hurdle rates, we should consider both differential debt capacity as well as differential risk measurement. However, the evaluation of debt capacity is more difficult to achieve than the measurement of risk, moreover, it is generally difficult to quantify debt capacity differential. Therefore, in practice, firms generally just use the corporate target capital structure when setting divisional and project hurdle rates unless the differences in debt capacity are large and obvious b. Discuss several arguments that Betty can use to help justify using the company rather than divisional capital structure to determine WACC Several compelling arguments that Betty can make to help justify using company rather than divisional capital structure. + The company issues the debt, not the division. Therefore, it is difficult to estimate an appropriate cost of debt for each division. + If a division were assigned a high debt ratio, its costs of debt and equity would rise, and this would tend to offset the greater use of lower-cost debt capital. + The WACC is not very sensitive to capital structure over a fairly wide range of debt ratios; therefore, the issue is not as critical as it might first appear. Question 6: How would your thought on 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? (In fact, Northern Forest Products raises debt capital at the corporate level, and headquarters then makes funds available to the various divisions). It should be recognized that some divisions have more “debt carrying capacity,” and if these divisions operated as separate firms, they would have more debt in their capital structure. In NFP’s case, the use of divisional capital structures would result in a wide range of debt ratios due to the diversity of asset structures. Major arguments for the use of a corporate capital structure is the ability to obtain capital at lower transaction costs, increased control over corporate financing, and especially for NFP, increasing the likelihood of gaining approval for implementing a risk adjusted cost of capital. Disadvantages of using the corporate capital structure are inefficiencies, cross subsidization of divisions, and incorrect structures for some divisions. For example, the result, though, may be that the real estate division is charged with too high a cost of capital, and this may prevent it from competing successfully in the marketplace. However, a counter argument could be made that real estate firms have been too heavily leveraged, as evidenced by the increase in bankruptcies in the early 1990s, the S&L crisis, and other empirical evidence supporting this position. b. Divisions issued their own debt, but the corporation guaranteed the divisional debt? If the divisions issued their own debt, but the parent corporation guaranteed this debt, then for all practical purposes, the debt would be corporate debt, not divisional debt. Thus, the fact that one division has a substantial amount of debt (or a small amount of debt) would have a significant impact on the overall corporate cost of debt, and on the cost of debt to other divisions. For example: a particular division’s high debt ratio would lower the quality of the debt sold by other divisions. Thus, the corporate guarantee would make us more inclined to use the corporate capital structure for all divisions. Question 7: 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? To define the new hurdle rates, we respectively multiply each original hurdle rate, which is added a premium of 4%, of the whole company and each division with the figure of each risk category. Therefore, we have the following table: Table 7.1. Three categories hurdle rate NAME | Hurdle rate | High risk | Average risk | Low risk | Adjustment | | 1.1 | 1.0 | 0.9 | COMPANY | 15.77% | 17.35% | 15.77% | 14.20% | Paper Products | 16.05% | 17.65% | 16.05% | 14.44% | Timber Production | 15.42% | 16.96% | 15.42% | 13.88% | Wood Milling | 14.71% | 16.18% | 14.71% | 13.24% | Plastic Products | 16.76% | 18.44% | 16.76% | 15.09% | Real Estate | 17.43% | 19.18% | 17.43% | 15.69% | NOTE: The difference between using calculator and Excel is due to rounding 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? Obviously, there is no theoretical foundation for the size of these adjustments. The firm just wants