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

• Question 241:

  Jim Williams, a security analyst with Smith, Kleen and Beetchnutty, identifies promising investments by first evaluating the global macroeconomic environment, then identifying the prospects of individual regions and companies. Once promising areas have been identified, Mr. Williams then determines which industries are expected to flourish within these areas. Finally, individual companies are examined within the aforementioned industries. Which of the following best describes the process used by Mr. Williams?

  A. None of these answers is correct.

  B. Macroeconomic Cycle Approach

  C. Sensitivity Analysis Approach to security evaluation

  D. Top down Approach

  E. Bottom up Approach

  Correct Answer: D

  The approach illustrated within this example is the Top Down, or "Macro" approach. When using this method, an analyst first begins by evaluating the macroeconomic environment, and then moves on to specific regions and countries. Next, individual industries are examined in an attempt to determine their fundamentals. The final step in the Top Down Approach is to examine individual companies.

  The Top Down Approach is contrasted with the Bottom Up Approach, which begins by evaluating the fundamentals of individual companies.

• Question 242:

  The P/E earnings multiplier can be set equal to

  A. the required rate of return minus the dividend growth rate, divided by the expected dividend payout ratio.

  B. next year's dividend divided by the spread between the required rate of return and the dividend growth rate.

  C. the spread between the required rate of return and the dividend growth rate, divided by next year's dividend.

  D. the expected dividend payout ratio, divided by the required rate of return minus the dividend growth rate.

  Correct Answer: D

  The earnings multiplier, which is the basis for a method of valuing stocks, is also known as the price / earnings (P/E) ratio. The infinite period Dividend Discount Model claims that the current price of a common stock is equal to D1 / (k - g), where D1 is next period's (most often next year's) dividend, k is the required rate of return, and g is the growth rate of dividends. If we divide both sides of the infinite period Dividend Discount Model equation by expected earnings during the next 12 months, we get P/E = (D1/E) / (k - g).

• Question 243:

  The NAV of an open-ended fund is $16.88. The fund charges a 7.2% sales charge and no redemption charges. If you invested a $1,000 with the fund, how many shares would you receive?

  A. 55.26

  B. 54.98

  C. none of these answers

  D. 59.24

  Correct Answer: C

  The offer price i.e. the price at which you can buy a share equals NAV/(1-load charge) = 16.88/(1-0.072) = $18.19. Therefore, the number of shares you receive equals 1000/18.19 = 54.98

  Be careful NOT to calculate the offer price as NAV*(1 + load charge). The sales charge is expressed as an percentage of the amount you deposit. In this example, you deposit $1,000 and get shares worth $1,000 * (1-0.072) = $928. Note that the 54.98 shares are worth 54.98 * 16.88 = $928 i.e. this is the amount you would get if you were to sell the shares immediately.

• Question 244:

  Assume the following information about a publicly traded pharmaceutical firm:

  Revenue: $16,000,000 Cash flow: $1,700,000 Net worth per share: $14.55 Number of common shares outstanding: 1,000,000 Required return: 21% per year Expected growth rate: 19% per year Next dividend: $1.05 per share

  Using this information, what are the price-to-sales, price-to-book, and price-to-cash flow ratios, respectively?

  A. The answer cannot be completely calculated from the information provided.

  B. 16, 52.5, 0.0324

  C. 0.106, 38.4, 0.0324

  D. None of these answers is correct.

  E. 16, 52.5, 30.88

  F. 0.106, 52.5, 30.88

  Correct Answer: A

  To calculate the price-to-sales, price-to-book, and price-to-cash flow ratios, it is necessary to know the price of the common stock in question at t0, which is not provided in this example.

• Question 245:

  If the debit balances in brokerage accounts decrease, the smart money technicians interpret it as:

  A. a bearish signal.

  B. none of these answers.

  C. a bullish signal.

  D. a hold signal.

  Correct Answer: A

  Debit balances in brokerage accounts represent margin debt i.e. borrowings by investors from the brokerages for investment in the market. Smart money technicians consider margin investors as a group of astute investors and hence interpret large leveraged investments as a bullish signal. Therefore, an large increase in the debit balances is considered a bullish sign while a decline is considered a bearish sign.

• Question 246:

  A stock has a beta of 1.44 and the market risk premium is 7.4%. Its dividend growth rate is 5% and its P/E ratio is 4.2. If the firm has a dividend payout ratio of 45%, the risk-free rate equals ________.

  A. 5.06%

  B. 4.64%

  C. 5.33%

  D. 4.89%

  Correct Answer: A

  If the expected return on the stock is K, then the Dividend Discount Model gives

  P/E = (dividend payout ratio)/(K - g). Therefore, K = g + (div. payout ratio)/(P/E) = 0.05 + 0.45/4.2 = 15.71%

  . Now, CAPM implies that the expected return on a stock equals the risk-free rate plus beta times the

  market premium. Hence, 15.71% = Rf + 1.44 * 7.4%, giving Rf = 5.06%.

