Question

Urban Utilities, Inc. has outstanding common stock that is not growing. The firm has been paying an annual $3.75 dividend each year. No growth in this dividend payment is expected for the foreseeable future. Investors require an annual 6% rate of return on this stock, due to its low risk level. Given this information, calculate the market value per share of this firm's outstanding common stock.

a. Now, assume that a large competitor enters the market, taking 20% of Urban Utilities' market share. With this increase in risk, investors now require a 10% annual rate of return on Urban Utilities common stock. Given this information, calculate the market value per share of Urban Utilities' common stock.

Answer 1

Before the competitor's entry, the market value per share of Urban Utilities' common stock was $62.50. After the competitor entered and increased the investment risk, requiring a 10% rate of return, the market value per share decreased to $37.50.

Step-by-step explanation:

To calculate the market value per share of Urban Utilities' common stock before the competitor enters the market, we use the dividend discount model (DDM) for a no-growth stock, which is calculated as:

Market Value Per Share = Dividend Per Share / Required Rate of Return

So, Market Value Per Share = $3.75 / 0.06 = $62.50

After the competitor takes a portion of the market share, increasing investment risk and the required rate of return to 10%, the calculation becomes:

Market Value Per Share = $3.75 / 0.10 = $37.50

The presence of a competitor and increased risk led to a decrease in the stock's market value.