The value of the firm before and after paying out current profits as dividends

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

Sample Answer

To determine the value of the firm before and after paying out current profits as dividends, we can use the Gordon Growth Model. The formula for the value of a firm using this model is:

Value of Firm = Current Profits / (Opportunity Cost of Funds – Growth Rate)

a. The instant before it pays out current profits as dividends:

Value of Firm = $900,000 / (0.04 – 0.02) = $900,000 / 0.02 = $45,000,000 million

b. The instant after it pays out current profits as dividends:

Since the firm pays out the current profits as dividends, the value of the firm will decrease by the amount of the profits.

Value of Firm = Value of Firm (before dividends) – Current Profits = $45,000,000 – $900,000 = $44,100,000 million

Therefore:
a. The value of the firm instant before it pays out current profits as dividends is $45 million.
b. The value of the firm instant after it pays out current profits as dividends is $44.1 million.

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The value of the firm before and after paying out current profits as dividends

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