The dividend yield on the S&P 500 index is 2% per year. That is, if you invest $100 in the portfolio of stocks underlying the index, during the next year you will receive dividends that total to $2. For simplicity, you can think of the index as being a stock with current price of P0 and dividends of D1 = 0.02 P0. You expect that dividends will grow in perpetuity at the rate of g = 0.06 or 6% per year. This estimate of a dividend growth rate of 6% is based on a long run inflation rate of 2%, growth in per capita GDP of 2.8926% per year, population growth of 1% per year, and a belief that the growth rate of the dividends on a broad stock market index will be the same as the growth rate of the economy. (Note that 1.02 1.028926 1.01 = 1.06.)

Given your estimate of the dividend growth rate g = 0.06, what is your estimate of the expected rate of return r on the portfolio of stocks underlying the S&P 500 index?

Hint: What model or formula relates P0, D1, r, and g?