Bap53: Corporate Finance - Assessment Answer

Part A: Investment Decision - project evaluation - BAP53

Blue Mountain Ltd manufactures a variety of snacks. The company is considering introducing a new product. The company’s manager has been provided with the following information by their business analyst. 

• An environmental impact study has been undertaken at a cost of $250,000. This indicates that the project is environmentally sustainable, but the project still needs to be evaluated to see if it is economically viable. 

• The project will require the use of storage capacity owned by the company. If not used for the project, this could be rented out for $90,000 per year. 

• The project will generate waste products which can be used by another of the firm’s operations, saving that operation $90,000 per year in raw material purchases. 

• The project has an anticipated economic life of 5 years. 

• The Company plans to spend $2,500,000 on an advertising campaign to boost sales. 

• The Company’s interest expense each year will be $1,100,000. 

• The Company is required to purchase a new machine to produce a new product. The machine’s initial cost is $13,000,000. The machine will be depreciated on a straight-line basis over 5 years. The Company anticipates that the machine will last for 10 years; the salvage value after 5 years is $1,200,000. 

• Six months ago, the Company also paid $800,000 to a firm to do research regarding a new product. 

• If the Company goes ahead with the new product, it will have an effect on the Company’s net operating capital. The forecasted net working capital will be $500,000 (at time zero) 

• The new product is expected to generate sales revenue of $2,000,000; $4,000,000; $6,000,000; $8,000,000 and $10,000,000 in year 1, 2, 3, 4 and 5 respectively. Each year the operating cost (not including depreciation) expected to equal 25 percent of sales revenue.

• In addition, the Company expects with the introduction of a new product, the sale of other snacks products increases by $1,100,000 after taxes each year. 

• The Company’s overall WACC is 7.5 percent. However, the proposed project is riskier than the average project; the new project’s WACC is estimated to be 9 percent. 

• The Company’s tax rate is 30 percent. 

Part B: Financing Decisions – Dividend policy and capital structure - BAP53

Modigliani and Miller (MM) suggested that in a perfect world with no taxes or bankruptcy cost, the dividend policy is irrelevant. They proposed that the dividend policy of a company has no effect on the stock price of a company or the company’s capital structure.” (Ani 2016) 

Based on the above statement you are required to write an essay on dividend irrelevance and capital structure theories that have been originally advanced by Franco Modigliani and Merton H. Miller (Modigliani and Miller 1958). In your demonstration, you must critically reflect on corporate tax consideration and firm values in the contemporary world. There is an expectation that you are using authentic academic and professional references. For all other requirements please go through the subject outline. 

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