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

• Question 51:

  An analyst is involved in the top-down equity valuation approach. He decides to compare an individual firm's performance within the entire industry using financial ratios and cash flow values. What stage of the top-down approach is he engaged in?

  A. Security selection.

  B. He is performing all three stages.

  C. General economic forecast.

  D. Projected economic outlook for the industry.

  Correct Answer: A

  This is a description of the final stage, security selection.

• Question 52:

  In contrast to ________, which generally is an evaluation of internal performance, ________ is a measure of external performance.

  A. economic value-added, the franchise factor

  B. the price/cash flow ratio, the price/book value ratio

  C. market value-added, economic value-added

  D. economic value-added, market value-added

  Correct Answer: D

  To properly analyze performance using either economic value-added or market value-added, it is necessary to look for changes over time, the percent change each year.

• Question 53:

  Which of the following is/are true about a closed-end fund?

  I. Shares of the fund trade on an exchange.

  II. The market price of the fund is determined by supply and demand.

  III.

  It issues shares only infrequently.

  A.

  I only

  B.

  II only

  C.

  I and III

  D.

  III only

  E.

  I, II and III

  F.

  II and III

  G.

  I and II

  Correct Answer: E

  Shares of a closed-end fund trade on an exchange like those of any other firm, with the share price determined by the laws of supply and demand. The fund issues new shares only infrequently, when it needs additional capital.

• Question 54:

  James Clinton, a portfolio manager with Middle Road Investment Advisors, is trying to estimate the appropriate earnings multiplier for the automobile industry. In his analysis, James examines the expected growth rate of dividends for the industry, as well as the expected dividend payout ratio and required rate of return. From this information, James proceeds toward an estimation of the earnings multiplier for the series.

  Which of the following best describes this method of estimating an earnings multiplier for an industry?

  A. Microanalysis

  B. The specific estimate approach

  C. The rate of change approach

  D. Input-output analysis

  E. Macroanalysis

  F. The arbitrage pricing method

  Correct Answer: A

  The answer called for in this question is "microanalysis." This method 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.

  Microanalysis is contrasted by macroanalysis, which 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.

  Input-output analysis is used in the examination of competitive forces within an industry. The arbitrage pricing model is a security valuation model which allows for several relevant "situation specific" variables. Finally, the "specific estimate" and "rate of change" approaches are used to estimate the earnings multiplier of a stock market series, rather than an industry.

• Question 55:

  Charles Ray, a portfolio manager with Bay Side Brokerage, is examining shares of a large money center bank. In his analysis, Mr. Ray has determined that the $1.20 per share dividend of this company isanticipated to grow at 14.5% annually. Additionally, Charles Ray has calculated his required rate of return as 16% per year. Assuming that Charles Ray can sell his shares of this bank for $85 at the end of three years, what is the value of this common stock?

  A. $57.96

  B. $54.82

  C. $63.88

  D. $92.45

  E. The Multiple Period DDM will produce a nonsensical answer for this stock.

  Correct Answer: A

  The Multiple Holding Period form of the Dividend Discount Model takes the following form: {V = {[d1 / (1 + k)] + [d2 / (1 + k)^2] + ... .[dn / (1 + k)^n] + [Pn / (1 + k)^n]} Where: V = the price of the common stock at t0, d1 = the annual dividend at t1 (this is found by multiplying the annual dividend at t0 by (1 + the anticipated growth rate), d2 = the annual dividend at t2 (this is found by multiplying the dividend at t1 by (1 + the anticipated growth rate), k = the required rate of return, n = period "n", and Pn = the sale price of the common stock at time "n". In this example, time "n" is the third year, as this is the end horizon for the investor's holding period. Had the investor in this example forecasted selling the shares at the end of the 9th year, then "n" would be the ninth year. Now that the formality of expressing the equation for this form of the DDM has been carried through, we can move toward a calculation of the value of this common stock. In this example, all of the necessary information has been provided, and the calculation of the value of this

  retail stock is as follows:

  {V = [($1.20 * 1.145) / (1 + 0.16)^1] + [($1.374 * 1.145) / (1 + 0.16)^2] + [($1.57323 * 1.145) / (1 + 0.16)^3]

  + [$85 / (1 + 0.16)^3]}

  which can be further reduced to the following:

  {V = [$1.184483 + $1.169166 + $1.154048 + $54.455902] = $57.96}

• Question 56:

  A portfolio manager with Churn Brothers Brokerage has recently been approached by one of its institutional accounts requesting that the dollar-weighted rate of return for the Microspeculative investment be calculated.

