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

• Question 611:

  An analyst is attempting to value shares of a regional bank, and has solicited the help of a senior financial analyst. During their conversation, the senior financial analyst provides the following information about the regional bank under examination: Required rate of return on the bank's equity: 12.75% per year Free cash flow to equity multiple at t4: 20 1,500,000 shares outstanding

  Additionally, the analyst has obtained the following estimates of free cash flow to equity over the next four years:

  Year 1: $1,750,000 Year 2: $2,225,000 Year 3: $2,500,000 Year 4: $2,650,000

  Using this information, what is the value per share of this regional bank according to the free cash flow to equity model?

  A. $18.99

  B. $45.54

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

  D. None of these answers is correct.

  E. $31.26

  F. $26.31

  Correct Answer: F

  When determining the value of a common stock using the free cash flow to equity model, it is necessary to determine three things:

  1.

  The required rate of return on equity investments.

  2.

  The estimated free cash flow to equity multiple at time "k."

  3.

  The estimated free cash flows figures for the time periods leading up to "k."

  In this example, the calculation must begin with the discounting the free cash flow to equity figures for each of the four years provided. These figures are discounted each period by the required return on equity investments, and the final answer is converted to a per-share basis. This process is illustrated below:

  Year 1: ($1,750,000 / 1.1275) / 1,500,000 shares outstanding = $1.03 Year 2: [$2,225,000 / (1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.17 Year 3: [$2,500,000 / (1.1275)(1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.16 Year 4: [$2,650,000 / (1.1275)(1.1275)(1.1275)(1.1275)] / 1,500,000 shares outstanding = $1.09

  Now that the free cash-flow-to-equity figures have been discounted and converted to a per-share basis, the next step in the valuation process is to determine the value of the final cash flow, which is defined as:

  [(Free cash flow to equity multiple * Final free cash flow) / (1 + r)(1+r)...(1 + k)]

  In the body of this question, we were given the anticipated multiple of free cash to equity that shares of Intelligent Semiconductor will sell for at time period: specifically, 20 times. Imputing this information into the terminal cash flow equation will yield the following:

  {[20 * ($2,650,000 / 1,500,000 shares outstanding)] / [(1.1275) (1.1275)(1.1275)(1.1275)]} = $21.86

  Adding the answers from step 1 to the final year cash flow will yield the following:

  Value of Intelligent Semiconductor = [$1.03 + $1.17 + $1.16 + $1.09 + $21.86] = $26.31 per share.

• Question 612:

  Given that the expected growth rate for a firm is 5%, the expected total asset turnover is 0.87, the expected financial leverage multiplier is 0.81, the expected return on capital is 1.4, and expected retention rate is 60%, what is the expected net profit margin of the firm?

  A. 11.8%

  B. 12.3%

  C. 14.8%

  D. Not enough information

  E. 6.9%

  F. 9.3%

  Correct Answer: A

  The growth rate of a firm is equal to the expected retention rate multiplied by the expected return on equity. Rearranging this yields that the expected ROE is equal to the growth rate divided by the retention rate (ROE = 0.05/0.60 = 0.0833). The expected ROE is itself equal to the expected profit margin multiplied by the expected asset turnover multiplied by the expected financial leverage multiplier. Rearranging this yields that the expected net profit margin is equal to the ROE divided by the total asset turnover and the financial leverage multiplier (0.0833 / (0.87 x 0.81) = 0.118 = 11.8%

• Question 613:

  A mature firm, in the face of a new product introduced by its competition, has suddenly seen its profit margins fall by 50%. The market expects the management to streamline its sales force in a very short time and increase the sales-to-assets ratio by 30%. The dividend growth rate due to these changes will:

  A. decrease by 50%.

  B. decrease by 15%.

  C. increase by 30%.

  D. decrease by 35%.

  Correct Answer: D

  Use g = ROE * retention ratio and

  ROE = profit margin * asset turnover * financial leverage.

