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

• Question 401:

  Which of the following is not an advantage of technical analysis?

  A. Technical analysis is not as time-consuming as fundamental analysis.

  B. All of these answers are advantages.

  C. Technical analysis assumes that securities prices move in trends, and identifying changes in these trends can lead to the discovery of superior investment opportunities more closely to their price moves than fundamental analysis.

  D. Technical analysis is not heavily dependent on financial statements.

  Correct Answer: B

  All of these reasons are cited by technical analysts as advantages of their method. One of the major advantages cited by technical analysts is the fact that technical analysis is not heavily dependent on financial statements. Technical analysts, as a community, are suspicious of financial statements, and believe that few fundamental analysts can identify relevant information in financial statements, and analyze the impact of this information on securities prices in time for superior investment returns to be realized.

  Additionally, technical analysts believe that securities markets "price in" material information gradually, and that securities prices move in identifiable trends and patterns. An astute technical analyst, it is argued, can identify superior investment opportunities by recognizing the implicit trends exhibited by securities prices and quantifiable past performance data. Assuming that fundamental analysis can identify whether a security is over or under-valued long before the security experiences a significant price realization, the fundamental analyst is left with the daunting decision of when to buy of sell. Ideally, the fundamental analyst would like to invest his money immediately before a security experiences a profitable increase (or, for short sellers, a profitable decrease) in price, preferring to hold the funds to invest in other opportunities until the change in price direction is initiated. Technical analysts argue that because they do not invest until the move to the new "equilibrium price" is underway, they are more likely to experience ideal timing compared to the fundamental analyst.

• Question 402:

  Consider the following series of cash flows for an institutional investment account:

  1st Quarter Ending portfolio value: $10,340,000 Total amount invested: $10,000,000

  2nd Quarter Ending portfolio value: $10,660,000 Total amount invested: $10,340,000 3rd Quarter Ending portfolio value: $11,110,000 Total amount invested: $10,660,000

  4th Quarter Ending portfolio value: $11,400,000 Total amount invested: $11,000,000

  Using this information, what is the annual time-weighted rate of return for this portfolio? Assume no taxes or transaction charges.

  A. None of these answers is correct.

  B. The time-weighted rate of return cannot be calculated from the information provided.

  C. 9.89% per year

  D. 18.13% per year

  E. 12.67% per year

  F. 15.14% per year

  Correct Answer: F

  The time-weighted rate of return is the preferred method of return calculation in the investment management industry, primarily because this method is not sensitive to significant additions and

  withdrawals of funds from portfolios under examination. The calculation of the time-weighted rate of return

  involves three steps, which are illustrated as follows:

  Step 1:

  Price the portfolio immediately prior to any significant additions or withdrawals. Separate the portfolio into a

  series of subperiods based on the dates of cash inflows and outflows.

  Step 2:

  Calculate the holding period return for each subperiod.

  Step 3:

  Determine the annualized holding period return by linking or compounding the holding period return of

  each subperiod. If the investment is for more than one year, use the geometric mean of the annual returns

  as the time-weighted rate of return. If the investment is for less than one year, compound the subperiod

  returns to obtain an annualized measurement.

  To begin the process of determining the time-weighted rate of return, we would break the portfolio up into

  the following series of cash flows. However, in this example, the cash flows are already aggregated for us

  and we can move on to the next step: determining the holding period return for each subperiod. This

  process is detailed as follows:

  Quarter 1 holding period return = [($10,340,000 ending value - $10,000,000 invested) / $10,000,000

  invested] = 3.40%

  Quarter 2 holding period return = [($10,660,000 ending value - $10,340,000 invested) / $10,340,000

  invested] = 3.095%

  Quarter 3 holding period return = [($11,110,000 ending value - $10,660,000 invested) / $10,660,000

  invested] = 4.221%

  Quarter 4 holding period return = [($11,400,000 ending value - $11,000,000 invested) / $11,000,000

  invested] = 3.636%

  Now that the holding period return for each subperiod has been determined, we must annualize the return

  measure by taking the product of all four quarterly returns. This process is illustrated below:

