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

• Question 411:

  Assume the following information about an international textile company:

  Next annual dividend: $1.10 Earnings per share next year: $2.45 Anticipated growth rate: 9% per year Required rate of return: 11% per year What is the expected earnings multiplier for this utility company?

  A. 50

  B. 31

  C. 26

  D. 19

  E. 16

  F. None of these answers is correct.

  Correct Answer: F

  The earnings multiplier for this company is found as 22.45, thus none of the answers is correct.

  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, and the calculation of the earnings

  multiplier is as follows:

  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 = [$1.10 / $2.45] = 0.44898, or 44.90%

  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 = [0.4490 / (0.11 - 0.09] = 22.45

  This is likely a realistic multiple for a company within the international textile sector.

• Question 412:

  The stock of Constagrow pays dividends that are expected to grow at a steady rate of 3.2% per year. Investors expect a rate of return of 11.5% from Constagrow stock. If the spread between this required rate of return and the dividend growth rate were to increase by 50 basis points, the percentage change in the stock price would be:

  A. -4.73%

  B. +3.94%

  C. -5.68%

  D. +4.22%

  Correct Answer: C

  In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). When k - g = 11.5% - 3.2% = 8.3% , the price is given by Po = D1/0.083. When the spread increases by 50 basis points and all else stays constant, the price becomes P1 = D1/(0.083 + 0.005) = D1/0.088. The percentage change in the price equals (P1 - Po)/Po = (1/0.088 - 1/0.083)*0.083 = 8.3/8.8 - 1 = -5.68%. Thus, the stock price falls by 5.68% when the spread between k and g increases by 50 basis points, all else equal.

• Question 413:

  Which of the following statements is true?

  A. There are two general approaches to the security valuation process: the top-down, three-step approach, and the bottom-up stock valuation approach. Advocates of the top-down, threestepapproach believe that the economy and the industry effect have a significant impact on total returns for individual stocks.

  B. There are two general approaches to the security valuation process: the bottom-up stock valuation approach, and the horizontal, two-step approach. Advocates of the horizontal, two-step approach believe that the economy and the industry effect have a significant impact on total returns for individual stocks.

  C. There are two general approaches to the security valuation process: the top-down, two-step approach, and the horizontal, four-step approach. Advocates of the top-down, two-step approach believe that the economy and the industry effect have a significant impact on total returns for individual stocks.

  D. There are three general approaches to the security valuation process: the top-down, four-step approach, the bottom-up stock valuation approach, and the horizontal, three-step approach. Advocates of the horizontal, three-step approach believe that the economy and the industry effect have a significant impact on total returns for individual stocks.

  Correct Answer: A

  While advocates of the top-down, three-step approach believe that the industry effect and the economy have a significant impact on total returns for individual stocks, advocates of the bottom-up stock valuation approach believe that is possible to find stocks that are undervalued relative to their market prices, and that these stocks will provide superior returns regardless of the market or industry outlook.

• Question 414:

  Marlene Gooseberry, an institutional money manager with Middle Road Brokerage, has been examining a stock market series and has determined the following information:

  Anticipated ending value: 2060 Expected dividends during the period: $41.20 Observed beginning value: 1579.81 Required rate of return: 21%

  Using this information, what is the anticipated rate of return for this stock market series? (Assume a oneyear holding period).

  A. 33.00%

  B. 27.79%

  C. 25.31%

  D. 21.31%

  E. None of these answers is correct.

  Correct Answer: A

  To calculate the expected rate of return for a stock market series, the following information must be known:

  The beginning value for the series, the anticipated ending value for the series, and the amount of any dividends and/or shareholder distributions during the period.

  Once this information has been determined, the expected return on a stock market index can be found by employing the following equation:{E(R) = [(EV - BV + Div) / BV]}. Where: E(R) = the expected return on the stock market series, EV = the anticipated ending value for the series, BV = the observed beginning value for the series, and Div = the amount of any dividends paid during the period.

  In this example, all of the necessary information has been provided and the calculation of the expected return on this stock market series is found as follows: {E(R) = [$2060 - $1579.81 + $41.20] / $1579.81} = 33.00%.

  This is significantly greater than the required rate of return (21%). If the assumptions behind the expected ending value and dividends are both realistic and accurate, investment in this stock market series is likely advisable.

• Question 415:

  Which of the following are challenges to technical analysis? Choose the best answer.

  I.The majority of studies have concluded that securities prices do not move in trends.

  II. Technical analysis assumes that supply-demand fluctuations lead to changes in securities prices.

  III. Technical analysis is heavily reliant on subjective judgement.

  IV.

  Technical analysis assumes that supply and demand are partially influenced by irrational factors, and that supply and demand fluctuations are the only determinant of shifts in securities prices.

  V.

  The majority of studies have supported the weak-form Efficient Market Hypothesis. VI. The standard rules that signal investment decisions can change over time.

