CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers
Question 71:
The best stock for investment purposes
A. is the one that is the most undervalued.
B. has the highest expected rate of return.
C. is the one issued by the best company.
D. has the least risk.
Correct Answer: A
The best stock for investment purposes is not necessarily issued by the best company, because the best company's stock may be overvalued. The stock with the highest expected rate of return may have excessive risk, while the stock with the lowest risk may have an excessively low expected rate of return. Rather, the stock that is the most undervalued is the best investment.
Question 72:
Assume the following information about a stock market series:
Retention rate at t1 = 63%
Expected growth rate of dividends at t1 = 10%
Expected growth rate of earnings at t1 = 12%
Required rate of return = 13%
EPS at t1 = $3.65
Given this information, what is the appropriate earnings multiplier for this stock market series? Further,
what is the value of this series?
A. 63; $229.95
B. 21; $76.65
C. 12.33; $45
D. 37; $135.05
E. None of these answers is correct.
F. The answer cannot be determined from the information provided.
Correct Answer: C
The earnings multiplier is found as 12.33 for this series, and the value of the series is computed as $45.
Estimating the earnings multiplier for a stock market series requires the estimation of each of the following components:
1.
The dividend payout ratio.
2.
The required rate of return on common stock in the country/region/industry/sector being analyzed.
3.
The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.
Once values for each of these components have been determined, they are imputed into the following formula: {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.
In this example, all of the necessary information has been provided. However, before the earnings multiplier can be determined, the dividend payout ratio must be found by manipulating the retention rate. Remember that the retention rate is equal to (1 - the dividend payout ratio), just as the dividend payout ratio is found as (1 - the retention rate). By this logic, the dividend payout ratio and the retention rate must always add up to one. The dividend payout ratio for this series is found as (1 - 0.63) = 0.37. Now that the dividend payout ratio has been determined, the calculation of the earnings multiplier is shown below: {P/E = [0.37 / (0.13 - 0.10)] = 12.33}. Notice that it is the anticipated growth rate of dividends that is used in this equation, not the anticipated growth rate in earnings. Once the earnings multiplier has been determined, the value of this stock market series can be found by multiplying the EPS figure by the earnings multiplier. This will lead to a value of $45 for this stock market series, or 12.33 x 3.65 = $45.02.
By definition: Nominal risk-free rate = (1 + Real Growth) (1 + Expected Inflation) - 1.
Question 74:
________ analysis should precede ________ analysis.
A. Industry; economic
B. Company; industry
C. Industry; company
D. Company; economic
Correct Answer: C
In general, an industry's prospects within the global business environment determine how well or poorly an individual firm will fare, so industry analysis should precede company analysis.
Question 75:
________ techniques are based on the strong relationship between the economy and security markets. Market projections are based on the outlook for the aggregate economy.
A. Micro
B. Macro
C. Fundamental
D. Technical
Correct Answer: B
Analysis of both economies and securities markets are macro-techniques to aid investment decision which includes deciding if certain asset classes or industries could be performing better or worse than they are actually weighted/valued at.
Question 76:
Suppose the inflation rate in the United States is expected to increase from 3% to 4.25% per year in the next year. Assume the current quoted risk-free rate of interest, as measured by the nominal rate on U.S. Treasury 10-year notes, is 5.25% per year. Further, assume that the news of an increase in inflation has not been factored into the risk-free rate. Given this information, what is the expected effect in the nominal risk-free rate? Assume that the inflation-free rate of interest and the inflation premium are not significantly large.
A. Risk-free rate will decrease by 125 basis points
B. The answer cannot be calculated from the information provided.
C. Risk-free rate will increase by 42 basis points
D. None of these answers is correct.
E. Risk-free rate will increase by 417 basis points
F. Risk-free rate will increase by 125 basis points
Correct Answer: F
Remember that the nominal risk-free rate of interest is comprised of two components, the real "inflationfree" rate of interest, and an inflation premium. The inflation premium is equal to the anticipated inflation rate.
The equation for the calculation of the nominal interest rate in situations where the real inflation-free rate of interest and/or the inflation premium are low is as follows:
Risk-free rate of return = k* + IP
where: k* = the real inflation-free rate of return and IP = the inflation premium
In this example, the anticipated inflation rate, IP, has increased by 125 basis points. The effect of this increase will be mirrored by an equal increase in the real-risk free rate of interest.
