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

• Question 1471:

  Assume an investor makes the following investments:

  During year one, the stock paid a $5.00 per share dividend. In year 2, the stock paid a $7.50 per share

  dividend. The investor's required return is 35.0 percent.

  The dollar-weighted return is:

  A. 48.9%.

  B. 16.1%.

  C. 46.5%.

  D. 102.4%.

  Correct Answer: A

  To calculate the dollar-weighted return:

  Step 1: Determine the timing and sign (inflow, outflow) of the cash flows

  Purchase share 2, $75.00 outflow

  Received dividend from share 2, $7.50 inflow

  Sell share 1, $100.00 inflow,

  Sell share 2, $100.00 inflow.

  Step 2: Calculate the net cash flows for each year (all amounts in $)

  Step 3: Use your financial calculator to solve for IRR (or use trial and error)

  

• Question 1472:

  Consider the following information for Magical Interactions, Inc.

  Based on the assumptions above, which of the following statements is TRUE?

  A. The stock is undervalued.

  B. If the earnings retention rate increases, the value of the stock will increase (all else equal).

  C. If management can increase the EBITDA ratio by only 1.0%, the stock will be properly priced (all else equal).

  D. If inflation expectations decrease, the value of the stock will increase (all else equal).

  Correct Answer: D

  The expected inflation rate is a component of ke (through the nominal risk free rate). ke is one component of the P/E ratio and can be represented by the following: nominal risk free rate + stock risk premium, where nominal risk free rate = [(1 + real risk free rate) * (1 + expected inflation rate)] ?1. The other statements are false. To determine the stock over/under valuation, we need to calculate both the P/E ratio and the EPS. The P/E ratio = Dividend Payout Ratio / (ke?g), EPS = [(Per share Sales Estimate) * (EBITDA%) ?D (per share) ?I (per share)] * (1 - t) = [($150 * 0.18) - $15 - $10] * (1 ?0.35) = $1.30 Value of stock = EPS * P/E = 7.14 * $1.30 =$9.30 Since the market value of the stock is greater than the estimated value, the stock is overvalued. An increase in earnings retention will likely decrease the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay dividends (absent tax concerns). Investors will likely value the company lower if it retains a higher percentage of earnings.

  If management increases EBITDA by 1.0%,the stock will be undervalued.

  EPS = [($150 * 0.19) - $15 - $10] * (1 ?0.35) = $2.28

  Value of stock = EPS * P/E = 7.14 * $2.28 = approximately$16.30, which is greater than the market value.

  Note: the EBITDA % that equates to the market price is approximately 18.5%, or a 0.5% increase. Small

  changes in EBITDA% have a large impact on the EPS and thus on the estimated stock value.

• Question 1473:

  Ted McGovern works in the economics branch of a government bank regulator. When he arrives at work

  this morning and checks his voicemail, he has a message from the Regional Director asking him to

  calculate the expected rate of return for a stock market series. More detailed information will be

  forthcoming in an e-mail. Fortunately, McGovern still has his CFA Program study guides in his office and

  finds the correct formulas. McGovern logs on to the computer network and downloads an attachment that

  contains the following estimates:

  Overall Assumptions:

  Index Estimates ?Bull Market:

  Index Estimates ?Bear Market:

  The expected return on the index is closest to:

  A. 67.4%.

  B. 39.4%.

  C. 30.8%.

  D. 98.2%.

  Correct Answer: C

  To calculate the expected index return, we need to calculate the expected return for the bull market and the expected return for the bear market. Then, we will use the given probabilities of each scenario to calculate the expected index return. Note: All amounts are in millions of $ unless noted otherwise. BULL MARKET BEAR MARKET EXPECTED VALUE OF INDEX = 0.35 * 110% + 0.65 * -11.8% =30.83%

• Question 1474:

  Daniel Tipton and Jesse Torrez are first-year MBA students at the Haas School of Business. Torrez has an economics background, but Tipton's background is in music. To help Tipton study one of the main tenets of competition theory, Torrez creates the following question and asks Tipton to identify the statement that is most inconsistent with Porter's five forces. Which statement should Tipton select?

