Question

A firm’s current profits are $900,000. These profits are expected to grow indefinitely at a constant annual rate of 2 percent. If the firm’s opportunity cost of funds is 4 percent, determine the value of the firm: a.The instant before it pays out current profits as dividends. b.The instant after it pays out current profits as dividends

Answer 1

Answer: a. The value of the firm the instant before it pays out current profits as dividends can be calculated using the Gordon Growth Model, which is given by the formula:

Value = Dividends / (Cost of Equity - Growth Rate)

Where Dividends = Current Profits, Cost of Equity = Opportunity Cost of Funds, and Growth Rate = Constant Annual Growth Rate.

Substituting the given values into the formula, we get:

Value = 900,000 / (0.04 - 0.02) = 900,000 / 0.02 = 45,000,000

b. The instant after it pays out current profits as dividends, the firm's value will be reduced by the amount of the dividends paid out. So, the value of the firm after paying out the dividends will be:

Value = 45,000,000 - 900,000 = 44,100,000

Explanation: