Question

The Ibbotson-Chen model can be used to estimate the equity risk premium based on four components: the expected inflation rate (EINFL), the expected growth rate in real earnings per share (EGREPS), the expected growth rate in the P/E ratio (EGPE), and an expected income component (EINC). You have estimated EINFL to be 4.0%, EGREPS to be 3.5%, EGPE to be 0.0%, and EINC to be 3.0%. The riskless rate of return is 3.0%. Use this model to estimate the equity risk premium. (Enter your answer to the nearest 0.01 percent. Leave the % sign off. In other words, if your answer is 1.23% or 0.0123, enter 1.23 for your answer.)

Answer 1

Solution :-

As per the Ibbotson-Chen model

Equity Risk Premium = { [ (1 + EINFL ) * (1 + EGREPS ) * ( 1 + EGPE ) - 1.0 ] + EINC } - Expected Risk Free Return

Where EINFL = Expected inflation rate = 4.0%

EGREPS = Expected growth rate in real earnings per share = 3.5%

EGPE = Expected growth rate in the P/E ratio = 0.0%

EINC =  Expected income component = 3.0%

Equity Risk Premium =  { [ (1 + 0.04 ) * (1 + 0.035 ) * ( 1 + 0.0 ) - 1.0 ] + 0.03 } - 0.03

Equity Risk Premium = { [ 1.0764 - 1.0 ] + 0.03 } - 0.03

Equity Risk Premium = 0.0764 = 7.64%

Therefore the answer is 7.64

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