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

• Question 121:

  An economist with Smith, Kleen and Beetchnutty Institutional Brokerage has been examining a stock market series and is trying to determine an appropriate earnings multiplier for the series. In her research, this economist has determined the following information:

  The annual dividend per share next year = $1.35 The earnings per share next year = $5.10 The anticipated growth rate of dividends is 12.5% per year The anticipated growth rate of earnings is 14% per year The required rate of return is 15.75% per year

  What is the appropriate earnings multiplier for this stock market series? Further, what is the appropriate value for this stock market series? Choose the best answer.

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

  B. None of these answers is correct.

  C. 14.93; $76.13

  D. 7.74; $39.46

  E. 15.13; $77.16

  F. 8.14; $41.51

  Correct Answer: F

  The appropriate earnings multiplier is found to be 8.14.

  Estimating the earnings multiplier for a stock market series requires the estimation of each of the following

  components:

  The dividend payout ratio.

  The required rate of return on common stock in the country/region/industry/sector bein analyzed.

  The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.

  Once values for each of these components have been determined, they are imputed into the following

  formula:

  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.

  In this example all of the necessary information has been provided. However, the dividend payout ratio

  must be calculated based on the anticipated dividend at t1 and the projected EPS figure for t1. The

  calculation of the dividend payout ratio is as follows:

  D/E = [$1.35 / $5.10] = 0.264706

  Now that the dividend payout ratio has been determined, the appropriate earnings multiplier is found as

  follows:

  P/E = [0.264706/ (0.1575 - 0.125)] = 8.14

  Notice that it is the anticipated growth rate of dividends, not the anticipated growth rate of earnings, which

  is used in the determination of the earnings multiplier.

  Multiplying this figure by the projected EPS will lead to an appropriate value of $41.51 for this series.

• Question 122:

  There are two popular methods for estimating the earnings multiplier for an industry or a stock market series, which of the following correctly lists these two techniques?

  A. The top-down and the bottom-up approach

  B. Discounted cash flow estimation, regression analysis

  C. Scenario Analysis, Monte Carlo Simulation

  D. More than one of these answers is correct

  E. The direction of change and the specific estimate approach

  F. Microanalysis and macroanalysis

  Correct Answer: D

  More than one of these answers is correct. Specifically, the "direction of change" and the "specific estimate" are methods of forecasting the earnings multiplier of a stock market series and "microanalysis" and "macroanalysis" are used to forecast the earnings multiplier for an industry. When estimating the earnings multiplier for an industry, there are two common methods - the "direction of change" and the "specific estimate" approaches. The direction of change approach begins with the present earnings multiplier for a stock market series and seeks to estimate both the amount and direction of any change based upon changes in the components of the P/E ratio - the required rate of return, the anticipated growth rate of dividends, and the dividend payout ratio. This approach is contrasted by the specific estimate approach, which involves the estimation of a specific value for the earnings multiplier based on a series of projections for values of the components of the earnings multiplier components. When using this approach, analysts commonly confine their estimates to a series of scenarios, typically a best case, worst case, and base case scenario. There are two common methods for estimating the earnings multiplier for an industry - macroanalysis and microanalysis. Macroanalysis involves an examination of the relationship between the earnings multiplier for an industry and the earnings multiplier for the market. Microanalysis involves an estimation of the specific variables that influence the earnings multiplier, including the required rate of return, the estimated growth rate, and the dividend payout ratio. While the top down and bottom up method are similar to macroanalysis and microanalysis, respectively, they do not represent the best possible answer. Specifically, the top-down and bottom up approaches are typically used to identify investment opportunities, not for the estimation of an industry earnings multiplier.

• Question 123:

  The earnings multiple for next year's earnings must take into account the ________ of common dividends.

