MGCR 341: Finance 1
Vadim di Pietro
Assignment 3 Solutions
Topic: Equity Valuation
True or False, no explanation required.
For the questions below, assume that a fraction
of earnings are paid out as dividends,
and thus the value of the S&P 500 is given by P =
-g), where r
, the required
rate of return on the market is given by the CAPM: r
). (Note, the beta
of the market is 1.) In each case below, assume
The answers to parts a) through e) are all TRUE. This follows simply from applying the
above formula. If the math/intuition is not clear to you, then ask me to explain during
a) If 1) the risk free rate increases, 2) the market risk premium E[r
remains unchanged, and 3) g remains unchanged, then the S&P 500’s PE
ratio will fall (i.e., earnings yields will rise).
b) If g increases, and everything else remains unchanged, the S&P 500’s PE
ratio will rise (i.e., earnings yields will fall).
Assume inflation expectations increase by 2%. Assume this causes the risk
free rate to increase by 2%. Also, assume this causes growth expectations
to increase by 2% (since equity earnings are derived from
Under these assumptions, and holding the market risk premium constant,
the S&P 500’s PE ratio and earnings yield will remain unchanged when
inflation expectations increase.
d) Holding all else equal, if the market risk premium increases, the S&P
500’s PE ratio will fall (i.e., earnings yields will rise).
Same assumptions as in part c, except assume the market risk premium
increases when inflation increases. Under this new assumption, the S&P
500’s PE ratio will fall (i.e., earnings yields will rise) when inflation