  A. Supplier power is higher when there are only a few suppliers to an industry.

  B. To sustain above average returns on invested capital, firms should strive for economies of scale.

  C. Porter's five forces are: rivalry among current competitors, economies of scale, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers.

  D. Rivalry increases when firms of equal size compete within an industry.

  Correct Answer: C

  Porter's five forces are: rivalry among current competitors, threat of new entrants, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers. Economies of scale are a way to lessen the threat of new entrants, but are not the only way to discourage competition. Companies can also have barriers to entry such as regulation or high start up capital. The other choices are true.

• Question 1475:

  Given the following estimated financial results, value the stock of Magic Holdings, Inc. using the infinite period dividend discount model (DDM). Which of the following choices is closest to the value of Magic Holding Inc. stock? (Note: Carry calculations out to at least 3 decimals.)

  A. $44.64.

  B. $23.54.

  C. Unable to calculate stock value because ke < g.

  D. $109.27.

  Correct Answer: D

  Here, we are given all the inputs we need. Use the following steps to calculate the value of the stock:

  First, expand the infinite period DDM:

  DDMformula: P0= D1/ (ke?g)

  D1

  = (Earnings * Payout ratio) / average number of shares outstanding

  = ($200,000 * 0.625) / 50,000 = $2.50.

  ke

  = nominal risk free rate + [beta * (expected market return ?nominal risk free rate)]

  Note: Nominal risk-free rate = (1 + real risk free rate) * (1 + expected inflation) ?1

  =(1.035)*(1.040) ?1 = 0.0764, or 7.64%.

  ke

  = 7.64% + [1.8 * (13.0% - 7.64%)] = 0.17288.

  g

  = (retention rate * ROE)

  Retention = (1 ?Payout) = 1 ?0.625 = 0.375.

  ROE = (net income/sales)*(sales/total assets)*(total assets/equity)

  = (200,000/1,000,000)*(1,000,000/750,000)*(750,000/500,000) = 0.40

  g

  = 0.375 * 0.40 = 0.15.

  Then, calculate:P0= D1/ (ke?g) = $2.50 / (0.17288 - 0.15) = 109.27.

• Question 1476:

  Tamira Scott, CFA, manager of an index fund, needs to raise money soon (although not immediately) to pay taxes. Although she believes in the efficient market hypothesis (EMH), she remembers that there are a few anomalies she may take advantage of to earn higher returns. Which of the following actions is most unlikely to provide excess returns? Scott should purchase stocks in:

  A. companies with low price/earnings ratios and/or with high book to market ratios.

  B. companies that announce stock splits.

  C. companies not followed by analysts.

  D. mid-December, with the intent to sell in early January.

  Correct Answer: B

  According to event studies of the semi-strong form of the EMH, stock splits do not have a short run or long run impact on returns. This finding supports the EMH. The other choices are considered anomalies. That is, they reject the semi-strong form of the EMH, and suggest that investors can earn excess returns by exploiting these anomalies. The January anomaly (from a time-series test of the semi- strong EMH) suggests that investors can earn excess returns by buying stocks in December and selling them in the first week of January, due to tax-induced trading at year-end. Cross-sectional tests of the semi-strong form EMH have shown that low P/E stocks, stocks of firms neglected by analysts, and stocks of firms with high book to value ratios can produce superior returns.

• Question 1477:

  Caleb Gold is studying for the Level 1 CFA examination with a fellow group of first year MBA students at the London School of Economics. During that night's study session, Stephan LeMond, the self-proclaimed group "leader," gives a short presentation on the forms of the efficient market hypothesis (EMH). As Gold listens, he hears LeMond make an obviously incorrect statement. He quickly speaks up, and identifies which of the following statements as INCORRECT?

  A. The weak-form EMH states that stock prices reflect current public market information and expectations.

  B. The semi-strong form EMH addresses market and non-market public information.

  C. The strong-form EMH assumes perfect markets.

  D. The weak-form EMH suggests that technical analysis will not provide excess returns while the semi-strong form suggests that fundamental analysis cannot achieve excess returns.

