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

• Question 471:

  Which of the following variables have a positive relationship with the P/E ratio?

  A. Dividend payout ratio

  B. Both the growth rate of dividends and the dividend payout ratio

  C. Growth rate of dividends

  D. Required rate of return

  Correct Answer: B

  If larger dividends are paid out, one is willing to pay a higher price for the stock. However, if a high rate of return is required, one should be paying less for the dividend streams in general.

• Question 472:

  A portfolio manager is examining shares of Ottawa Industries to determine if the shares are fairly valued. Ottawa Industries common stock is currently trading at $70 per share on the New York Stock Exchange. In her analysis, the portfolio manager determines the value of Ottawa Industries common stock using the two-stage dividend growth rate model. Due to the release of several important new products, the Company is anticipated to grow at a rate of 16% per year for the next three years. After this supernormal growth rate period, Ottawa Industries is anticipated to return to its long-term growth rate of 12% per year. The Company recently paid an annual dividend of $0.90 per share, and investments of a similar nature have warranted a 13.5% per year rate of return.

  Given this information, what is the value of Ottawa Industries common stock? Use the dividend discount model. Additionally, are shares of Ottawa Industries currently overvalued, undervalued, or fairly valued in the stock market?

  A. None of these answers is correct.

  B. $74.56, undervalued

  C. $103, undervalued

  D. $98, overvalued

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

  F. $100, fairly valued

  Correct Answer: B

  The multi-stage dividend discount model is a more realistic way of valuing fast-growing companies that pay dividends. With this model, it is necessary to estimate the above-average, or "supernormal," rate of growth, as well as the long-term rate of growth. Once these growth rates have been determined, they are used to calculate the anticipated annual dividends leading up to the "horizon point" at which the growth rate decelerates to the long-run rate of growth.

  Incorporating the given information into the two-stage dividend discount model will yield the following

  P = {[$0.90 * 1.16) / 1.135] + [($1.044 * 1.16 / 1.28823] + [($1.21104 * 1.16) / 1.46214] + [($1.40481 * 1.12) / (.135 - .12)]/1.46214}

  Which can further be developed into:

  P = {$0.91982 + $0.94008 + $0.96079 + $71.74} = $74.56

  Assuming that the results produced by the multi-stage dividend discount model are accurate, Ottawa industries common stock appears to be undervalued.

• Question 473:

  Given current earnings of $2 per share, an expected dividend growth rate of 10% and a P/E of 12.5, what is the value of the stock?

  A. $30.50

  B. $22.50

  C. None of these answers

  D. $27.50

  Correct Answer: D

  The next period earnings is $2.00 x 1.10 or $2.20. The value of the stock is thus the P/E ratio times the earnings = 12.5 x $2.20 or $27.50

• Question 474:

  Which of the following represents a "contrary opinion" technical indicator?

  A. The Diffusion Index.

  B. Investment advisor opinions.

  C. T-Bill-Eurodollar spread.

  D. The Confidence Index.

  E. Short sales by specialists.

  F. More than one of these answers is correct.

  Correct Answer: B

  Of the choices listed, only "investment advisor opinions" represents a contrary opinion technical indicator. Technical analysts often believe that the majority of market participants are incorrect in their opinions about market direction and valuation, especially preceding market peaks and troughs. This style of thinking is often referred to as "contrary opinion" technical analysis.

  Contrarian technical analysts often examine the opinions of market participants, including investment advisors and futures speculators, for insight into the overall sentiment of securities professionals.

  Believing these individuals to be inaccurate in their forecasts, contrary opinion technical analysts assume the contra-side opinion. So said, a high degree of bullishness amongst investment advisors is viewed as bearish by contrary opinion technical analysts. Conversely, a high degree of bearishness amongst investment advisors is viewed as a bullish signal by contrary opinion technical analysts.

  The Confidence Index is a measure of yield spreads between high-grade corporate bonds and the yields on average corporate bonds. The Diffusion Index measures the breadth of the market, and is found by taking the total volume of advancing shares plus one-half of the issues unchanged, divided by the total number of issues traded.

• Question 475:

  Interest rate expense per share

  A. has consistently increased from 1977 to the present.

  B. increased throughout the 1980s and decreased in the early 1990s.

  C. has fluctuated widely from year to year.

  D. has consistently decreased from 1977 to the present.

  Correct Answer: B

  U.S. firms in the 1980s assumed increased debt financing and financial risk. As a result, interest rate expenses increased consistently during that period. This growth was reversed after the 1989-1990 recession because of a decrease in debt levels and interest rates.

