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

• Question 11:

  When using macroanalysis in estimating an industry earnings multiplier

  A. you first estimate the industry growth rate (g) which is determined by the retention rate and the return on equity.

  B. you examine the relationship between the multiplier for the industry and the market.

  C. you first estimate the industry required rate of return (k) because this is influenced by the risk-free rate and the expected inflation rate.

  D. you compute an average multiplier for the industry.

  E. you examine the specific variables that influence the earnings multiplier.

  Correct Answer: B

  The two alternative techniques to estimate an industry earnings multiplier aremacroanalysis, where you examine the relationship between the multiplier for the industry and the market, and microanalysis where you examine the specific variables that influence the earnings multiplier.

• Question 12:

  If the 200-day moving average for a stock is well above its current price, then

  A. the stock price must have experienced an overall upturn. If the current price slide reverses itself, and the stock price moves above its 200-day moving average on heavy volume, technical analysts would view this as a very positive sign.

  B. the stock price must have experienced an overall downturn. If the current price slide reverses itself, and the stock price moves above its 200-day moving average on heavy volume, technical analysts would consider this to be a sign that the stock is overbought.

  C. the stock price must have experienced an overall downturn. If the 50-day moving average is also below the 200-day moving average, but then moves up above the 200-day moving average, technical analysts would consider this a sign that the market is overbought.

  D. the stock price must have experienced an overall downturn. If the 50-day moving average is also below the 200-day moving average, but then moves up above the 200-day moving average on heavy volume, technical analysts would consider this to be a bullish sign.

  Correct Answer: D

  In order for a moving average of a stock price to be below the current price, the stock price must have experienced an overall decline. Technicians believe that the current price breaking through the moving average from below on heavy volume is a very positive sign, and may well signal the reversal of the declining trend. If the current price breaks through the moving average from above on heavy volume, this would be taken as a very negative sign. The same is true of changes in the relative positions of a longer moving average and a shorter moving average.

• Question 13:

  Which of the following events would a technical analyst interpret as bearish?

  A. a low rate of odd-lot short sales as a percentage of total odd-lot sales

  B. decline in credit balances

  C. all of these answers

  D. a low mutual fund cash position

  Correct Answer: B

  Credit balances result when investors sell stocks and leave the proceeds with their brokers, expecting to reinvest them shortly. Technicians view a decline of credit balances as a decrease in buying power and a bearish sign.

• Question 14:

  The ________ index shows the number of stocks advancing plus one-half the number unchanged, divided by the total number of issues traded.

  A. short

  B. cumulative

  C. contrarian

  D. diffusion

  Correct Answer: D

  By definition: The diffusion index shows the number of stocks advancing plus one-half the number unchanged, divided by the total number of issues traded. Such an index gives an idea of how many individual stocks are advancing as a percentage of all the individual stocks in a composite index.

• Question 15:

  The divergence between the trend for the stock market series and the cumulative advance-decline series signals a market ________.

  A. peak

  B. adjustment

  C. crash

  D. trough

  Correct Answer: A

  The usefulness of the advance-decline series is supposedly greatest at market peaks and troughs. The divergence between the trend for the stock market series and the cumulative advance-decline series signals a market peak.

• Question 16:

  Which of the following is not one of the three steps of the top-down, three-step approach to stock valuation?

  A. Analysis of alternative industries

  B. Analysis of countries and regions

  C. Analysis of the economy and security markets

  D. Analysis of individual firms and stocks

  Correct Answer: B

  Although analysis of alternative countries and regions may be undertaken, that analysis is done under the more general step of analyzing the economy and security markets.

• Question 17:

  The ________ approach begins with the current earnings multiplier and estimates the direction and extent of a change in the specific factors affecting dividend payout, required rate of return and growth rate of dividends.

  A. specific estimate

  B. current earnings

  C. direction of change

  D. gross magnitude

  Correct Answer: C

  There are two ways to estimate the earnings multiplier: (1) Direction of change approach and (2) Specific estimate approach. The first focuses on change and change direction, while the other focuses on scenariobased estimates.

• Question 18:

  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; debt

  C. Retail banking; equity

  D. Automobile manufacturing; equity

  E. Pharmaceuticals; debt

  F. Pharmaceuticals; equity

  Correct Answer: F

  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 19:

  A junior analyst with Smith, Kleen and Beetchnutty is performing an analysis of Microscam Incorporated. Assume the following information:

  g = 20% per year k = 21% per year EPS = $3.10

  D0 = $0.68

  Using this information, what is the P/E ratio for Microscam shares?

  A. None of these answers is correct.

  B. 24.32

  C. 26.32

  D. 15.82

  E. 18.78

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

  Correct Answer: C

  By dividing each side of the infinite period dividend discount equation by the EPS figure, it is possible to determine the P/E ratio. This is illustrated as follows:

  P/E = (D1 / EPS)/(k-g)

  Where: D1 = the dividend at t1, EPS = the earnings per share calculation for t1, k = the required rate of return, and g = the expected growth rate.

  Manipulating the infinite period dividend discount model to solve for the PE is a rather intuitive process. Consider the fact that an investment's value is truly nothing more than the present value of all future returns. So said, dividing both sides of the infinite period dividend discount model equation should yield the appropriate multiple, or "earnings multiplier." This is the price-to-earnings ratio.

  In this example, we are provided all of the necessary information. However, the dividend at t1 must be calculated manually by multiplying D0 by (1 + growth rate). This will yield a figure of $0.816 for D1.

  Now that D1 has been determined, we can solve for the P/E. Imputing all the given information into the equation provided above will yield the following:

  P/E = ($0.816 / $3.10) / (21% - 20%) = 26.32

• Question 20:

  Assume the following information about a publicly traded utility company:

  Next annual dividend: $2.10 Earnings per share next year: $2.91 Anticipated growth rate: 7.5% per year Required rate of return: 10.5% per year

  What is the expected earnings multiplier for this utility company?

  A. 24.05

  B. None of these answers is correct.

  C. 13.30

  D. 26.60

  E. 46.20

  F. 75.25

  Correct Answer: A

  To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula:

  P/E = [(d1 / e1) / (k - g)]

  Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate. In this example, all of the necessary information has been provided, but some rearranging is necessary. Specifically, the dividend payout ratio must be determined. This figure is found as follows:

  Dividend payout ratio = [$2.10 / $2.91] = 0.721649, or 72.16%

  Now that the dividend payout ratio has been determined, we can solve for the appropriate earnings multiplier. The calculation of this figure is found as follows:

  P/E = [0.7216 / (0.105 - 0.075)] = 24.05

  This is a relatively high multiple for a utility company growing by 7.5% per year. (Although this figure is not completely beyond the realm of reason.) An analyst examining this stock would likely regard this earnings multiplier with some degree of caution. Further analysis would probably be warranted.