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

• Question 371:

  Consider the following annual growth forecasts for a common stock:

  Growth in years 1-2 = 20% Growth in year 3 = 15% Growth after year 3 = 12%

  Assuming that the last dividend was $1.80 per share, and the required rate of return is 17% per year, what is the value of this common stock?

  A. $22.27

  B. $25.34

  C. None of these answers is correct.

  D. $35.82

  E. $17.89

  F. $31.92

  Correct Answer: C

  None of these answers is correct.

  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.

  In this example, the supernormal growth period is followed by a transitional growth period of one year,

  during which the growth rate of this stock is expected to grow at 15% annually. This period will follow the

  two-year supernormal growth period, and would be denoted as "g subset t" if we were to rewrite the basic

  equation listed above. The calculation of the value of this common stock is illustrated as follows:

  {V = {[$1.80 * (1.20)^1] / (1.17)} + {[$1.80 * (1.20)^2] / (1.17)^2} + {[$1.80 * (1.20)^2 * (1.15)^1] / (1.17)^3} +

  {{[$1.80 * (1.20)^2 * (1.15)^1 * (1.12)^1]/ (0.17 - 0.12)}/ (1.17)^3}

  Which can be deduced to the following:

  {V = [$1.846154 + $1.893491 + $1.861124 + $24.814983] = $30.415752}

• Question 372:

  Total assets/equity measures ________.

  A. financial leverage

  B. net profit margin

  C. retention rate

  D. operating performance

  Correct Answer: A

  Total assets divided by equity measures financial leverage.

• Question 373:

  The NAV of an open-ended fund is $31.22. The fund charges a 6.3% sales charge and no redemption charges. The price at which you can sell a share of the fund equals ________.

  A. $29.37

  B. $29.25

  C. $31.22

  D. none of these answers

  Correct Answer: C

  The price at which you can redeem an open-ended fund equals its NAV (in the absence of any redemption charges).

• Question 374:

  The exact estimate of future dividends depends on the outlook for ________ and the firm's ________.

  A. earnings; sales

  B. earnings growth; dividend policy

  C. stock price; dividend policy

  D. sales price; earnings

  Correct Answer: B

  The exact estimate of future dividends depends on the outlook for earnings growth and the firm's dividend policy.

• Question 375:

  Marlene Gooseberry, an institutional money manager with Middle Road Brokerage, has been examining a

  stock market series and has determined the following information:

  The dividend payout ratio at t1 has been estimated at: 31% The required rate of return is 16%

  The anticipated future growth rate of dividends is 13.75%

  The anticipated future growth rate of earnings is 14.25%

  The corporate tax rate is 35%

  Using this information, what is the earnings multiplier for this stock market series? Choose the best

  answer.

  A. 8.96

  B. 7.75

  C. 13.78

  D. 17.71

  E. None of these answers is correct.

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

  Correct Answer: C

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

  1.

  The dividend payout ratio.

  2.

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

  3.

  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, and the calculation of the earnings multiplier is shown as follows: {P/E = [0.31 / 0.16 - 0.1375] = 13.78}.

  Notice that it was the anticipated growth rate of dividends, not the anticipated growth rate of earnings, which was used in determining the earnings multiplier. Additionally, note that the tax rate was not explicitly factored in to the equation, as the earnings figure used in the dividend payout ratio is already an after-tax figure.

• Question 376:

  The objective of analysis of alternative economies and security markets in the three-step, top-down approach is to decide how to allocate investment funds

  A. among countries and industries.

  B. among countries.

  C. among countries and industries, and between bonds stock and cash.

  D. between bonds, stock and cash.

  E. among countries and between bonds, stock and cash.

  Correct Answer: E

  The analysis of alternative economies and security markets is the first step in the three step process, and involves the decision to allocate funds at a general level between countries and types of securities. Making the decision to allocate between different industries is made in the second step.

