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

• Question 531:

  Which of the following best describes the primary reason for the greater volatility of the earnings multiplier of a stock market series compared to the EPS for the same series? Choose the best answer.

  A. The price-to-earnings ratio is less insulated from accounting distortions than is the EPS figure; i.e. it is harder to "normalize."

  B. The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking."

  C. The EPS figure is subject to a deleveraging effect caused by changes in the capital structure. * None of these answers is correct.

  D. The P/E ratio is more sensitive to increases in a company's dividends.

  E. The earnings multiplier is more sensitive to changes in the spread between "k" and "g."

  Correct Answer: E

  The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

  {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, k = the required rate of return, and g = the anticipated growth rate of dividends.

  As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier figure for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure.

• Question 532:

  A stock that you are considering for purchase has the following characteristics:

  Current dividend $2.00

  Expected dividend in 1 year $2.20

  Long term growth rate of dividends 10%

  Required rate of return 14%

  Using the infinite period Dividend Discount Model, what is the maximum price that you would pay for this

  stock?

  A. $10.00

  B. $12.00

  C. $120.00

  D. $15.00

  E. $55.00

  F. $150.00

  Correct Answer: E

  The infinite period Dividend Discount Model indicates that:

  Value = (Dividend for period 1)/(k-g) where k is the required rate of return and g is the growth rate. In this case Value = ($2.20)/(.16-.10) = $2.20/.04 = $55.

• Question 533:

  Technical analysis

  A. holds that superior returns can be gained from the use of fundamental economic and company variables.

  B. holds that past stock performance has no influence on future performance.

  C. holds that past market price and volume data can be used to predict future performance.

  D. is supported by the efficient market hypothesis.

  Correct Answer: C

  Technical analysis, in contrast to the efficient market hypothesis and fundamental analysis, holds that past price and volume data can be used to discover market trends that can predict future market behavior. Technical analysts believe that "the market is its own best predictor."

• Question 534:

  Which would have the most impact on an economy?

  A. The increasing amount of older people.

  B. The trend of less manufacturing jobs and more service industries.

  C. More disparity between the rich and poor.

  D. Population shifts to the Sun Belt, away from the Northeast.

  E. None of these answers.

  F. All of these answers are correct.

  Correct Answer: F

  All of these important demographic and social changes have profound affects on the economy.

• Question 535:

  A telecommunications analyst is attempting to value shares of Ludicrous Telecom, a multinational fiberoptics and networking company. Assume the following information for Ludicrous shares:

  Required rate of return: 14.50% per year Free cash flow to equity multiple at t4: 30 1,000,000 shares outstanding

  Additionally, the analyst has obtained the following estimates of free cash flow to equity for Ludicros Telecom over the next four years:

  Year 1: $4,000,000 Year 2: $4,500,000 Year 3: $3,500,000 Year 4: $4,800,000

  Using this information, what is the value per share of Ludicrous Telecom according to the free cash flow to equity model?

  A. $24.64

  B. $83.44

  C. None of these answers is correct.

  D. $54.60

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

  F. $99.34

  Correct Answer: C

  When determining the value of a common stock using the free cash flow to equity model, it is necessary to determine three things:

  1.

  The required rate of return on equity investments.

  2.

  The estimated free cash flow to equity multiple at time "k."

  3.

  The estimated free cash flows figures for the time periods leading up to "k."

