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

• Question 221:

  ROE is equal to

  A. net sales divided by equity.

  B. net income divided by total capital.

  C. net income divided by equity.

  D. Risk-free rate divided by equity.

  Correct Answer: C

  Return on equity (ROE) multiplied by the retention rate is equal to the growth rate of earnings and dividends. The growth rate, in turn, is used to derive the earnings multiplier, which is used to value stocks.

• Question 222:

  SandP 500 sales have been estimated at $723 per share while the operating profit margin has been estimated at 16.6%. The average tax rate on SandP 500 companies is about 40%, with an average depreciation of 4.7% and an interest expense of 1.3%, all expressed as a percentage of sales. The average payout ratio on SandP 500 is 17%. Assuming a 2.8% growth rate in the economy and an investor demand of 12% return on equity, the per share SandP 500 must be valued at:

  A. $123.22

  B. $87.34

  C. $79.11

  D. $84.96

  Correct Answer: B

  operating profits = Earnings before depreciation, interest and taxes = EBDIT and operating profit margin = EBDIT/net sales. Therefore, net income/sales = (EBDIT/sales - depreciation/sales - interest/sales)*(1-tax rate) = (16.6% - 4.7% - 1.3%)* (1-40%) = 6.36%.

  Thus, earnings = 6.36% * 723 = $45.98 per share.

  In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). In this case, g = 2.8% and the expected dividend per share next year = 45.98 * 17%*(1+2.8%) = $8.04 per share. Therefore, Po = 8.04/ (12% - 2.8%) = $87.34 per share.

• Question 223:

  Preferred stock is

  A. like a perpetuity. The holder of the stock receives a promise from the issuer to pay a stated dividend, usually each quarter, for an infinite period. Because of tax advantages, the yields on preferred stocks tend to be lower than those on bonds.

  B. like an annuity. The holder of the stock receives a promise from the issuer to pay a stated dividend, usually once a year, for a long but finite period of time (usually 100 years). Because the dividend payments on preferred stocks are not as certain as coupon payments on bonds, preferred stocks tend to have higher required rates of return than most bonds.

  C. like an annuity. The holder receives a promise from the issuer to pay a stated dividend, usually semiannually, for an infinite period of time. Because the dividend payments on preferred stocks are not as certain as coupon payments on bonds, preferred stocks tend to have higher required rates of return than most bonds.

  D. like a perpetuity. The holder of the stock receives a promise from the issuer to pay a stated dividend, usually semiannually, for a long but finite period of time (usually 100 years). Because of tax advantages, the yields on preferred stocks tend to be lower than those on bonds.

  Correct Answer: A

  Payments of dividends for preferred stocks are only made after the firm meets its bond interest payments. One would expect the required rates of return on preferred stocks to be higher than those onbonds for this reason, but because of tax advantages, the preferred stock yields are actually lower than those on even the highest-grade corporate bonds. 80% of intercompany preferred dividends are tax-exempt, thereby increasing demand for preferred stocks and decreasing yields.

• Question 224:

  Firms in which of the following industries would likely have the highest earnings retention rate? Further, are firms in this industry are likely to be financed primarily through debt or equity?

  A. Media; debt

  B. Fiber optics networking; equity

  C. Fiber optics networking; debt

  D. Media; equity

  E. Computer manufacturing; debt

  F. Computer manufacturing; equity

  Correct Answer: B

  Of the industries listed, fiber optics networking would be expected to have the highest earnings retention rate. The fiber optics networking industry is characterized by a high degree of investment in research and development, along with a high growth rate and level of uncertainty. All of these factorsare conducive to a high retention rate, i.e. a low dividend payout ratio. Further, firms within industries associated with high growth rates and high levels of uncertainty are likely to be financed primarily with equity. This is reasoned by several factors, some of which include the following: Firms in new industries typically have a balance sheet weighted heavily toward intangible assets, which can neither be easily liquidated nor pledged as collateral for a loan. Firms in new industries are characterized by a high degree of research and development expenses. Equity provides firms in emerging industries with a higher degree of agility than debt financing. The cash flows of firms in developing industries are characterized by a high degree of uncertainty, which often prevents the reliable payment of debt obligations.

• Question 225:

  You are going to hold a stock for an infinite amount of time. The current dividend is $1 per share and is expected to grow at 9% a year. Your long run required return is 13%. Using the infinite period dividend discount model calculate the value of the stock.

  A. $27.25

  B. none of these answers

  C. $28.04

  D. $26.45

  Correct Answer: A

  First determine D1, which is the next period dividend. In this case it should be $1.09. Next use the formula V = D1/(k - g) or V = $1.09/(0.13 - 0.09) = $27.25.