  A. country risk

  B. expected growth rate

  C. required return on equity

  D. aggregate business risk

  Correct Answer: B

  Assuming that the dividend payout ratio is to remain constant, growth in earnings can be related to the firm's growth. It then logically follows that a faster growing firm, with faster increase in dividends will be higher priced (i.e. high earnings multiple).

• Question 124:

  An financial analyst is in the process of measuring the annualized return of an investment portfolio. Consider the following information:

  t0: purchase an initial 1 share of Microscam for $65.40 t1: purchase an additional 1 share of Microscam for $68.12 t1: receive a dividend of $0.75 t2: purchase an additional 1 share of Microscam for $75.95 t2: receive a dividend of $0.77 t3: sell 3 shares for $82.76 per share

  Assuming no taxes or transaction costs, that dividends are not reinvested, and that each period represents one year, what is the time-weighted rate of return per year on this portfolio?

  A. 8.27% per year

  B. The answer cannot be calculated from the information provided.

  C. None of these answers is correct.

  D. 10.73% per year

  E. 14.43% per year

  F. 8.92% per year

  Correct Answer: F

  The time-weighted rate of return is the preferred method of return calculation in the investment

  management industry, primarily because the return calculation it produces is not sensitive to significant

  additions and withdrawals of funds from portfolios under examination. The calculation of the time-weighted

  rate of return involves three steps, which are illustrated as follows:

  Step 1:

  Price the portfolio immediately prior to any significant additions or withdrawals. Separate the portfolio into a

  series of subperiods based on the dates of cash inflows and outflows.

  Step 2:

  Calculate the holding period return for each subperiod.

  Step 3:

  Determine the annualized holding period return by linking or compounding the holding period return of

  each subperiod. If the investment is for more than one year, use the geometric mean of the annual returns

  as the time-weighted rate of return. If the investment is for less than one year, compound the subperiod

  returns to obtain an annualized measurement.

  To begin the process of determining the time-weighted rate of return, we would break the portfolio up into

  the following series of cash flows. However, in this example, the cash flows are already aggregated for us

  and we can move on to the next step: determining the holding period return for each subperiod. This

  process is detailed as follows:

  t1: [($68.12 ending price + $0.75 dividend received - $65.40 beginning price) / $65.40 beginning price] =

  5.306%.

  t2: [($75.95 ending price + $0.77 dividend received - $68.12 beginning price) / $68.12 ending price] =

  12.625%

  t3: [$82.76 ending price - $75.95 beginning price / $75.95 beginning price] = 8.966%

  Now that the holding period returns for each subperiod have been calculated, the determination of the time-weighted rate of return can take place. Since the duration of these transactions exceeds one year,we must take the geometric mean of the annual returns to obtain the time-weighted rate of return. This is done by taking the cube root of [(1 + .05306) * (1 + .12625) * (1 + .08966], subtracting 1, and multiplying by 100%, which leads to a time-weighted rate of return of .0892 or 8.92%.

  If you chose 10.73%, remember that it is the geometric mean that is used in the time-weighted rate of return calculation, not the arithmetic mean.

• Question 125:

  Which of the following usually occurs at the peak of the business cycle?

  A. Wages decrease.

  B. Profit margin increases.

  C. Capacity utilization increases significantly.

  D. Unit labor costs increase substantially.

  Correct Answer: D

  During the peak of the business cycle, firms are already operating near full capacity, leading to very small increases or declines in capacity utilization. Inflation tends to be high, resulting in workers' demands for higher wages. Because firms now tend to be using marginal labor and production facilities, productivity increases only slowly. These factors result in substantial increases in unit labor costs, which along with the otherfactors, also help push profit margins lower.

• Question 126:

  Firms in which of the following industries would likely have the highest earnings retention rates? Further, would firms within this industry likely be financed primarily through debt or equity?