• Question 377:

  Given that the P/E ratio on a common stock is 12, the expected dividend payout ratio is 0.7, and the dividend growth rate is 6%, what is the required rate of return?

  A. 9.3%

  B. Not enough information

  C. 17.4%

  D. 12.5%

  E. 11.8%

  Correct Answer: E

  The infinite period Dividend Discount Model claims that the current price of a common stock is equal to D1 / (k - g), where D1 is next period's (most often next year's) dividend, k is the required rate of return, and g is the growth rate of dividends. The earnings multiplier model goes a step further by dividing both sides of the infinite period Dividend Discount Model equation by expected earnings during the next 12 months, yielding P/E = (D1/E) / (k - g). Rearranging this results in k = (D1/E) / (P/E) + g. In this question the required rate of return is equal to 0.7/12 + 0.06 = 0.118 = 11.8%.

• Question 378:

  If the OTC-to-NYSE volume is high, the contrarians interpret it as implying that investors are:

  A. bullish.

  B. about to enter the market with more cash.

  C. aggressive.

  D. bearish.

  Correct Answer: A

  Since the OTC market is dominated by small stocks which are riskier than the large stocks on NYSE, a high OTC volume relative to NYSE (above 110-112%) implies that investors are bullish. Of course, since the contrarians bet against the market at market turning points, they will consider this behavior by investors as a bearish signal if the market is at a high.

• Question 379:

  Fund A is a no-load fund but it charges a 2% redemption fee. Fund B is a 5% load fund which charges no redemption fee. Fund A is expected to have a return of 13% while fund B is expected to have a return of 17%. If your investment horizon is 1 year, which fund should you invest in and what is your expected net rate of return per year?

  A. A; 11.00%

  B. B; 10.9%

  C. A; 10.75%

  D. B; 11.15%

  Correct Answer: D

  Fund A's rate of return over 1 year equals 1.13 *0.98 - 1 = 10.74%. Fund B's return equals 0.95 * 1.17 - 1 = 11.15%. Hence, select fund B for a 1-year horizon.

• Question 380:

  An intern at Smith, Kleen, and Beetchnutty has recently been asked to value shares of Dynamic Impact, a multinational media conglomerate, using the Gordon Model. Dynamic Impact is a stable firm which has experienced steady growth for much of the last twenty years, and this growth rate is not anticipated to change. In his assignment, the intern has been provided with the following information:

  Expected dividend at t5: $1.45 Required rate of return on equity: 14.25% per year Growth rate of dividends: 10.00% per year

  Using the information provided, what is the value of Dynamic Impact's common shares?

  A. $18.90

  B. None of these answers is correct.

  C. $21.12

  D. $26.65

  E. $31.34

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

  Correct Answer: B

  Since the growth rate of dividends is not expected to change in the future, the Gordon Model can be applied. The Gordon Model is commonly referred to as the "constant growth dividend discount model." This model of common stock valuation is illustrated as follows:

  P0 = [D1 / (r - g)]

  Where P0 = the price of common stock X at time 0 D1 = the expected dividend at t1 r = the required rate of return on equity investments and g = the expected growth rate of dividends.

  Since we are not provided the dividend at t1, we must determine it manually be discounting the dividend at t5 by the growth rate of dividends. The determination of D1 is as follows:

  D1 = {D5 / [(1 + g)(1 + g)(1 + g)(1 + g)]}

  D1 = {$1.45 / [1 + 0.10)(1 + 0.10)(1 + 0.10)(1 + 0.10)]}

  D1 = {$1.45 / 1.1461} = $0.9904

  Now that the dividend at t1 has been determined, the given information can be put into the equation

  provided, leading to the following series of calculations:

  P0 = [$0.9904 / (0.1425 - 0.10)] = $23.30

  This is illustrated by none of the answers provided.

  When using the Gordon model, remember that the required rate of return "r" must be greater than the

  expected growth rate "g." Otherwise, this equation will produce a nonsensical answer.