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

• Question 541:

  The real risk-free rate of return depends most on

  A. the real growth rate of the economy.

  B. money supply.

  C. interest rates.

  D. inflation.

  Correct Answer: A

  The real risk-free rate of return does not take inflation into account (in contrast to the nominal risk-free

  rate). It should depend on the real growth rate of the economy because the capital invested should grow at

  least as fast as the economy.

  The rate can also be temporarily affected by tightness or ease in the capital markets.

• Question 542:

  If the ratio of specialists' short sales to total short sales is 25%, then technicians would view this as

  A. neither particularly bullish nor bearish.

  B. a bearish sign.

  C. a sign of an approaching flat market trend.

  D. a sign of a approaching market peak.

  E. a bullish sign.

  Correct Answer: E

  Technical analysts trying to follow the "smart money" sometimes use the proportion of specialists' short sales to total short sales as a market indicator. A decline of the ratio below 30% is viewed as a bullish sign, indicating that specialists are trying to minimize participation in short sales in expectation of a rising market. A increase in the ratio above 50%, conversely, is viewed as a bearish sign.

• Question 543:

  An analyst with Churn Brothers Brokerage is examining shares of the common stock of Nexis Pharmaceuticals. Consider the following information about Nexis' common stock:

  Price per share: $98.73 Last dividend per share: $1.30 Expected growth rate: 12% per year Required return: 11% per year

  What is the value of Nexis' common stock? Choose the best answer.

  A. $130

  B. The Infinite Period DDM will produce a nonsensical answer in this case.

  C. $146

  D. $110

  E. $89

  Correct Answer: B

  The Infinite Period DDM will produce a nonsensical answer in this case because the required rate of return

  is less than the growth rate. This will lead to a negative answer for the value of Nexis Pharmaceutical

  common stock! The following equation illustrates the Infinite Period DDM:

  {P0 = [D1 / (k - g)]}

  Where: P0 = the price of the common stock at t0, D1 = the annual dividend at t1 (this is found by

  multiplying the dividend at t0 by (1 + expected growth rate), k = the required rate of return, and g = the

  anticipated growth rate.

  As you can see, the Infinite Period DDM should not be used in this case, because the annual growth rate is

  in excess of the required rate of return. In this instance, the analyst should first reexamine his figures for

  the growth rate and required rate of return. If these figures are indeed accurate, then another method

  should be used to value the stock.

• Question 544:

  Growth companies are:

  A. all of these answers.

  B. companies whose shares generate returns higher than stocks with similar risks.

  C. companies that have consistently above-average sales and earnings.

  D. companies that have management abilities and investment opportunities that yield rates of return higher than the required rate of return.

  Correct Answer: D

  Growth companies need not have stocks that generate higher than required rates of return. They have rates of return on their investments which are higher than that required by the risks in the investments since the market impounds all available information in the stock price. Further, growth companies are measured in terms of the growth and not the level of sales and earnings.

• Question 545:

  What is the value of a bond with coupon payments of $150 every six months, a final payment of $5,500 in 12 years, and a risk-premium of 8%?

  A. Not enough information

  B. $3,864

  C. $2,239

  D. $3,046

  E. $1,240

  Correct Answer: A

  In order to take the present value of the coupon and principal payments, one must know the required rate of return on the bond. The required rate of return is equal to the risk-free rate plus the risk premium. The risk-free rate is not given, so there is not enough information to answer the question.

• Question 546:

  A firm has a dividend growth rate of 4.3%. It typically pays out 45% of its earnings as dividends. Recently, it paid out $1.2 per share dividend and the required rate of return on its stock is 12.6%. The firm's return on equity equals ________.

  A. 7.82%

  B. none of these answers

  C. 9.56%

  D. 12.60%

  Correct Answer: A

  The dividend growth rate equals the product of ROE and the earnings retention ratio. The earnings retention in this case equals 1 - 0.45 = 0.55. Hence, the ROE equals 4.3%/0.55 = 7.82%.

