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

• Question 341:

  A market analyst is examining the financial performance of a large pharmaceutical firm, and has assimilated the following information:

  Adjusted operating profits before taxes: $26,700,000 Cash operating taxes: $9,000,000 Cost of capital: 14.5% per year Total capital employed: $127,000,000

  Using this information, what is the Economic Value Added for this large pharmaceutical firm? Further, should the management of this Company be considered to have created value for shareholders?

  A. None of these answers is correct.

  B. $611,354; management has created economic value

  C. $611,354; management may have created economic value

  D. ($715,000); management has not created economic value

  E. ($715,000); management has created economic value

  F. $715,000; management has created economic value

  Correct Answer: D

  Economic Value Added, a value-based measure of economic profit, is a registered trademark of Stern, Stewart and Company. The equation used to calculate EVA is as follows:

  EVA = {Net Operating Profits Less Adjusted Taxes - [Total Capital Employed * (Cost of Capital)]}.

  In this case, the NOPLAT figure must be calculated manually by subtracting the Cash Operating Taxes from the Adjusted Operating Profit before Tax (AOPBT) figure. Doing so will produce an answer of $17,700,000 for the Net Operating Profit Less Adjusted Taxes figure. Now that the necessary information has been determined, the calculation of EVA is as follows:

  EVA = {$17,7000,000 - ($127,000,000 * 0.145)} = ($715,000)

  A negative EVA calculation indicates that management has failed to provide economic profits to shareholders, as evidenced by the fact that the opportunity cost of capital employed is less than the AOPAT figure. In this example, the management of Intelligent Semiconductor should be considered as having failed to provide shareholder value. The calculation of Adjusted Operating Profit Before Taxes (AOPBT), and Cash Operating Taxes are important. The calculation of AOPBT is as follows: Operating profit (after depreciation and amortization) + Implied interest on operating leases + any increase in the LIFO reserve + goodwill amortization = Adjusted Operating Profit Before Taxes.

  Cash Operating Taxes, another important component of EVA, is calculated as follows: Cash Operating Taxes = Income Tax Expense + tax benefit from interest expenses + tax benefit from interest on leases + taxes on non-operating income

  Adjusted Operating Profit Before Taxes minus Cash Operating Taxes = Net Operating Profit Less Adjusted Taxes (NOPLAT). Subtracting the dollar cost of capital from the NOPLAT figure will yield the EVA.

• Question 342:

  Changes in nominal GNP have been found to have

  A. little correlation with sales per share for stock series such as the SandP 400.

  B. a relatively high correlation with EBIT for stock series such as the SandP 400.

  C. a relatively high correlation with sales per share for stock series such as the SandP 400.

  D. a relatively high correlation with net profits for stock series such as the SandP 400.

  Correct Answer: C

  Studies have found that about 40% of the variance in percentage changes in SandP 400 sales can be explained by percentage changes in nominal GNP. Estimating GNP is thus used to help estimate earnings per share for stock series such as the SandP 400.

• Question 343:

  Assume the following information about a stock market series:

  Retention rate = 63% Expected growth rate of dividends = 10% per year Expected growth rate of earnings = 12% per year Required rate of return = 13% per year Earnings per share next year = $3.65

  What is the appropriate earnings multiplier for this stock market series? Further, what is the value of this series?

  A. 12.33; $45

  B. None of these answers is correct.

  C. 21; $76.65

  D. 63; $229.95

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

  F. 37; $135.05

  Correct Answer: A

  The earnings multiplier is found as 12.33 for this series, and the value of the series is computed as $45.

  Estimating the earnings multiplier for a stock market series requires the estimation of each of the following

  components:

  The dividend payout ratio.

  The required rate of return on common stock in the country/region/industry/sector being analyzed.

  The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.

  Once values for each of these components have been determined, they are imputed into the following

  formula:

  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.

  In this example, all of the necessary information has been provided. However, before the earnings

  multiplier can be determined, the dividend payout ratio must be found by manipulating the retention rate.

  Remember that the retention rate is equal to (1 - the dividend payout ratio), just as the dividend payout

  ratio is found as (1 - the retention rate). By this logic, the dividend payout ratio and the retention rate must

  always add up to one. The dividend payout ratio for this series is found as (1 - 0.63) = 0.37.

  Now that the dividend payout ratio has been determined, the calculation of the earnings multiplier is shown

  below:

  P/E = [0.37 / (0.13 - 0.10)] = 12.33

  Notice that it is the anticipated growth rate of dividends that is used in this equation, not the anticipated

  growth rate in earnings.

  Once the earnings multiplier has been determined, the value of this stock market series can be found by

  multiplying the EPS figure by the earnings multiplier. This will lead to a value of $45 for this stock market

  series.

• Question 344:

  Which of the following represents a "contrary opinion" technical indicator? Choose the best answer.

  A. Futures traders bullish on stock index futures.

  B. Investment Advisor Opinions.

  C. Diffusion Index.

  D. Confidence Index.

  Correct Answer: B

  Contrarian technical analysts often examine the opinions of market participants, including investment advisors and futures speculators, for insight into the overall sentiment of securities professionals. Believing these individuals to be inaccurate in their forecasts, contrary opinion technical analysts assume the contra-side opinion. So said, a high degree of bullishness amongst investment advisors is viewed as bearish by contrary opinion technical analyst. Conversely, a high degree of bearishness amongst investment advisors is viewed as a bullish signal by contrary opinion technical analysts. In this same light, a high degree of bullishness amongst stock index futures traders is viewed as a bearish signal by contrarian technical analysts, and a low degree of bullishness amongst stock index futures traders is viewed as a bullish signal.

