CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 91:

  Contrarians interpret a high cash ratio in mutual funds at market lows as an indication that the mutual fund managers are:

  A. about to enter the market with more cash.

  B. aggressive.

  C. bullish.

  D. bearish.

  Correct Answer: D

  According to the contrarians, most market participants make wrong investment decisions as the market approaches the peak or trough in a cycle. One category of market participants they consider is mutual funds. The cash ratio of mutual funds is the fraction of total assets that mutual funds maintain in the form of cash. A high ratio (around 12-13%) at a market low is considered by contrarians as a signal that the funds are bearish and a low ratio (7-8%) at a market high is interpreted as an indication that the funds are bullish. The Contrarians then take exactly the opposite position

• Question 92:

  Which of the following is/are true about open-ended funds?

  I. The redemption price equals the NAV in the absence of a redemption charge.

  II. The load charge, if any, typically is a constant percentage of the amount invested.

  III.

  The NAV of a no-load fund equals its purchase price.

  A.

  III only

  B.

  I and III

  C.

  II and III

  D.

  I and II

  E.

  II only

  F.

  I only

  Correct Answer: B

  The offer price i.e. the price at which you can buy a share equals

  NAV/(1-load charge) while the redemption price, in the absence of a redemption fee, equals the NAV. The load charge, if any, typically declines as the size of the order increases.

• Question 93:

  The common stock of Blooth, Incorporated currently pays a $0.35 per share dividend, and this dividend is anticipated to grow 13% annually. Assuming that investors require a 16% per year rate of return on their investment, what is the value of this common stock?

  A. The answer cannot be determined from the information provided.

  B. $13.18

  C. $19.01

  D. None of these answers is correct.

  E. $24.72

  F. $16.83

  Correct Answer: B

  To determine the value of this common stock using the Infinite Period Dividend Discount Model, the following equation is used:

  {P0 = [D1 / (k - g)]}

  Where: P0 = the price of the common stock at t0, D1 = the annual dividend at t1 (this is found by multiplying the dividend at t0 by (1 + expected growth rate), k = the required rate of return, And g = the anticipated growth rate.

  In this equation, all of the necessary information has been provided, and the calculation of the price of this common stock is as follows:

  {P0 = [(0.35 * 1.13) / (0.16 - 0.13)] = $13.18.

  While the Infinite Period DDM is a useful tool, it frequently inappropriate for valuation purposes because of its generous assumptions. Specifically, the Infinite Period DDM assumes that dividends will grow at a steady rate indefinitely, and that this rate is both known and measurable. For most common stocks, the use of the Infinite Period DDM will produce a measure of value that is skewed from objective reality. Nonetheless, this valuation model is frequently cited and represents a powerful tool within specified parameters.

• Question 94:

  If the dividend payout ratio for a stock market series is anticipated to increase as the industry advances towards relative maturity, which of the following would occur assuming that both the required return and expected growth rate remain constant? Further, what would occur if the growth rate of dividends were to exceed the required rate of return?

  A. The earnings multiplier would increase; the earnings multiplier would produce a nonsensical (negative) answer.

  B. The earnings multiplier would increase; the earnings multiplier would produce a nonsensical (very large) answer.

  C. The earnings multiplier would decrease; the earnings multiplier would increase.

  D. The earnings multiplier would decrease; the earnings multiplier would produce a nonsensical (negative) answer.

  E. The earnings multiplier would increase; the earnings multiplier would decrease.

  Correct Answer: A

  Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

  P/E = [D/E / (k - g)]

  Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.

  From observing this equation, we can determine what would happen if the dividend payout ratio were to increase. The result is largely intuitive once an understanding of dividend discount methodology is gained. An increase in the dividend payout ratio will lead to an increase in the earnings multiplier assuming that both the required rate of return and the anticipated growth rate are assumed to remain unchanged. In reality, this assumption is nonsensical in this case. Specifically, the dividend payout ratio is anticipated to increase because the industry is advancing toward relative maturation. In other words, companies comprising the series are expected to pay out more of their earnings as dividends due to diminishing positive NPV investment opportunities. By definition this would decrease the anticipated growth rate, which would in turn lead to a decline in the earnings multiplier.

  If the anticipated growth rate were to exceed the required rate of return, the resulting earnings multiplier would be nonsensical. Specifically, the earnings multiplier produced would be a negative number.

• Question 95:

  The change in ________ is a compound effect of changes in wages per hour and changes in worker productivity.

  A. the rate of inflation

  B. unit labor costs

  C. foreign competition

  D. the profit margin

  Correct Answer: B

  Unit labor will cost more if wages increase and cost less if worker productivity increases. Both these effects are considered.

• Question 96:

  ABC Company has consistently paid out 40% of its earnings in dividends. The company's return on equity is 16%. Calculate ABC's estimated dividend growth rate.

  A. 40%

  B. 16%

  C. 6.4%

  D. 10.0%

  E. 12%

  F. 9.6%

  Correct Answer: F

  The estimated growth rate of dividends = (Retention Rate) x (Return on Equity). In this case, the estimated growth rate of dividends = 60% x 16% = 9.6%.

