CFA Institute CFA-LEVEL-1 Online Practice Questions and Exam Preparation

CFA Institute CFA-LEVEL-1 Online Questions & Answers

• Question 231:

  Given that the correct value of a common stock is $29, the dividend growth rate is 6%, and next period's dividend is $2, using the infinite period Dividend Discount Model, what is the required rate of return on the common stock?

  A. 6. 9%
  B. Not enough information
  C. 18.3%
  D. 14. 8%
  E. 12. 9%
  E. 12. 9%

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  Explanation

  The infinite period Dividend Discount Model postulates that the current value of a common stock is equal to D1 / (k - g), where D1 is next period's dividend, k is the required rate of return, and g is the growth rate of dividends. Rearranging this yields k = D1/(current value) + g. In this question, the required rate of return is (2 / 29) + 0.06 = 0.129 = 12. 9%.

• Question 232:

  When investor inflation expectations increase, all else equal, the security market line (SML) will:

  A. shift downward in a parallel manner.
  B. rotate counterclockwise.
  C. shift upward in a parallel manner.
  D. rotate clockwise.
  C. shift upward in a parallel manner.

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  Explanation

  Parallel shifts in the SML result from changing market conditions (such as an increase in expected inflation). When inflation expectations increase, investors want to be compensated for the increased risk and to insure that their purchasing power is not eroded. Thus, the SML shifts upward, increasing the expected return at each level of risk. The SML will shift downward in response to decreasing inflation expectations, decreased economic growth, and expanding capital markets. Changes in slope cause the SML to rotate. The slope of the SML will change in response to changes in attitudes of investors toward risk that affects the market risk premium. If there is an increase in the market risk premium, the SML will rotate counterclockwise about the risk free rate. If there is a decrease in the market risk premium, the SML will rotate clockwise about the risk free rate.

• Question 233:

  The following data are available for a firm for a given year:

  Net Sales 21,896 Sales and marketing expenses 4,346 Administrative expenses 2,143 COGS 10,084 Depreciation 967 Interest expense 573 Tax rate 35% Dividends paid 3,445 Preferred Dividends 897 Average total equit y37,432 Average common equity 26,782 Average total liabilities 18,583

  In the above example, the firm's return on total equity equals ________.

  A. 8.31%
  B. 4. 22%
  C. 6. 57%
  D. 5. 91%
  C. 6. 57%

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  Explanation

  Return on total equity = Net income/average total equity. In the above example, Net Income = Earnings after depreciation, interest expense and taxes = (21,896 - 4,346 - 2,143 - 10,084 - 967 - 573)*(1 - 0.35) = 2,459. Therefore, Return on total equity = 2,459/37,432 = 6. 57%.

• Question 234:

  A financial analyst with Smith, Kleen, and Beetchnutty is examining shares of Clay Industries for possible investment. Assume the following information:

  EPS: $4. 19

  ROE: 11.25%

  Growth rate of dividends: 6. 75%

  Discount rate: 11.50%

  Tax Rate 35%

  Using this information, what is the dividend payout ratio for Clay Industries? Further, what is the annual dividend?

  A. 35. 87%, $1.50
  B. 60.00%, $2. 51
  C. 60.00%, $1.68
  D. The answer cannot be determined from the information provided.
  E. 40.00%, $1.68
  F. 40.00%, $2. 51
  E. 40.00%, $1.68

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  Explanation

  To determine the dividend payout ratio, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows:

  {g = ROE (1 - Dividend Payout Ratio)}

  In order to determine the Dividend Payout Ratio, the equation must be rearranged to the following: {(1 - Dividend Payout Ratio) = Growth Rate of Dividends / ROE}.

  Imputing the given information into this equation will yield:

  {(1 - Dividend Payout Ratio) = 0.0675/0.1125)} = 0.60

  Finally, subtracting this answer from 1 will yield the answer of 40%. We must subtract the first answer from one because the first answer represents the retention rate, i.e. the percentage of earnings that is retained and reinvested at the firm's

  ROE, and not the Dividend Payout Ratio. The retention rate and the payout ratio will always combine to equal positive one. In order to determine the annual dividend, take the Dividend Payout Ratio, which was found to be 40%, and multiply

  this figure by the Earnings Per Share calculation, which is given as $4. 19. This will yield an annual dividend of $1.676. As you can see, neither the discount rate nor the tax rate is factored into the equation

• Question 235:

  Which of the following statements is false in reference to confidence intervals and/or tests of significance? Choose the best answer.

