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

• Question 31:

  The trough is

  A. the bottom price.

  B. a trend indicating declining prices.

  C. a trend indicating rising prices.

  D. a period of low-volume trading.

  E. the peak price.

  Correct Answer: A

  Technical analysts would purchase a stock if they think that it has hit its trough, and is now in a rising trend channel.

• Question 32:

  Which of the following is/are growth stocks?

  I. The stock of Omega Corp., which is a highly successful firm that has had above average growth in sales and earnings in the past 5 years.

  II. The stock of InstyPrints, a paper company which has been poorly managed in the past, causing the firm's stock price to plunge below what most analysts consider to be its fair value.

  III.

  The stock of Zygotes, Etc., a biotech firm that has high business and financial risk.

  A.

  I only

  B.

  II only

  C.

  I and III

  D.

  III only

  E.

  I and II

  F.

  I, II and III

  Correct Answer: B

  You have to be careful in distinguishing between a growth stock and a growth firm. A growth stock need not represent a growth firm. Rather, it is defined as a stock that has consistently generated returns higher than those justified by the risks. Such a situation arises either because the company has surprise windfalls or because at some point in the past, the market underestimated the firm's growth potential. Since InstyPrints has been identified and commonly tagged as being "undervalued," one can reasonably expect the stock to generate higher than required rates of return in the near future. (Again, keep in mind that the return on the stock is different from the return on the firm's investments in various projects). Therefore, InstyPrints' stock is a growth stock. On the other hand, Omega Corp. is a growth firm but its stock need not necessarily be a growth stock. Indeed, if Omega's stock is "overvalued," it may be a bad investment.

• Question 33:

  Consider the following information about an automobile manufacturer:

  Next annual dividend: $4.11 Earnings per share next year: $7.02 Anticipated growth rate: 6% per year Required rate of return: 11% per year

  What is the expected earnings multiplier for this utility company?

  A. 12.41

  B. Manipulating the Infinite Period DDM will produce a nonsensical answer in this case.

  C. 18.51

  D. 11.71

  E. 13.51

  Correct Answer: D

  To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula:

  P/E = [(d1 / e1) / (k - g)]

  Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate. In this example, all of the necessary information has been provided, but some rearranging is necessary. Specifically, the dividend payout ratio must be determined. This figure is found as follows:

  Dividend payout ratio = [$4.11 / $7.02] = 0.58547, or 58.55%

  Now that the dividend payout ratio has been determined, we can solve for the appropriate earnings multiplier. The calculation of this figure is found as follows:

  P/E = [0.5855 / (0.11 - 0.06) = 11.71

  In generally favorable economic conditions, this is a realistic earnings multiple for an average automobile manufacturer.

• Question 34:

  The P/E ratio of a stock is 12.3. Its current earnings are $12.1 per share and a growth rate of 3.9%. The current price of the stock is:

  A. $159.22

  B. $148.83

  C. $143.24

  D. $154.60

  Correct Answer: D

  It is important to remember that the P/E ratio is the ratio of the current stock price and next year's expected earnings. Therefore, current stock price = 12.3 * 12.1 * 1.039 = $154.6

• Question 35:

  Which of the following should be taken into account when estimating country risk?

  I.Political risk II.Expropriation risk III.Currency risk IV.Economic environment V.Inflation trends VI.Trade policy VII.Consumer tastes

  A. I, III, IV, V, VII

  B. I, II, III,

  C. I, II, III, IV, V, VI, VII

  D. II, IV, V

  E. I, III, III, IV, V, VII F. None of these choices are correct

  Correct Answer: C

  In assessing country risk, one must consider various sources of risk and instability prevalent within the country being examined. The two basic components of country risk are political risk and financial risk. However, there are many considerations in assessing country risk that exist beyond the boundaries of simple classification. For instance, attitudes of consumers must be taken into effect, as well as such things as trends in consumer spending, unemployment rates, threats of ideological instability, etc. So said, the determination of a finite "country risk premium" is often a complex and daunting task. When assessing a country risk premium, the five sources of risk must be considered (business risk, financial risk, liquidity risk, exchange rate risk, and country risk).

