CFA CFA Certifications CFA-LEVEL-1 Questions & Answers

• Question 1:

  Contrarians consider an increase in credit balances in brokerage accounts as:

  A. a hold signal.

  B. a bearish signal.

  C. none of these answers.

  D. a bullish signal.

  Correct Answer: B

  Credit balances with brokerages result when investors sell their stock holdings and leave the cash balances with their brokers, expecting to reinvest them shortly. Technical analysts view these balances as pools of potential purchasing power overhanging the market and hence believe that the market is bullish. Contrarians, on the other hand, believe that most market participants make wrong investment decisions as the market approaches the peak or trough in a cycle. Hence, contrarians consider a large increase in credit balances as a bearish signal.

• Question 2:

  What is the value of a preferred stock with company earnings of $30 and a required rate of return of 10%?

  A. $600

  B. $283

  C. $129

  D. $300

  E. Not enough information

  Correct Answer: E

  The value of a preferred stock is the present value of its dividends, which is equal to the annual dividend divided by the required rate of return. Since the annual dividend is not given, one cannot answer this question.

• Question 3:

  The increase in OTC trading relative to NYSE trading over time

  A. is a sign of growing government regulation of the NYSE.

  B. is a sign of the increased influence of institutional investors.

  C. is a sign of the increased influence of individual investors.

  D. demonstrates the decreasing level of speculative activity.

  Correct Answer: C

  Irrespective of the level of speculative activity in the market, there has been a trend toward relatively high volume on the OTC compared with the NYSE. This is partly an indication of the growing importance of individual investors, who are more prone to invest in the OTC market, and of the growing number of firms listed on the OTC relative to the NYSE.

• Question 4:

  All else equal, which of the following is/are true?

  I. The stock price increases as the dividend growth rate increases.

  II. The stock price increases as the expected rate of return increases.

  III. The stock price increases as the current dividend increases.

  IV.

  The payout ratio increases as current earnings increase.

  A.

  III only

  B.

  I, II and IV

  C.

  I only

  D.

  II and IV

  E.

  IV only

  F.

  I, III and IV

  G.

  I and III

  H.

  II only

  Correct Answer: G

  The Dividend Discount Model implies, in standard notation, that Po = D1/(k-g). This equation serves to justify the choices. It should be noted that in this question, the phrase, "all else equal" is critical. In III, for e.g., you cannot expect the stock price to rise solely because dividend increases (indeed, the priceshould fall because part of the firm is being paid out as cash). The "all else equal" stipulates that the growth rate of dividend and expected return remain constant, which is what causes the stock price to rise.

• Question 5:

  Which of the following represents a "smart money" technical indicator? Choose the best answer.

  A. More than one of these answers is correct.

  B. Confidence Index.

  C. Futures traders bullish on stock index futures.

  D. Diffusion Index.

  E. Breadth of market.

  F. Block Uptick/Downtick Ratio.

  Correct Answer: B

  Of the choices listed, only the Confidence Index represents a "smart money" technical indicator. The Confidence Index, published weekly by Barron's, is used to measure the degree of confidence amongst bond traders. The Confidence Index is constructed by measuring the ratio of Barron's average yield on 10 top-grade corporate bonds to the yield on the Dow Jones average of 40 bonds. The Confidence Index is designed to measure the difference in yield between high grade and more-speculative bonds. As the yield spread between the two sets of bonds narrows, (i.e. high-grade bonds are being bid down and low-grade bonds are being bid up) the ratio will approach one. Remember that the yields on high- gradebonds is always less than that on lower-grade issues, so this ratio will never exceed 1. Technicians would view an increase in the Confidence Index as a bullish signal. The reasoning behind this opinion is relatively straightforward - more money is being directed toward speculative bonds, indicating that investor confidence in the economy is high.

  "Breadth of market" refers to the measure of advancing versus declining issues. The "Diffusion Index" is a measure of market breadth and is defined as the volume of advancing issues plus one-half of the volume of unchanged issues, divided by the total number of issues traded. Short interest measures the total volume of outstanding short positions, and the sentiment of futures traders is used by contrarian technical analysts, who take a contra approach. The "Block Uptick/ Downtick Ratio" is used to measure the near-term sentiment of institutions.