  Consider the following series of transactions:

  t0: Purchase 20,000 shares for $0.90 per share t1: Purchase 50,000 shares for $1.13 per share t2: Purchase 50,000 shares for $1.20 per share t3: Sell 20,000 shares of for $1.22 per share Sell 80,000 shares of for $1.20 per share Sell 20,000 shares of for $1.17 per share

  Ignoring commissions, what is the dollar-weighted rate of return for this investment?

  A. (3.77%)

  B. (1.20%)

  C. 4.02%

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

  E. 4.94%

  F. None of these answers is correct.

  Correct Answer: C

  Remember that the dollar-weighted rate of return uses the IRR equation in the determination of its answer.

  Further, the dollar-weighted rate of return is another name for the IRR equation, and this nomenclature is

  commonly used within the field of investment management. The logic behind this characterization is the

  fact that the IRR equation takes into account both the timing and scale of all project cash flows. In the

  determination of the dollar-weighted rate of return calculation, the first step should be to identify the cash

  flows for each period. This process is illustrated as follows:

  t0: -[20,000 shares purchased * $0.90 per share] = [$18,000]

  t1: -[50,000 shares purchased * $1.13 per share] ] = [$56,500]

  t2: -[50,000 shares purchased * $1.20 per share] = [$60,000]

  t3: [(20,000 shares sold * $1.22 per share) + (80,000 shares sold * $1.20) + (20,000 shares sold * $1.17

  per share)] = $143,800

  Now that the cash flows have been determined, incorporating this information into your calculator's cash

  flow worksheet and solving for IRR will yield a dollar-weighted rate of return of 4.02% for this investment.

• Question 57:

  In estimating a firm's earnings multiplier, finding the firm's required rate of return involves analyzing the firm's fundamental risk characteristics. Which of the following is not considered a fundamental risk?

  A. Business risk

  B. Exchange rate risk

  C. Financial risk

  D. Country risk

  E. Liquidity risk

  F. Government risk

  Correct Answer: F

  In addition to the consideration of fundamental factors, one should consider market-determined risk (beta) based on the CAPM. A low beta combined with below-average fundamental risk, for example, would indicate that the firm's risk is quite low compared to the aggregate market. This means that the risk premium and the required rate of return for this firm should be lower than the market. By itself, this lower required rate of return would suggest an earnings multiplier above the market multiplier.

• Question 58:

  A restrictive monetary policy will not

  A. raise firms' costs by raising interest rates.

  B. increase firms' costs by decreasing interest rates.

  C. have an influence on individual firms.

  D. reduce the supply of funds for working capital and expansion available to firms.

  Correct Answer: B

  A restrictive monetary policy often raises interest rates (and never lowers them). Such increases in rates would increase the cost of borrowing for firms. A restrictive monetary policy may also reduce the growth rate of monetary supply, and thus reduce the supply of funds for working capital and expansion available to businesses.

• Question 59:

  According to the contrarians, if a substantial number of investment advisory services are bearish, it implies:

  I. the market is reaching a peak.

  II. the onset of a market decline.

  III.

  the beginning of a bull market.

  A.

  III only

  B.

  I and II

  C.

  II only

  D.

  I only

  Correct Answer: A

  Contrarians believe that most market participants make wrong investment decisions as the market approaches the peak or trough in a cycle. Therefore, if a large number of advisory services are bearish, they believe that the market is about to turn bullish after having reached a trough.

• Question 60:

  The required rate of return on a security is determined by

  A. three factors: the real risk-free rate of return, the expected rate of inflation, and the risk premium. The real risk-free rate of return and the expected rate of inflation are used to arrive at the nominal risk-free rate. The risk premium of a security is a function of its variance, and may well fluctuate over time.

  B. two factors: the real risk-free rate of return and the risk premium. The risk-free rate of return may be influenced in the short-term by tightness or ease in the capital markets. The risk premium of a security is a function of its variance, and tends to be stable over time.

  C. two factors: the real risk-free rate of return, and the risk premium. The risk-free rate of return should depend on the real growth rate of the economy because capital should grow at least as fast as the economy. The risk premium of a security is a function of its risk relative to the market, and tends to be stable over time.

  D. three factors: the real risk-free rate of return, the expected rate of inflation, and the risk premium. The risk-free rate of return (which along with inflation determines the nominal risk-free rate) may be influenced in the short-term by tightness or ease in the capital markets. The risk premium of a security is a function of its risk relative to the market, and may well fluctuate over time.

  Correct Answer: D

  Although the long-term risk-free rate of return should depend on the real growth rate of the economy, it may be influenced in the short-term by tightness or ease in the capital markets. The nominal risk-free rate is equal to (1 + real risk-free rate) x (1 + inflation rate) - 1. The risk premium is the extra yield that a security requires over the nominal risk-free rate to be attractive to investors.