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

• Question 451:

  Net profit margin for a market series is difficult to estimate because it is very ________.

  A. stable

  B. costly

  C. volatile

  D. inaccurate

  Correct Answer: C

  Net profit margin for a market series is difficult to estimate because it is highly volatile, a result of changes in depreciation, interest and tax rate over time.

• Question 452:

  Given that the retention rate of earnings of a firm is 0.30, the required rate of return on its stock is 17%, the expected growth rate is 12%, and expected 12 month earnings per share are $2.32, what should the current market price of the stock be?

  A. $43.00

  B. Not enough information

  C. $32.48

  D. $39.18

  E. $29.66

  F. $14.12

  Correct Answer: C

  According to the earnings multiplier model, the price/earnings ratio is equal to the dividend payout ratio divided by the spread between the required rate of return and the expected growth rate. The dividend payout ratio is equal to 1 - the retention rate of earnings (everything the firm does not retain is paid out in dividends). In this question, it is 1 - 0.30 = 0.70. The P/E ratio is thus equal to 0.70 / (0.17 - 0.12) = 14. Multiplying the P/E ratio by earnings per share yields the current market price. In this question, it is 14 x

  2.32 = $32.48.

• Question 453:

  According to Porter, which is not a competitive force that determines the intensity of competition?

  A. none of these are competitive forces

  B. bargaining power of suppliers

  C. bargaining power of buyers

  D. substitute products

  E. rivalry among competitors

  F. all of these are competitive forces

  Correct Answer: F

  The remaining force is the threat of new entrants.

• Question 454:

  In order to value an asset, one needs

  A. the stream of expected future cash flows.

  B. the stream of expected future cash flows and the ROE of the asset.

  C. the stream of expected future cash flows, and the book value of the asset.

  D. the book value of the asset, and its ROE.

  E. the stream of expected returns and the required rate of return on the asset.

  Correct Answer: E

  In order to value an asset, one needs to find the present value of its expected future cash flows. In order to do this, one needs the stream of expected future cash flows, and the required rate of return to discount that stream in order to arrive at its present value.

• Question 455:

  Which of the following are assumptions of the dividend discount model?

  A. The required rate of return is greater than the growth rate

  B. Earnings will not be negative

  C. Dividends will be paid on stocks

  D. All of these answers

  Correct Answer: A

  The infinite period Dividend Discount Model has the following assumptions:

  1.

  Dividends grow at a constant rate

  2.

  The constant growth rate will continue for an infinite period

  3.

  The required rate of return (k) is greater than the infinite growth rate (g). If it is not, the model gives meaningless results because the denominator becomes negative.

• Question 456:

  Consider the following preferred stock:

  Price per share: $70.10 Semiannual dividend: $3.75 per share Required rate of return: 12% per year

  Is the preferred stock realistically overvalued, undervalued, or correctly valued? Further, should this preferred stock be valued as a perpetuity or a finite series of cash flows? (Assume a long-term holding period).

  A. Correctly valued; perpetuity

  B. Undervalued; perpetuity

  C. Overvalued; finite series of cash flows

  D. Undervalued; finite series of cash flows

  E. Correctly valued; finite series of cash flows

  F. Overvalued; perpetuity

  Correct Answer: F

  The preferred stock profiled in this example is trading above its theoretical value, which is found to be

  $62.50. Assuming that this value is accurate, then the stock appears to be overvalued in the marketplace.

  To determine the value of a preferred stock, use the following equation: {P0 = [d1 / k]}

  Where: P0 = the price of the preferred stock at time 0, d1 = the annual dividend at t = 1, k = the required

  rate of return.

  In this example, the dividend is provided as a semiannual figure, which must be doubled to show the

  annual dividend. After this adjustment has been made, the value of the preferred stock can be found as

  follows.

  {P0 = [$7.50 / 0.12] = $62.50.

  Preferred stock is commonly valued as a perpetuity because there is no finite conclusion to the projected

  series of cash flows for a preferred stock. Unlike a bond, whose cash flows are characterized by a finite

  lifespan (i.e. the cash flows of a bond cease at maturity), the cash flows (dividends) produced by a

  preferred stock could theoretically last forever.

• Question 457:

  If a stock has an expected dividend payout of 50 percent, a required rate of return of 14 percent and an expected dividend growth rate of 9 percent, what is the P/E ratio?

  A. 12.5

  B. None of these answers

  C. 8.5

  D. 10

  Correct Answer: D

  The price/earnings ratio can be computed by dividing the expected dividend payout ratio (dividends divided by earnings) by the required rate of return (k) minus the expected growth rate of dividends (g).

  In this case, P/E = .50/(.14-.09) = 10

• Question 458:

  The earnings multiplier of a stock

  A. is determined by the expected dividend payout ratio, the return on capital, and the expected growth rate of dividends for that stock. The earnings multiplier tends to be rather stable between stocks and industries, and does not vary significantly over time.

  B. is determined by the expected dividend payout ratio, the required rate of return, and the expected growth rate of dividends for that stock. The earnings multiplier tends to vary considerably between stocks and industries, and over time.

  C. is determined by the expected earnings, the required rate of return, and the expected growth rate of dividends for that stock. The earnings multiplier tends to vary between stocks and industries, but is

  rather stable over time.

  D. is determined by the expected dividends, the required rate of return, and the expected growth rate of dividends for that stock. The earnings multiplier tends to vary considerably between stocks and industries, and over time.

  Correct Answer: B

  The earnings multiplier (or price/earnings ratio) is equal to the expected dividend payout ratio, divided by the spread between the required rate of return and growth rate of dividends on the stock. Estimation of the earnings multiplier is important because it varies between stocks and industries as well as over time. It, along with future earnings, is used to estimate the future market value of stocks or stock market series.

• Question 459:

  Which of the following is not one of the three direct variables that affect an economy's real growth rate?

  A. Technological progress

  B. Growth rate of the labor force

  C. Growth rate of labor productivity

  D. Growth rate of the average number of hours worked

  Correct Answer: A

  While technological progress is exceedingly important to an economy's real growth rate, its effect is always indirect. Technological progress most often increases labor productivity, which in turn increases the real growth rate.

• Question 460:

  The confidence index is:

  A. the ratio of the average yield on 10 top grade bonds to Dow Jones average of 40 bonds.

  B. the ratio of the volume of the 5 top grade bonds to the volume of on-the-run T-bills.

  C. the ratio of the total NYSE capitalization to the outstanding short interest.

  D. The ratio of long-term bond spread to aggregate market dividend yield.

  Correct Answer: A

  The Confidence index, published by Barron's, is the ratio of the average yield on 10 top grade bonds to the Dow Jones average of 40 bonds. The index measures the difference in yield spreads between high-grade bonds and a large cross- section of available bonds. Since high-grade bonds always have lower yields, the index value never exceeds 100. An increase in this index implies that yields on high-grade bonds and those on ordinary bonds have converged i.e. the yield spread between the bonds has narrowed. From a demand perspective, this will happen when the demand for riskier bonds rises i.e. when investors are bullish.