to apply a risk-adjustment for they hope that the beta will be also compatible with the modified hurdle rate of the company and within each division. It means that with the riskiest project such as Plastic Products Division, the beta in the high risk category may be relatively high compared to 1.0. To check this assumption, we have hurdle rate (new WACC)= 18.44% and the cost of equity will be: WACC= wd×rd× 1-T+ws×rs =18.44% =0.42×12%×1-0.35+1-0.42×rs =18.44% =>rs =26.14% This result leads to: rs=rRF+ rM-rRF × β =>26.14%=6.5%+7.7%× β => β=2.55 β=2.55 is absolutely high, which is correct with our supposition. Therefore, the 1.1 or 0.9 project riskadjustment factors seem to be acceptable. Question 8: Betty’s analysis requires estimated betas for NFP’s five decisions. Suppose she did not feel comfortable with betas analysis. Could divisional (and project) hurdle rates be established using total risk analysis? If so, describe how it might be done. Betty could establish divisional hurdle rates on the basis of total risk by measuring the standard deviations of returns for each division. The divisions could then be ranked relative to each other, with the division having the highest standard deviation of returns being the most risky. To subsequently adjust for the riskiness of each division, Betty could add or subtract a predetermined number of percentage points from the overall corporate cost of capital. For example, if the Plastic Products Division was found to have the highest standard deviation of returns within the company, Betty could add 2 or 3 percent to the corporate cost of capital to determine the cost of capital for the division. This method could be valid, however, only for those divisions whose returns were highly correlated with the market. For instance, a particular division could have a very high standard deviation of returns, but if these returns were negatively correlated with those of the market, the division would actually be much less risky than indicated by a total risk analysis. In NFP’s case, the various divisions’ result are all highly correlated both with others and the market, thus, we can use the above method using total risk analysis. Question 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 influence of the risky projects like what in the Plastic Products Division is that the division’s beta will pull both the firm’s corporate beta and overall cost of capital up. To have a clearly understand, we assume that Plastic Products Division‘s beta rises from 1.28 to 1.35. The corporate beta would increase from 1.0587 to 1.065 β=∑ωi×βi=38%×1.12+33%×0.98+15%×0.82+9%×1.35+5×1.43 =1.065 The overall cost of capital would jump from 11.77% to 16.21% Cost of equity: rs=rRF+ rM-rRF × β =6.5%+7.7%×1.065 =14.7% Cost of capital: WACC= wd×rd× 1-T+ws×rs =0.42×12%× 1-0.35+1-0.42×14.7% = 11.8% The corporate beta would be impacted instantly after the firm’s announcement of investment. However, it could take several years for the brokers and investments to estimate the risk of these investments or for the changes to show up in reported betas. Question 10: Compute the Payback, IRR, MIRR, and NPV for the example cash flows. Discuss how the risk adjustment affects the acceptability of the projects At first sight, there is an evident truth that whatever the WACCs of the company and each divisions are, they do not influence the IRR and Payback period, as to calculate these indices, we do not need to use WACC, in other words, the reason is these indices do not require cost of capital. So IRR and Payback period are the same for each division. Nevertheless, the MIRR and NPV will changes spontaneously with the hurdle rate. Since, as usual, WACC is used as a discounted rate in capital budgeting, however, when the boss wants to have an exact additional premium at 4%, the hurdle rate now is the discounted rate for NPV and calculating MIRR. It also leads to a fact that NPV and MIRR for the company and each division is different. Here, we calculate the Payback, IRR, MIRR, and NPV of the whole project with a hurdle rate of 15.77% (r) Besides, although MIRR and NPV both assume reinvest at opportunity cost, MIRR does not always lead to the same decision as NPV when mutually exclusive projects are being considered. In particular, small projects