• Question 547:

  Which statement is true concerning Americans living longer?

  A. All of these statements are true.

  B. None of these statements are true.

  C. The elderly have more disposable income than the younger population.

  D. The income group that has advanced the most is that of the elderly.

  E. The health care industry should expect to grow.

  F. Youth-oriented industries should expect to shrink.

  Correct Answer: A

  These are all trends that have happened or should expect to happen in the future given the fact that there will be more older people in the population.

• Question 548:

  Alpha is a 9% load-fund, which you expect to have an annual rate of return of about 19% over the next 2 years. Beta is a no-load fund, which is expected to have a rate of return of around 13%. If your investment horizon is 2 years, which fund should you invest in and what is your expected net rate of return per year?

  A. Alpha; 13.5%

  B. none of these answers

  C. Beta; 13.0%

  D. Alpha; 17.3%

  Correct Answer: A

  With fund Alpha, a deposit of $100 will give you shares worth $91 after the load charge is taken into account. This amount is expected to grow to 91*(1+0.19)^2 = $128.87. Thus, the net return with Alpha is expected to be (128.87/100)^0.5 - 1 = 13.52% per year, annually compounded. Hence, for a 2 year horizon, you should select Alpha, since Beta has an annual rate of 13%.

• Question 549:

  An economist with Smith, Kleen and Beetchnutty Institutional Brokerage has been examining a stock market series and is trying to determine the anticipated rate of return for the series. In her research, this economist has determined the following information:

  Anticipated ending value: 11,800 Expected dividends during the period: $521 Observed beginning value: 10,050.14 Required rate of return: 17.50%

  Using this information, what is the anticipated rate of return for this stock market series? (Assume a oneyear holding period).

  A. 19.24%

  B. None of these answers is correct.

  C. 12.23%

  D. 24.41%

  E. 22.60%

  Correct Answer: E

  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) = [$11,800 - $10,050.14 + $521]/10,050} = 22.60%. This figure is significantly higher than the required rate of return. Assuming that the anticipated ending value and expected dividends prove accurate, investment in this stock market series is likely advisable.

• Question 550:

  Joe Wellworth, an oil analyst with Smith, Kleen and Beetchnutty institutional brokerage, is trying to determine an appropriate earnings multiplier for the natural gas industry. In his research, Mr. Wellworth has examined the relationship between the earnings multiplier of the natural gas industry and the Price-to-Earnings ratio of the Standard and Poors 500. Using a time series analysis, Joe examines the trend in the relationship between the natural gas industry and the overall market and uses this information to estimate the appropriate earnings multiplier for the natural gas industry.

  Which of the following best characterizes this method of estimating the earnings multiplier of an industry? Choose the best answer.

  A. Correlation analysis

  B. Microanalysis

  C. The bottom-up approach

  D. Time series analysis

  E. Macroanalysis

  Correct Answer: E

  The answer called for in this example is macroanalysis. This method involves an examination of the relationship between the earnings multiplier of a stock market series and the earnings multiplier of the overall market. For example, an individual projecting an earnings multiplier for a software index using macroanalysis would begin by examining the relationship between the P/E ratio of the software index and the P/E ratio of a broad market index such as the Standard and Poors 500. Both historical trends and point estimates would be examined, and from this information, a projection of the earnings multiplier for the stock market series is deduced. This is precisely the process illustrated in this example.

  This is contrasted by microanalysis, which involves an examination of the components of the earnings multiplier, including the anticipated growth rate of dividends, the required rate of return, and the dividend payout ratio. Once these variables have been examined, both from the perspective of trend analysis and point estimation, a value for the earnings multiplier is deduced.

  The bottom-up approach is used in the investment selection process, and involves identifying superior investments by first examining companies, rather than beginning with an examination of macroeconomic cycles and influence. Time series analysis, while materially correct, does not represent the best possible answer. L1 SS 13