  A. Automobile manufacturing; debt

  B. Retail banking; equity

  C. Pharmaceuticals; debt

  D. Pharmaceuticals; equity

  E. Retail banking; debt

  F. Automobile manufacturing; equity

  Correct Answer: D

  Firms in the pharmaceutical industry would likely retain a higher proportion of their earnings than automobile manufacturers or retail banks. This is reasoned primarily by two factors. First, pharmaceutical companies have high research and development costs, and their success depends largely on the discovery of promising drugs. This requires that adequate funds be held within the firm. Secondly, growth opportunities in the pharmaceuticals industry are much more abundant than in either the automobile manufacturing or retail banking, and this is largely due to the maturity of the industry as a whole. Pharmaceutical companies typically have numerous positive NPV investment opportunities. In terms of financing, pharmaceutical firms would be expected to have a capital structure weighted more heavily toward equity than debt. As the cash flows of an industry become more certain and stable, the level of debt financing should be expected to increase. Automobile manufacturers and retail banks have very predictable cash flows, along with high degrees of leverage. Certainty of revenues and earnings is a very important consideration in the financing decision, and firms whose cash flows are both stable and easily forecasted will likely prefer a high degree of debt versus equity financing. Another important note to consider is the fact that the balance sheet of a pharmaceutical firm is more heavily weighted toward intangible assets than is a retail bank or an automobile manufacturer. Intangible assets cannot easily be pledged as collateral for a loan, neither can intangible assets be liquidated with any degree of certainty. A high proportion of intangible assets within the asset structure of a firm is conducive to a low degree of debt financing.

• Question 127:

  Given that the risk-free rate is 7%, what is the value of a zero-coupon bond in which $10,000 will be paid in 15 years?

  A. $4,759

  B. $4,522

  C. $5,628

  D. Not enough information

  E. $3,624

  Correct Answer: D

  In order to take the present value of the coupon and principal payments, one must know the required rate of return on the bond. The required rate of return is equal to the risk-free rate plus the risk premium. The risk premium is not given, so there is not enough information to answer the question.

• Question 128:

  An investor had invested in 50 shares of firm Z at the beginning of the year, when the stock price was $56 per share. On September 18th, the stock underwent a 3-for-2 split. At year-end, the stock price stood at $38. The investor realized a return of 17% during the year. His total dividend income during the year was:

  A. $284

  B. $517

  C. $426

  D. $639

  Correct Answer: C

  When the stock split, the investor was left with 50 * 3 / 2 = 75 shares. Hence, the year-end portfolio value equaled 75 * 38 = $2,850. The original amount invested was equal to 50 * 56 = $2,800. Since the investor realized a return of 17%, his total value inclusive of dividends at year-end was 2,800 * 1.17 = $3,276. Therefore, the dividend income during the year was 3,276 - 2,850 = $426.

• Question 129:

  For an American investor, Japanese securities tend to have

  A. higher financial, liquidity, and exchange rate risk than American securities.

  B. lower financial and liquidity risk and higher exchanger rate risk than American securities.

  C. higher financial and exchange rate risk and lower liquidity risk than American securities.

  D. lower financial risk and higher liquidity and exchange rate risk than American securities.

  E. lower financial and exchange rate risk and higher liquidity risk than American securities.

  Correct Answer: A

  Japanese firms use considerably more financial leverage than American firms, and therefore tend to have higher financial risk. American capital markets are acknowledged to be the most liquid in the world, followed closely by those in Japan and London. Japanese securities therefore tend have higher liquidity risk than American securities. For an American investor, American securities have no exchange rate risk because they are denominated in dollars, while Japanese securities are denominated in a yen.

• Question 130:

  If worker productivity increases by 4%, wages per hour increase by 4%, and hours worked increases by 8%, what is the change in unit labor cost?

  A. 4% increase

  B. 8% increase

  C. 4% decrease

  D. 12% increase

  E. There is no change

  Correct Answer: E

  Per-unit labor cost is a function of the percentage change in hourly wages minus the percentage change in productivity during some period of time. In this question, the increase in worker productivity exactly offsets the increase in hourly wages.