Question

2.a. A utility company services a growing community. Its management is considering raising outside capital by issuing equity. It is exploring changing its energy mix, which will require various one-time costs associated with its transition to low-carbon energy sources. It uses an internal cost of capital of 10% to make investment decisions. Last year, it paid dividends of $4. The investment banker working with the company is trying to determine its share price to determine how to price additional equity, and is exploring 3 scenarios.

2.a. Historical dividend growth of 2%/year will continue, even after the energy mix changes.

2.b. Demand will as ratepayers begin to use more electricity as they switch to electric vehicles -- especially if they understand their electricity is fueled by renewables. What would an additional 1% dividend growth mean for the share price?

2.b. An alternative scenario is put forth by a recent graduate of an MBA in Sustainability. She suggests that many of the people who buy electric cars will also buy solar panels for their homes, irrespective of the utility's energy mix. She believes is likely to decrease, and expects dividends growth to decline to negative 1% a year. What would this mean for the share price?

Answer 1

We have to use the Gordon dividend discount model to determine the value of equity

The following information is given

·         The last year dividend is$ 4

·         The cost of capital is 10%

The formula to calculate value of equity

P₀= D₁/(k-g)

P₀= value of stock

D₁ = Next year annual dividend per share

K = cost of capital

G= Expected dividend growth rate

2.a. Historical dividend growth of 2%/year will continue, even after the energy mix changes

Ans

The formula to calculate value of equity

P₀= D₁/(k-g)

P₀= value of stock

D₁ = Next year annual dividend per share

K = cost of capital

G= Expected dividend growth rate

Calculate the D₁

D₁= last year dividend x current year growth rate x next year growth rate

= $4 x (1+0.02) x (1+0.02)

=$4 x 1.02 x 1.02

= $4.08 x 1.02

= $4.1616

K = 10% or 0.10

G = 2% or .02

Putting values in the formula

P₀= D₁/(k-g)

= $4.1616 /(0.10 – 0.02)

=$4.1616 /0.08

= $52.02

The value of equity will be $52.02

2.b. Demand will as ratepayers begin to use more electricity as they switch to electric vehicles -- especially if they understand their electricity is fueled by renewables. What would an additional 1% dividend growth mean for the share price?

Ans

The formula to calculate value of equity

P₀= D₁/(k-g)

P₀= value of stock

D₁ = Next year annual dividend per share

K = cost of capital

G= Expected dividend growth rate

Calculate the D₁

D₁= last year dividend x current year growth rate x next year growth rate

= $4 x (1+0.03) x (1+0.03)

=$4 x 1.03 x 1.03

= $4.12 x 1.03

= $4.2436

K = 10% or 0.10

G = 3% or .03

Putting values in the formula

P₀= D₁/(k-g)

= $4.2436 /(0.10 – 0.03)

=$4.2436 /0.07

= $60.6228 or $60.62

The value of equity will be $60.62

2.b. An alternative scenario is put forth by a recent graduate of an MBA in Sustainability. She suggests that many of the people who buy electric cars will also buy solar panels for their homes, irrespective of the utility's energy mix. She believes is likely to decrease, and expects dividends growth to decline to negative 1% a year. What would this mean for the share price?

Ans

The formula to calculate value of equity

P₀= D₁/(k-g)

P₀= value of stock

D₁ = Next year annual dividend per share

K = cost of capital

G= Expected dividend growth rate

Calculate the D₁

D₁= last year dividend x current year growth rate x next year growth rate

= $4 x (1+0.01) x (1+0.01)

=$4 x 1.01 x 1.01

= $4.04 x 1.01

= $4.0804

K = 10% or 0.10

G = 1% or .01

Putting values in the formula

P₀= D₁/(k-g)

= $4.0804 /(0.10 – 0.01)

=$4.0804 /0.09

= $45.3377 or $ 45.34

The value of equity will be $45.34