  The Confidence Index, a "smart money" technical indicator, is a measure of yield spreads between high-grade corporate bonds and the yields on average corporate bonds. The Diffusion Index measures the breadth of the market, and is found by taking the total volume of advancing shares plus one-half of the issues unchanged, divided by the total number of issues traded.

• Question 345:

  A portfolio manager with Old School Securities is trying to determine whether shares of Ludicrous Telecom are undervalued. In his analysis, this portfolio manager has determined that the firm's current dividend of $0.40 per share is anticipated to grow 16% annually. Additionally, this portfolio manager has forecasted that she will be able to sell shares of Ludicrous Telecom for $27 per share in four years. Assuming a 18.75% per year required rate of return, what is the value of Ludicrous Telecom's shares?

  A. $15.09

  B. $17.34

  C. $19.19

  D. None of these answers is correct.

  E. $14.10

  Correct Answer: A

  The Multiple Holding Period form of the Dividend Discount Model takes the following form: {V = {[d1 / (1 + k)] + [d2 / (1 + k)^2] + ... .[dn / (1 + k)^n] + [Pn / (1 + k)^n]} Where: V = the price of the common stock at t0, d1 = the annual dividend at t1 (this is found by multiplying the annual dividend at t0 by (1 + the anticipated growth rate), d2 = the annual dividend at t2 (this is found by multiplying the dividend at t1 by (1 + the anticipated growth rate), k = the required rate of return, n = period "n", and Pn = the sale price of the common stock at time "n".

  In this example, time "n" is the fourth year, as this is the end horizon for this investor's holding period. Had the investor in this example forecasted selling the shares at the end of the 10th year, then "n" would be the tenth year.

  Now that the formality of expressing the equation for this form of the DDM has been carried through, we can move toward a calculation of the value of this common stock. In this example, all of the necessary information has been provided, and the calculation of the value of this retail stock is as follows:

  {V = [($0.40 * 1.16) / (1 + 0.1875)^1] + [($0.464* 1.16) / (1 + 0.1875)^2] + [($0.53824 * 1.16) / (1 + 0.1875) ^3] + [($0.624358 * 1.16) / (1 + 0.1875)^4] + [$27 / (1 + 1.1875)^4]}

  Which can be further broker down into the following:

  {V = [$0.390737 + $0.381688 + $0.372849 + $0.364214 + $13.577796] = $15.09}

• Question 346:

  Given that the correct value of a common stock is $43, the required rate of return on the stock is 17%, and next period's dividend will be $4.50, using the infinite period Dividend Discount Model, what is the growth rate of dividends?

  A. Not enough information

  B. 7.1%

  C. 6.5%

  D. 8.4%

  E. 4.8%

  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. Rearranging this yields g = k - D1/(current value). In this question, the dividend growth rate is equal to 0.17 - (4.5 / 43) = 0.065 = 6.5%.

• Question 347:

  A preferred stock has a $100 par value and a dividend payout of $8 per year. Your required return is 10%. What is the value of the preferred stock?

  A. $90

  B. $180

  C. not enough information to calculate it

  D. $80

  Correct Answer: D

  Value of preferred stock is Dividend/Required return or $8/0.1 = $80.

• Question 348:

  For the past 30 years or so, the retention rate of earnings for firms in the SandP 400 has fluctuated largely between

  A. 45 and 60%.

  B. 20 and 30%.

  C. 10 and 20%.

  D. 75 and 90%.

  Correct Answer: A

  Between 1977 and 1994, the retention rate has fluctuated largely between 45 and 60%, although there was a period in the early 1990s when it fell to a low of 25%. The retention rate is used to derive the growth rate of earnings and dividends, which is used to derive the earnings multiplier.

• Question 349:

  Assuming estimates of .30, .15 and 0.135 for the dividend payout, required rate of return, and expected growth rate, respectively, calculate the earnings multiplier.

  A. 50X

  B. 14X

  C. 5X

  D. 13X

  E. 20X

  Correct Answer: E

  The earnings multiplier or P/E ratio = Dividend payout ratio/Required rate of return-Expected growth rate. Analyzing these inputs and the underlying factors, and comparing these to the indications of the macroanalysis, the analyst forecasts an earnings multiplier for the firm. In this example, P/E = .3/(.15-.135) = 20 times.

• Question 350:

  Which of the following is not one of the three main determinants of the required rate of return on an asset?

  A. The risk premium on the asset

  B. The expected rate of inflation during the holding period

  C. The economy's real risk-free rate of return

  D. The Markowitz efficient frontier

  Correct Answer: D

  Although the Markowitz efficient frontier may be used in the process of deriving the risk premium on the asset, it is not in itself one of the three main determinants of the required rate of return on an asset. All investments are affected by the real risk-free rate of return and the expected rate of inflation, because those two factors determine the nominal risk-free rate of return. The nominal risk-free rate of return plus the risk premium on the asset is equal to the asset's required rate of return.