often have a higher MIRR, but a lower NPV, than larger projects. Hence, MIRR is not a perfect substitute for NPV, and NPV remains the single best decision rule. Therefore, we do risk adjusted NPVs to evaluate the most exact acceptability of the project by discussing each division's NPV in different risk level (different return) in detail. Project's Payback: Payback is found by determining the number of years required to recover a project's cost. Table 10.1. Example Cash Flows with Cumulative CF PROJECT CASH FLOWS | Year | Cash flow | Cumulative CF | 0 (start up) | -255,000 | -255,000 | 1 | 47,000 | -208,000 | 2 | 52,000 | -156,000 | 3 | 55,000 | -101,000 | 4 | 57,000 | -44,000 | 5 | 58,000 | 14,000 | 6 | 60,000 | 74,000 | 7 | 62,000 | 136,000 | 8 (+ terminal CF) | 125,000 | 261,000 | In 5th year, NFP has a positive cumulative cash flow so the payback is calculated as below: Payback = 4 years + 14,000/58,000 = 4 years+ 0.76 = 4.76 years Project's IRR IRR is the discount rate that forces PV in flows equal to cost (PV out flows) r = IRR=? 012345678 -255.0 47.0 52.0 55.0 57.0 58.0 60.0 62.0 125.0 PV1 PV2 PV3 PV4 PV8 PV7 PV6 PV5 NPV = 0 Means: ------------------------------------------------0= 08CFt(1+IRR)t ------------------------------------------------0= CF0(1+IRR)o+CF1(1+IRR)+CF2(1+IRR)2+CF3(1+IRR)3+CF4(1+IRR)4+CF5(1+IRR)5+CF6(1+IRR)6+CF7(1+IRR) 7+CF8(1+IRR)8 ------------------------------------------------0=255,000(1+IRR)o+47,000(1+IRR)+52,000(1+IRR)2+55,000(1+IRR)3+57,000(1+IRR)4+58,000(1+IRR)5+60,0 00(1+IRR)6+62,000(1+IRR)7+125,000(1+IRR)8 ------------------------------------------------=> IRR≈0.1634 =16.34% Project's MIRR MIRR is the discount rate which causes the PV of a project's terminal value (TV) to equal the PV of costs ------------------------------------------------PV Out Flows=TV In Flows(1+MIRR)Cash in Period r = hurdle rate 012345678 -255.0 47.0 52.0 55.0 57.0 58.0 60.0 62.0 125.0 TV7 TV6 TV5 TV4 TV1 TV2 TV3 MIRR PV out flows = CFO TV in flows = 18CFt×(1+r)8-t * r = hurdle rate = 15.77 % * PV Out Flows = CF0 = $255,000 * TV in flows ------------------------------------------------= 18CFt×(1+r)8-t ------------------------------------------------------------------------------------------------=CF1×1+r7+ CF2×1+r6+ CF3×1+r5+ CF4×1+r4+ CF5×1+r3+ CF6×1+r2+ CF7×1+r1+CF8 ------------------------------------------------------------------------------------------------=47,000×1+15.77% 7+ 52,000×1+15.77% 6+ 55,000×1+15.77% 5+ 57,000×1+15.77% 4+ 58,000×1+15.77% 3+ 60,000×1+15.77% 2+ 62,000×1+15. 77% 1+125,000 ------------------------------------------------= $ 840,149.01 ------------------------------------------------=> 255,000=840,149.01(1+MIRR)8 ------------------------------------------------=> MIRR ≈ 0.1607= 16.07% To summarize, the table below is the IRR, MIRR and Payback of the project ( in order to compare with other average risk in question 11 ) Name | Average Risk ( 4%) | Project IRR | 16.34% | Project MIRR | 16.07% | Payback | 4.76 years | Project's NPV NPV is net gain in wealth. r = hurdle rate 012345678 -255.0 47.0 52.0 55.0 57.0 58.0 60.0 62.0 125.0 PV1 PV2 PV3 PV4 PV5 PV8 PV7 PV6 NPV = PV In Flows - PV Out Flows Means: NPV = PV Inflows - PV Outflows = o8CFt(1+r)t = CF0(1+r)0+CF1(1+r)+CF2(1+r)2+CF3(1+r)3+CF4(1+r)4+CF5(1+r)5+CF6(1+r)6+CF7(1+r)7+CF8(1+r)8 =255,000(1+15.77%)o+47,000(1+15.77%)+52,000(1+15.77%)2+55,000(1+15.77%)3+57,000(1+15.77%)4+5 8,000(1+15.77%)5+60,000(1+15.77%)6+62,000(1+15.77%)7+125,000(1+15.77%)8 = $ 5,368 However, using excel, we have a project NPV of approximately $5329 (as shown in Table 10.3 below). This figure is more precise than $5369 of the calculation above because in the calculation, we rounded WACC to 11.77% while Excel using an accurate number without rounding. Consequently, we take the nearest result of project NPV is $5,329 Risk adjusted NPVs Applying the same equation to calculate NPV to calculate NPVs with risk adjusted hurdle rates of the company and each division in table 10.2. Table 10.2 - Risk adjusted hurdle rates RISK ADJUSTED HURDLE RATES | Name | High Risk | Avg. Risk | Low Risk | COMPANY | 17.35% | 15.77% | 14.20% | Paper Products | 17.65% | 16.05% | 14.44% | Timber Production | 16.96% | 15.42% | 13.88% | Wood Milling | 16.18% | 14.71% | 13.24% | Plastic Products | 18.44% | 