  In this example, the calculation must begin with the discounting the free cash flow to equity figures for each of the four years provided. These figures are discounted each period by the required return on equity investments, and the final answer is converted to a per-share basis. This process is illustrated below:

  Year 1: ($4,000,000 / 1.145) / 1,000,000 shares outstanding = $3.49 Year 2: [$4,500,000 / (1.145)(1.145)] / 1,000,000 shares outstanding = $3.43 Year 3: [$3,500,000 / (1.145)(1.145)(1.145)] / 1,000,000 shares outstanding = $2.33 Year 4: [$4,800,000 / (1.145)(1.145)(1.145)(1.145)] / 1,000,000 shares outstanding = $2.79

  Now that the free cash-flow-to-equity figures have been discounted and converted to a per-share basis, the next step in the valuation process is to determine the value of the final cash flow, which is defined as:

  [(Free cash flow to equity multiple * Final free cash flow) / (1 + r)(1+r)...(1 + k)]

  In the body of this question, we were given the anticipated multiple of free cash to equity that shares of Intelligent Semiconductor will sell for at time period: specifically, 30 times. Imputing this information into the terminal cash flow equation will yield the following:

  {[30 * ($4,800,000 / 1,000,000 shares outstanding)] / [(1.145) (1.145)(1.145)(1.145)]} = $83.78. Adding the answers from step 1 to the final year cash flow will yield the following:

  Value of Intelligent Semiconductor = [$3.49 + $3.43 + $2.33 + $2.79 + $83.78] = $95.82 per share. This is illustrated by none of the answers provided.

• Question 536:

  Studies have found that the confidence index

  A. has been moderately useful for predicting stock price movements.

  B. has not been very useful for predicting stock price movements.

  C. has been very useful for predicting stock price movements.

  D. has varied more or less logarithmically with stock index values.

  Correct Answer: B

  Many technical analysts believe that the confidence index accurately reflects investors' attitudes toward financial markets. They view it as a useful way to follow the "smart money" on Wall Street. Yet several studies have found that the index is not very useful for predicting stock price movements.

• Question 537:

  Which of the following is not a stage in the industrial life cycle?

  A. Market deceleration and decline.

  B. All of these are stages in the industrial life cycle.

  C. Mature growth.

  D. Horizon growth.

  E. Accelerating growth.

  F. Development.

  Correct Answer: D

  The industry life cycle is divided into five distinct stages. Specifically, the industrial life cycle progresses from the development stage to an accelerating growth stage to a mature growth stage to a market maturation and stabilization stage. Finally, the fifth stage of the industrial life cycle is characterized by decelerating growth and sales decline. As you can see, "horizon growth" is not a stage in the industrial life cycle.

  As an industry or company progresses through the industrial life cycle, sales begin to grow rapidly (accelerating growth) then slow considerably as the product or service begins to reach critical mass (mature growth). During the mature growth stage, the industry or company grows at a slower pace, until eventually growth begins to slow considerably (market maturity and stabilization) as the market for the industry or company's products becomes more completely defined. An industry or company typically reaches the fifth stage of the industrial life cycle, growth deceleration and decline, only after many years of stabilization. For example, the automobile became widely available in the early 20th century, and the automobile industry has experienced a period of stabilization for nearly 50 years. The market for automobiles is still experiencing single digit annual growth, and has arguably not progressed into the decline stage.

• Question 538:

  Projecting a firm's net profit margin should include an analysis of:

  A. all of these answers

  B. the firm's relationship with its industry, which should indicate whether the company's past performance is attributable to its industry or if it is unique to the firm

  C. the firm's specific competitive strategy, either low cost or differentiation

  D. the firm's internal performance, including general company trends and consideration of any problems that might affect its future performance

  Correct Answer: A

  These three examinations help in understanding the firm's past performance and provide the background to make meaningful estimates for the future.

• Question 539:

  The government decides to change its fiscal stance by raising levels of general taxation. What layer of the top-down equity valuation would the change impact the most?

  A. It impacts all steps equally.

  B. General economic forecast.

  C. Security selection.

  D. Projected economic outlook for the industry.

  Correct Answer: B

  Government economic activity primarily impacts the first stage of the top down approach.

• Question 540:

  Which of the following have a clear positive relationship with operating profit margin?

  A. Inflation

  B. Unit labor costs

  C. Capacity utilization rates D. Foreign competition

  Correct Answer: C

  Higher capacity utilization rates intuitively improves operating margin because of economies of scale, though up to certain volume whereby typically there will be some diminishing returns.