  VII.

  Technical analysis is heavily reliant on financial statements.

  A.

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

  B.

  None of these choices represents the best possible answer.

  C.

  I, III, IV, V, VII

  D.

  II, III, IV, V, VI, VII

  E.

  I, II, III, V, VI

  Correct Answer: B

  None of these answers are completely correct. Of the choices listed, only II and VII are incorrect. While II appears correct, it is not. In fact, both fundamental and technical analyses recognize the importance of supply and demand fluctuations. The difference is that technical analysis assumes that supply and demand are influenced by both rational and irrational factors, whereas the EMH assumes that investors are rational. Further, technical analysis assumes that supply and demand fluctuations are the sole cause of shifts in securities prices.

• Question 416:

  Given that the correct value of a common stock is $25, the required rate of return on the stock is 15%, and the dividend growth rate is 5%, using the infinite period Dividend Discount Model, what will next period's dividend be?

  A. $2.28

  B. $2.79

  C. Not enough information

  D. $2.50

  E. $3.16

  Correct Answer: D

  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 D1 = current value x (k - g). In this question, next period's dividend is equal to 25 x (0.15 - 0.05) = $2.50.

• Question 417:

  The ________ ratio has been used extensively in the valuation of bank stocks because bank assets often have similar book values and market values.

  A. price/book value

  B. economic value added

  C. market value-added

  D. franchise factor

  E. price/cash flow

  Correct Answer: A

  The P/BV ratio has become important as a measure of relative value for stocks. The relationship between the market price of a stock and its book value per share can be used as a relative measure of valuation because, under theoretically ideal conditions, the market value of a firm should reflect its book value. However, particularly with industrial firms, an increase in the estimates of breakup value has caused the average P/BV ratio to experience a volatile increase over time.

• Question 418:

  Stock ABC has the following characteristics:

  Current dividend $1.00

  Expected dividend in 1 year $1.10

  Long term growth rate of dividends 10%

  Required rate of return 12%

  Using the infinite period Dividend Discount Model, what is the maximum price that you would pay for stock

  ABC?

  A. $10.00

  B. $120.00

  C. $55.00

  D. $550.00

  E. $15.00

  F. $12.00

  Correct Answer: C

  The infinite period Dividend Discount Model indicates that:

  Value = (Dividend for period 1)/(k-g) where k is the required rate of return and g is the growth rate. In this case, Value = ($1.10)/(.12-.10) = $1.10/.02 = $55.

• Question 419:

  Assume the following information about a stock market series:

  Retention rate = 70% Expected growth rate of dividends = 8% per year Expected growth rate of earnings = 20% per year Required rate of return = 15% per year

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

  A. None of these answers is correct.

  B. 4.29; $53.63

  C. The answer cannot completely be determined from the information provided.

  D. 6.00; $30.00

  E. 6.00; $120.00

  F. 4.29; $21.43

  Correct Answer: C

  The answer cannot completely be determined from the information provided. Specifically, while the appropriate earnings multiplier can be found from the given information (and it is 4.29), the correct value for the series cannot be determined without an estimation of EPS at t1. The following explains the derivation of the earnings multiplier for a stock market series.

  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.

  Had this example provided a figure for the EPS at t1, then the value of the index could be found by multiplying the EPS at t1 by the earnings multiplier.

• Question 420:

  Consider the following transactional information for the investment account of an individual investor:

  1st Quarter Ending portfolio value: $100,000 Total amount invested: $95,000

  2nd Quarter Ending portfolio value: $110,000 Total amount invested: $90,000

  3rd Quarter Ending portfolio value: $114,000 Total amount invested: $100,000

  4th Quarter Ending portfolio value: $105,000 Total amount invested: $114,000 Using this information, what is the annual time-weighted rate of return for this portfolio? Assume no taxes or transaction charges.

  A. 30.05% per year

  B. 26.67% per year

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

  D. 25.22% per year

  E. None of these answers is correct.

  Correct Answer: E

  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 = [($100,000 ending value - $95,000 invested) / $95,000 invested] =

  5.263%

  Quarter 2 holding period return = [($110,000 ending value - $90,000 invested) / $90,000 invested] =

  22.22%

  Quarter 3 holding period return = [($114,000 ending value - $100,000 invested) / $100,000 invested] =

  14.00%

  Quarter 4 holding period return = [($105,000 ending value - $114,000 invested) / $114,000 invested] =

  (7.895%)

  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 + .0526) * (1 + .2222) * (1 + .14) * (1 - .07895) - 1] = .3508 or 35.08 %. This is characterized by none of

  the answers provided.

  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 third quarter, the total amount invested does

  not equal the ending amount for the second quarter. 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 ending value of quarter 2 and the amount invested in quarter 3) was not invested,

  and should not be included in the holding period return for the third 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.