16.76% | 15.09% | Real Estate | 19.18% | 17.43% | 15.69% | Applying NPV's equation: NPV = PV Inflows - PV Outflows = o8CFt(1+r)t =255,000(1+r)o+47,000(1+r)+52,000(1+r)2+55,000(1+r)3+57,000(1+r)4+58,000(1+r)5+60,000(1+r)6+62,00 0(1+r)7+125,000(1+r)8 In which r is risk adjusted hurdle rate. Table 10.3 - Project NPV with risk adjusted hurdle rate, Using Excel Name | High Risk | Avg. Risk | Low Risk | COMPANY | ($9,086) | $5,329 | $21,099 | Paper Products | ($11,696) | $2,734 | $18,540 | Timber Production | ($5,671) | $8,720 | $24,438 | Wood Milling | $1,506 | $15,828 | $31,422 | Plastic Products | ($18,308) | ($3,852) | $12,030 | Real Estate | ($24,253) | ($9,791) | $6,143 | Theoretically, a project will be accepted if NPV > 0, conversely, or else, it will be rejected. In light of low risk class, the project is acceptable with all division. In contrast, if the project is considered as high risk project, the project certainly is thrown away because of the majority of negative NPVs. Wood Milling is the only sufficient division having positive NPV under all risk scenarios. In brief, with S+5,329 and $+21,099 NPV , average risk adjusted company project and low risk adjusted company project, respectively, at some extent, can be invested immediately or deferred. Question 11: How do the Payback, IRR, MIRR, and NPV change if the additional premium is reduced to 2 percentage points or to 0? When addition premium is reduced from 4% to 2% or to 0%, the Payback remains at 4.76 years and the IRR also remains at 16.34 percent because they do not require cost of capital inputs to calculate and are the same for each division. Table 11.1 - Payback and IRR at three categories hurdle rate NAME | Average risk (0%) | Average risk (2%) | Average risk (4%) | Payback | 4.76 years | 4.76 years | 4.76 years | Project IRR | 16.34% | 16.34% | 16.34% | In contrast, the NPV and MIRR change as the discount rate changes * At 2 percentage point premium adjustment To calculate project NPV, we follow this below information: The hurdle rate (1) is found by adding the 2 percentage point premium over the cost of capital (WACC). Based on the result of the previous step, we can create the table which illustrates the new hurdle rate assigned to each risk category for the company and within each division. (Stages in the procedure are respectively the same as what we have pointed out in question 3; 4 and 7) Table 11.2 - Three categories hurdle rate with 2% additional adjustment NAME | WACC | Hurdle rate | High risk | Average risk | Low risk | COMPANY | 11.77% | 13.77% | 15.15% | 13.77% | 12.40% | Paper Products | 12.05% | 14.05% | 15.45% | 14.05% | 12.64% | Timber Production | 11.42% | 13.42% | 14.76% | 13.42% | 12.08% | Wood Milling | 10.71% | 12.71% | 13.98% | 12.71% | 11.44% | Plastic Products | 12.76% | 14.76% | 16.24% | 14.76% | 13.29% | Real Estate | 13.43% | 15.43% | 16.98% | 15.43% | 13.89% | Finally, we have the table for the risk adjusted NPVs (The formula and the method to compute NPV have already been mentioned in question 10 or we can use function in Excel) Project NPV (2% premium) Table 11.3 - Project NPV at 2% additional adjustment NAME | High risk | Average risk | Low risk | COMPANY | $11,382 | $25,574 | $40,960 | Paper Products | $8,427 | $22,662 | $38,114 | Timber Production | $15,252 | $29,382 | $44,675 | Wood Milling | $23,391 | $37,371 | $52,450 | Plastic Products | $949 | $15,277 | $30,881 | Real Estate | $(5,766) | $8,625 | $24,345 | To calculate project’s MIRR, the discount rate now is 13.77% and we apply the procedure inferred in question 10 or Excel to accomplish Project MIRR (2% premium) = 15.14% * At 0 percentage point premium adjustment: To compute project NPV, the hurdle rate (1) is the cost of capital (WACC) and the table below depicts the new hurdle rate allocated to each risk type for the company and within each division. Table 11.4 - Three categories hurdle rate with 0% additional adjustment NAME | Hurdle rate (1) | High risk | Average risk | Low risk | COMPANY | 11.77% | 12.95% | 11.77% | 10.60% | Paper Products | 12.05% | 13.25% | 12.05% | 10.84% | Timber Production | 11.42% | 12.56% | 11.42% | 10.28% | Wood Milling | 10.71% | 11.78% | 10.71% | 9.64% | Plastic Products | 12.76% | 14.04% | 12.76% | 11.49% | Real Estate | 13.43% | 14.78% | 13.43% | 