Nothern Forest Product Case Study

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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:

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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:

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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.

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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.