• Question 226:

  If the debit balances in brokerage accounts increase, the smart money technicians interpret it as:

  A. none of these answers.

  B. a bullish signal.

  C. a hold signal.

  D. a bearish signal.

  Correct Answer: B

  Debit balances in brokerage accounts represent margin debt i.e. borrowings by investors from the brokerages for investment in the market. Smart money technicians consider margin investors as a group of astute investors and hence interpret large leveraged investments as a bullish signal. Therefore, an large increase in the debit balances is considered a bullish sign while a decline is considered a bearish sign.

• Question 227:

  According to the Dow Theory, a typical bullish price pattern

  A. will have periodic sell-offs at high volume.

  B. will not have troughs.

  C. will have continuously increasing stock prices.

  D. may have troughs.

  Correct Answer: D

  According to the Dow Theory, there should be a general upward price movement during a bull market, perhaps punctuated by occasional low-volume sell offs because of profit taking. Every recovery from a sell off should reach a higher peak than that resulting from the previous recovery.

• Question 228:

  If the spread between the required rate of return and the anticipated dividend growth rate were to decrease significantly and suddenly while the remaining components of the P/E ratio were to remain unchanged, which of the following would likely occur? Further, a decrease in the retention rate wouldlead to what effect on the earnings multiplier, holding both the required return and expected growth rate constant?

  A. The earnings multiplier would decrease; the earnings multiplier would decrease.

  B. The earnings multiplier would increase; the earnings multiplier would increase.

  C. The earnings multiplier would increase; the earnings multiplier would decrease.

  D. The earnings multiplier would decrease; the earnings multiplier would increase.

  E. The earnings multiplier would increase; the earnings multiplier would either increase or decrease depending on the firm's return on equity compared to its cost of capital.

  Correct Answer: B

  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 the spread between k and g narrows, the earnings multiplier figure will increase. Indeed, the earnings multiplier is very sensitive to changes in the spread between k and g, and this is the primary reason for the greater relative volatility of the P/E ratio versus the EPS figure for a stock market series.

  A decrease in the retention rate will lead to an increase in the earnings multiplier figure, holding everything else equal. Remember that the retention rate is simply (1 - dividend payout ratio). So said, a decline in the retention rate is analogous to an increase in the dividend payout ratio. An increase in the dividend payout ratio, holding everything else equal, will lead to an increase in the earnings multiplier figure.

• Question 229:

  An analyst with Churn Brothers is examining shares of Microscam International, a multinational software firm, for possible investment. Shares of Microscam are anticipated to grow at a rate of 20% per year for the next two years, then grow at 15% in the third year. Thereafter, the growth rate of Microscam International is expected to be at 11% per year forever. Similar investments have warranted a 15% per year rate of return, and Microscam paid a dividend of $0.50 at t0. Using this information, what is the value of Microscam International common stock? Use the two-stage dividend discount model.

  A. $16.72

  B. $26.39

  C. $21.39

  D. $22.59

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

  F. None of these answers is correct.

  Correct Answer: A

  The multi-stage dividend discount model is a more realistic way of valuing fast-growing companies that pay dividends. With this model, it is necessary to estimate the above-average, or "supernormal" rate of growth, as well as the long-term rate of growth. Once these growth rates have been determined, they are used to calculate the dividends at various points in the future. In this example, you are provided with two supernormal growth rates, in addition to the long-term rate of growth, and the calculation is somewhat more complex than a situation characterized by a single supernormal growth rate. Nonetheless, the multistage dividend discount model can be applied.

  The multi-stage dividend discount model is often referred to as the "two-stage dividend discount model," and these two titles should be considered interchangeable for all intents and purposes, i.e. the "two stage" dividend discount model can be used to determine the value of a company that has multiple growth rate changes.

  Incorporating the given information into the multi-stage dividend discount model will yield the following: P = {[$0.50 * 1.20) / 1.15] + [($0.60 * 1.20) / 1.3225] + [($0.72 * 1.15) / 1.52087] + [($0.828 * 1.11) / (.15 11)]/1.52087}

  which can further be developed into:

  P = {$0.52174 + $0.54442 + $0.54442 + $15.11} = $16.72

• Question 230:

  The NAV of an open-ended fund is $6.35. The fund charges a 9% sales charge and no redemption charges. The price at which you can purchase a share of the fund equals ________.

  A. none of these answers

  B. $6.98

  C. $6.92

  D. $6.35

  Correct Answer: B

  The offer price i.e. the price at which you can buy a share equals NAV/(1-load charge) = 6.35/(1-0.09) =

  $6.98

  Be careful NOT to calculate the offer price as NAV*(1 + load charge). The sales charge is expressed as an

  percentage of the amount you deposit. In this example, you deposit $6.98 and get a share worth $6.35 =

  $6.98*(1-0.09)