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

• Question 581:

  Consider the following information about a natural gas driller:

  Next annual dividend: $1.18 Earnings per share next year: $4.60 Anticipated growth rate: 12.5% per year Required rate of return: 15% per year

  What is the expected earnings multiplier for this utility company?

  A. 12.46

  B. 10.26

  C. 53.10

  D. 15.59

  E. 47.20

  F. None of these answers is correct.

  Correct Answer: B

  To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula:

  P/E = [(d1 / e1) / (k - g)]

  Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate.

  In this example, all of the necessary information has been provided, but some rearranging is necessary.

  Specifically, the dividend payout ratio must be determined. This figure is found as follows:

  Dividend payout ratio = [$1.18 / $4.60] = 0.256522, or 25.65%

  Now that the dividend payout ratio has been determined, we can solve for the appropriate earnings multiplier. The calculation of this figure is found as follows:

  P/E = [0.2565 / (0.15 - 0.125)] = 10.26

  In generally favorable economic conditions, this is a pretty realistic multiple for an average natural gas drilling company.

• Question 582:

  The estimate of ________ combined with the firm's retention rate will indicate its growth potential.

  A. ROE

  B. assets

  C. ROA

  D. current ratio

  E. equity

  Correct Answer: A

  The estimate of ROE combined with the firm's retention rate will indicate its growth potential.

• Question 583:

  The current dividend yield on a stock A is 3.2%. The stock has a required rate of return of 9%. If the firm just paid a dividend of $1.65, what's the expected dividend for next year, assuming a constant growth rate?

  A. $2.01

  B. $1.89

  C. $1.75

  D. $1.83

  Correct Answer: C

  The dividend yield, defined as the expected dividend next period divided by current price, equals D1/Po, in

  standard notation. Using the Dividend Discount Model, this is equal to k - g. With k = 9%, we get 3.2% =

  9% - g. Therefore, g = 5.8%.

  The expected dividend next year is then equal to 1.65 * 1.058 = $1.75.

• Question 584:

  When studying industry analysis, which would be of most importance when concentrating on financial performance?

  A. all of these would be important

  B. financial leverage

  C. components of return on equity

  D. return on total capital

  E. return on foreign investments

  Correct Answer: A

  These are all factors in financial performance when studying industry analysis.

• Question 585:

  Which of the following is not an assumption of technical analysis?

  A. Securities markets are weak-form efficient.

  B. Changes in the market value of any good are determined solely by supply and demand fluctuations.

  C. Securities prices exhibit identifiable patterns.

  D. Supply and demand is governed by both rational and irrational factors.

  E. More than one of these answers is correct.

  F. Securities prices move in identifiable trends.

  Correct Answer: A

  Technical analysis is primarily grounded on three major assumptions - (1.) the market value of any good is determined solely by supply and demand, (2.) supply and demand fluctuations are caused by both rational and irrational factors, and (3.) the prices of individual securities and securities markets move in trends, i.e. securities markets "price-in" information slowly. The third assumption of technical analysis negates any belief in the Weak Form Efficient Market Hypothesis, which assumes that past performance data cannot be used to predict securities prices, and that the securities markets "price-in" information instantly. This "incongruence" with all forms of the EMH is cited as the greatest criticism of technical analysis.

• Question 586:

  Jim, an investment manager with Smith, Kleen and Associates, is in the process of determining the

  annualized return for a client portfolio. Jim uses a specific three-step process to determine this annualized

  return, which is detailed as follows:

  Step 1:

  Jim prices the portfolio immediately prior to any significant addition or withdrawal of funds. The portfolio is

  broken into specific subperiods based on the dates of cash inflows and outflows. The product of the

  subperiods is 10 years.

  Step 2:

  Jim calculates the holding period return of the portfolio for each subperiod.

  Step 3:

  Jim calculates the geometric mean of the annual returns. This calculation is used as the annual portfolio

  return measure.

  Which of the following best describes the final calculation produced by Jim?

