CFA® Level 1: CFA® Level 1 Exam Answer

Expected Return on Index Calculation

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Question

The current earnings per share on a value-weighted index is $3.7. If the growth rate in the index is expected to be 3%, its average payout ratio is 35% and the index value is $9.3 per share, the expected return on the index is:

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A. B. C. D.

C

You should remember that the Dividend Discount Model is applicable to individual stocks as well as stock indices. Indeed, that and estimation of the variables involved in the Dividend Discount Model are the thrust of Reilly & Brown, chapter 18.

In standard notation, Po = D1/(k-g). In this case, g = 3%. The expected dividend per share next year = $3.7 * 35%*(1+3%) = $1.33. Therefore, 9.3 = 1.33/(k-3%).

Solving for k gives k = 3% + 1.33/9.3 = 17.3%. This is the expected return on the index.

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