Gordon Growth Model

The equity risk premium for Germany is estimated at 4.9%, using the dividend discount model approach. A German equity ETF will pay a USD 6.42 dividend at year-end, with a 1.5% growth rate. The risk-free rate is 60bp. The fund's share price is _closest to_:

Incorrect. This result can be obtained by ignoring the growth rate of dividends, but this error significantly understates the index price.

Correct! The estimated equity return is found as the sum of the estimated equity risk premium of 4.9% and the risk-free rate of 0.6%. This equity return of 5.5% can then be used in the Gordon growth model to obtain the estimated value of the index fund: $$\displaystyle P_0 = \frac{D_1}{r_e-g} = \frac{6.42}{0.055 - 0.015} = 160.50 $$.

Incorrect. This result can be obtained by using the equity risk premium in the Gordon growth model rather than the estimated equity return, but recall that the Gordon growth model equates the discounted dividends with the price, not the risk premium.

$117\.

$160\.

$188\.