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

• Question 171:

  A portfolio manager with Smith, Kleen and Beetchnutty is examining shares of Microscam for possible investment. In her research, this portfolio manager has assimilated the following information about Microscam from the Company's most recent fiscal year:

  Adjusted operating profit before tax: $30,040,000 Cash operating taxes: $10,500,000 Cost of capital: 18.25% per year Total capital employed: $98,750,000

  Using this information, what is the Economic Value Added for Microscam? Further, should the management of Microscam be considered to have created value for shareholders?

  A. $1,743,071; management has created economic value

  B. None of these answers is correct.

  C. ($1,150,000); management has not created economic value

  D. ($1,518,125); management has created economic value

  E. $1,518,125; management has created economic value

  F. $1,518,125; management has not created economic value

  Correct Answer: E

  Economic Value Added, a value-based measure of economic profit, is a registered trademark of Stern, Stewart and Company. The equation used to calculate EVA is as follows:

  EVA = {Net Operating Profits Less Adjusted Taxes - [Total Capital Employed * (Cost of Capital)]}.

  In this case, the NOPLAT figure must be calculated manually by subtracting the Cash Operating Taxes from the Adjusted Operating Profit before Tax (AOPBT) figure. Doing so will produce an answer of $19,540,000 for the Net Operating Profit Less Adjusted Taxes figure. Now that the necessary information has been determined, the calculation of EVA is as follows:

  EVA = {$19,540,000 - ($98,750,000 * 0.1825)} = $1,518,125

  A positive EVA calculation indicates that management has provided economic profits to shareholders, as evidenced by the fact that the opportunity cost of capital employed is less than the AOPAT figure. In this example, the management of Intelligent Semiconductor should be considered as having succeeded to provide shareholder value. The calculation of Adjusted Operating Profit Before Taxes (AOPBT), and Cash Operating Taxes are important. The calculation of AOPBT is as follows:

  Operating profit (after depreciation and amortization) + Implied interest on operating leases + any increase in the LIFO reserve + goodwill amortization = Adjusted Operating Profit Before Taxes.

  Cash Operating Taxes, another important component of EVA, is calculated as follows: Cash Operating Taxes = Income Tax Expense + tax benefit from interest expenses + tax benefit from interest on leases + taxes on non-operating income Adjusted Operating Profit Before Taxes minus Cash Operating Taxes = Net Operating Profit Less Adjusted Taxes (NOPLAT). Subtracting the dollar cost of capital from the NOPLAT figure will yield the EVA.

• Question 172:

  Which of the following variables are hypothesized to affect the aggregate profit margin?

  A. All of these answers

  B. Rate of inflation

  C. Unit labor costs

  D. Foreign competition

  Correct Answer: A

  Economists Finkel and Tuttle hypothesized that 4 variables affect the aggregate profit margin. (1) Capacity utilization rate (+); (2) Unit labor costs (-); (3) Rate of inflation (+); (4) Foreign competition.

• Question 173:

  The infinite period dividend discount model assumes that

  A. dividends grow at a constant rate, that constant rate will continue for an infinite period of time, and that the required rate of return on the stock is greater than the growth rate. Making these assumptions, the model states that the value of a stock is equal to the current dividend payment divided by the spread between the required rate of return and the growth rate of dividends.

  B. dividends grow at a constant or increasing rate, and that the required rate of return on the stock is greater than the growth rate. Making these assumptions, the model states that the value of a stock is equal to the dividend payout ratio divided by the spread between the required rate of return and the growth rate of dividends.

  C. dividends grow at a constant or increasing rate, and that the growth rate of dividends is higher than the required rate of return on the stock. Making these assumptions, the model states that the valueof a stock is equal to the dividend payout ratio divided by the spread between the required rate of return and the growth rate of dividends.

  D. dividends grow at a constant rate, and that constant rate will continue for an infinite period of time. Making these assumptions, the model states that the value of a stock is equal to the dividend payout ratio divided by the spread between the required rate of return and the growth rate of dividends.

  Correct Answer: A

  The dividend discount model's fundamental assumption is that the value of a share of common stock is equal to the present value of all future dividends. The assumption that a firm's dividends grow at a constant rate for an infinite period of time is seldom true for companies growing at above-average rates. For example, although Intel and Wal-Mart have both grown at rates in excess of 30% a year for several years, it is doubtful that they will be able to maintain such high growth for an infinite period.

• Question 174:

  Estimates of GNP

  A. are used to estimate aggregate net sales for the firms in a stock market series such as the SandP 400. About 90% of the variance in percentage changes in SandP 400 net profits can be attributed to percentage changes in the GNP. Net sales are more volatile than GNP.

  B. are used to estimate aggregate net profits for the firms in a stock market series such as the SandP 400. About 30% of the variance in percentage changes in SandP 400 net profits can be attributed to percentage changes in the GNP. The GNP is more volatile than net profits.

  C. are used to estimate aggregate net sales for the firms in a stock market series such as the SandP 400. About 40% of the variance in percentage changes in SandP 400 net profits can be attributed to percentage changes in the GNP. Net sales are more volatile than GNP.

