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 firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity valuation model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar.

Question

Quizplus · Accepted Answer

The value of the firm without debt, using the perpetuity valuation model, is calculated as the pretax annual cash flows divided by the discount rate. Since the firm's pretax annual cash flows are $1,000 and the discount rate is 12%, the calculation is $1,000 / 0.12 = $8,333.33. However, because the firm is in the 35% tax bracket, the after-tax cash flows are $1,000 * (1 - 0.35) = $650. Using the after-tax cash flows for valuation, the correct calculation is $650 / 0.12 = $5,416.67, which rounds to $5,417.

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