• Question 97:

  Technical analysts believe that speculative trading peaks at market ________.

  A. mid-points

  B. troughs

  C. none of these answers

  D. peaks

  Correct Answer: D

  Technicians consider speculative activity high when the ratio of OTC volume on the NASDAQ system to NYSE volume gets to 90 percent or more. Speculative trading typically peaks at market peaks.

• Question 98:

  A high-growth firm is expected to have a dividend growth of 15% for the next 2 years. It is then expected to stabilize at 5%. The firm has just paid a dividend of $1 and investors require a rate of return of 12%. The market price of the firm's stock is ________.

  A. $16.15

  B. $14.22

  C. $17.77

  D. $19.86

  Correct Answer: C

  Since the dividends do not grow at a constant rate, you cannot directly apply the Dividend Discount Model

  valuation formula. However, note that 2 years from now, looking into the future, you will see a constant

  growth rate of 5% and the dividend 3 years from now will be $1 * 1.15^2 * 1.05 = $1.39. Therefore, the

  stock price 2 years from now, using the required rate of return of 12%, will equal P = 1.39/(12% - 5%) =

  $19.86. Thus, the current stock price equals 1.15/1.12 + (1.15/1.12)^2 + 19.86/1.12^2 = $17.77.

  Note that you must be very careful about the time line. In the Dividend Discount Model valuation formula,

  the price at time t uses the dividend paid at time (t+1). That's the reason we had to use the dividend paid in

  year 3 to calculate the price at the end of year 2.

• Question 99:

  If the dividend payout ratio for a stock market series is anticipated to increase as the industry advances towards relative maturity, which of the following would occur assuming that both k and g remain constant? Further, what would occur if the growth rate of dividends were to exceed the required rate of return?

  A. The earnings multiplier would decrease; the earnings multiplier would produce a nonsensical (negative) answer.

  B. The earnings multiplier would decrease; the earnings multiplier would increase.

  C. The earnings multiplier would increase; the earnings multiplier would decrease.

  D. The earnings multiplier would increase; the earnings multiplier would produce a nonsensical (very large) answer.

  E. The earnings multiplier would increase; the earnings multiplier would produce a nonsensical (negative) answer.

  Correct Answer: E

  Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

  {P/E = [D/E / (k - g)]}

  Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends. According to this equation, an increase in the dividend payout ratio will lead to an increase in the earnings multiplier, assuming that both the required rate of return and the anticipated growth rate remain unchanged. In reality, this assumption is nonsensical in this case. Specifically, the dividend payout ratio is anticipated to increase because the industry is becoming more mature. In other words, companies comprising the series are expected to pay out more of their earnings as dividends due to diminishing positive NPV investment opportunities. By definition this would decrease the anticipated growth rate, which would in turn lead to a decline in the earnings multiplier. If the anticipated growth rate were to exceed the required rate of return, the resulting earnings multiplier would be a negative number, a result that doesn't make sense.

• Question 100:

  Genetree Labs, a small biotechnology company focused on human stem cell research, is best characterized by which stage of the industrial life cycle? Further, what degree of earnings payout are shareholders likely to require from Genetree Labs? Assume that Genetree Labs is exclusively a research firm, and is in the process of developing its product line.

  A. Pioneering and development stage, high payout ratio

  B. Market stabilization stage, low payout ratio

  C. Pioneering and development stage, low payout ratio

  D. Accelerating growth stage, high payout ratio

  E. None of these answers is correct.

  F. Accelerating growth stage, low payout ratio

  Correct Answer: C

  The industry life cycle is divided into five distinct stages. Specifically, the industrial life cycle progresses from the development stage to an accelerating growth stage to a mature growth stage to a market maturation and stabilization stage. Finally, the fifth stage of the industrial life cycle is characterized by decelerating growth and sales decline. During the mature growth stage, sales are still growing, albeitslowly. During the last stage of the industrial life cycle, however, is characterizes by a decline in annual sales.

  As an industry or company progresses through the industrial life cycle, sales begin to grow rapidly (accelerating growth) then slow considerably as the product or service begins to reach critical mass (mature growth). During the mature growth stage, the industry or company grows at a slower pace, until eventually growth begins to slow considerably (market maturity and stabilization) as the market for the industry or company's products becomes more completely defined. An industry or company typically reaches the fifth stage of the industrial life cycle, growth deceleration and decline, only after many years of stabilization.

  The firm profiled in this example is in the pioneering and development stage, as evidenced by the Company's complete lack of sales or product line. Genetree Labs is in the process of developing a product, and is exclusively a RandD firm. So said, this Company is an example of the pioneering and development stage of the industrial life cycle. Shareholders of Genetree will likely expect a low dividend payout ratio, giving up current income for the prospect of future earnings growth, i.e. shareholders will prefer that earnings are "plowed back" into the operation of Genetree rather than be distributed as dividends. This is augmented by the fact that firms in the pioneering and development stage are likely to have superior investment opportunities, which leads directly to a lower payout ratio. If you chose "accelerating growth," remember that the firm profiled in this example has no sales or existing product. Genetree Labs is in the development stage.