• Question 6:

  The dividend discount model assumes that

  A. dividends must be discounted in favor of earnings to arrive at the correct valuation for common stock.

  B. the value of a share of common stock is the present value of all future earnings.

  C. the value of a share of common stock is the present value of all future dividends.

  D. dividends are worth more in the future than in the present.

  Correct Answer: C

  The dividend discount model (Dividend Discount Model) assumes that the value of a share of common stock is the present value of all future dividends, not earnings. The Dividend Discount Model assumes that a dollar today is worth more than a dollar tomorrow.

• Question 7:

  The Dow Theory postulates that there are

  A. two types of price movements over time.

  B. ten types of price movements over time.

  C. four types of price movements over time.

  D. five types of price movements over time.

  E. three types of price movements over time.

  Correct Answer: E

  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 8:

  A market strategist with East Coast Brokerage is examining a stock market series and trying to determine an appropriate EPS figure. In her analysis, this market strategist has determined the following information:

  1.

  Regressing sales for the series against Nominal GDP, the sales figure for the index has been estimated at: $21.

  2.

  Analyzing capacity utilization rates, foreign competition, rates of inflation and unit labor costs, the operating profit margin for the series has been determined to be 32%.

  3.

  Creating a time series based upon inputs such as levels of capital expenditures and PPandE turnover, next year's depreciation-per-share has been determined to be $1.10.

  4.

  Creating a time series based upon levels of debt outstanding and prevailing debt yields, the interest expense for next year is determined to be $1.03 per share.

  5.

  Coordinating his research with a legislative consultant, the corporate tax rate for this series has been estimated at: 35.15%.

  Using this information, what is the EPS figure for this stock market series?

  A. None of these answers is correct.

  B. $2.23

  C. $2.98

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

  E. $4.01

  F. $4.07

  Correct Answer: C

  All of the necessary information has been provided in this example. To determine the EPS for a stock market series, the following steps are necessary:

  Step 1: Estimate sales-per-share for the series: Step 2: Estimate operating profit margin for the series Step 3: Estimate the depreciation-per-share for next year Step 4: Estimate the interest expense-per-share for the next year Step 5: Estimate next year's corporate tax rate

  Once these five steps have been completed, the calculation of EPS for a stock market series is found by the following:

  EPS = [(Sales per share * Operating profit margin) - Depreciation-per-share - Interest Expense] * (1 Corporate Tax Rate)

  The calculation of EPS for this stock market series is shown as follows: EPS = [($21 * 0.32) - $1.10 $1.03] * (1 - 0.3515) = $2.98

• Question 9:

  Assume the following series of transactions

  t0: Unknown t1: Purchase 10,000 shares of Intelligent Semiconductor for $98.90 per share t2: Sell 10,000 shares of Intelligent Semiconductor for $105.30 per share t3: Sell 5,000 shares of Intelligent Semiconductor for $111.65 per share t4: Sell 5,000 shares of Intelligent Semiconductor for $140.00 per share

  Similar investments have merited a 13.45% discount rate. Assuming no taxes or transaction charges, what is the dollar-weighted rate of return for this series of investments?

  A. 66.11%

  B. None of these answers is correct.

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

  D. 46.76%

  E. 58.27%

  Correct Answer: C

  Remember that the dollar-weighted rate of return uses the IRR equation in the determination of the answer. In fact, 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. So said, in the determination of the dollar-weighted rate of return calculation, the first step should be to identify the cash flows for each period, beginning with t0: the initial investment outlay. In this example, the initial cash outlay is not specified, and therefore the calculation of the dollar-weighted rate of return cannot accurately be determined.

• Question 10:

  A growth stock:

  A. is a stock which generates rates of returns higher than stocks with similar risks.

  B. all of these answers.

  C. promises rates of return higher than those that can be obtained by investing in the market portfolio.

  D. represents a company that has management abilities and investment opportunities that yield rates of return higher than the required rate of return.

  Correct Answer: A

  You have to be careful in distinguishing between a growth stock and a growth firm. A growth stock need not represent a growth firm. Rather, it is defined as a stock that has consistently generated returns higher than those justified by the risks. Such a situation arises either because the company has surprise windfalls or because at some point in the past, the market underestimated the firm's growth potential. Note that this is not in violation of efficient markets theory, which says that on average, investors correctly impound the available information in the stock price, though in any individual case, the market might over- or underestimate the impact of the new information on the value of the firm.