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

• Question 521:

  The NAV of a closed end fund _______ the market price of the fund.

  A. can be less than, equal to or greater than

  B. is greater than

  C. is equal to

  D. is less than

  Correct Answer: A

  Historically, the market price of a closed end fund has been 5 to 20 percent below the NAV of the fund. Closed end funds also can and do at times trade at a premium. Therefore the NAV can be less than, equal to, or greater than the market price.

• Question 522:

  Assume the following information for the common stock of Clay Industries, a large industrial firm: Required rate of return on equity: 14.5% per year Expected growth rate: 12.50% per year Dividend at t0: $0.70

  Assuming that the growth rate will remain constant, what is the projected value of Clay Industries common stock?

  A. $39.38

  B. None of these answers

  C. $32.78

  D. The answer cannot be calculated from the information provided

  E. $30.76

  F. $35.34

  Correct Answer: A

  In this example, the growth rate of dividends is assumed to remain stable, allowing the use of the Gordon Model. The Gordon Model is also known as the "constant growth dividend discount model" and takes the following form:

  P0 = [D1 / (r - g)]

  Where P0 = the price of common stock X at time 0 D1 = the expected dividend at t1 r = the required rate of return on equity investments and g = the expected growth rate of dividends.

  Since the dividend at t1 is not provided, we must calculate it manually by multiplying the dividend at t0 by (1 + g). This will produce an answer of $0.7875 at t1.

  Now that the dividend at t1 has been determined, the given information can be put into the equation provided, leading to the following series of calculations:

  P0 = [$0.7875 / (.145 - .125)] = $39.38.

  When using the Gordon model, remember that the required rate of return "r" must be greater than the expected growth rate "g." Otherwise, this equation will produce a nonsensical answer.

• Question 523:

  If the earnings per share on the Dow Jones were to fall, the Dow Jones:

  A. the question is based on a false premise. Dow Jones is an index and does not have an associated "earnings per share."

  B. will increase in value.

  C. will decrease in value.

  D. may increase or decrease in value.

  Correct Answer: D

  The index value = earnings multiplier * earnings per share.

  Even if the earnings per share fall, the earnings multiplier can increase if the outlook for future earnings

  improves. Hence, a decrease in the earnings itself does not automatically imply that the Dow Jones will

  fall.

• Question 524:

  Which of the following factors determine the growth rate of dividends?

  A. Growth rate of earnings and the payout ratio

  B. Growth rate of earnings

  C. Depends on the individual firm

  D. Growth rate of earnings and cash flow

  Correct Answer: A

  While growth rate of earnings gives a sense of future opportunities, the payout ratio determines how much reinvestment is made to capture these opportunities. The better the firm performs, the higher the chances of higher future dividends.

• Question 525:

  Dewpoint Systems is a renowned firm, with a total asset turnover of 1.3. A conservative firm, it has a low debt-to-equity ratio of 0.2. It manages to keep 15% of its sales as net profit and pays out 63% of the earnings as dividends. It has a beta of 0.79, at a time when the market risk premium is 6.3%. Assuming a risk-free investment rate of 6.4%, Dewpoint's price-to-earnings multiple equals ________.

  A. 18.22

  B. 23.16

  C. 11.59

  D. 13.62

  Correct Answer: B

  The Dividend Discount Model implies that the firm's price-to-earnings ratio is given by Po/E1 = (D1/E1)/(kg) = (dividend payout ratio)/(k-g), using standard notation.

  The dividend growth rate is given by g = ROE*(1-dividend payout ratio).

  ROE = net income/common equity = (net income/sales)*(sales/assets)*(assets/equity) = profit margin * asset turnover*(1 + debt / equity) = 0.15 * 1.3*(1+0.2) = 23.4%.

  Therefore, g = 23.4%*(1-63%) = 8.66%.

  The CAPM expected rate of return on the stock is equal to the risk-free rate plus beta times the market premium. So the expected return on the stock is 6.4% + 0.79 * 6.3% = 11.38%. Therefore, the price-toearnings ratio equals 0.63/(11.38 - 8.66)% = 23.16.

• Question 526:

  Which of the following is not a component of Porter's Five Force Model of industry competition?

