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

• Question 141:

  Estimating company earnings per share is a function of the ________ and the ________.

  A. firm's historical sales levels; relationship between sales and various relevant economic and industry series

  B. firm's internal performance; problems that might affect its future performance

  C. firm's competitive strategy; the firm's relationship with the industry

  D. sales forecast; estimated profit margin

  E. historical earnings per share; historical earnings multiplier

  Correct Answer: D

  The future value of a stock is derived by predicting the stock's earnings per share and expected earnings multiplier. Expected earnings per share is a function of the sales forecast and the estimated profit margin.

• Question 142:

  Empire Builders is in need of capital to finance its current expansion plans. For this, it has decided not to raise dividends for the next 4 years, maintaining them constant at $2 per share. Analysts expect the growth rate after that to be about 3% per year. If the investors expect a 9% rate of return on the stock, the market price of Empire Builders is ________.

  A. $34.33

  B. $27.61

  C. $30.80

  D. $32.23

  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 4 years from now, looking into the future, you will see a constant growth rate of 3% and the dividend 5 years from now will be $2 * 1.03 = $2.06. Therefore, the stock price 4 years from now, using the required rate of return of 9%, will equal P = 2.06/(9% - 3%) = $34.33. Thus, the current stock price equals $2*(1/1.09 + 1/1.09^2 + 1/1.09^3 + 1/1.09^4) + 34.33/1.09^4 = $30.80.

  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 5 to calculate the price at the end of year 4.

• Question 143:

  The P/E ratio of a stock equals 7.1. The company has just released its earnings figures at $12.20 per share. The firm's dividend payout ratio is 28%. If the current stock price is $100, what is its 1-year expected return under the Dividend Discount Model?

  A. 19.40%

  B. none of these answers

  C. 14.83%

  D. 13.65%

  Correct Answer: A

  It is important to remember that the P/E ratio is the ratio of the current stock price and next year's expected earnings. Therefore, the firm's expected earnings next year equal 100/7.1 = $14.09 per share. Since the current earnings equal $12.2, the dividend growth rate equals (14.09/12.2 - 1) = 15.45%.

  To get the 1-year expected return, first calculate the expected price next year. Under Dividend Discount Model, the P/E ratio remains constant if the firm makes no policy changes and there are no market disruptions. Therefore, price next year is expected to be $14.09*(1 + 15.45%)*7.1 = $115.45. The dividend next year equals $14.09 * 0.28 = $3.95 per share. Thus, 1-year expected return (capital gains + dividends) = (P1+D1)/Po = (115.45 + 3.95)/100 - 1 = 19.4%.

• Question 144:

  Which of the following is not one of the reasons why the valuation of common stock is difficult?

  A. Uncertainty of the risk-free rate of return

  B. Uncertainty of size of returns

  C. Uncertainty of the required rate of return

  D. Uncertainty of time pattern of returns

  Correct Answer: A

  The risk-free rate of return is widely known. It is simply the rate of return on risk-free U.S. government bonds.

• Question 145:

  The technicians' interpretation of the confidence index assumes that changes in the yield spread are caused

  A. almost entirely by changes in investor demand.

  B. in equal parts by changes in the supply of bonds and changes in investor demand.

  C. mostly by changes in the supply of bonds.

  D. almost entirely by changes in the supply of bonds.

  Correct Answer: A

  Technicians interpret the confidence index as indicative of broader investment bullishness or bearishness toward the market. But changes in the relative yields of bonds (which determine the value of the index) can be caused by changes in the supply of bonds as well as by changes in investor demand.

• Question 146:

  The stock market tends to reach a ________ shortly after times of international crisis or a ________ of the T-Bill-Eurodollar spread.

  A. trough; narrowing

  B. peak; widening

  C. peak; narrowing

  D. trough; widening

  Correct Answer: D

  An alternative measure of investor attitude or confidence on a global basis is the spread between T-bill yields and Eurodollar rates. It is reasoned that, at times of international crisis, this spread widens as money flows to safe-haven U.S. T- bills, which cause a decline in this ratio. The stock market tends to reach a trough shortly thereafter.

• Question 147:

  If a stock that you are holding for one year has an estimated dividend payout of $1.10 and an expected sale price of $22, what is the value of the stock?

  A. not enough information to calculate it

  B. $22

  C. $23.10

  D. $20.26

  Correct Answer: A

  In order to value the stock, a discount rate must be provided.

• Question 148:

  An analyst with Smith, Kleen, and Beetchnutty is attempting to value shares of an insurance company. The insurance company has been growing at a very stable rate for much of the last decade, and is expected to continue growing at a similar pace in the future. In determining the value of the insurance company's common stock, assume the following information:

  Required rate of return on equity: 12.75% per year Expected dividend growth rate: 9.50% per year Dividend at t0: $0.88

  Using this information, determine the value per-share of this insurance company's common stock.

  A. None of these answers is correct.

  B. $29.65

  C. $32.72

  D. $28.55

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

  F. $24.12

  Correct Answer: B

  In this example, the growth rate of dividends is assumed to remain stable, allowing the use of the Gordon Model. The Gordon Model is also known as the "constant growth dividend discount model" and takes the following form:

  P0 = [D1 / (r - g)]

  Where

  P0 = the price of common stock X at time 0

  D1 = the expected dividend at t1

  r = the required rate of return on equity investments and g = the expected growth rate of dividends.

  Since the dividend at t1 is not provided, we must calculate it manually by multiplying the dividend at t0 by (1 + g). This will produce an answer of $0.9636 at t1. Now that the dividend at t1 has been determined, the given information can be put into the equation provided, leading to the following series of calculations:

  P0 = [$0.9636 / (.1275 - .095)] = $29.65.

  When using the Gordon model, remember that the required rate of return "r" must be greater than the expected growth rate "g." Otherwise, the equation will produce a nonsensical answer.

• Question 149:

  Which measure may be interpreted as a measure of prospective growth rates in earnings and dividends that are expected by the market?

  A. Price/Earning Ratios

  B. Dividend Yield

  C. Return on Assets

  D. Payout Ratio

  E. Return on Equity F. Debt to Equity

  Correct Answer: A

  P/E ratios must be compared across an entire industry to view relative valuations. It is useful to compare P/ E ratios for individual firms with the industry average P/E ratio and P/E ratios of other firms in the same industry.

• Question 150:

  The top-down, three-step approach to valuation has

  A. been disproved by studies.

  B. generally been supported by studies.

  C. generally not been supported by studies.

  D. been proven by studies.

  Correct Answer: B

  The top-down, three-step approach to valuation has tended to be supported by various studies. Studies have found that earnings and rates of return are significantly influenced by the economy, industry, and market.