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

• Question 1501:

  Given the following assumptions about a companyfinancial estimates, calculate the P/E ratio, and

  determine whether the stock is undervalued or overvalued.

  Which of the following statements is most correct? The P/E ratio is:

  A. 7.41 and the stock is overpriced.

  B. 7.41 and the stock is underpriced.

  C. 6.78 and the stock is overpriced.

  D. 6.78 and the stock is underpriced.

  Correct Answer: A

  First, determine the value of the stock. Then, compare your calculation to the current market price. The assumptions lead us to use the P/E (earnings multiplier) and EPS to calculate the value. Step 1: Estimate the P/E ratio Step 2: Estimate Earnings Per Share (given at $2.75) Step 3: Calculate value Step 4: Determine under/over valuation Since the market value is greater than the estimated value, the stock is overpriced.

• Question 1502:

  Following is a graph of the Industry Life Cycle with the names of the phases omitted.

  

  Using the graph above, which of the following choices is CORRECT?

  A. To value a firm in Phase B, an analyst should use the infinite period dividend discount model (DDM).

  B. Competition most likely intensifies in Phase B.

  C. During Phase E, industry growth rates approach that of the economy.

  D. The P/E ratio for a company in Phase D is approximated by 1/ke.

  Correct Answer: D

  Phase D represents the Stabilization and Market Maturity Phase. Corporate finance shows that a mature company has a return on equity (ROE) approximately equal to the required rate of return, ke. Then, the formula: P/E = (dividend payout) / (ke?retention rate * ROE) becomes = (1 ?retention rate) / (ke?retention rate * ke) = 1/ke The other statements are incorrect. The infinite period dividend discount model is most likely not appropriate for a firm in Phase B, which represents the rapid accelerating growth phase (the multi-stage model is best). Remember that the infinite period DDM is most useful for a company with the following assumptions: Phase B, the Rapid Accelerating Growth phase, is characterized by limited competition and very high sales and profit margin growth. Companies in this phase likely have supernormal growth. Competition increases in Phase C, the mature growth phase. The industry growth rates approach that of the economy in Phase D, Stabilization and Market Maturity. Phase E is the Deceleration of Growth and Decline phase. During this phase, demand shifts away from the industry and growth of substitute products may cause growth rates to be negative.

• Question 1503:

  Which of the following choices is NOT a characteristic of an efficient market?

  A. Market participants react quickly to news, and these reactions are quickly reflected in prices.

  B. A large number of participants value securities independent of other parties.

  C. Major news announcements are made on the second Friday of each month.

  D. Expected returns implicitly include a risk component.

  Correct Answer: C

  One assumption of efficient markets is that the timing of a news announcement is independent of the timing of other news announcements. The other statements are examples of efficient markets.

• Question 1504:

  An investor is considering investing in Tawari Company for one year. He expects to receive $2 in dividends over the year and feels he can sell the stock for $30 at the end of the year. What is the maximum he can pay now to earn at least a 14 percent return on his investment?

  A. $28.

  B. $29.

  C. $30.

  D. $32.

  Correct Answer: A

  HPR = [D + (End - Beginning]/Beginning 14 = [2 + (30 - P)]/P 1.14P = 32 so P = $28.07

• Question 1505:

  Using the one-year holding period and multiple-year holding period dividend discount model (DDM),

  calculate the change in value of the stock of Monster Burger Place under the following scenarios. First,

  assume that an investor holds the stock for only one year. Second, assume that the investor intends to

  hold the stock for two years. Information on the stock is as follows:

  The value of the stock if held for one year and the value if held for two years are, respectively:

  A. $27.50 and $35.25.

  B. $25.22 and $29.80.

  C. $27.50 and $29.80.

  D. $29.80 and $32.50.

  Correct Answer: B

  First, we need to calculate the required rate of return. When a stock's beta equals 1, the required return is

  equal to the market return, or 10.0%. Thus, ke= 0.10.Alternative: Using the capital asset pricing model

  (CAPM), ke= Rf+ Beta * (Rm?Rf) = 4.5% + 1 * (10.0% - 4.5%) = 4.5% + 5.5% = 10.0%.

  Next, we need to calculate the dividends for years 1 and 2.

  Then, we use the one-year holding period DDM to calculate the present value of the expected stock cash

  flows (assuming the one-year hold).

  Finally, we use the multi-period DDM to calculate the return for the stock if held for two years.

  P0= [D1/ (1 + ke)] + [D2/ (1 + ke)2]+[P2/ (1 + ke)2] = [$2.75 / (1.10)] + [$3.03 / (1.10)2] + [$30.0 / (1.10)2]

  =$29.80.Note:since the growth rate in dividends, g, was equal to ke, the present value of next year's

  dividend is equal to last year's dividend (for periods 1 and 2). Thus, a quick calculation would be 2.5 * 2 +

  $30.00 / (1.10)2 = 29.80.

• Question 1506:

  Which of the following statements about bond indexes and international asset indexes is FALSE?

