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

• Question 1551:

  An analyst just received the following information for Mythical Interactions, Inc. A senior equity trader in her

  group wants to know if he should purchase a large block of the stock.

  Based on the assumptions above, which of the following recommendations is CORRECT? The analyst

  should advise the trader to:

  A. not purchase the stock. It is overvalued by approximately $10.00.

  B. purchase the stock. It is undervalued by approximately $8.00.

  C. purchase the stock. It is undervalued by approximately $14.20.

  D. not purchase the stock. It is overvalued by approximately $14.20.

  Correct Answer: B

  To determine whether the trader should purchase the stock, we need to determine if the stock is overvalued or undervalued. Given the information in this problem, we will use the price/earnings (P/E) ratio and the earnings per share (EPS) to calculate an estimated value.

  The P/E ratio = Dividend Payout Ratio / (ke– g),

  EPS = [(Per share Sales Estimate) * (EBITDA%) – D (per share) – I (per share)] * (1 - t)

  = [($175 * 0.22) - $20 - $12] * (1 – 0.40) = $3.90

  Value of stock = EPS * P/E = 13.725 * $3.90 = approximately$53.50 Conclusion:The trader should purchase a block of the stock. It is undervalued by the difference between the market price and the estimated value, $53.50 - $45.50, or approximately $8.00.

• Question 1552:

  Which of the following statements about asset valuation is FALSE?

  A. The price to book value ratio can be used to value firms with negative cash flows.

  B. Economic value added (EVA? measures the economic profit generated per dollar of invested capital.

  C. When estimating the profit margin of a company, the higher the export/import level, the higher the competition.

  D. The purpose of top-down stock analysis is to determine the best company within the best performing industry.

  Correct Answer: B

  EVA measures management's ability to add value to the firm. One of the problems with the EVA calculation is that it is not measured relative to the capital invested in the firm. As a workaround, the ratio of EVA to capital is used, and it is this ratio that measures the economic profit generated per dollar of invested capital. The other statements are true. Use Porter's five forces to determine the level of competition within an industry and to determine the company's strategy for dealing with that competition. Do not forget about the impact of foreign competitors!

• Question 1553:

  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 INCORRECT?

  A. The return on equity (ROE) on new projects is likely greater than ke for firms in Phase B.

  B. The infinite period dividend discount model (DDM) works well for valuing firms in Phases C and D.

  C. In general, profit margins are lower in Phase A than in Phase B.

  D. For most companies, Phase C lasts the longest.

  Correct Answer: D

  For most companies, Phase D, the Stabilization and Market Maturity Phase, lasts the longest. Phase C is the Mature Growth Phase. The other statements are true. During Phase B, the Rapid Accelerating Growth Phase, it is likely that the firm is earning a higher return on new projects than the required rate of return. During this phase, investors likely prefer for the firm to reinvest rather than pay dividends. The infinite period DDM works well for valuing firms in Phase C, the Mature Growth Phase, and Phase D, the Stabilization and Market Maturity Phase. Remember that the infinite period DDM is most useful for a company with the following assumptions: Phase A, the Pioneering Phase, is the start-up phase. Here, the market is small and firms incur major development costs. Sales growth is low and profit margins may be negative. In Phase B, the Rapid Accelerating Growth Phase, markets develop and demand grows exponentially. Competition is low and sales growth and profit margins are very high

• Question 1554:

  Marc Juneau, equity analyst, has just been assigned the task of valuing Avalon Games, Inc. The company is expected to grow at 30 percent for the next two years. Beginning in the year 4, the growth rate is expected to reach seven percent and stabilize. The required return for this type of company in the non-electronic games sector is estimated at 13 percent. The dividend in year 1 is estimated at $3.00. Which of the following is closest to the value Juneau should calculate for the stock of Avalon Games?

  A. $71.88.

  B. $64.68.

  C. $73.01.

  D. $45.41.

  Correct Answer: A

  The high "supernormal" growth in the first three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and finite dividend growth models (DDM) to value the stock of Avalon Games. Step 1:Determine the Dividend stream through year 4 Step 2:Calculate the value of the stock at the end of year 3 (using D4) Step 3:Calculate the PV of each cash flow stream at ke= 13%, and sum the cash flows.Note:We suggest you clear the financial calculator memory registers before calculating the value.

  

  Note: 1Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that the question asks you to select the closest answer.

• Question 1555:

  Kaylee Sumners, Level 1 CFA candidate, has just finished reviewing flash cards for the reading on the efficient market hypothesis (EMH). Confused by the different tests for the different forms of the EMH, she outlines the information (of which four summary points appear below) from memory. It appears that Sumners should review the material because three of the points are incorrect. Which of her summary points is CORRECT?

  A. Early tests of the semi-strong form used the equation: ReturnAbnormal = ReturnActual - (RMarket * BetaStock).

  B. The superior historical performance of exchange specialists and corporate insiders rejects the semi-strong form of the EMH.

  C. Cross-sectional tests such as the price-earnings ratio, neglected firms tests, and book value to market value tests support the semi-strong form of the EMH.

  D. Statistical and trading rule tests support the weak-form of the EMH.

  Correct Answer: D

  Explanation:These two tests support the weak-form EMH contention that security prices reflect all historical market information and that mechanical trading rules do not result in superior returns. The other statements are false.Latertests of the semi-strong form EMH used the equation: ReturnAbnormal= ReturnActual?(RMarket* BetaStock). Early tests omitted beta, using the formula: ReturnAbnormal= ReturnActual?RMarket. The superior historical performance of exchange specialists and corporate insiders rejects thestrongform of the EMH. Cross-sectional tests such as the price-earnings ratio, neglected firms tests, and book value to market value testsrejectthe semi- strong form of the EMH. These tests show that certain stocks have high realized returns (for example, low P/E stocks and high book value to market value stocks).

