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

• Question 291:

  Consider the following annual growth forecasts for a common stock:

  Growth in years 1-2 = 50% Growth in years 3-4 = 25% Growth after year 4 = 10%

  Assuming that the last dividend was $0.45 per share, and the required rate of return is 20% per year, what is the value of this common stock?

  A. $13.81

  B. $8.36

  C. $19.05

  D. $11.15

  E. $7.25

  Correct Answer: D

  To determine the value of a common stock experiencing temporary supernormal growth, use the following equation: {V = {[d0 * (1 + gs)^1] / k} + {[d1 * (1 + gs)^2} + ... {dn * (1 + gs)^n} + {[dn * (1 + gs)^n * (1 + gn] / (k - g)}/ (1

  + k)^n}}

  Where: V = the value of common stock at t0, d0 = the dividend at t0, d1 = the dividend at t1, dn = the dividend at tn, gs = the supernormal rate of growth, gn = the normal rate of growth, n = the time period "n", and k = the required rate of return.

  where

  In this example, there is a transitional growth period of two years, during which the growth rate is expected to grow at 25% annually. This period will follow the two-year supernormal growth period, and would be denoted as "g subset t" if we were to reproduce the equation illustrated above. The calculation of the value of this common stock is illustrated as follows:

  {V = {[$0.45 * (1.50)^1] / (1.20)} + {[$0.45 * (1.50)^2] / (1.20)^2} + {[$0.45 * (1.50)^2 * (1.25)^1] / (1.20)^3} + {[$0.45 * (1.50)^2 * (1.25)^2] / (1.20)^4} + {{[$0.45 * (1.50)^2 * (1.25)^2 * (1.10)^1]/ (0.20 - 0.10)}/ (1.20)^4}

  which can be deduced to the following:

  {V = [$0.5625 + $0.703125 + $0.732422 + $0.762939 + $8.392334] = $11.15}

• Question 292:

  Advocates of the top-down, three-step approach believe that

  A. an underpriced stock can be found from technical analysis.

  B. political considerations are not relevant to stock values.

  C. the economy and industry have a significant effect on the returns of individual stocks.

  D. the economy and industry have little effect on the returns of individual stocks.

  Correct Answer: C

  Advocates of the top-down, three-step approach stress the importance of economy and industry-wide conditions on stock values and returns.

• Question 293:

  Given the following estimated information, compute the estimated earnings per share.

  Net profit margin 3.2%

  Gross profit margin 28.1%

  Sales $11.44B

  Common shares outstanding 246,141M

  A. $13.06 per share

  B. none of these answers

  C. cannot compute with the information given

  D. $1.49 per share

  Correct Answer: D

  Earnings per share in this example equals sales x the estimated net profit margin/common shares outstanding = (.032 * 11.44)/.246141 = $1.49.

• Question 294:

  A value investor is examining shares of Clay Industries common stock for possible investor. This investor

  has a history of investing in companies trading below their "intrinsic value" and believes that ClayIndustries

  represents such a situation.

  In her research, this value investor has gathered the following information about Clay Industries:

  Total assets: $150,000,000

  Total liabilities: $119,000,000

  Number of common shares outstanding: 1,000,000

  Current stock price: $26.43 per share

  Required return: 17% per year

  Expected growth rate: 14.5% per year

  Next dividend: $1.05 per share

  Earnings per share: $2.85

  Using this information, what is the price-to-book ratio for Clay Industries common stock? Further, are the

  beliefs of this value investor justified, assuming that the book value of Clay Industries accurately illustrates

  the liquidation value of the firm?

  A. 1.17, no

  B. 9.27, yes

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

  D. 0.85, no

  E. 9.27, no

  F. 0.85, yes

  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 = [($150,000,000 - $119,000,000) / 1,000,000] = $31.

  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 = ($26.43 / $31) = 0.8526.

  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 less than one, a stock is said to be "trading at a discount to book."

  Frequently, investment professionals will use the term "intrinsic value" when referring to the book value,

  and thus stocks trading below their book value are often referred to as being priced "below their intrinsic

  value." Stocks trading below book value are often sought after by value investors, who believe that these

  shares have been discounted below their real value.

  A figure of more than one for the price-to-book ratio is commonly referred to as "trading at a premium to

  book."

  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 easily

  manipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buy-backs and

  write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.

• Question 295:

  Given that next period's dividend is 4, the required rate of return is 14%, and the dividend growth rate is 5%, what is the current value of the common stock (using the infinite period Dividend Discount Model)?

  A. $28.57

  B. Not enough information

  C. $44.44

  D. $31.50

  E. $29.84

  Correct Answer: C

  The infinite period Dividend Discount Model postulates that the current value of a common stock is equal to D1 / (k - g), where D1 is next period's dividend, k is the required rate of return, and g is the growth rate of dividends. In this question, the common stock is worth 4 / (0.14 - 0.05) = $44.44.