• Question 247:

  Holding other things equal, an increase in net income will

  A. decrease the ROE.

  B. have no effect on the ROE.

  C. increase the earnings multiplier.

  D. have no effect on the earnings multiplier.

  Correct Answer: C

  An increase in net income increases the return on equity ratio (ROE), which would increase the growth rate of earnings and dividends. This, in turn, would increase the earnings multiplier.

• Question 248:

  A value investor is considering investing in shares of Microscam International, believing that the market price of Microscam is less than the "intrinsic value" of the shares. In his research, this value investor has gathered the following information about Microscam International:

  Total assets: $200,000,000 Total liabilities: $130,000,000 Number of common shares outstanding: 3,000,000 Current stock price: $22.15 per share Required return: 18.75% per year Expected growth rate: 17% per year Next dividend: $0.30 per share Earnings per share: $3.88

  Using this information, what is the book value of Microscam International? Further, are the beliefs of this value investor justified? Assume that the book value calculation accurately illustrates the liquidation value of Microscam.

  A. 5.709, yes

  B. 0.949, no

  C. 0.949, yes

  D. 5.709, no

  E. 0.244, yes

  F. None of these answers is correct.

  Correct Answer: C

  The book value of a common stock is found by dividing the net worth of a company by the number of outstanding shares. While there exists several different methods for calculating net worth, the most simplistic involves subtracting total liabilities from total assets, giving us the shareholder's equity figure. Investment professionals often see the book value as a "floor" for common stock prices, and the price-tobook ratio is quite popular in the field of investment management. The calculation of the price-to-book ratio involves the following equation:

  Price-to-book ratio = {Market price of common stock at t0 / [(total assets - total liabilities) / # of common

  shares outstanding]} While the # of common shares outstanding has been provided, the shareholder's

  equity figure must be calculated manually. The calculation of the per share shareholders equity is

  illustrated as follows:

  Shareholders equity = [($200,000,000 - $130,000,000) / 3,000,000] = $23.33.

  Now that the shareholders equity has been calculated and transformed into a per-share figure, the pricetobook value can be calculated as follows:

  Price-to-book value = ($22.15 / $23.33) = 0.94942.

  As you can see, the required rate of return, along with the expected growth rate, is not necessary in the

  calculation of the price-to-book ratio.

  Any time the price-to-book ratio is less than one, a stock is said to be "trading at a discount to book."

  Frequently, investment professionals will use the term "intrinsic value" when referring to the book value,

  and thus stocks trading below their book value are often referred to as being priced "below their intrinsic

  value." Stocks trading below book value are often sought after by value investors, who believe that these

  shares have been discounted below their real value.

  A figure of more than one for the price-to-book ratio is commonly referred to as "trading at a premium to

  book."

  While the price-to-book value is a useful tool in the stock selection process, it possesses some important

  flaws. One problem with the Price-To-Book Ratio is that one of the terms - Book Value - is so easily

  manipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buy-backs and

  write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.

• Question 249:

  Which of the following variables has/have an inverse relationship with the P/E ratio?

  A. Dividend payout ratio

  B. Required rate of return

  C. All of these answers

  D. Growth rate of dividends

  Correct Answer: B

  One can remember the formula P/E = (D/E)/(k - g); and note that k, which is the required rate of return, is in the denominator, i.e. inverse relationship. Or one can remember that a high P/E ratio means paying a high price for some earnings, i.e. the rate of return required is low.

• Question 250:

  An economist with Smith, Kleen and Beetchnutty Institutional Brokerage has been examining a stock market

  series and is trying to determine an appropriate earnings multiplier for the series. In her research, this

  economist has determined the following information:

  The annual dividend at t1 = $1.35

  The EPS at t1 = $5.10

  The anticipated growth rate of dividends is 12.5%

  The anticipated growth rate of earnings is 14%

  The required rate of return is 15.75%

  Using this information, what is the appropriate earnings multiplier for this stock market series? Further,

  what is the appropriate value for this stock market series? Choose the best answer.

  A. None of these answers is correct.

  B. 14.93; $76.13

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

  D. 7.74; $39.46

  E. 8.14; $41.51

  F. 15.13; $77.16

  Correct Answer: E

  The appropriate earnings multiplier is found to be 8.14. 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. However, the dividend payout ratio must be calculated based on the anticipated dividend at t1 and the projected EPS figure for t1. The calculation of the dividend payout ratio is as follows: {D/E = [$1.35 / $5.10] = 0.264706}. Now that the dividend payout ratio has been determined, the appropriate earnings multiplier is found as follows: {P/E = [0.264706/ (0.1575 - 0.125)] = 8.14. Notice that it is the anticipated growth rate of dividends, not the anticipated growth rate of earnings, which is used in the determination of the earnings multiplier. Multiplying this figure by the projected EPS will lead to an appropriate value of $41.51 for this series.