  A. Dollar-weighted rate of return

  B. Time-weighted rate of return

  C. Modified Internal Rate of Return

  D. Annualized holding period return

  E. Geometrical rate of return

  F. Asset-weighted rate of return

  Correct Answer: B

  The process illustrated in this example is the calculation of the time-weighted rate of return. This method of calculating portfolio returns is superior in many respects to the dollar-weighted rate of return, which is also known as the IRR. The reason for this relative superiority is the fact that the time-weighted rate of return is not sensitive to portfolio additions or withdrawals. So said, the time-weighted rate of return is more popular in the field of investment management.

  While "annualized holding period return" is a tempting choice, it does not represent the best possible answer. "Geometrical rate of return" could refer to several return measures, but not the time-weighted rate of return.

• Question 587:

  If the spread between the required rate of return and the anticipated dividend growth rate were to decrease significantly and suddenly while the remaining components of the P/E ratio were to remain unchanged, which of the following would likely occur? Further, a decrease in the retention rate would lead to what effect on the earnings multiplier, holding both k and g constant?

  A. The earnings multiplier would increase; the earnings multiplier would increase.

  B. The earnings multiplier would decrease; the earnings multiplier would decrease.

  C. The earnings multiplier would increase; the earnings multiplier would either increase or decrease depending on the firm's ROE compared to its cost of capital.

  D. The earnings multiplier would increase; the earnings multiplier would decrease.

  E. The earnings multiplier would decrease; the earnings multiplier would increase.

  Correct Answer: A

  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 the spread between k and g narrows, the earnings multiplier figure will increase. Indeed, the earnings multiplier is very sensitive to changes in the spread between k and g, and this is the primary reason for the greater relative volatility of the P/E ratio versus the EPS figure for a stock market series.

  A decrease in the retention rate will lead to an increase in the earnings multiplier figure, holding everything else equal. Remember that the retention rate is simply (1 - dividend payout ratio). So, a decline in the retention rate is analogous to an increase in the dividend payout ratio. An increase in the dividend payout ratio, holding everything else equal, will lead to an increase in the earnings multiplier figure.

• Question 588:

  Which of the following is NOT typically true for a firm which has adopted the low-cost competitive strategy?

  A. The firm will enjoy above-average rates of return only if its price premium based on its differentiation exceeds the extra cost of being unique.

  B. None of these answers.

  C. All of these answers.

  D. The firm seeks to differentiate itself based on its distribution system, through some unique marketing approach, or by providing an important service to its customers.

  E. The firm seeks to identify itself as unique in its industry in an area that is important to buyers.

  Correct Answer: C

  The above are all true for a company that has adopted the differentiation strategy. With the low-cost strategy, the firm is determined to become the low-cost producer and, hence, the cost leader in the industry. Cost advantage might include economies of scale, proprietary technology, or preferential access to raw materials. The objective is to charge less for the product or service but still enjoy higher profit margins and returns on capital.

• Question 589:

  Which of the following is not an advantage of technical analysis?

  A. It does not involve adjusting for accounting problems.

  B. It tells when to buy and sell not why investors are buying and selling.

  C. It only incorporates economic reasoning.

  D. It is quick and easy.

  Correct Answer: C

  It incorporates economic and psychological reasoning.

• Question 590:

  Analytics Software Incorporated currently pays 20% of its earnings in dividends and the Company has a steady growth rate of 25% per year. Assuming a 27.5% per year required rate of return, what is the appropriate earnings multiplier for Analytics Software?

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

  B. 16

  C. 18

  D. 22

  E. 8

  F. 9

  Correct Answer: E

  To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula:

  P/E = [(d1 / e1) / (k - g)]

  Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate.

  In this example, all of the necessary information has been provided, and the calculation of the earnings multiplier is as follows:

  P/E = [0.20 / (0.275 - 0.25)] = 8

  This multiplier is likely low for a software firm growing at 25% annually. An analyst examining shares of Analytics Software would likely take this disparity into account in his or her analysis. Perhaps the use of the Infinite Period DDM to determine an earnings multiplier for this company is unrealistic. Perhaps valuing this company in accordance to anticipated free cash flows would provide a more realistic measure of value.