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

• Question 621:

  The P/E ratio is not determined by

  A. the required rate of return.

  B. the expected dividend payout ratio.

  C. the expected growth rate of dividends for the stock.

  D. the financial leverage ratio.

  Correct Answer: D

  Using the dividend discount model, the price of a stock is equal to D / (k - g), where D is the expected dividend, k is the required rate of return, and g is the expected growth rate of dividends for the stock. Dividing both sides of the equation by expected earnings (E) yields P/E = (D/E) / (k - g), where D/E is the expected dividend payout ratio. Thus, the P/E ratio is determined by the expected dividend payout ratio, the required rate of return, and the expected growth rate of dividends for the stock. Financial leverage does not help determine P/E ratio.

• Question 622:

  The Dow Theory

  A. is widely used today.

  B. was invented in the 1960s.

  C. was invented in the early 19th century.

  D. was one of the first theories of technical analysis.

  Correct Answer: D

  The Dow Theory was invented in the late 19th century by Charles Dow, publisher of the Wall Street Journal. It postulated that there were three types of price movements over time: major trends, intermediate trends, and short-term movements. These three types of trends interacted with one another, and identifying and isolating them individually would lead to profit opportunities.

• Question 623:

  A junior financial analyst with Churn Brothers brokerage has been instructed to value shares of Intelligent Semiconductor, a diversified technology company. A senior analyst at Churn Brothers has provided the following information:

  The required rate of return on equity is 15% per year

  The senior analyst has predicted that shares of Intelligent will sell at a multiple of 25 times predicted free cash flow to equity in four years.

  The estimated free cash flows for each of the next four years are:

  Year 1: $15,000,000 Year 2: $18,500,000 Year 3: $21,000,000 Year 4: $35,000,000

  Intelligent Semiconductor has 1,000,000 shares of common stock outstanding.

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

  A. $65.81

  B. $561.13

  C. $56.67

  D. $650.34

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

  F. None of these answers is correct.

  Correct Answer: B

  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: ($15,000,000 / 1.15) / 1,000,000 shares outstanding = $13.04 Year 2: [$18,500,000 / (1.15)(1.15)] / 1,000,000 shares outstanding = $13.99 Year 3: [$21,000,000 / (1.15)(1.15)(1.15)] / 1,000,000 shares outstanding = $13.81 Year 4: [$35,000,000 / (1.15)(1.15)(1.15)(1.15)] / 1,000,000 shares outstanding = $20.01

  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 4: 25 times. Imputing this information into the terminal cash flow equation will yield the following:

  {[25 * ($35,000,000 / 1,000,000 shares outstanding)] / [(1.15) (1.15)(1.15)(1.15)]} = $500.28.

  Adding the answers from step 1 to the final year cash flow will yield the following:

  Value of Intelligent Semiconductor = [$13.04 + $13.99 + $13.81 + $20.01 + $500.28] = $561.13 per share.

• Question 624:

  A firm issues debt to repurchase equity and at the same time, experiences an increase in its profit margin. All else equal, using the Dividend Discount Model, its stock price ________.

  A. is not affected

  B. increases

  C. decreases D. insufficient information given

  Correct Answer: B

  Intuitively, it should be clear that the stock price rises since the profit margin has gone up and at the same time, the percentage of equity holders has gone down. To see this mathematically, note that the duPont system gives ROE = Profit margin * Total Asset Turnover * Financial Leverage. In the present case, the ROE increases since profit margin and Financial Leverage have both increased. The dividend growth rate, g, equals ROE*(1 - payout ratio). Hence, as ROE increases, the dividend growth rate increases with a constant payout ratio. In the Dividend Discount Model, the stock price increases as the dividend growth rate increases, all else equal.

• Question 625:

  Assume the following information about a publicly traded automobile manufacturer:

  Revenue: $16,000,000 Cash flow: $1,700,000 Net worth per share: $14.55 Current stock price: $30.25 per share Number of common shares outstanding: 1,300,000

  Using this information, what are the price-to-sales, price-to-book, and price-to-cash flow ratios, respectively?