• Question 36:

  Consider the following information about a common stock:

  Price per share: $115.88 Next dividend per share: $2.80 Required return: 15.25% per year Expected growth rate: 12.75% per year

  What is the value of this common stock?

  A. $129

  B. $112

  C. $101

  D. None of these answers is correct.

  E. $103

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

  Correct Answer: B

  To determine the value of a common stock using the Infinite Period Dividend Discount Model, use the following equation:

  {V = [d1 / (k - g)]}

  Where: V = the value of the common stock at t0, d1 = the annual dividend at t1 (which is found by multiplying d0 by (1 + g), k = the investor's required rate of return, and g = the anticipated annual growth rate.

  In this example, all of the necessary information has been provided, and incorporating this information into the Infinite Period DDM will lead to the following:

  {V = [$2.80 / (0.1525 - 0.1275] = $112}

  This value is very close to the value of the common stock in the open market.

  An important observation: notice that we have valued this common stock as a perpetuity, rather than a finite series of cash flows. The reasoning behind this approach should be somewhat intuitive. Specifically, unlike a bond, whose cash flows possess a finite lifespan, the cash flows (i.e. dividends) produced by a common stock could theoretically last forever. Is this a realistic assumption for most common stocks? What about a stock that pays little or no dividend?

• Question 37:

  A firm has an ROE of 13% and a required rate of return on the stock of 16%. The firm currently has a dividend payout ratio of 26%. Investors pay no personal taxes on dividends. To increase value, it must:

  A. change its retention ratio to 1.

  B. incomplete information to answer.

  C. reduce its payout ratio to around 5%.

  D. pay out all of its earnings as dividends.

  Correct Answer: D

  If the firm cannot invest the funds at a rate of return at least equal to that which the investors require, then the shareholders are better off if the firm pays out all it earns (provided these distributions are not taxed) so that the investors can invest the funds on their own at higher rates.

• Question 38:

  An increase in the tax rate, while holding everything else equal, would have what effect on the earnings multiple of a stock market series? Further, what effect should be anticipated from an increase in the depreciation per-share figure?

  A. Earnings multiple would increase, earnings multiple would increase.

  B. Earnings multiple would increase, earnings multiple would increase.

  C. Earnings multiple would remain unchanged, earnings multiple would decrease.

  D. Earnings multiple would decrease, earnings multiple would decrease.

  E. Earnings multiple would decrease, earnings multiple would remain unchanged.

  F. Earnings multiple would increase, earnings multiple would remain unchanged.

  Correct Answer: D

  The following equation is used to determine the earnings multiple of a stock market series:

  EPS = {[(Sales per share * operating profit margin) - depreciation per share - interest expense per share] *

  (1 - corporate tax rate).

  As you can see, an increase in the tax rate, holding everything else equal, will lead to a decrease in the

  earnings multiple. Likewise, an increase in the per-share depreciation figure will lead to a decrease in the

  earnings multiplier.

• Question 39:

  One of the assumptions of technical analysis is that the market value of any good or service is determined solely by the interaction of ________.

  A. consumers and investors

  B. investment professionals and credit agencies

  C. supply and demand

  D. none of these answers

  Correct Answer: C

  Both technicians and non-technicians agree that, at any point in time, the price of a security (or good or service) is determined by the interaction of supply and demand for it. The four assumptions that support technical analysis are these:

  1.

  The market value of any good or service is determined solely by the interaction of supply and demand for it.

  2.

  Supply and demand are governed by numerous factors, both rational and irrational, including the economic variables relied upon by the fundamental analyst, as well as opinions, models and guesses. The market weights all of these factors continually and automatically.

  3.

  Disregarding minor fluctuations, the prices for individual securities and the overall value of the market

  tend to move in trends, which persist for appreciable lengths of time.

  4.

  Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

• Question 40:

  What three factors are examined in the three-step valuation process?

  A. industry influences, company analysis, market analysis

  B. economic influences, global analysis, company analysis

  C. economic influences, industry influences, company analysis

  D. industry influences, company analysis, technical analysis

  Correct Answer: C

  Economic influences such as government spending and tax; Industry influences such as how industries respond to the business cycle or economic changes; and Company analysis using cash flow values and financial ratios - are examined in the three-step valuation process. Remember: the factors are in increasing in scope.