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

• Question 81:

  Which of the following best characterizes the last stage in the industrial life cycle?

  A. Growth deceleration and decline

  B. Saturation

  C. Insolvency

  D. Obsolescence

  E. None of these answers is correct.

  F. Mature growth

  Correct Answer: A

  The industry life cycle is divided into five distinct stages. Specifically, the industrial life cycle progresses from the development stage to an accelerating growth stage to a mature growth stage to a market maturation and stabilization stage. Finally, the fifth stage of the industrial life cycle is characterized by decelerating growth and sales decline. During the mature growth stage, sales are still growing, albeit slowly. During the last stage of the industrial life cycle, however, is characterizes by a decline in annual sales.

  As an industry or company progresses through the industrial life cycle, sales begin to grow rapidly (accelerating growth) then slow considerably as the product or service begins to reach critical mass (mature growth). During the mature growth stage, the industry or company grows at a slower pace, until eventually growth begins to slow considerably (market maturity and stabilization) as the market for the industry or company's products becomes more completely defined. An industry or company typically reaches the fifth stage of the industrial life cycle, growth deceleration and decline, only after many years of stabilization.

• Question 82:

  What is the best proxy for the risk-free rate?

  A. The rate on T-bills.

  B. The rate on 20-year Treasury bonds.

  C. The rate on 5-year Treasury notes.

  D. The rate on AAA corporate bonds.

  Correct Answer: C

  Treasury securities are essentially risk-free because of the seeming impossibility of a U.S. government default. In the recent past, the 5-year Treasury note rate has been used as a proxy for the risk-free rate because it is said to reflect the investment horizon of most investors.

• Question 83:

  A recent graduate of Atlantis University has been debating whether to invest in a popular retail stock. In this research, this graduate has determined that his required rate of return is 15% per year, and that thecompany's current $0.45 per share annual dividend is expected to grow by 12.5% annually. Additionally, the investor anticipates that he will be able to sell the common stock for $28 per share in four years. What is the value of this common stock?

  A. $18.00

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

  C. $17.70

  D. $31.40

  E. The DDM will produce a nonsensical answer in this case.

  F. $21.23

  Correct Answer: C

  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 fourth 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 10th year, then "n" would be the tenth 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 = [( $0.45* 1.125) / (1 + 0.15)^1] + [($0.50625* 1.125) / (1 + 0.15)^2] + [($0.56953 * 1.125) / (1 + 0.15) ^3] + [($0.640723 * 1.125) / (1 + 0.15)^4] + [ $28/ (1 + 0.15)^4]}

  which becomes

  {V = [$0.440217 + $0.430647 + $0.421285 + $0.412127 + $16.00909] = $17.71

• Question 84:

  Due to an impending recession in the industrial and high tech sectors, combined with dramatic mismanagement of U.S. fiscal policies, the U.S. economy is expected to slip into a significant recession. Given this shift, the U.S. inflation rate is expected to decrease significantly from its current level. Specifically, the inflation rate is expected to decrease from 4.0% to a deflationary (2)% per year, and this decrease 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 8.25% per year. Further, the real inflation-free rate of interest is currently at 4.25%, and this rate is not anticipated to change. Assuming this decrease in inflation has not been factored in, what is the appropriate value for the nominal risk-free rate?

  A. 2.165% per year

  B. The answer cannot be calculated from the information given.

  C. (0.225)% per year

  D. None of these answers is correct.

  E. 2.25% per year

  F. (2.165)% per year

  Correct Answer: A

  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 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:

  Nominal risk-free interest rate = {[(1 + 0.0425)(1 - 0.02) - 1] * 100} = 2.165%

  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 2.25%, 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 85:

  If a firm has historically had a lower earnings multiplier than similar firms in its industry, which of the following factors could be responsible for this?

  I. the firm has maintained a higher than average payout ratio.

  II. the firm's profit margin is lower than average.

  III.

  the firm's stock has a high financial risk.

  A.

  III only

  B.

  I, II and III

  C.

  II only

  D.

  II and III

  E.

  I only

  Correct Answer: B

  Recall the Dividend Discount Model formula: P/E = payout ratio/(k - g) in standard notation. From this formula, you may be misled into believing that increasing the payout ratio increases P/E. However, remember that g = ROE*(1-payout ratio). The more the firm pays out, the lower its growth rate is. Thus, it is not always necessary that P/E ratio will increase with increasing payout ratio. Indeed, in Walgreen's case, a low payout ratio was associated with low P/E.

  If a firm has high financial risk, its required rate of return (k) is higher, depressing P/E.

• Question 86:

  A firm has an expected dividend payout ratio of 40%, and an expected dividend growth rate of 4% per year. What is the firm's Price/Earnings ratio if the appropriate discount rate is 8% per year?

  A. 10

  B. Not able to compute with the above data.

  C. 1

  D. 100

  Correct Answer: A

  Value = 0.40/(0.08-0.04) = 10.

• Question 87:

  Given that the risk-free rate of return is 5%, what is the value of a zero-coupon bond with a principal payment of $15,000 in 15 years, and a risk-premium of 5%?

  A. $7,864

  B. $3,591

  C. $6,415

  D. $9,249

  E. Not enough information

  F. $11,358

  Correct Answer: B

  The value of a zero-coupon bond is the present value of its principal payments. The required rate of return is the risk-free rate of return plus the risk premium (5 + 5 = 10%). Using appendix C in the book by Reilly and Brown, the present value of the bond is $15,000 x 0.2394 = $3,591, or $15,000/(1.1^15).

• Question 88:

  ABC (a large manufacturer of farm equipment) is a stable company reporting the following financial information:

  Earnings per share $1.50 Dividends per share $0.50

  Net Income $12 million Equity $50 million

  Given the above information, calculate the company's expected dividend growth rate.

  A. 8%

  B. 20%

  C. 33%

  D. 16%

  E. 80%

  F. 1.6%

  Correct Answer: D

  The expected dividend growth rate = (Retention Rate) x (Return on Equity). Retention Rate = 1 - Payout Rate. Return on Equity = NI/E. Thus in this case the expected dividend growth rate = 1 - (.5/1.5) x ($12 million/$50 million) = (1 - .33) x (.24) = .16 or 16%.

• Question 89:

  This valuation technique breaks a firm's observed P/E down into two components: The P/E, based on the company's ongoing business (its base P/E), plus a franchise P/E the market assigns to the expected value of new and profitable business opportunities. It is known as:

  A. the franchise factor

  B. market value-added

  C. economic value-added

  D. none of these answers

  Correct Answer: A

  The franchise P/E is a function of the relative rate of return on new business opportunities (the franchise factor) and the size of the superior return opportunities (the growth factor).

• Question 90:

  A stock has a beta of 0.9 and the risk-free rate is 5%. Its dividend growth rate is 2.2% and the dividend payout ratio is 55%. If the market risk premium is 8%, the P/E ratio of the stock equals ________.

  A. 5.2

  B. 4.9

  C. 6.1

  D. 5.5

  Correct Answer: D

  Using CAPM, the expected return on the stock equals 5% + 0.9 * 8% = 12.2%. Using the Dividend Discount Model, P/E = (dividend payout ratio)/(K - g). This gives P/E = 0.55/(12.2% - 2.2%) = 5.5