2.5% 3.3%
Average P/E 12.5 13.5 13.2
Average dividend
yield 2.5% 1.7%
Average real
economic growth 6.2% 4.1%
C. i. Calculate the historical equity risk premium and use it to calculate the appropriate equity discount rate based on current bond market conditions. ii. Calculate the equity risk premium and the appropriate expected equity return based on Grinold-Kroner assuming a 1% reduction in shares outstanding. Grading GuideAnswer for Question 4-C i. The historical risk premium was: 9.5 - 6.8 = 2.7% Using the current bond yield, this is an equity discount rate of 2.7 + 4.8 = 7.5%. Candidate discussion: 1 point for each correct calculation. ii. GK is a variation on yield plus growth as the expected return. The 1% reduction in shares outstanding is stock repurchase, and it supplements the dividend yield of 1.7%. Growth is real plus expected inflation. The expected decline in P/E is a downward revaluation, which reduces expected return.
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