  D. are used to estimate aggregate net profits for the firms in a stock market series such as the SandP 400. About 80% of the variance in percentage changes in SandP 400 net profits can be attributed to percentage changes in the GNP. Net profits are more volatile than GNP.

  Correct Answer: C

  There is a strong relationship between GNP percentage changes and SandP 400 net sales percentage changes; about 40% of the variance of SandP 400 net sales percentage changes is due to percentage changes in the GNP. Estimating GNP changes allows one to then estimate net sales changes based on a regression formula.

• Question 175:

  The confidence index

  A. is equal to Barron's average yield on 10 top-grade bonds divided by the yield on the Dow Jones average of 40 bonds, multiplied by 100. Technical analysts who try to follow the "smart money" would view the confidence index as a bullish indicator; an increase in its value is a bullish sign.

  B. is equal to Barron's average yield on 10 top-grade bonds divided by the yield on the Dow Jones average of 100 bonds, multiplied by 100. Technical analysts who try to follow the "smart money" would view the confidence index as a bearish indicator; an increase in its value is a bearish sign.

  C. is equal to the yield on the Dow Jones average of 40 bonds divided by Barron's average yield on 40 topgrade bonds, multiplied by 100. Technical analysts who try to follow the "smart money" would view index values of under 100 to be bearish, and index values over 100 to be bullish.

  D. is equal to the yield on the Dow Jones average of 80 bonds divided by Barron's average yield on 80 topgrade bonds, multiplied by 100. Technical analysts who try to follow the "smart money" would view the index as a bullish indicator; an increase in its value is a bullish sign.

  Correct Answer: A

  The confidence index measures the yield spread between high-grade bonds (Barron's 10 top-grade bonds) and a large cross section of bonds (the Dow Jones average of 40 bonds). The yields on high-grade bonds should always be lower than the average on a wide cross-section, so the index should always have a value below 100. During periods of high confidence, investors are willing to invest more in low-quality bonds, causing their yields to decrease relative to the yields on high-grade bonds. So when confidence is high, the value of the index increases.

• Question 176:

  A firm's stock has a coefficient of variation of 0.85. It has a beta of 1.23 and a firm specific variance of 0.06. The market portfolio has an expected return of 14% and a standard deviation of 19%. The firm has a payout ratio of 0.3 and it obtains a return on equity equal to 10.3%. The firm's stock is trading at $25.1 per share. The risk-free rate in the economy is 5.4%. What's the dividend that the market expects the firm to pay out next year?

  A. $2.20

  B. $2.41

  C. $2.05

  D. $1.99

  Correct Answer: A

  The Dividend Discount Model implies that the firm's share price is given by Po = D1/(k-g), using standard notation. The dividend growth rate is given by g = ROE*(1-dividend payout ratio) = 10.3% * 0.7 = 7.21%. The CAPM expected rate of return on the stock is equal to the risk-free rate plus beta times the market premium. So the expected return on the stock is 5.4% + 1.23*(14 - 5.4)% = 15.98%. Therefore, the firm is expected to pay out $25.1*(15.98% - 7.21%) = $2.2.

• Question 177:

  Historically, the EPS figure for a stock market series has been less volatile than the earnings multiplier for the same series. Which of the following best characterizes the primary reason for the greater volatility experienced by the earnings multiplier? Choose the best answer.

  A. None of these answers is correct.

  B. The EPS figure is less volatile due to accounting manipulations and the malleability of international and domestic accounting standards including GAAP.

  C. The price-to-earnings figure experiences a tax leveraging effect that is not passed on to the EPS figure.

  D. The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking."

  E. The price-to-earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate.

  F. The earnings multiplier is more sensitive to changes in dividend policies than is the EPS figure.

  Correct Answer: E

  The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." 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.

  As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure.

• Question 178:

  The real Risk-Free Rate in different countries will vary widely due to which of the following factors?

  A. All of these answers

  B. Growth rate of the labor force

  C. Growth rate of the average number of hours worked

  D. Growth rate of labor productivity

  Correct Answer: A

  The real risk free rate is dependent on the growth rate, because typically an investor will want to have a return larger than the projected growth rate of an economy. The growth rate of an economy is affected by variables like the growth rates of the labor force, the work hours and productivity.

• Question 179:

  Technical analysis assumes that shifts in trends can be detected sooner or later in the action of the ________.

  A. consumer price index

  B. investment managers

  C. all of these answers

  D. market

  Correct Answer: D

  The four assumptions that support technical analysis are these:

  1.

  The market value of any good or service is determined solely by the interaction of supply and demand for it.

  2.

  Supply and demand are governed by numerous factors, both rational and irrational, including the economic variables relied upon by the fundamental analyst, as well as opinions, models and guesses. The market weights all of these factors continually and automatically.

  3.

  Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time.

  4.

  Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

• Question 180:

  Which of the following is not necessary to determine the price/earnings ratio for a stock market series?

  A. All of these are necessary to determine the P/E ratio for a stock market series.

  B. The dividend at D1.

  C. The EPS figure at t1.

  D. The expected growth rate of dividends.

  E. The required rate of return.

  Correct Answer: A

  All of the choices listed are components in the equation used to determine the earnings multiplier of a stock market series, as shown below:

  P/E = [(D1 / E1) / (k-g)

  Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.