When either the real "inflation-free" interest rate or the expected inflation rate are significantly large, the calculation of the nominal risk-free rate differs from the equation used when these factors are significantly small. Specifically, the calculation of the nominal risk-free rate of interest when theinflation-free rate of interest and/or the inflation premium are significantly high, the calculation of the nominal risk-free rate is as follows:
Nominal RFR = (1 + Real RFR)(1 + E(I)) - 1
Where: Real RFR = the real inflation-free rate of interest and E(I) = the anticipated inflation rate
Question 77:
How much would you pay for a 15 year bond with a semiannual coupon rate of 6%, and a par value of $15,000 if you want a 14% percent annual return on your investment? What would be the value of the coupons and principal to you?
A. The value of the bond would be $15,024. The present value of the coupons would be $10,833, and that of the principal would be $4,191.
B. The value of the bond would be $13,860. The present value of the coupons would be $11,457, and that of the principal would be $2,403.
C. The value of the bond would be $17,239. The present value of the coupons would be $14,828, and that of the principal would be $2,411.
D. Not enough information.
E. The value of the bond would be $13,140. The present value of the coupons would be $11,169, and that of the principal would be $1,971.
Correct Answer: E
The semiannual coupon payment would be 0.06 x 15000 = $900. Using Appendix C of "Investment Analysis and Portfolio Management," by Reilly and Brown, one sees that the present value of annuity of $1 for 30 periods at a required rate of 7% (half of 14%) would be 12.410. The present value of the coupon payments is therefore 900 x 12.410 = $11,169. Using the same appendix, one sees that the present value of $1 after 30 periods at a required rate or 7% is 0.1314. The present value of the principal payment is therefore 15000 x 0.1314 = $1,971. The total value of the bond to you would be 11169 + 1971 = $13,140.
Question 78:
Holding everything else equal, which of the following firms would likely have a high payout ratio? Further, as time progresses (in the long run), would the retention ratio of similar firms be expected to increase or decrease?
A. Pharmaceutical firm; decrease
B. Specialty retailer; increase
C. Automobile manufacturer; increase
D. Pharmaceutical firm; increase
E. Automobile manufacturer; decrease
F. Specialty retailer; decrease
Correct Answer: E
Remember that a positive relationship exists between the maturity of an industry and the payout ratio of firms within that industry. The automobile industry is a mature industry, more so than most other industries including pharmaceuticals or specialty retailers. As an industry advances in maturity, growth of the overall industry will decline. As growth opportunities diminish, companies within the industry will be forced to pay out a larger proportion of their earnings as dividends; i.e. the dividend payout ratio of firms within the industry will increase. Remember that the retention ratio is equal to (1 - the dividend payout ratio). Thus, the retention ratio of companies will likely decline as the industry advances inmaturity. The relationship between the dividend payout ratio and the maturity of the industry is negative and loosely linear.
As an industry becomes more mature, growth opportunities decline. This relationship is also loosely linear.
Question 79:
Due to an overheated economy and dramatic monetary stimulus, the U.S. inflation rate is anticipated to increase significantly from its current level. Specifically, the inflation rate is expected to increase from 3.5% to 8% per year, and this increase should be considered significantly large by historical standards. The current nominal interest rate in the U.S., as measured by the quoted rate on U.S. 10-year notes, is 6.75%. Further, the real inflation-free rate of interest is currently at 3.25% per year, and this rate is not anticipated to change. Assuming this increase in inflation has not been factored in, what is the appropriate value for the nominal risk-free rate?
A. 9.51% per year
B. 10.85% per year
C. 11.51% per year
D. The answer cannot be calculated from the information provided.
E. 11.25% per year
F. None of these answers is correct.
Correct Answer: C
When either the real "inflation-free" interest rate or the expected inflation rate are significantly large, the nominal risk free rate is calculated using a different equation than that which is used for lower expected inflation rates. Specifically, the calculation of the nominal risk-free rate of interest when the inflation-free rate of interest and/or the inflation premium are significantly high, the calculation of the nominal risk-free rate is as follows:
Nominal RFR = (1 + Real RFR)(1 + E(I)) - 1
Where: Real RFR = the real inflation-free rate of interest and E(I) = the anticipated inflation rate,
In this example, all of the necessary inputs have been provided. Imputing these values into the equation above will yield the following:
When the inflation-free rate of interest and/or the inflation premium are low, then the equation above can be simplified to the following:
Nominal RFR = Real RFR + Inflation premium.
If you chose 11.25%, remember that when the real inflation-free rate of interest and/or the inflation premium are significantly large, the calculation of the nominal risk-free rate must involve a different equation than when these rates are small.
Question 80:
You are going to hold a stock for 3 years. It is estimated to pay dividends of $2.50, $2.60 and $2.80. The estimated sale price at the end of the holding period is $68. Using the dividend discount model, calculate the value of the stock if your required rate of return is 14%.
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