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

• Question 431:

  Which of the following correctly lists the two techniques for estimating the earnings multiplier for an industry? Choose the best answer.

  A. Residual earnings method and the arbitrage pricing theory.

  B. The top-down approach and the bottom-up approach.

  C. The industry life cycle method and the free-cash flow method.

  D. Macroanalysis and Microanalysis.

  E. The time series method and regression analysis.

  F. None of these answers is completely correct.

  Correct Answer: D

  There is two common methods for estimating the earnings multiplier for an industry - macroanalysis and microanalysis. Macroanalysis involves an examination of the relationship between the earnings multiplier for an industry and the earnings multiplier for the market. Microanalysis involves an estimation of the specific variables that influence the earnings multiplier, including the required rate of return, the estimated growth rate, and the dividend payout ratio. While the top down and bottom up method are similar to Macroanalysis and Microanalysis, respectively, they do not represent the best possible answer. Specifically, the top-down and bottom up approaches are typically used to identify investment opportunities, not for the estimation of an industry earnings multiplier.

• Question 432:

  If a stock has an expected dividend payout ratio of 50 percent, a required rate of return of 13 percent and an expected growth rate for dividends of 9 percent, what is the P/E ratio?

  A. 8.5

  B. 12.5

  C. 10

  D. None of these answers

  Correct Answer: B

  The P/E ratio is calculated as: P/E = (D/E)/(k - g). In this case P/E = 0.5/(0.13 - 0.09) = 12.5

• Question 433:

  Which would not be considered an important characteristic when studying industry analysis?

  A. sales growth comparisons

  B. evaluation of stage in industrial life cycle

  C. effective tax rate comparisons

  D. common stock yields

  E. regulatory changes

  Correct Answer: C

  Tax issues would not be of overall importance in industry analysis, yet are to be considered when forecasting industry profit margins.

• Question 434:

  The real risk free rate is 5% per year and the expected inflation rate is 3% per year. What is the annual nominal rate of interest?

  A. 8.2%

  B. Not able to compute with the above data.

  C. 8%

  D. 2%

  Correct Answer: A

  Nominal rate = (1.05)*(1.03)=8.2%.

• Question 435:

  To determine whether to make an investment you must estimate the value of the investment based on your ________ and compare that to the market price.

  A. opportunity costs

  B. required rate of return

  C. all of these answers

  D. risk-return preferences

  Correct Answer: B

  Typically one invests in order to get a series of returns in the future, to discount these future returns to net present value (NPV), one must use a discount rate, which is the rate one requires the investment to yield. Using this discount rate, one can then compare the NPV with the market price to determine if the investment is attractive.

• Question 436:

  A company pays a dividend of $6 per share to the holders of its perpetual preferred stock. The firm's bonds are currently yielding 8% per year and the firm's preferred stock are selling to yield 100 basis points below the firm's bond yield. What is the value of the preferred stock?

  A. $8.64

  B. $75.45

  C. $85.71

  D. Not able to compute with the above data.

  Correct Answer: C

  Value = dividend/discount rate = 6/0.07= $85.71. The discount rate on the preferred stock is below that of the bonds.

• Question 437:

  Technical analysts may view a buildup in credit balances as

  A. an increase in market buying power.

  B. a decrease in market buying power.

  C. an exit of investors out of the market.

  D. a rush of investors into the market.

  Correct Answer: A

  A credit balance results when an investor sells stocks and deposits the proceeds with his broker. Technical analysts view a buildup of credit balances as an increase in a pool of potential buying power that will soon be reinvested in the market. For this reason, such a buildup is viewed as a bullish sign.

• Question 438:

  Economic Value Added (EVA) equals

  A. Operating profits after adjusted taxes less the cost of total capital.

  B. Operating profits minus the cost of borrowed capital.

  C. Net income minus the cost of equity capital.

  D. Gross profits minus the cost of capital, including equity capital.

  Correct Answer: A

  The EVA measures the net value added by the firm's operations to the firm once operating costs are taken into account. It should be remembered that the EVA is designed to evaluate the value added by the operating activities over and above that required by the equity holders.

• Question 439:

  A ________ level is the price range at which the technician would expect a substantial increase in demand for the stock. A ________ level is the price range at which the technician would expect an increase in the supply of the stock to cause any price increase to reverse abruptly.

  A. base; ceiling

  B. support; resistance

  C. sell; buy

  D. bottom; top

  Correct Answer: B

  Increase demand will resist price falls, so when a price falls to a level which triggers strong demand - the price will not fall below this support level. Resistance level is a price range where trade activity in that stock will tend to reverse the price trend - this is usually due to investors having set a target price range for trade execution.

• Question 440:

  Assume the following information about a stock market series:

  Retention rate at t1 = 70%

  Expected growth rate of dividends at t1 = 8%

  Expected growth rate of earnings at t1 = 20%

  Required rate of return = 15%

  Given this information, what is the appropriate earnings multiplier for this stock market series? Further,

  what is the value of this series?

  A. 4.29; $21.43

  B. 6.00; $30.00

  C. 6.00; $120.00

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

  E. None of these answers is correct.

  F. 4.29; $53.63

  Correct Answer: D

  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 found as 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:

  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 [remember this is equal to (1 - the retention rate)], 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. The earnings multiplier of 4.29 is calculated as (1Payout ratio)/(required rate of return- growth rate) = (1-.7)/(.15-.08) = 4.29.