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Capital Budgeting: Case of Northern Forest Products

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The case which full name is "Northern Forest Products Case: Risk Adjusted Rate of Return and Divisional hurdle Rates" is attached below for your perusal.

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Hello Student,

Before approaching the questions that you have requested help with, let me start by giving you a brief overview of the capital budgeting process, especially as it relates to capital structure, cost of equity, cost of debt and the weighted average cost of capital. The capital structure of a corporation is the way in which it decides to finance its assets through a combination of either debt and/or equity. Note the following excerpt:

"The capital structure is how a firm finances its overall operations and ...

Solution Summary

This solution provides information that may used to assist in answering question 4, 5 and 6 of the Northern Forest Case. Before doing this however, an overview of the capital budgeting process, especially as it relates to capital structure, cost of equity, cost of debt and the weighted average cost of capital was given. These notes will not only assist you with answering this case - but can also help you to answer other capital budgeting questions. The solution has been adequately referenced. (The response itself contains 1,572 words plus an excel file with computations.)

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Risk and cost

Could you please check the anwser below if it is correct, if not please help me fix the errors for number 12.

12. a.
The incentive-based compensation plan for managers seems conceptually flawed. The growth rates, risks, industry practices and market conditions in the industry that each division faces is different. The value of each division to NFP is because it offers different risk and return combinations to the corporation as a whole. Tying compensation to factors outside a manager's control such as the maturity of the timber or wood products industries is not a valid incentive structure. Sales and earnings growth would likely be fastest in Plastics and Real Estate. ROE should be steadier but lower in Wood Products. ROE would align the managers' interests closest to stockholder interests but would differ across industries by factors outside the managers' control.

12. b. The managers would all dislike the compensation plan. It depends too much on factors outside their control, and fluctuates too widely from year to year.

These reactions would be bad for maximizing the price of NFP stock since some managers may not strive to achieve results in years where they expect no incentive bonuses due to poor industry conditions.

12 c.
NFP has other options to reduce the impact of differences in division results on incentive-based compensation. One way is to measure manager performance against other companies in the same industry. ROE compared to ROE outcomes in the industry is fairer and isolates each division's results instead of making unequal comparisons across different industries. Other management efficiencies can also be measured against industry averages such as asset turnover, etc.

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