  A. All of these are components of Porter's Five Force Model.

  B. Threat of new entrants.

  C. Threat of substitute products.

  D. Bargaining power of buyers.

  E. Bargaining power of suppliers.

  F. Threat of technological obsolescence.

  Correct Answer: F

  Porter's Five Force Model of industry competition, named after its creator, famed Harvard professor Micheal Porter, is used to measure the amount of competition within industries. The five forces within this model are as follows:

  Threat of new entrants Threat of substitute products Bargaining buyer of buyers Bargaining power of suppliers Rivalry of existing firms

  A shift in any of these threats will lead to a change in industry competition. As you can see, "threat of technological obsolescence" is not named as an explicit threat within the Five Forces Model.

• Question 527:

  A mutual fund started last year by issuing 1,000 shares at $100 per share. This amount was invested in 3 different stocks,

  A - 500 shares at $50 per share B - 600 shares at $70 per share C - 1,000 shares at $33 per share

  The current stock prices are $58 for A, $63 for B and $37 for stock C. The fund's NAV equals ________.

  A. $100

  B. $98.3

  C. none of these answers

  D. $102.9

  Correct Answer: C

  The fund's total assets are worth 500 * 58 + 600 * 63 + 1,000 * 37 = 103,800. Hence, the NAV equals 103,800/1,000 = $103.8

• Question 528:

  A firm follows the simple growth model and can invest $1000 every year into new projects which have a rate of return of 17%. Each project generates a constant stream of earnings year after year. The firm's stock has a required rate of return of 13%. If the firm is founded today, the firm value equals ________.

  A. $3,165

  B. $1,895

  C. $2,675

  D. $2,440

  Correct Answer: C

  You should be careful in solving such a problem.

  Suppose the firm invests $1,000 today in a project. This first project generates a constant stream of perpetuity with an annual payment of $1,000 * 0.17 = $170. The present value of this stream is 170/0.13 = $1,307.6. The NPV of the project is then $1,307.6 - $1,000 = $307.6. Since the firm does this every year, it has a perpetuity of $307.6 (the NPVs of projects 2 and on, at the time the projects are started).The present value of these NPVs is $307.6/0.13 = $2,367. Thus, the total value of the firm is $2,367 + $307.6 (first project) = $2,675.

• Question 529:

  Which of the following statements is true?

  A. Given a small decrease in the real risk-free rate, a large increase in the risk premium for a stock, and a large decrease in the return on equity, one would expect the required rate of return on the stock to increase, the growth rate to decrease, and the earnings multiplier to increase.

  B. Given a large decrease in the rate of inflation and the risk premium for a stock, and a large increase in the return on equity, one would expect the required rate of return on the stock to decrease, the growth rate to increase, and the earnings multiplier to increase.

  C. Given a large increase in the rate of inflation, a small decrease in the risk premium for a stock, and a large decrease in the return on equity, one would expect the required rate of return on the stock to decrease, the growth rate to decrease, and the earnings multiplier to decrease.

  D. Given a small increase in the rate of inflation, a small increase in risk premium for a stock, and a larger decrease in the return on equity, one would expect the required rate of return on the stock to increase, the growth rate to decrease, and the earnings multiplier to increase.

  Correct Answer: B

  The direction of change approach to estimating an earnings multiplier begins with the current earnings multiplier and estimates the direction of change for the dividend payout ratio and the variables that influence the required rate of return and growth rate. The required rate of return is positively correlated with the real risk-free rate, the rate of inflation, and the risk premium. The growth rate is positively correlated with the return on equity and earnings retention rate. The earnings multiplier is positively correlated with the growth rate, and negatively correlated with the required rate of return.

• Question 530:

  Which of the following events would a technical analyst interpret as bullish?

  A. a decline in the ratio of specialist's short sales to total short sales

  B. all of these answers

  C. an increase in debit balances in brokerage accounts

  D. when the proportion of bullish speculators declines to 30 percent

  Correct Answer: B

  (1)

  Decline of specialist's short sale ratio to below 30%;

  (2)

  Increase in debit balance means that investors have to post increasing margin to for more investments;

  (3)

  Percentage of bullish stock futures speculators decline (because if market is bullish then speculation is irrelevant) - are all signs that the market may be turning bullish.