  A. Global equity indexes were created to alleviate problems with local indexes (sample selection and weighting).

  B. Low correlation among monthly country indexes supports international diversification.

  C. Some of the reasons that a bond index is more difficult to create than an equity index are that the universe of bonds is less than the universe of stocks and it is difficult to price the bonds because of the lack of continuous trade data.

  D. Investment-grade bond indexes have a higher correlation than high-yield bond indexes.

  Correct Answer: C

  This statement contains correct and incorrect points. A bond index is more difficult to create than an equity

  index because the universe of bonds is greater than the universe of stocks. The point about pricing

  difficulties is correct.

  The other statements are true.

• Question 1507:

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

  A. 50.0, 10.6.

  B. 50.0, 110.6.

  C. -6.3, 10.6.

  D. -6.3, 8.4.

  Correct Answer: A

  Calculations are as follows:

  

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

  return on the market-weighted index.

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

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

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

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

  First, we will calculate the year-end market-weighted index value, then we will calculate the return percentage. Value of market-weighted index = [(market capitalization year-end) / (market capitalization beginning of year)]* Beginning index value = (442,500 / 400,000) * 100 = 110.625 One-Year Return = [(Index value year-end/ Index value beginning of year) -1]* 100 = [ (110.625 / 100) ?1] * 100 =10.625, or approximately 10.6%.

• Question 1508:

  Which of the following projects would have multiple internal rates of return (IRRs)? The cost of capital for all projects is 10.0%.

  

  A. Project South only.

  B. Projects South and West.

  C. Project West only.

  D. Projects South and East.

  Correct Answer: A

  The multiple IRR problem occurs if a project has non-normal cash flows, that is, the project has negative (net) cash flows over its life or at the end of its life. In short, the sign of the net cash flows changes from negative to positive to negative, or vice versa. For the exam, a shortcut to look for is the project cash flows changing signs more than once. Only Project South has this cash flow pattern. The 0 net cash flow in T2 for Project West and likely negative net present value (NPV) for Project East would not necessarily result in multiple IRRs.

• Question 1509:

  Given the following information on the annual operating results for ArtFrames, a producer of quality metal

  picture frames, calculate the degree of operating leverage (DOL) and the degree of financial leverage

  (DFL).

  Which of the following choices is closest to the correct answer? ArtFrameDOL and DFL are, respectively:

  A. 3.00 and 1.50.

  B. 2.20 and 1.06.

  C. 2.20 and 1.08.

  D. 4.53 and 1.19.

  Correct Answer: C

  The calculations are as follows:

  

  1Variable costs = 0.45 * 3,500,000

  2Interest Expense = 0.09 * 750,000

  Second,calculate DOL:

  DOL = (Sales ?Variable Costs) / (Sales ?Variable Costs ?Fixed Costs)

  = (3,500,000 ?1,575,000) / (3,500,000 ?1,575,000 ?1,050,000) =2.20

  Third,calculate DFL:

  DFL = EBIT / (EBIT ?I) = 875,000 / 807,500 =1.08.

• Question 1510:

  Gerard Rouleau is studying for the Level 2 CFA examination. His friend, Sonia Fennell, is studying for Level 1. One weekday morning they are sitting at the local Cafe drinking espresso when she asks him for help with the section on margin trading. Rouleau creates the following scenario: Assume Fennell purchases 1,000 shares of Xpressoh Inc. for $35 per share. The initial margin requirement is 50 percent and the maintenance margin is 25 percent One year later, she sells the stock for $42 per share. Rouleau asks Fennell to calculate the one-year return under two cases: first, assuming an all-cash transaction,and second, assuming she buys on margin. She is to ignore transaction and borrowing costs. The earnings retention rate is 100%. Which of the following choices is closest to the correct answer? The return on an all cash transaction is:

  A. 20.00%, and the return on the margin transaction is 80.00%.

  B. 20.00%, and the return on the margin transaction is 40.00%.

  C. 40.00%, and the return on the margin transaction is 80.00%.

  D. 20.00%, and the return on the margin transaction is -40.00%.

  Correct Answer: B

  One quick (and less than intensive) way to calculate the answer to this on the examination (and is it very

  important to save time on the examination) is to first calculate the return if all cash, then calculate the

  margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the

  margin return.

  Calculations:

  Step 1: Calculate All Cash Return:

  Cash Return % = [(Ending Value / Beginning Equity Position) ?1] * 100

  = [(($42 * 1,000) / ($35 * 1,000)) ?1] * 100 = 20%

  Step 2: Calculate Leverage Factor:

  Leverage Factor = 1 / Initial Margin % = 1 / 0.50 = 2.00

  Step 3: Calculate Margin Return:

  Margin Transaction Return = All cash return * Leverage Factor = 20% * 2.00 = 40%

  Note: You can verify the margin return as follows:

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

  = [(([$42 * 1,000] ?[$35 * 1,000 * 0.50]) / ($35 * 0.50 * 1,000)) ?1] * 100 = 40%