Question

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 What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual.

Answer 1

What the firm is basically doing is that it is replacing its equity with the Debt of $1,500.

Let's calculate the value of the firm before any such thing happened.

Posttax annual cash flow = $1,000*(1- tax rate (35%) =$6,500

Value = 6,500 / 12% = $54,167

As pe MM theory with taxes, the difference between the firm with debt and without debt is only of tax shield.

Tax shiled value on perpertual debt = Debt amount * Tax rate = 1,500*35% = $525

Thus, the only change would be that the total value of the old firm will increase by tax shield.

New Value = 54,167 + 525 = 54,691