  Correct Answer: A

  The weak-form EMH assumes the price of a security reflects all currently available historical information. Thus, the past price and volume of trading has no relationship with the future, hence technical analysis is not useful in achieving superior returns. The other statements are true. The strong-form EMH states that stock prices reflect all types of information: market, non-public market, and private. No group has monopolistic access to relevant information; thus no group can achieve excess returns. For these assumptions to hold, the strong-form assumes perfect markets ?information is free and available to all.

• Question 1478:

  The table below lists information on price per share and shares outstanding for three stocks ?Rocking, Payton, and Strand.

  

  Using the information in the table, calculate the value of a market-value weighted index at year-end and the one-year return on the price-weighted index. The beginning value for the market index is 100. (Note: The choices are listed in the order market-value weighted index value and price-weighted index percent return, respectively). Which of the following choices is closest to the correct answer?

  A. 10.6, 6.3.

  B. 110.6, -6.3.

  C. 110.6, 50.0.

  D. 10.6, 8.4.

  Correct Answer: B

  Calculations are as follows:

  

  First, we will calculate the value of the market-value weighted index at year-end, and then we will calculate

  the return on the price-weighted index.

  Step 1: Calculate value of the market-weighted index at year-end:

  Value of market-weighted index =

  [(market capitalization year-end) / (market capitalization beginning of year)]* Beginning index value

  = (442,500 / 400,000) * 100 = 110.625, or approximately 110.6

  Step 2: Calculate the one-year return on the price-weighted index:

  First, we will calculate the price-weighted index value for both the beginning of year and end of year, then

  we will calculate the return percentage.

  Value of price-weighted index beginning= (sum of stock per share prices beginning) / (number of stocks

  beginning)

  = (10 + 50 + 100) / 3 =53.333

  Value of price-weighted index end= (sum of stock per share prices end) / (number of stocks end)

  = (15 + 50 + 85) / 3 =50.0

  One-Year Return = [(Index value year-end/ Index value beginning of year) -1]* 100

  = [ 50.0 / 53.333) ?1] * 100 =-6.3%

  Note:Your calculation may differ slightly due to rounding. Remember that the question asks you to select

  the closest choice.

• Question 1479:

  Using the following assumptions, calculate the rate of return on a margin transaction and the stock price at

  which the investor who purchases the stock will receive a margin call.

  What of the following choices is closest to the correct answer? The margin transaction return is:

  A. 83.33%, and the investor will receive a margin call at a stock price of $15.43.

  B. 33.33%, and the investor will receive a margin call at a stock price of $15.43.

  C. 111.11%, and the investor will receive a margin call at a stock price of $21.00.

  D. 111.11%, and the investor will receive a margin call at a stock price of $15.43.

  Correct Answer: A

  To obtain the result:

  Part 1: Calculate Margin Return:

  Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) – 1] * 100 =

  = [(([$24 * 1,000] – [$18 * 1,000 * 0.60]) / ($18 * 0.40 * 1,000)) – 1] * 100 =

  = 83.33%

  Alternative (Check): Calculate the all cash return and multiply by the margin leverage factor.

  = [(24,000 – 18,000)/18,000] * [1 / 0.40] = 33.33% * 2.5 = 83.33%

  Part 2: Calculate Margin Call Price:

  Since the investor is long (purchased the stock), the formula for the margin call price is:

  Margin Call = (original price) * (1 – initial margin) / (1 – maintenance margin)

  = $18 * (1 – 0.40) / (1 – 0.30) = $15.43

• Question 1480:

  Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to break even (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows: Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year's booth costs, Korotkin needs to sell:

  

  A. 42 more blankets than last year.

  B. 42 fewer blankets than last year.

  C. 30 fewer blankets than last year.

  D. the same amount of blankets as last year.

  Correct Answer: C

  To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven

  Quantity, and calculate the difference.

  Step 1: Determine Last Year's (Basic Blanket) breakeven quantity:

  QBE= (Fixed Costs) / (Sales Price per unit ?Variable Cost per unit) = 750 / (25 ?20) = 150

  Step 2: Determine This Year's (New Blanket) breakeven quantity:

  QBE= (Fixed Costs) / (Sales Price per unit ?Variable Cost per unit) = 840 / (40 ?33) = 120

  Step 3: Determine Change in Units:

  Q = QThis Year?QLast Year= 120 ?150 = -30. Korotkin needs to sell 30fewerblankets.