• Question 296:

  Changes in unit labor costs

  A. are the results of three factors: changes in wages per hour, changes in hours worked, and changes in worker productivity. Increased wages and hours worked increase unit labor costs, while increased productivity decreases unit labor costs. One would expect a logarithmically negative relationship between unit labor costs and the aggregate profit margin.

  B. are the results of three factors: changes in wages per hour, changes in hours worked, and changes in worker productivity. Increased wages, hours worked, and productivity all increase unit labor costs. One would expect a bell-shaped relationship between unit labor costs and the aggregate profit margin.

  C. are the results of two factors: changes in wages per hour, and changes in worker productivity. Increased wages increase unit labor costs, while increased productivity decreases unit labor costs. One would expect a negative relationship between unit labor costs and the aggregate profit margin.

  D. are the results of two factors: changes in wages per hour, and changes in worker productivity. Increased wages increase unit labor costs, while increased productivity decreases unit labor costs. One would expect a negative relationship between unit labor costs and the aggregate profit margin.

  Correct Answer: C

  Increases in the hourly wage increase unit labor costs, while productivity growth decreases unit labor costs. Because unit labor costs are a major variable cost of a firm, one would expect a negative relationship between unit labor costs and the aggregate profit margin.

• Question 297:

  Which of the following is not involved in determining a company's profit margin?

  A. Identifying and evaluating the firm's competitive strategy (low-cost-high-volume, differentiation).

  B. Evaluating the firm's dependency on the overall conditions prevailing in its industry.

  C. Identifying the firm's internal performance like past trends and potential future problems.

  D. Identifying and evaluating the risks involved in the company's cash flows.

  Correct Answer: D

  A company's profit margin is determined by many factors like its competitive strategy, the degree of monopoly it enjoys, the relative dependency on external factors versus internally generated performance, etc. However, while the risks involved in the cash flows are relevant considerations in determining the total level of earnings of a firm, they do not affect the percentage of the sales which translate into profits i.e. the profit margin. Of course, higher risks can and do lower the return on capital.

• Question 298:

  In a research report, a securities analyst with Smith, Kleen and Beetchnutty claims that the newly issued perpetual preferred stock of Ludicrous Telecom should be purchased because its current market price does not reflect its "intrinsic value." The analyst cites a higher valuation as evidenced by the results produced by the perpetuity valuation model. Assume the following information:

  Market price of Ludicrous Telecom preferred stock: $20.75 Quarterly preferred dividend: $0.80

  Expected return on the market: 14.75% per year Risk-free rate of return: 5.00% per year

  Given this information, are the claims of the analyst justified? If not, at what price is the preferred stock of Ludicrous Telecom fairly valued?

  A. None of these answers is correct.

  B. $4.05

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

  D. $21.70

  E. $16.00

  F. $5.42

  Correct Answer: C

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

  Value of preferred stock = {Annual dividend / required rate of return}

  However, in this example, the required rate of return on preferred stock is not provided, and thus the answer cannot be calculated.

• Question 299:

  Mermen, Inc., a manufacturer of male swimwear, has a return on equity of about 7.2%. It typically pays out about 33% of its earnings as dividends. The firm's stock has a covariance with the market of 0.045. The market has an expected return of 12.9% and a standard deviation of 19.4%. The prevailing risk-free rate is 4.9% and Mermen's stock return has a standard deviation of 23%. Most analysts in the market are of the opinion that Mermen's EPS next year is likely to be around $9.20 per share. Given these data, Mermen's share price should be about:

  A. $41.62

  B. $29.28

  C. $37.22

  D. $38.94

  Correct Answer: C

  The CAPM expected rate of return on the stock is equal to the risk-free rate plus beta times the market premium. The beta of the stock equals 0.045/(0.194 * 0.23) = 1.01. So the expected return on Mermen's stock is 4.9% + 1.01*(12.9 - 4.9)% = 12.98%. The Dividend Discount Model implies that Mermen's share price is given by Po = D1/(k-g), using standard notation. We have D1 = 0.33 * 9.2 = $3.036. The dividend growth rate is given by g = ROE*(1-dividend payout ratio) = 7.2% * 0.67 = 4.824%. The price of the stock then equals 3.036/(12.98% - 4.824%) = $37.22.

• Question 300:

  Which of the following is/are true about the confidence index?

  I. It measures the spread between high-grade bonds and a broad cross-section of bonds.

  II. It indicates investor confidence and their appetite for risk.

  III.

  A high value of the confidence index is interpreted by technicians as a bullish indicator.

  A.

  I, II and III

  B.

  II only

  C.

  II and III

  D.

  I and III

  E.

  III only

  F.

  I only

  Correct Answer: A

  The Confidence index is the ratio of the average yield on 10 top grade bonds to the Dow Jones average of 40 bonds. The index measures the difference in yield spreads between high-grade bonds and a large cross-section of available bonds. An increase in this index implies that the yield spread between the bonds has narrowed. From a demand perspective, this will happen when the demand for riskier bonds rises i.e. when investors are bullish. Similarly, a fall in the index value indicates that investors are bearish.