  A. The answer cannot entirely be calculated from the information provided.

  B. None of these answers is correct.

  C. 1.18, 2.08, 23.13

  D. 2.46, 0.48, 23.21

  E. 2.46, 2.08, 23.13

  F. 1.18, 2.08, 23.13

  Correct Answer: E

  To calculate the price-to-sales ratio, divide the market price of a common stock by its sales-per share

  figure. The equation for the price-to-sales ratio is as follows:

  Price-to-sales ratio = [P0 / sales per share].

  Incorporating the given information into this equation will yield the following:

  Price-to-sales ratio = [$30.25 / ($16,000,000 / 1,300,000)] = 2.4578

  The calculation of the price-to-book ratio involves dividing the market price of a common stock by its net

  worth per share. The equation for the price-to-book ratio is as follows:

  Price-to-book ratio = [P0 / net worth per share].

  Where: net worth per share = (total assets - total liabilities) / # of common shares outstanding.

  In this example, the net worth figure has been converted to a per-share basis, and the calculation of the

  price-to-book ratio is straightforward:

  Price-to-book ratio = ($30.35 / $14.55) = 2.0859

  The calculation of the price-to-cash flow ratio involves dividing the market price of a common stock by the

  cash-flow-per-share figure. The calculation of the price-to-cash flow ratio is as follows:

  Price-to-cash flow = (P0 / cash flow per share)

  Incorporating the given information into this equation will yield the following:

  Price-to-cash flow = [$30.35 / (1,700,000 / 1,300,000)] = 23.132

• Question 626:

  Given that the beginning value on a stock is $530, expected earnings are $50, the dividend payout ratio is 40%, and the required rate of return is 14%, what is the minimum expected ending value of the stock that makes it a profitable investment?

  A. $611.20

  B. $584.20

  C. $591.20

  D. $604.20

  E. Not enough information

  Correct Answer: B

  Expected dividends equal 50 x 0.4 = $20. In order for a stock to be a good investment, its rate of return should be equal to or greater than the required rate of return. The minimum ending value that would make the stock investment in this question profitable is given by the equation (P2 + D) / P1 = 1 + k, where P2 is the ending value, P1 is the beginning value, D is the expected dividend, and k is the required rate return. Rearranging this yield P2 = ((k + 1) x P1) - D. In this question, the minimum ending value is (1.14 x 530) 20 = $584.20.

• Question 627:

  You are going to hold a stock for an infinite amount of time. The current dividend is $1 per share and is expected to grow at 10% a year. Your long run required rate of return is 13%. Using the infinite period dividend discount model calculate the value of the stock.

  A. $40.01

  B. $27.25

  C. none of these answers

  D. $38.89

  Correct Answer: C

  g = .10 k = .13 Dividend = 1.10 x $1.00 V = 1.10/(.13 - .10) = $36.67

• Question 628:

  Which of the following is an assumption of technical analysis?

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

  B. All of these choices are assumptions of technical analysis.

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

  D. Securities markets are weak-form inefficient.

  E. Securities prices move in identifiable trends.

  Correct Answer: B

  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 629:

  You have a 15-year bond that pays $500 every 6 months. The face value is $10,000. The required rate of return is 10. What is the bond's value?

  A. $10,000

  B. $8,435

  C. $12,000

  D. none of these answers

  Correct Answer: A

  Present value of interest payments at 10%: $500 x 15.3725 = $7,686 Present value of principal payment at 10%: $10,000 x .2314 = 2,314 $7,686 + 2,314 = 10,000

• Question 630:

  The resistance level of a stock is the price at which the technician expects:

  A. the stock price to break out of the falling trend channel.

  B. a substantial supply of the stock.

  C. a substantial demand for the stock.

  D. an unstable trading volume.

  Correct Answer: B

  The resistance level can be thought of as a temporary ceiling on the stock price in the sense that if the price rises above this level, additional supply from investors trying to cash in will depress the price below the resistance level.