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

• Question 441:

  Jones Rutherford, a portfolio manager with Churn Brothers Brokerage, has been examining a stock market series and is trying to determine the anticipated rate of return for the series. In his analysis, Jones has amassed the following information:

  Anticipated ending series value: 1475 Expected dividends during the period: $35 Observed beginning series value: 1310 Required rate of return: 19% per year

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

  A. 15.27%

  B. 13.56%

  C. 8.81%

  D. 9.92%

  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 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) = [$1475 - $1310 + $35] / $1310 = 15.27%

  This is less than the required rate of return. Assuming that the figures for the ending value and the expected dividends are accurate, then investment in this stock market series is not likely warranted.

• Question 442:

  Contrary-opinion rules hold that

  A. imitation of the trading patterns of astute investors will lead to superior returns.

  B. technical analysis is false.

  C. the majority of investors are wrong as the market approaches peaks and troughs.

  D. it is always best to trade against the general market sentiment.

  Correct Answer: C

  Contrary-opinion rules are technical trading rules that work on the assumption that the majority of investors are wrong as the market approaches peaks and troughs. Technical analysts try to determine when the majority of investors are either very bullish or bearish, and then trade in the opposite direction.

• Question 443:

  Using the dividend discount model, the spread between the required rate of return on a stock and the expected growth rate of dividends on that stock is equal to

  A. the expected dividend payment divided by its price.

  B. the dividend payout ratio divided by the price.

  C. its price divided by the dividend payout ratio.

  D. its price divided by the expected dividend payment.

  Correct Answer: A

  Using the dividend discount model, the price of a stock is equal to D / (k - g), where D is the expected dividend, k is the required rate of return, and g is the expected growth rate of dividends for the stock. Rearranging this equation yields D/P = k - g.

• Question 444:

  This shows the number of stocks advancing plus one-half the number unchanged, divided by the total number of issues traded.

  A. Odd-Lot, Short-Sales Theory

  B. Relative Trend

  C. Mutual Fund Cash Positions

  D. Diffusion Index

  E. Margin Debt

  F. Dow Theory

  G. Block Uptick-Downtick Ratio

  H. Short Sales by Specialists

  Correct Answer: D

  The diffusion index shows the daily total of stocks advancing plus one-half the number unchanged, divided by the total number of issues traded.

• Question 445:

  The ________ approach derives specific estimates for the earnings multiplier based on a range of estimates for the dividend payout, required rate of return and dividend growth rate.

  A. Gauss-Markowitz

  B. market driven

  C. specific estimate

  D. direction of change

  Correct Answer: C

  There are two ways to estimate the earnings multiplier: (1) Direction of change approach and (2) Specific estimate approach. The first focuses on change and change direction, while the other focuses on scenario-based estimates.

• Question 446:

  Assume the following information about a large pharmaceutical company.

  Net income / sales = 0.22 Total assets / common equity = 1.43 Sales / total assets = 0.65 Dividend payout ratio = 0.20

  What is the expected annual growth rate of this firm's dividends?

  A. 16.36%

  B. None of these answers is correct.

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

  D. 4.09%

  E. 8.00%

  F. 38.72%

  Correct Answer: A

  A popular model for determining the growth rate of dividends is the following: g = RR * ROE

  Where: g = the expected growth rate of dividends, RR = the retention rate (this is equal to 1 - dividend payout ratio), and ROE = the return on equity.

  Although it may at first appear otherwise, all of the necessary information has been provided. Remember the Du Pont decomposition process for ROE, which breaks down the ROE figure into the following:

  ROE = (Net Income / Sales) * (Sales / Total Assets) * (Total Assets * Common Equity)

  Mathematically, this will break down into (Net Income / Common Equity) --- the ROE figure. The calculation of the return on equity for this company is as follows:

  ROE = [0.22 * 0.65 * 1.43] = 0.204490, or 20.45%.

  Now that the ROE figure has been determined, the calculation of the growth rate of dividends is as follows:

  g = [(1 - 0.20) * 0.2045] = 16.36%

• Question 447:

  According to the infinite period Dividend Discount Model, an increase in the spread between the required rate of return on a common stock and the expected growth rate in its dividends will probably cause

  A. the stock price to decrease.

  B. price effects that cannot be predicted with the given information.

  C. earnings to fall.

  D. the stock price to increase.

  Correct Answer: A

  According to the infinite period Dividend Discount Model, the value of a common stock is equal to a fraction with next period's dividend in the numerator, and the spread between the required rate of return and the expected growth rate in dividends in the denominator. An increase in the spread will increase the value of the denominator, thereby decreasing the value of the stock.

• Question 448:

  If the OTC-to-NYSE volume is low after a substantial market decline, the contrarians interpret it as

  A. a bearish signal.

  B. none of these answers.

  C. a hold signal.

  D. a bullish signal.

  Correct Answer: D

  Since the OTC market is dominated by small stocks which are riskier than the large stocks on NYSE, a low OTC volume relative to NYSE (less than 87-90%) implies that investors are bearish. Since the contrarians bet against the market at market turning points, they will consider this behavior by investors as a bullish signal if the market is at a low.

• Question 449:

  By what factor will earnings per share will have to change for a 5% change in earnings multiplier to induce a change of 9% in the price of the stock?

  A. -12.62%

  B. +14.45%

  C. -3.67%

  D. +3.81%

  Correct Answer: D

  Stock price = earnings multiplier * earnings per share. Therefore, the earnings multiplier will have to increase by 1.09/1.05 - 1 = 3.81%.

• Question 450:

  A finance major works evenings as an intern at Churn Brothers Brokerage. As a test of her abilities, this intern has been asked to calculate the earnings multiplier of a software index. The firms that comprise this index are all high-technology names for whose products there exists great demand. Further, this demand is expected to be explosive in the future and the earnings visibility of these software firms is clear, reliable, and concise.

  In her research of the software index, the intern has gathered the following information:

  EPS: 0.39

  k: 62% per year

  g: 60% per year D1: 0.02

  Using this information, what is the earnings multiplier of this software index? Further, is this earnings multiplier realistic given the demand for the firms' products and the visibility of future earnings?

  A. 19.5, multiple is unrealistic

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

  C. None of these answers is correct.

  D. 1, multiple is unrealistic

  E. 2.56, multiple is unrealistic

  F. 2.56, multiple is realistic

  Correct Answer: E

  To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/ E = [(D1 / E1) / (k-g)

  Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.

  In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following:

  P/E of a stock market series = [($0.02*1.6 / ($0.39*1.6)) / (0.62 - 0.60)] = 2.56

  This is an extremely low multiple, appropriate for virtually no-growth industries. The fact that the index under examination is a compilation of firms in high-tech software business, for whose products there exists great demand and promise of future growth, this low multiple seems very unrealistic. Consider the fact that the P/E ratio is a proxy for future growth. Firms in the automobile, basic materials, or other mature industries, which are expected to grow slowly, are characterized by lower earnings multiples and higher dividend payout ratios. Firms in the software, networking, biotechnology, and other high-growth industries, are typically characterized by high earnings multiples and low dividend payout ratios. What is happening here is that investors are giving up current income (i.e. dividends) in the hopes of rapid earnings growth

  (i.e. greatly increased EPS in the future).