12.09% | We calculate project NPV with 0% additional premium by the method indicated in question 10 or using Excel Project NPV (0% premium) Table 11.5 - Project NPV at 0% additional adjustment NAME | High risk | Average risk | Low risk | COMPANY | $34,611 | $48,340 | $63,080 | Paper Products | $31,251 | $45,060 | $59,908 | Timber Production | $39,013 | $52,630 | $67,225 | Wood Milling | $48,282 | $61,640 | $75,906 | Plastic Products | $22,759 | $36,751 | $51,847 | Real Estate | $15,144 | $29,275 | $44,571 | With the discount rate is 11.77%, project MIRR (0% premium) = 14.23% Conclusion: * In both payback and IRR of addition premium of 2% or 0%, the new lower hurdle rates make the project acceptable * In both NPV and MIRR of addition premium of 2% or 0%, with lower hurdle rates, the project remains acceptable except as a high risk Real Estate project in the situation of 2 % premium adjustment. NOTE: The difference between using calculator and Excel is due to rounding Question 12: a. Do you see any obvious conceptual problems with the company’s compensation program? As Betty mentioned, the percentage of compensation of division managers depends on three factors: * Divisional ROE * Divisional Sale growth * Divisional earnings growth In other words, there are two big things impacting the compensation amount, which are: Return and Growth of the division And all are averaged over the last three years. However, there are some problems of this program: * Using divisional return and growth does not reflect exactly the real performance of the divisional managers. As each division often belongs to different industry, so the growth rate of each is different from the others. However, the growth rate is not the efficient and effective reflection of the division. For example, though a division may performs very potential, if it is too sensitive with external factors, the growth rate is not high. So it does not bring high ROE or sales or earnings as hope. * Using 3 year period to average will create an incorrect performance of divisional manager. If the figured record in the first year is very good but terrible in the third, the final report is still good. On the contrary, if the first two years is averaged followed by a unacceptable third year, the manager's attempt may be rated at lower level. * NFP wants to use only one additional rate for all division, which means the higher risk division now is higher and higher. Moreover, the fact of using returns to weigh up compensation will encourage divisional managers to focus on more risky and return project. Unsurprisingly, this increases the whole company's risk. In long run, this will be dangerous and alerted. b. How would you expect the compensation plan to influence managers’ reaction to Betty’s recommendations? Would these reactions be good or bad from the standpoint of maximizing the price of NFP’s stock? Betty has two recommendations that are * Recommendation 1: Different hurdle rate for different division * Recommendation 2: Only one debt ratio Firstly, as mentioned, only one hurdle rate could make the company become more risky in long run. Besides, the by far larger distance of the hurdle of two competitors will decrease the competiveness in the market. Using different hurdle will erase this. Secondly, compensation is a part of debt. Division that has higher debt ratio will have higher compensation. However, this will not make company safer. Moreover, if using only one debt ratio for all division, the difference in cost of capital now only is reflected through cost of equity. Divisional manager want to have higher compensation will pay their effort on increasing cost of equity. And this absolutely a good reaction from the standpoint of maximizing the stock price of NFP. c. What other options could NFP consider to reduce the division impact on compensation? * By comparing divisions in different divisions, NFP may accurate incorrectly about divisional manager's performance. Now, instead of that, a better way is comparing it to the respective division in different competitors. * Using annual data instead of three year average These both options will reflect more exactly about the performance of manager and calculate more reasonable amount of compensation.
Purchase answer to see full attachment