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NEW QUESTION: 3
Travis Smith, CFA, is chief economic strategist and market analyst for Nashville Capital Management. He is developing a forecast of the S&P 500 stock market index utilizing different approaches.
Using microeconomic analysis, Smith wants to value the S&P using a dividend discount model (DDM) valuation approach. The trailing recent 52-week dividend for the S&P 500 equaled $60. Used as a proxy for the nominal risk-free rate, Treasury rates are as follows:
* 3-month T-bill rate: 3.5%
* 30-year T-bond rate: 5.0%
Smith uses an equity market premium equal to 6%. His estimate for the long-term outlook for ROE is 11%, and the long-run earnings retention rate is estimated at 40%.
Smith also is forecasting the market trends using varied macroeconomic techniques. He believes that security prices reflect expectations about the general economy. During his monitoring and forecasting of the overall economy, Smith is evaluating cyclical indicators and the business cycle. Smith has focused his analysis on three indicators:
1. Index of industrial production.
2. Interest rate spread between 10-year T-bonds and the fed funds rate.
3. Stock prices.
Smith is particularly interested in using stock market trends to predict economic turning points.
In conducting his research, Smith has found that the business cycle appears to be in the slowdown phase.
In his capital markets forecasting activities, Smith looks at government policy, and attempts to predict business and consumer activity, along with foreign trade. Smith has determined that government policy has a significant influence on the business cycle, and he is trying to predict changes in government policy.
Smith predicts that the government fiscal policy will loosen and that the Federal Reserve monetary policy will tighten. Smith estimates the following variables:
* Short-term neutral interest rate: 3.5%
* Nominal GDP long-term growth rate trend: 4.25%
* Federal Reserve inflation target: 2.25%
Smith forecasts that inflation will increase to 3.0%, and nominal GDP will grow at a 1.5% rate.
Smith's supervisor, Rasheed Gupta, requests a valuation of the S&P500 using a free cash flow to equity (FCFE) model. Gupta makes the following statement:
"A valuation model that replaces dividends with free cash flow to equity is a good alternative to the DDM If
1 remember correctly, free cash flow to equity equals net income plus depreciation." Using the dividend discount model. Smith's estimate of the current S&P 500 valuation should be closest to:
A. 950.
B. 545.
C. 0
Answer: A
Explanation:
Explanation/Reference:
Explanation:
The reduced form DDM refers to the constant growth model:
V0=D1= / (k-g)
The growth rate in dividends is estimated as the product of the return on equity (ROE) and the earnings retention rare:
g - 0.40 x 0.11 -= 0.044 - 4.4% (retention rate x ROE)
The required return is estimate-d as the sum of the risk-free rare plus marker equity risk premium:
k = 0.05 + 0.06 = 0.11 (long-term RFR + risk premium)
D1= = $60 (1 + g) = 560 (1.044) = $62.64
V0= = D1 = / (k - g) = $62.64 I (0.11 - 0.044) = 949.09
(Study Session 7, LOS 24.c)

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