Assume that the stock market index is trading at a level of 4,200. The long-term risk-free rate is 2%. The aggregate earnings of the firms in the stock market index are expected to be 180 next year and the payout ratio has been 33% and is expected to remain 33%.

Part A - What additional assumptions can justify the stock market index level of 4,200? Show your calculations and explain your reasoning carefully.

Part B - Suppose that the stock market index is fairly valued at 4,200 if the long-term risk free rate is 2%. Assume that the assumptions above still hold, including your additional assumptions that justify a level of the stock market index of 4,200. Now suppose that the long-term risk-free rate changes, but all the other assumptions that together with a long term risk-free rate of 2% justified the stock market index level of 4,200 stay the same.


Which level of the long-term risk-free rate would justify a decline of the stock market index level by 50% to 2,100? 

Answer rating: 100% (QA)

Part A To justify a stock market index level of 4200 we need to estimate the present value of the future earnings of the firms in the index We can use ... View the full answer