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

• Question 201:

  What is the value of coupon and principal payments on a 10-year bond with coupon payments of $50 every six months (for a total of 20 payments), a principal payment of $8,000 in 10 years, and a required rate of return of 8%?

  A. Coupons: $938.48, Principal: $4932.34

  B. Coupons: $743.39, Principal: $5546.50

  C. Coupons: $679.50, Principal: $3705.60

  D. Coupons: $549.50, Principal: $2834.65

  E. Not enough information

  Correct Answer: C

  The value of coupon payments can be thought of as the value of an annuity with 20 periods, and with a rate of return of 4% (half of 8%) for each period. Using appendix C in the book by Reilly and Brown, the present value of the coupons is equal to 50 x 13.59 = $679.50. Using the same appendix, the present value of the principal payment is equal to 8000 x 0.4632 = $3705.60. Note that many textbooks recommend using the six-month interest rate and doubling the number of yearly periods in making this calculation. Using 4% for 20 periods, the value of the final payment is $8,000/(1.04^20) = $3,651.

• Question 202:

  Which of the following calculations can be successfully performed without knowing the required rate of return?

  I.Net Present Value II.Internal Rate of Return III.Modified Internal Rate of Return IV.Time-Weighted Rate of Return V.Dollar-Weighted Rate of Return VI.Valuing a common stock using the Dividend Discount Model VII.Valuing a common stock using the Free-Cash-Flow-to-Equity Model

  A. II, V, VI

  B. II, IV, V

  C. I, II, VI

  D. II, IV, V, VI, VII

  E. II, IV, VI, VII

  Correct Answer: B

  Of the financial figures listed, only the Internal Rate of Return, which is also known as the "Dollar-weighted Rate of Return," and the Time-Weighted Rate of Return, can be calculated without knowing the required rate of return.

• Question 203:

  Which of the following best describes the relationship between the relative maturation of an industry and the retention ratio of companies within the industry? Further, what is the proposed relationship between expected growth and the relative maturity of an industry?

  A. Negative relationship; negative relationship

  B. Positive relationship; negative relationship

  C. Negative relationship; positive relationship

  D. Negative relationship; no correlation E. Positive relationship; positive relationship

  Correct Answer: A

  As an industry advances in maturity, growth of the overall industry will decline. As growth opportunities diminish, companies within the industry will be forced to pay out a larger proportion of their earnings as dividends; i.e. the dividend payout ratio will increase. Remember that the retention ratio is equal to (1 - the dividend payout ratio). Thus, the retention ratio of companies will likely decline as the industryadvances in maturity. The relationship between the dividend payout ratio and the maturity of the industry is negative and loosely linear.

  As an industry becomes more mature, growth opportunities decline. This relationship is also loosely linear.

• Question 204:

  An analyst is attempting to value shares of a Clay Industries, and has solicited the help of a senior financial analyst. During their conversation, the senior financial analyst provides the following information about Clay Industries:

  Required rate of return on the bank's equity: 13.50% per year Free cash flow to equity multiple at t4: 21

  2,000,000 shares outstanding

  Additionally, the analyst has obtained the following estimates of free cash flow to equity over the next five years:

  Year 1: $3,500,000 Year 2: $3,750,000 Year 3: $3,400,000 Year 4: $4,000,000 Year 5: $4,150,000

  Using this information, what is the value per share of this Clay Industries' shares according to the Free Cash Flow to Equity Model?

  A. $34.02

  B. None of these answers is correct.

  C. $23.78

  D. $29.60

  E. $21.34

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

  Correct Answer: D

  When determining the value of a common stock using the free cash flow to equity model, it is necessary to determine three things:

  1.

  The required rate of return on equity investments.

  2.

  The estimated free cash flow to equity multiple at time "k."

  3.

  The estimated free cash flows figures for the time periods leading up to "k."

