Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the company issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders. The cost of equity: What is Millennium's value after the debt issuance?

Question

Quizplus · Accepted Answer

Firstly, we need to calculate the cost of equity:

Cost of equity = (1,000 / (1 - 0.35)) / Value + 0.12

Cost of equity = 1,538.46 / Value + 0.12

We know that the bond issuance raises $1,500 which is paid out to shareholders. This will increase the value of equity by $1,500. Therefore:

Value after bond issuance = (1,000 + 1,500) / (0.12 - 0.35) = $5,942.31

Hence, the answer is B.

Millennium Motors Has Current Pretax Annual Cash Flows of $1,000