Question
Jim is an analyst evaluating Hellenic Water Company (HWC), which is a utility company. The net income growth has been 8% for the past five
Jim is an analyst evaluating Hellenic Water Company (HWC), which is a utility company. The net income growth has been 8% for the past five years. For this period of time, the average HWCs return on equity is 10%. The respective industry average is 11%. HWC appears to have a dividend payout ratio of at least 80%. Other facts and forecasts include the following: HWCs dividend per share for 2020 (D0) was 0.9. Jim forecasts an annual earnings growth rate of 7%. HWCs raw and adjusted betas are 0.645 and 0.923, respectively. Jim estimates that HWCs pretax cost of debt is 7.5%. Jims estimate of HWCs required rate of return on equity is 11%. HWCs current market price is 17.9.
a) Estimate the rate of return on equity for HWC with CAPM, taking into account that the equity risk premium is 5% and the risk-free-rate is 6%. b) Find the HWCs required rate of return, with the Gordon growth model, using: (i) as cost of equity the answer in question (a), or (ii) a pretax cost of debt plus a 2.5% risk premium. c) Comment on the effect of different required returns on equity have on the value of equity of the company.
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