  A. More than one of these answers is correct.
  B. The specification of a confidence level is the third step in the hypothesis testing process.
  C. Determining the significance level of a hypothesis test after calculating the test statistic can lead to an erosion of objectivity.
  D. The significance level is denoted by the Greek letter theta.
  E. The confidence level can be found by (1 - the probability of a Type I error).
  F. The significance level is equal to the probability of a Type I error.
  D. The significance level is denoted by the Greek letter theta.

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  Explanation

  The significance level is denoted by the Greek letter alpha. The significance level is equal to the probability of a Type I error, and can be found by subtracting the confidence level from the letter one. The relationship between the confidence

  level and the significance level is illustrated as follows:

  Confidence level = (1 - significance level)

  which can also be expressed as:

  Confidence level = (1 - probability of a Type I error).

  The Greek letter theta is used to represent the population parameter in the null and alternate hypotheses.

  The remaining answers are all correct. It is important to remember that the level of significance should be determined prior to the calculation of the test statistic. Specifying the significance level after the calculation of the test statistic can

  detract from the objectivity of the test.

• Question 236:

  Hupta Corporation reports cost of goods sold for the year ended December 31, 1998 of $3,500. Other information as of December 31 is as follows: 1997 1998 Accounts Receivable $500 $550

  Inventory $400 $380 Accounts Payable $250 $290 Cash paid to suppliers for year ended December 31, 1998 is ________.

  A. $3,520
  B. $3,480
  C. $3,440
  D. $3,560
  C. $3,440

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  Explanation

  An increase in accounts payable shows that $40 less than the $3,480 of purchases ($3,500 COGS + (20) change in inventory) was paid: $3,480 - $40 = $3,440.

• Question 237:

  The probability of the occurrence of an airplane crash and a successful resolution to a labor strike is called:

  A. a conditional probability.
  B. an unrelated probability.
  C. a joint probability.
  D. an unconditional probability.
  C. a joint probability.

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  Explanation

  A joint probability takes the form of P(AB), the probability that an event A (an airplane crash) and an event B (the resolution of a strike) both happen.

• Question 238:

  Marlene Gooseberry, an institutional money manager with Middle Road Brokerage, has been examining a stock market series and has determined the following information:

  The dividend payout ratio at t1 has been estimated at: 31% The required rate of return is 16%

  The anticipated future growth rate of dividends is 13. 75%

  The anticipated future growth rate of earnings is 14. 25%

  The corporate tax rate is 35%

  Using this information, what is the earnings multiplier for this stock market series? Choose the best answer.

  A. 8.96
  B. 7. 75
  C. 13. 78
  D. 17. 71
  E. None of these answers is correct.
  F. The answer cannot be determined from the information provided.
  C. 13. 78

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  Explanation

  Estimating the earnings multiplier for a stock market series requires the estimation of each of the following components:

  1. The dividend payout ratio.

  2. The required rate of return on common stock in the country/region/industry/sector being analyzed.

  3. The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.

  Once values for each of these components have been determined, they are imputed into the following formula: {P/E = [D/E / (k - g)]}. Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the

  required rate of return, and g = the anticipated growth rate of dividends.

  In this example, all of the necessary information has been provided, and the calculation of the earnings multiplier is shown as follows: {P/E = [0.31 / 0.16 - 0.1375] = 13. 78}.

  Notice that it was the anticipated growth rate of dividends, not the anticipated growth rate of earnings, which was used in determining the earnings multiplier. Additionally, note that the tax rate was not explicitly factored in to the equation, as

  the earnings figure used in the dividend payout ratio is already an after-tax figure.

• Question 239:

  Which of the following statements is most correct?

  A. The component cost of preferred stock is expressed as k(ps) (1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
  B. Due to the way the Marginal Cost of Capital (MCC) schedule is constructed, the first breakpoint in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.
  C. The cost of equity obtained by using retained earnings is generally regarded as being the rate of return stockholders require on the firm's outstanding common stock.
  D. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost.
  E. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
  C. The cost of equity obtained by using retained earnings is generally regarded as being the rate of return stockholders require on the firm's outstanding common stock.

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  Explanation

  Preferred stock dividends are not tax deductible; therefore, the component cost of preferred stock is only k(ps). The risk premium in the bond-yield-plus-risk premium approach would be added to the firm's cost of debt, not the risk-free rate. The first break point does not have to be associated with retained earnings. It could be from other sources of funds such as debt. The choice between preferred stock or common equity financing depends on a number of factors, including required return, flotation costs, management's desired capital structure, etc.

• Question 240:

  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
  B. I, II and III

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  Explanation

  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.