• Question 476:

  Given that the expected dividend payout ratio for a firm is 0.25, its expected profit margin is 0.12, its expected financial leverage is 0.95, its expected return on capital is 1.26, its expected EBIT is $403, and its expected growth rate is 8%, what is the firm's expected total asset turnover?

  A. 1.39

  B. 0.939

  C. 1.02

  D. Not enough information

  E. 0.839

  Correct Answer: B

  The growth rate of a firm is equal to expected retention rate of earnings multiplied by its expected ROE. The retention rate is equal to 1 - dividend payout ratio (1 - 0.25 = 0.75). The ROE is thereby equal to the growth rate divided by the retention rate (0.08 / 0.75 = 0.107). The ROE can be set equal the profit margin multiplied by the total asset turnover multiplied by financial leverage. Rearranging this yields that the total asset turnover is equal to the ROE divided by the profit margin and the financial leverage: 0.107 / (0.12 x 0.95) = 0.939.

• Question 477:

  Given that the correct value of a common stock is $29, the dividend growth rate is 6%, and next period's dividend is $2, using the infinite period Dividend Discount Model, what is the required rate of return on the common stock?

  A. 6.9%

  B. Not enough information

  C. 18.3%

  D. 14.8%

  E. 12.9%

  Correct Answer: E

  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 k = D1/(current value) + g. In this question, the required rate of return is (2 / 29) + 0.06 = 0.129 = 12.9%.

• Question 478:

  The dividend payout ratio

  A. varies positively with the retention rate of earnings.

  B. varies inversely with the retention rate of earnings.

  C. varies convexly with the retention rate of earnings.

  D. does not vary with the retention rate of earnings.

  Correct Answer: B

  The dividend payout ratio is simply one minus the retention rate (what is not retained is paid out in dividends). An increase in the dividend payout ratio would increase the earnings multiplier. But this would be partially offset by the decrease in the retention rate, which would decrease the growth rate in earnings and dividends, which would, in turn, decrease the earnings multiplier.

• Question 479:

  Which of the following firms would likely have the lowest dividend payout ratio? Further, the capital structure of this firm would likely be weighted more heavily with debt or equity? Choose the best answer.

  A. A large computer manufacturer; debt

  B. A nationwide grocery chain; debt

  C. A specialty retailer; equity

  D. A healthcare company specializing in home care; debt

  E. A fledgling biotechnology company; equity

  Correct Answer: E

  Of the firms listed, the biotechnology company would be expected to have the lowest dividend payout ratio. The nascent biotechnology industry is characterized by a high degree of investment in research and development, along with a high growth rate and high level of uncertainty. All of these factors are conducive to a high retention rate, i.e. a low dividend payout ratio.

  Further, firms within industries associated with high growth rates and high levels of uncertainty are likely to be financed primarily with equity. This is reasoned by several factors, some of which include the following:

  Firms in new industries typically have a balance sheet weighted heavily toward intangible assets, which can neither be easily liquidated nor pledged as collateral for a loan.

  Firms in new industries are characterized by a high degree of research and development expenses.

  Equity provides firms with a higher degree of agility than debt financing.

  The cash flows of firms in developing industries are characterized by a high degree of uncertainty.

• Question 480:

  Which of the following securities is commonly valued as a perpetuity? Further, which of the following best describes the equation used to value this security?

  A. Zero coupon bond; {P0 = [Face value / (1 + k)^n]}

  B. More than one of these answers is correct

  C. Preferred stock; {P0 = [d1 / k]}

  D. Common stock; {P0 = [d1 / g]}

  E. Zero coupon bond; {P0 = [Face value / (1 + k)^n] + g}

  F. Preferred stock; {P0 = [(d1 / k) +g]}

  Correct Answer: C

  A "perpetuity" is an investment which is expected to last forever. Preferred stock is commonly valued as a perpetuity, using this equation:

  {P0 = [d1 / k]}

  Where: , P0 = the price of the preferred stock at time 0, d1 = the dividend at t = 1 and k = the required rate of return.

  A zero coupon bond is not an example of a perpetuity, because the duration of the cash flows produced by a zero coupon bond has a finite and measurable life. Common stock, on the other hand, is sometimes valued as a perpetuity, but the equation provided in this example is incorrect.