  In this example, the calculation must begin with the discounting the free cash flow to equity figures for each

  of the four years provided. These figures are discounted each period by the required return on equity

  investments, and the final answer is converted to a per-share basis. This process is illustrated below:

  Year 1: ($3.500,000 / 1.135) / 2,000,000 shares outstanding = $1.54

  Year 2: [$3,750,000 / (1.135)(1.135)] / 2,000,000 shares outstanding = $1.46

  Year 3: [$3,400,000 / (1.135)(1.135)(1.135)] / 2,000,000 shares outstanding = $1.16

  Year 4: [$4,000,000 / (1.135)(1.135)(1.135)(1.135)] / 2,000,000 shares outstanding = $1.21

  Year 5: [$4,150,000 / (1.135)(1.135)(1.135)(1.135)(1.135)] / 2,000,000 shares outstanding = $1.10

  Now that the free cash-flow-to-equity figures have been discounted and converted to a per-share basis,

  the next step in the valuation process is to determine the value of the final cash flow, which is defined as:

  [(Free cash flow to equity multiple * Final free cash flow) / (1 + r)(1+r)...(1 + k)]

  In the body of this question, we were given the anticipated multiple of free cash to equity that shares of

  Intelligent Semiconductor will sell for at time period: specifically, 21 times. Imputing this information into the

  terminal cash flow equation will yield the following:

  {[21 * ($4,150,000 / 2,000,000 shares outstanding)] / [(1.135) (1.135)(1.135)(1.135)(1.135)]} = $23.13.

  Adding the answers from step 1 to the final year cash flow will yield the following:

  Value of Intelligent Semiconductor = [$1.54 + $1.46 + $1.16 + $1.21 + $1.10 + 23.13] = $29.60 per share.

• Question 205:

  An increase in debit balances would be a bullish sign. This relates to:

  A. Block Uptick-Downtick Ratio

  B. Mutual Fund Cash Positions

  C. Relative Trend

  D. Odd-Lot, Short-Sales Theory

  E. Dow Theory

  F. Short Sales by Specialists

  G. Margin Debt

  H. Diffusion Index

  Correct Answer: G

  Debit balances in brokerage accounts represent borrowing by knowledgeable investors from their brokers. Such borrowing is called margin debt. In such cases, an increase in debit balances would be a bullish sign.

• Question 206:

  The real risk free rate is 6% per year and the expected inflation rate is 2% per year. What is the annual nominal rate of interest?

  A. Not able to compute with the above data.

  B. 8.1%

  C. 4%

  D. 8%

  Correct Answer: B

  Nominal rate = (1.06)*(1.02)=8.1%.

• Question 207:

  James Clinton, a portfolio manager with Middle Road Investment Advisors, is trying to estimate the appropriate earnings multiplier for the automobile industry. In his analysis, James examines the expected growth rate of dividends for the industry, as well as the expected dividend payout ratio and required rate of return. From this information, James proceeds toward an estimation of the earnings multiplier for the series.

  Which of the following best describes this method of estimating an earnings multiplier for an industry?

  A. The specific estimate approach

  B. Macroanalysis

  C. Microanalysis

  D. The rate of change approach

  E. The arbitrage pricing method

  F. Input-output analysis

  Correct Answer: C

  The answer called for in this question is "microanalysis." This method involves an examination of the components of the earnings multiplier, including the anticipated growth rate of dividends, the required rate of return, and the dividend payout ratio. Once these variables have been examined, both from the perspective of trend analysis and point estimation, a value for the earnings multiplier is deduced. Microanalysis is contrasted by macroanalysis, which involves an examination of the relationship between the earnings multiplier of a stock market series and the earnings multiplier of the overall market. For example, an individual projecting an earnings multiplier for a software index using macroanalysis would begin by examining the relationship between the P/E ratio of the software index and the P/E ratio of a broad market index such as the Standard and Poors 500. Both historical trends and point estimates would be examined, and from this information, a projection of the earnings multiplier for the stock market series is deduced.

