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

• Question 421:

  Which of the following is a reason for why valuation of bonds is difficult?

  A. Uncertainty of the required rate of return

  B. Uncertainty of time pattern of returns

  C. Uncertainty of size of returns

  D. Uncertainty of the market interest rate

  Correct Answer: A

  The size and time pattern of returns is known with bonds. Payments follow a regular schedule. But the required rate of return, which is needed to value bonds, is generally not known.

• Question 422:

  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 series value: 2060 Expected dividends during the period: $41.20 Observed beginning series value: 1579.81 Required rate of return: 21% per year

  What is the anticipated annual rate of return for this stock market series? (Assume a one-year holding period.)

  A. 27.79%

  B. 33.00%

  C. None of these answers is correct.

  D. 25.31%

  E. 21.31%

  Correct Answer: B

  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 423:

  Which of the following defines the investment decision?

  A. Compute the expected value of the stock discounted to the present and compare it to the prevailing market price. If the present value of the expected price exceeds the market price, the particular stock is an attractive investment.

  B. All of these answers

  C. Compute an expected long-run rate of return based on the expected dividend yield plus the expected growth rate. If this expected return exceeds the required rate of return, the particular stock is an attractive investment.

  D. Compute the expected rate of return during the holding period on the basis of the expected value of the stock and the expected dividend. If this expected rate of return exceeds the required rate of return, the particular stock is an attractive investment.

  E. None of these answers

  Correct Answer: B

  The investment decision, i.e., whether or not a particular stock is an attractive investment, is based on all three of these comparisons.

• Question 424:

  A portfolio manager for Smith, Kleen and Beetchnutty is examining the performance of several of her institutional customers. The following transactions apply to the account of Dotcominous, a fledgling "new media" advertising conglomerate:

  t0: Purchase five Kansas City District 14 General Obligation Bonds for $5,545.00 t1: Purchase three Kansas City District 14 General Obligation Bonds for $3,229.50 Receive coupon payment of $300.00 t2: Purchase three Kansas City District 14 General Obligation Bonds for $3,185.00 Receive coupon payment of $480.00 t3: Receive coupon payment of $660.00 t4: Sell eleven Kansas City District 14 General Obligation Bonds for $11,780.00

  Investments with similar characteristics merit an 11.75% required rate of return. Assuming that taxes and commissions have already been incorporated into the cash flows provided, what is the dollar-weighted rate of return for this series of transactions?

  A. 1.68%

  B. 3.44%

  C. None of these answers is correct.

  D. 5.44%

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

  F. (3.34%)

  Correct Answer: B

  Remember that the dollar-weighted rate of return uses the IRR equation in the determination of its answer.

  Further, the dollar-weighted rate of return is another name for the IRR equation, and this nomenclature is

  commonly used within the field of investment management. So said, the required rate of return is not

  explicitly factored into the calculation of the dollar-weighted rate of return, rather what is being determined

  is the rate which equates the present value of the cash inflows to the present value of the cash outflows. In

  the determination of the dollar-weighted rate of return calculation, the first step should be to identify the

  cash flows for each period. In this example, the cash flows have been stated, and little calculation is

  necessary. The cash flows associated with this series of investments are illustrated as follows:

  t0: ($5,545.00)

  t1: [($3,229.50 paid for the bonds) + $300.00 coupon payment] = ($2,929.50)

  t2: [($3,185.00 paid for the bonds) + $480.00 coupon payment] = ($2,705.00)

  t3: $660 coupon payment

  t4: $11,780

  Now that the cash flows have been determined, incorporating this information into your calculator's cash

  flow worksheet and solving for IRR will yield a dollar-weighted rate of return of 3.44% for this investment

• Question 425:

  Capacity utilization rate is

  A. logarithmically related to profit margin.

  B. not related to profit margin.

  C. positively related to profit margin.

  D. inversely related to profit margin.

  Correct Answer: C

  Finkel and Tuttle found that the capacity utilization rate, unit labor costs, rate of inflation, and foreign competition were the four major variables that affected the aggregate profit margin. If production increases as a proportion of the total capacity (raising the capacity utilization rate), per-unit fixed production costs and fixed financial costs decrease, thereby raising the profit margin.