  [(1 + .034) * (1 + .03095) * (1 + .04221) * (1 + .03636) - 1] = .015139 or 15.139%

  When calculating the time-weighted rate of return, remember that the total amount invested is the relevant

  figure, not the beginning portfolio value. Notice that during the fourth quarter, the total amount invested

  does not equal the ending amount for quarter 3. This differential could be explained by numerous

  phenomena. Perhaps the difference is due to a cash withdrawal from the account. Maybe it was used to

  pay expenses or meet an outstanding margin call. What is important to note is the fact that this money (the

  difference between the beginning portfolio value and the amount invested) was not invested in securities,

  and should not be included in the holding period return for the fourth quarter. So said, whenever possible

  you should use the total amount invested rather than the beginning portfolio value in the calculation of the

  subperiod holding period return.

• Question 403:

  An investor is examining shares of Intelligent Semiconductor to determine if they are trading at an appropriate multiple. Assume the following information:

  k = 14.25% per year g = 13.4% per year D0 = $2.15 P0 = $110.80

  Using the information provided, what is the appropriate P/E ratio for Intelligent Semiconductor?

  A. 25.89

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

  C. 51.53

  D. 2.59

  E. 45.11

  F. None of these answers is correct.

  Correct Answer: B

  In this example, not all of the necessary information has been provided. Specifically, the EPS figure must be known in order for the P/E ratio to be determined.

  If the EPS figure is known, however, the infinite period dividend discount equation can be manipulated to solve for the P/E multiple. Specifically, by dividing each side of the infinite period dividend discount equation by the EPS figure, it is possible to determine the P/E ratio. This is illustrated as follows:

  P0/EPS = (D1 / EPS)/(k-g)

  Where: P0 = the price of the common stock at t0, D1 = the dividend at t1, EPS = the earnings per share calculation for t1, k = the required rate of return, and g = the expected growth rate.

  Manipulating the infinite period dividend discount model to solve for the PE is a rather intuitive process.

  Consider the fact that an investment's value is truly nothing more than the present value of all future returns. So said, dividing both sides of the infinite period dividend discount model equation by the EPS figure should yield the appropriate multiple, or "earnings multiplier." This is the price-to-earnings ratio.

• Question 404:

  All else equal, an increase in the expected inflation rate ________ the value of a stock.

  A. does not affect

  B. decreases

  C. increases

  D. can be all of these answers

  Correct Answer: B

  When expected inflation rises, the expected rate of return demanded by the investors increases. All else equal, this can happen only if the price of the stock drops.

• Question 405:

  High payout ratios are closely correlated with which of the following attributes?

  A. The level of regulation in an industry.

  B. The growth rate of earnings.

  C. The level of competition in the industry.

  D. More than one of these answers is correct.

  E. All of these answers are correct.

  F. Maturity of the industry.

  Correct Answer: D

  All but one of these answers is correct. Specifically, the dividend payout ratio is very closely related to the maturity of the industry, the level of competition in the industry, and the growth rate in earnings. Remember that all of these factors are interrelated. As an industry becomes more mature, competition becomes maximized, margins shrink, and the growth potential of the industry declines. This will lead to a decrease in positive NPV investment opportunities in the industry, forcing firms to increase the proportion of earnings paid out to shareholders in the form of dividends.

  The level of regulation in an industry is not necessarily highly correlated with the dividend payout ratio of firms within the industry. For example, the financial services industry is very heavily regulated, yet firms within this sector do not pay a disproportionate amount of their earnings as dividends. However, he utility industry, also heavily regulated, pays a very high proportion of earnings as dividends.