  Input-output analysis is used in the examination of competitive forces within an industry. The arbitrage pricing model is a security valuation model which allows for several relevant "situation specific" variables. Finally, the "specific estimate" and "rate of change" approaches are used to estimate the earnings multiplier of a stock market series, rather than an industry.

• Question 208:

  A retail investor is considering the purchase of Intelligent Semiconductor common stock, believing the shares have bottomed. In his analysis, the retail investor has gathered the following information:

  Total assets: $640,000,000 Total liabilities: $510,000,000 Number of common shares outstanding: 1,500,000 Current stock price: $110.56 per share Required return: 17.75% per year Expected growth rate: 15.50% per year Next dividend: $2.26 per share Earnings per share: $7.89

  Using this information, what is the price-to-book ratio for Intelligent Semiconductor? Further, should Intelligent Semiconductor be considered as trading at a discount or a premium to its book value?

  A. None of these answers is correct.

  B. 1.27, discount

  C. 14.01, premium

  D. 34.84, premium

  E. 14.01, discount F. 1.27, premium

  Correct Answer: F

  The book value of a common stock is found by dividing the net worth of a company by the number of outstanding shares. While there exists several different methods for calculating net worth, the most simplistic involves subtracting total liabilities from total assets, giving us the shareholder's equity figure. Investment professionals often see the book value as a "floor" for common stock prices, and the price-tobook ratio is quite popular in the field of investment management. The calculation of the price-to-book ratio involves the following equation:

  Price-to-book ratio = {Market price of common stock at t0 / [(total assets - total liabilities) / # of common shares outstanding]}

  While the # of common shares outstanding has been provided, the shareholder's equity figure must be calculated manually. The calculation of the per share shareholders equity is illustrated as follows:

  Shareholders equity = [($640,000,000 - $510,000,000) / 1,500,000] = $86.67.

  Now that the shareholders equity has been calculated and transformed into a per-share figure, the pricetobook value can be calculated as follows:

  Price-to-book value = ($110.56 / $86.67) = 1.276.

  As you can see, the required rate of return, along with the expected growth rate, is not necessary in the calculation of the price-to-book ratio.

  Any time the price-to-book ratio is greater than one, a stock is said to be "trading at a premium to book." Frequently, investment professionals will use the term "intrinsic value" when referring to the book value. A figure of less than one for the price-to-book ratio is commonly referred to as "trading at a discount to book." Stocks trading below book value are often sought after by value investors, who believe that these shares have been discounted below their real value.

  While the price-to-book value is a useful tool in the stock selection process, it possesses some important flaws. One problem with the Price-to-Book Ratio is that one of the terms - Book Value - is so easilymanipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buybacks and write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.

• Question 209:

  ________ means that the present value of expected cash inflows exceeds the asset's market price.

  A. Expected value

  B. Extra value

  C. Excess present value

  D. Past value

  Correct Answer: C

  By definition: the amount the PV of expected cash flows exceeds the asset's market price is excess present value. This is also called excess economic value or excess economic returns.

• Question 210:

  A portfolio manager with Churn Brothers Brokerage is examining shares of a newly-issued perpetual preferred stock for possible investment. The preferred stock is expected to pay a quarterly dividend of $0.70, and the required rate of return is 12.50% per year. At what price would this preferred stock be fairly valued?

  A. None of these answers is correct.

  B. $14.29

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

  D. $18.00

  E. $5.60

  F. $22.40

  Correct Answer: F

  Assuming that the quarterly dividend is to remain unchanged forever allows us to use the standard perpetuity model for preferred stock, which is illustrated as follows:

  Value of preferred stock = (Annual dividend / required rate of return)

  In this example, we are given the quarterly dividend, which must be annualized before it can be imputed into the perpetuity valuation equation. So said, a quarterly dividend of $0.70 translates into a yearly dividend of $2.80. Incorporating this yearly dividend into the perpetuity valuation model will result in the following:

  Value of preferred stock = {$2.80 / 0.125} = $22.40