Chartered Financial Analyst Level 3 test

22:00

Stop

CFA Level 3 - Economics - Capital Market Expectations, Part 1

Intermediate

1/22

As the head of the Capital Markets Expectations team at a global investment firm, you are developing long-term return forecasts for the German equity market. Your team has gathered the following data: the current dividend yield on the DAX index is 3%, the expected earnings growth rate for German large-cap stocks over the next 10 years is 4% per annum, and the current price-to-earnings (P/E) ratio of the DAX is 14. Your team also expects the P/E ratio to expand by 15% over the forecast period due to anticipation of structural reforms and increased investor confidence in the German economy. Additionally, your team anticipates that the dividend payout ratio will remain stable at 50% over the next decade. Based on this information, what is the most appropriate long-term capital market expectation for the total return on German large-cap equities over the next 10 years?

According to the dividend discount model, the expected total return is the sum of the current dividend yield (3%) and the expected earnings growth rate (4%). Assuming a stable payout ratio of 50%, the expected dividend growth rate is also 4%. The P/E expansion of 15% over 10 years translates to an additional return of approximately 1.4% per annum. Therefore, the most appropriate long-term capital market expectation for the total return on German large-cap equities over the next 10 years is 8.4% per annum.

The long-term capital market expectation for the total return on German large-cap equities over the next 10 years should be calculated as follows: Current dividend yield of 3% + Expected earnings growth rate of 4% + Impact of P/E expansion (15% over 10 years, which translates to an annualized return of approximately 1.4%) - Reduction in return due to the stable dividend payout ratio of 50%. This results in an expected total return of approximately 7% per annum.

To calculate the expected total return on German large-cap equities, we should first determine the expected dividend growth rate. Given the expected earnings growth rate of 4% and the stable payout ratio of 50%, the expected dividend growth rate is 2%. Adding this to the current dividend yield of 3% and the impact of the 15% P/E expansion over 10 years (approximately 1.4% per annum), we arrive at a long-term capital market expectation for the total return on German large-cap equities of 6.4% per annum.