• Question 406:

  An increase in the ratio of short sales by specialists to total short sales is interpreted by smart-money technicians as:

  A. a bullish signal.

  B. none of these answers.

  C. a hold signal.

  D. a bearish signal.

  Correct Answer: D

  As part of their market-making activities, specialists regular indulge in short-selling activity. However, since they have some discretionary authority over short selling, smart-money technicians (who track the behavior of "smart" investors) consider a low participation rate by specialists in the short-selling activity as a bullish signal. This participation rate is characterized by the ratio of specialist short sales to total short sales. When this ratio falls below 30%, smart money says it is a bullish signal and when it rises above 50%, it is considered a bearish signal.

• Question 407:

  If a stock has an expected dividend payout ratio of 30 percent, a required rate of return of 10 percent and an expected growth rate for dividends of 5 percent, what is the P/E ratio?

  A. 12

  B. 6.5

  C. None of these answers

  D. 10

  Correct Answer: B

  The price/earnings ratio can be computed by dividing the expected dividend payout ratio (dividends divided by earnings) by the required rate of return (k) minus the expected growth rate of dividends (g).

  In this case, P/E = .3/(.1-.05) = 6.5

• Question 408:

  A diffusion index with a value of over 70 is considered by technical analysts to be

  A. not particularly bullish or bearish.

  B. a sign of caution.

  C. a sign of an approaching trough.

  D. a bullish sign.

  Correct Answer: B

  The diffusion index is an alternative specification of advance-decline series, and is used as an indicator of the direction of the market. If the index reaches up to levels of 56 to 60, the market is considered overbought. If it comes down to levels of 40 to 44, the market is considered over oversold.

• Question 409:

  An intern at Smith, Kleen and Beetchnutty has recently been asked to value shares of General Manufacturing, a multinational conglomerate, using the Gordon Model. General Manufacturing 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 t3: $1.05 Required rate of return on equity: 11.75% per year Growth rate of dividends: 9.00% per year

  Using the information provided, what is the value of General Manufacturing shares?

  A. None of these answers is correct.

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

  C. $32.14

  D. $34.45

  E. $37.63

  F. $28.81

  Correct Answer: C

  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 t3 by the growth rate of dividends. The determination of D1 is as follows:

  D1 = {D3 / [(1 + g)(1 + g)]}

  D1 = {$1.05 / [1 + 0.09)(1 + 0.09)]}

  D1 = {$1.05 / 1.1881} = $0.8838

  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 = [$0.8838 / (.1175 - .09)] = $32.14

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

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

• Question 410:

  A portfolio manager with Smith, Kleen, and Beetchnutty is trying to determine the earnings per share (EPS) for a software index, and has gathered the following information:

  Sales per share: $340 Next year's operating profit margin: 50% Next year's depreciation per share: $50 Next year's interest expense: $68 Next year's common stock dividend: $14 Next year's corporate tax rate: 35%

  Using this information, what is the EPS figure for this stock market series?

  A. $72.15

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

  C. $24.70

  D. $33.80

  E. $83.80

  F. None of these answers is correct.

  Correct Answer: D

  The estimation of EPS for a stock market series involves five steps. Specifically, to determine an estimate of EPS for a stock market series, it is necessary to:

  Estimate the sales per share Estimate next year's operating profit (EBIDT), or operating profit margin Estimate next year's depreciation per share Estimate next year's interest expense per share Estimate next year's corporate tax rate

  Once estimates for these components have been determined, they are put into the following equation:

  EPS for a stock market series = {[(Sales per share * operating profit margin) - depreciation per share interest expense per share] * (1 - corporate tax rate).

  Imputing the given information into this equation will yield the following:

  EPS for a stock market series = {[($340 * 0.50) - $50 - $68] * (1 - 0.35)} = $33.80

  If you chose $83.80, remember that the depreciation figure is not added back to the EPS calculation. What we are looking at is an operating earnings after tax figure, not a cash-based figure.

  If you chose $24.70, remember that common stock dividends are not incorporated into the EPS figure, only interest payments on debt and preferred securities.