• Question 426:

  ________ interest is the cumulative number of shares that have been sold short by investors and not covered.

  A. Minority

  B. Selling

  C. Short

  D. None of these answers

  Correct Answer: C

  The short interest is the cumulative number of shares that have been sold short by investors and not covered. Technicians consider a high short-interest ratio bullish because it indicates potential demand when those who previously sold short must cover their sales.

• Question 427:

  Technical analysts using contrary-opinion rules would consider

  A. a low cash position by mutual funds to be indicative of an upcoming market peak. When mutual funds invest a relatively low proportion of their portfolios into cash, this is usually indicative of bullish sentiment among the mutual fund managers. Technical analysts believe that the managers are wrong, and that there will be a market peak.

  B. a low cash position by mutual funds to be indicative of an upcoming market peak. When mutual funds invest a relatively low proportion of their portfolios into cash, this is usually indicative of a bearish sentiment among the mutual fund managers.

  C. a high cash position by mutual funds to be indicative of an upcoming market peak. When mutual funds invest a relatively high portion of their portfolios into cash, this is usually indicative of a bearish sentiment among the mutual fund managers.

  D. a high cash position by mutual funds to be indicative of a continuing bear market. When mutual funds invest a relatively high portion of their portfolios into cash, this is usually indicative of a bullish sentiment among the mutual fund managers. Technical analysts believe that the managers are wrong, and that there will be a continuing bear market.

  Correct Answer: A

  Contrary-opinion rules hold that the majority of investors (including mutual fund managers) are wrong as the market approached peaks or troughs. When mutual funds have a low cash position (7%, for example), technical analysts would take this as a sign that mutual fund managers are too bullish about the market, and that it will instead soon reach a peak, and fall after that.

• Question 428:

  A stock has an expected dividend growth rate of 3.5%. The firm has just paid a dividend of $1.5 per share. With a required rate of return of 8%, the stock is trading at $36.40. The stock is ________.

  A. overpriced

  B. underpriced

  C. fairly priced

  D. insufficient information

  Correct Answer: A

  In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). In this case, g = 3.5%, D1 = Do*(1 +g) = 1.5 * 1.035 = $1.5525. The price that will give k = 8% equals P = 1.5525/(8% - 3.5%) = $34.5. Since the stock is trading at a price higher than this, it is overpriced (by $1.90).

• Question 429:

  A technical analyst with Smith, Kleen and Beetchnutty is examining the automobile parts industry to determine whether its current earnings multiple is justified. In his analysis, this technical analyst examines the underlying components of the earnings multiplier, the dividend payout ratio, the required rate of return, and the expected growth rate, and the relationship between the values of these components for the automobile parts industry and the overall market. Which of the following best characterizes this method of estimating an earnings multiplier for an industry? Choose the best answer.

  A. Porter method

  B. Microanalysis

  C. Macroanalysis

  D. Sensitivity analysis

  E. Simulation analysis

  F. None of these

  Correct Answer: B

  The method profiled in this example is "microanalysis," which is one of two methods for estimating the earnings multiplier of an industry. Microanalysis involves examining the variables underlying theearnings multiplier - the required rate of return, the growth forecast, and the dividend payout ratio. In microanalysis, these variables are examined for the industry and then compare them with the values of these variables for the entire market.

  The microanalysis method is contrasted by the macroanalysis method, which involves examining the historical relationship between the earnings multiplier of an industry with that of the overall market. Macroanalysis forecasts often use a time series.

  When examining and forecasting an industry earnings multiplier, it is recommended that both macroanalysis and microanalysis be used. This should produce a more reliable answer. "Simulation analysis," and "scenario analysis," are methods of measuring stand-alone risk, and the "Porter Method" is used to measure industry competition.

• Question 430:

  Given that this period's dividend is $3, the required rate of return is 16%, and the dividend growth rate is 4%, what is the current value of the common stock (using the infinite period Dividend Discount Model)?

  A. Not enough information

  B. $18.75

  C. $25.00

  D. $26.00

  E. $19.50

  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. Next period's dividend is equal to this period's dividend multiplied by the dividend growth rate. In this question, next period's dividend is 3 x 1.04 = 3.12. The common stock is worth 3.12 / (0.16 - 0.04) = $26.