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

• Question 181:

  When investors are pessimistic about the market, the confidence index should have A. a value over 100.

  B. a low value.

  C. a high value.

  D. a value over 85.

  Correct Answer: B

  The confidence index measures the yield spread between high-grade bonds and a large cross section of bonds. Technical analysts believe that during periods of low confidence, investors are less willing to invest in lower-quality bonds, thereby pushing up their yields, and decreasing the confidence index. A low index value is thus viewed as a bearish sign.

• Question 182:

  Using a time series, an economist with Churn Brothers Brokerage examines the relationship between the historical earnings multiple of the banking industry with that of the SandP 500 index. The results of this time series are used to project an estimate of the future earnings multiple for the banking industry. Which of the following best characterizes this method of forecasting an industry earnings multiple? Choose the best answer.

  A. Monte Carlo simulation

  B. Macroanalysis

  C. Time series regression

  D. Microanalysis

  E. None of these answers is correct

  F. Porter Method

  Correct Answer: B

  The method profiled in this example is "macroanalysis," which is one of two methods for estimating the earnings multiplier of an industry. Macroanalysis involves examining the historical relationship between the earnings multiplier of an industry with that of the overall market. Macroanalysis forecasts often use a time series.

  The macroanalysis method is contrasted by microanalysis, which involves examining the variables underlying the earnings multiplier - the required rate of return, the growth forecast, and the dividend payout ratio. In microanalysis, these variables are examined for the industry and then compare them with the values of these variables for the entire market.

  The "Porter Method" is used to examine the level of competition in an industry, and "Monte Carlo simulation" is a method of measuring stand-alone risk. While "time series regression" is an appealing choice, it does not represent the best possible answer.

• Question 183:

  A firm has an expected dividend payout ratio of 60%, and an expected dividend growth rate of 5% per year. What is the firm's Price/Earnings ratio if the appropriate discount rate is 8% per year?

  A. 20

  B. Not able to compute with the above data.

  C. 200

  D. 2

  Correct Answer: A

  Value = 0.60/(0.08-0.05) = 20.

• Question 184:

  The multiplier effect is caused by

  A. government fiscal and monetary policy.

  B. government fiscal policy.

  C. government monetary policy.

  D. inflation.

  E. inflation and interest rates.

  Correct Answer: B

  The multiplier effect is the effect government (fiscal) spending has on the broader economy. For example, a certain amount of spending on roads by the government increases demand for earthmoving equipment, concrete, and other items, causing firms that supply those items to themselves require more materials and employees. This results in the government's spending being amplified (or multiplied) beyond the amount that is directly spent.

• Question 185:

  Given that the risk-free rate of return is 7%, what is the value of a bond with coupon payments of $100 every six months, a final payment of $2,000 in 8 years, and a risk-premium of 5%?

  A. $1,532.69

  B. $2,320.56

  C. $1,818.40

  D. Not enough information

  E. $1,285.38

  Correct Answer: C

  The value of bond is equal to the present value of the stream of coupon payments (which can be thought of as an annuity for a certain number of years) plus the present value of the final payment. The required rate of return on the bond is equal to the risk-free rate of return plus the risk-premium (7+5=12% for the year, 6% for six months). Using appendix C in the book by Reilly and Brown, the present value of the coupons is $100 x 10.106 = $1,010.60. The present value of the final payment is $2,000 x 0.4039 = $807.80, or $2,000/(1.06^16). The value of the bond is 1010.60 + 807.80 = $1818.40. Note that many textbooks recommend using the six-month interest rate and doubling the number of yearly periods in making this calculation. Using 6% for 16 periods, the value of the final payment is $787.40 and the total value of the bond is 1010.60 + 787.40 = $1,798.

• Question 186:

  The infinite period ________ model assumes that k is greater than g.

  A. growth

  B. SP

  C. Dividend Discount Model

  D. valuation

  Correct Answer: C

  The infinite period Dividend Discount Model has the following assumptions:

  1.

  Dividends grow at a constant rate

  2.

  The constant growth rate will continue for an infinite period

  3.

  The required rate of return (k) is greater than the infinite growth rate (g). If it is not, the model gives meaningless results because the denominator becomes negative.

• Question 187:

  The infinite period Dividend Discount Model is likely to be more effective in the case of a ________.

  A. mature firm

  B. all of these answers

  C. small firm

  D. growth firm

  Correct Answer: A

  The infinite period Dividend Discount Model assumes a constant dividend growth rate (which could well be zero). This assumption is only reasonable for a mature firm that has settled in its industry. A growth firm will have highly erratic dividends, depending on the available cash flows.

• Question 188:

  In general, the earnings multiplier for a stock market series is a more volatile figure than the earnings-pershare for the same series. The greater relative volatility of the earnings multiplier is mostly attributable to which of the following?

  A. The EPS figure is subject to cash flow adjustments, which "normalize" the EPS figure over time.

  B. The earnings multiplier is subject to a tax-deleveraging effect.

  C. The earnings multiplier is more sensitive to changes in the payout ratio.

  D. The earnings multiplier is more sensitive to changes in the spread between k and g.

  E. None of these answers is correct.

  Correct Answer: D

  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 earningsmultiplier 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 189:

  Given that the expected dividend payout ratio on a common stock is 0.65, the required rate of return is 15%, and the dividend growth rate is 6%, using the earnings multiplier model, what is the P/E ratio?

  A. Not enough information

  B. 8.20

  C. 6.75

  D. 7.22

  E. 10.59

  Correct Answer: D

  The infinite period Dividend Discount Model claims that the current price of a common stock is equal to D1 / (k - g), where D1 is next period's (most often next year's) dividend, k is the required rate of return, and g is the growth rate of dividends. The earnings multiplier model goes a step further by dividing both sides of the infinite period Dividend Discount Model equation by expected earnings during the next 12 months, yielding P/E = (D1/E) / (k - g). In this question, the P/ E ratio is equal to 0.65 / (0.15 - 0.06) = 7.22.

• Question 190:

  Assume the following information about a stock market series:

  Observed beginning series value: 515.60 Anticipated ending series value: 609.15 Expected dividends during the period: $24 Required rate of return: 21% per year

  What is the expected annual rate of return for this index? (Assume a one-year holding period.)

  A. None of these answers is correct.

  B. 13.49%

  C. 19.30%

  D. 11.42%

  E. 22.80%

  Correct Answer: E

  To calculate the expected rate of return for a stock market series, the following information must be known:

  The beginning value for the series

  The anticipated ending value for the series, and

  The amount of any dividends and/or distributions during the period

  Once this information has been determined, the expected return on a stock market index can be found by

  employing the following equation:

  E(R) = [(EV - BV + Div) / BV]

  Where: E(R) = the expected return on the stock market series, EV = the anticipated ending value for the

  series, BV = the observed beginning value for the series, and Div = the amount of any dividends paid

  during the period.

  In this example, all of the necessary information has been provided and the calculation of the expected

  return on this stock market series is found as follows:

  E(R) = [$609.15 - $515.60 + $24] / $515.60 = 22.80%

  This is slightly higher than the required rate of return. Assuming that the ending value and dividends prove

  accurate, investment in this stock market series is likely advisable.