• Question 1556:

  Which of the following statements about the implications of tests for the efficient market hypothesis (EMH) is FALSE?

  A. By purchasing an index fund, an investor can match the market return and minimize costs.

  B. Technical trading rules do not consistently provide excess returns after adjusting for trading costs and taxes.

  C. Other than corporate insiders and market specialists, most traders have monopolistic access to information, which rejects the strong-form EMH.

  D. The best way to measure the performance of investments professionals is against a randomly selected buy-hold strategy of stocks (assuming the same risk level).

  Correct Answer: C

  Other than corporate insiders and market specialists, no other group has monopolistic access to information, which supports the strong-form EMH. The other statements are true.

• Question 1557:

  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, determine which of the following statements is FALSE?

  A. The geometric return is less than 11.7%.

  B. If the three stocks comprise an index, a change in Stock Payton would have the biggest impact if the index was market-value weighted.

  C. An investor creating a price-weighted index of these three stocks would need to change his holdings at year-end to reflect the price changes.

  D. If the three stocks comprise an index, a change in Stock Strand would have the biggest impact if the index was price-weighted.

  Correct Answer: C

  A price-weighted index assumes that the investor holds an equal number of shares of each stock in the index. Since the number of stocks did not change, the investor would not need to change his holdings. The other statements are true. A price-weighted index is most influenced by the stock with the highest per-share price (Strand). A market-value weighted index is most influenced by the stock with the largest market capitalization (Payton). The geometric return is always less than the arithmetic return (see calculation). The arithmetic and geometric return are calculated as follows:

  Arithmetic return = sum of: (1 + stock return) divided by the number of stocks minus 1, or [(1.5 + 1.0 + 0.85) / 3] – 1 = 0.117, or 11.7%. Thus, the geometric average must be less than 11.7%. Check of geometric average: = product of (1+ stock return), all to the 1/n power (or nth root) minus 1. = [(1.5)*(1.0)*(0.85)]1/3- 1 = 0.084, or 8.4%

• Question 1558:

  Which of the following statements about dividend policy and capital structure is FALSE?

  A. A company's growth rate equals the retention ratio multiplied by return on equity.

  B. Companies should use the residual dividend model to set the long-run target dividend payout ratio, but should not use it to set the dividend payment in any one year.

  C. If the board of directors decreases the target payout ratio, the stock price may increase or decrease.

  D. Assuming a world of taxes and bankruptcy, there is an optimal capital structure that maximizes earnings per share (EPS) and minimizes the cost of debt.

  Correct Answer: D

  The optimal capital structure is the one that maximizes the stock price and minimizes the cost of capital. The other statements are true. "A company's growth rate equals the retention ratio multiplied by return on equity," is simply the word version of the equation g = (1 - Payout Ratio) * ROE. Know this equation for the exam! A company that uses the residual dividend model to set the dividend payment in any one year will not have a stable payout ratio, and investors will likely demand a higher required return to offset this uncertainty. The higher required return will result in a lower stock price. If the board of directors decreases the target payout ratio, the stock price may increase or decrease because there will be two opposing effects. For example, this may result in a decrease in stock price (due to lower dividend payout, D1), and an increase in the stock price due to increased funds available for reinvestment. Remember: g = (1 ? Payout) * ROE. The net effect partially depends on investor's preference for dividends over capital gains or vice versa.

• Question 1559:

  Using the following assumptions, calculate the rate of return on a margin transaction for an investor who

  purchases the stock and the stock price at which the investor who shorts the stock will receive a margin

  call.

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

  A. -12.00%, and the investor will receive a margin call at a stock price of $16.67.

  B. 24.00%, and the investor will receive a margin call at a stock price of $30.00.

  C. 48.00%, and the investor will receive a margin call at a stock price of $20.83.

  D. -24.00%, and the investor will receive a margin call at a stock price of $30.00.

  Correct Answer: D

  To obtain the result: Part 1: Calculate Margin Return: Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) – 1] * 100 = [(([$22 * 1,000] – [$25 * 1,000 * 0.50]) / ($25 * 0.50 * 1,000)) – 1] * 100 =-24.00%. Alternative (Check):Calculate the all cash return and multiply by the margin leverage factor. = [(22,000 – 25,000)/22,000] * [1 / 0.50] = -12.00% * 2.0 = -24.00% Part 2:Calculate Margin Call Price:

  Since the investor isshort(sold the stock), the formula for the margin call price is:

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

  = $25 * (1 + 0.50) / (1 + 0.25) =$30.00

• Question 1560:

  Which of the following statements about securities markets is FALSE?

  A. Characteristics of a well-functioning securities market include: many buyers and sellers willing to trade at below market price, low bid-ask spreads, timely information on price and volume of past transactions, and accurate information on supply and demand.

  B. Secondary markets, such as the over-the-counter (OTC) market, provide liquidity and price continuity.

  C. A limit buy order and a stop buy order are both placed below the current market price.

  D. When Conglomerate, Inc. trades directly with MultiNational, Ltd., it is using the fourth market.

  Correct Answer: C

  A limit buy is placed below the current market price, but a stop buy order is placed above the current market price (stop buy orders are often placed to protect a short sale from a rising market). The other choices are true. A well-functioning securities market includes the following characteristics: The fourth market is the direct exchange of securities (no intermediaries and no transaction costs).