QUFSTION ONE (COMPUI.SOKY) As an analyst fir a domenie equity ineome mutual fund, Robert Ass is evaluating Mosah Water Company (MWC), a publicly traded water utility, for possible inclusion in the approved list of investments. Robert Ass is conducting the analysis in mid-2013. Not all countries have traded water ubiily stocks. In developed economies such as the United States, about 85 pereent of the population gets its water from government entities. A group of investor-owned water utilities, howeser, also supplies water to the public. With a market capitalization of about GHle327 million as of mid-2013, MWWC is among the ten largest publicly traded water utilities. MWC's historieal base is the Middlesex System, serving residential, industrial, and commercial customers in a welldeveloped area of central business district. Through various subsidiaries, MWC also provides water and wastewater collection and treatment services to areas of southem sectors. Hampered by a decline in earnings during the recent recession, net income growth during the past five years has been somewhat less than 2 percent. During the last five years, MWC's return on equity averaged 7.8 pereent with relatively little variation, and its profit margins are above industry averages. Because MWC obtains most of its revenue from the regulated business providing an important staple, water, to a relatively stable population, Robert Ass feels confident in forecasting future earnings and dividend growth. MWC appears to have a policy of small annual increases in the dividend rate, maintaining an average dividend payout ratio of approximately 80 percent. Other facts and forecasts include the following: MWC's per-share dividends for 2020 (D0) were GH0.74. Robert Ass forecasts a long-term earnings growth rate of 3.5 percent per year, somewhat above the 2.7 percent consensus 3-5-year earnings growth rate forecast reported by Zacks Investment Research (based on two analysts) MWC's raw beta and adjusted beta are, respectively, 0.70 and 0.80 based on 60 monthly returns. The R2 associated with beta, however, is under 20 percent. Robert Ass estimates that MWC's pretax cost of debt is 5.6 percent based on Standard \& Poor's issuer rating for MWC of A - and the current corporate yield curve. Kim's estimate of MWC's required return on equity is 7.00 percent. MWC's current market price is GH\&20.50. Required: a) Calculate the Gordon growth model estimate of value for MWC using Robert Ass's required return on equity estimate. [4 marks] b) State whether MWC appears to be overvalued, fairly valued, or undervalued based on the Gordon growth model estimate of value. [4 marks] c) Justify the selection of the Gordon growth model for valuing MWC. [ 3 marks] d) Calculate the CAPM estimate of the required return on equity for MWC under the assumption that beta regresses to the mean. (Assume an equity risk premium of 4.5 percent and a risk-free rate of 3 percent as of the price quotation date.) 4 marks] Total [15 marks]