  If profit margin falls by 50% and asset turnover increases by 30%, the change in ROE is (1-0.5)*(1+0.3) - 1 = -0.35. With retention ratio constant, a 35% fall in ROE translates into a 35% fall in dividend growth rate.

• Question 614:

  According to the contrarians, if a large number of investment advisory services are bullish, it implies:

  I. the market is reaching a peak.

  II. the onset of a market decline.

  III.

  the beginning of a bull market.

  A.

  I and II

  B.

  I only

  C.

  III only

  D.

  II only

  Correct Answer: A

  Contrarians believe that most market participants make wrong investment decisions as the market approaches the peak or trough in a cycle. Therefore, if a large number of advisory services are bullish, they believe that the market is about to turn bearish after having reached a peak.

• Question 615:

  Which is a measure of a stockholder's return?

  A. Return on Equity

  B. Debt to Equity Ratio

  C. Dividend Yield

  D. Return on Assets

  E. Payout Ratio

  Correct Answer: C

  The dividend yield = Dividends for the Year/Stock Price at the Beginning of the Year; It is one of the two important measures of a stock investor's return, with the other being capital gain.

• Question 616:

  If the spread between the required rate of return on a stock and the dividend growth rate decreases, the price of the stock:

  A. is not affected.

  B. decreases.

  C. is not affected or increases.

  D. increases.

  Correct Answer: D

  In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). When k - g decreases, all else equal, the stock price rises.

• Question 617:

  What would be indicative of a high-growth industry?

  A. A relatively low payout ratio.

  B. A relatively high debt-to-equity ratio.

  C. All of these answers are correct.

  D. A relatively low return on assets ratio.

  E. A relatively low return on equity ratio.

  F. None of these answers.

  Correct Answer: A

  In order to sustain a high rate of growth in earnings and dividends, a firm will needfinancing and if a large cash dividend is paid, it gives up one source of financing. Theresult being low payout of dividends for these high-growth companies.

• Question 618:

  Which of the following is the preferred method of return calculation in the investment management industry?

  A. Time-weighted rate of return

  B. Dollar-weighted rate of return

  C. Internal rate of return

  D. None of these answers is correct.

  E. Asset-weighted rate of return

  Correct Answer: A

  The time-weighted rate of return is the preferred method of return calculation in the investment management industry, and this is precisely because the time-weighted rate of return is not sensitive to significant portfolio additions or withdrawals, unlike the dollar weighted rate of return.

  Remember that the dollar-weighted rate of return is another name for the Internal Rate of Return. Knowing this fact allows you to narrow the answer down to three possible choices. The asset-weighted rate of return is by definition sensitive to additions and withdrawals of portfolio assets.

• Question 619:

  The confidence index is equal to the ratio of

  A. the yield on 10 top-grade corporate bonds divided by the yield on the Dow Jones average of 40 bonds, multiplied by 100.

  B. the yield on the Dow Jones average of 40 bonds divided by the average yield on 10 top-grade corporate bonds, multiplied by 100.

  C. the expected return on the SandP 500 divided by the yield on 10 top-grade corporate bonds, multiplied by

  100.

  D. the yield on the Dow Jones average of 40 stocks divided by the expected return on the SandP 500.

  E. the expected return on the SandP 500 divided by the yield on the Dow Jones average of 40 stocks.

  Correct Answer: A

  The confidence index measures the yield spread between high-grade bonds and a large cross section of bonds. Some technical analysts believe that during periods of high confidence, investors are more willing to invest in lower-quality bonds, thereby pushing down their yields, and increasing the confidence index. An increase in the index is viewed as a bullish sign.

• Question 620:

  The Dividend Discount Model:

  I. is primarily used to price mature stocks.

  II. assumes constant dividends.

  III. assumes a constant dividend payout ratio.

  IV.

  works only if the growth rate is higher than the expected rate of return.

  A.

  II only

  B.

  III only

  C.

  I only

  D.

  III and IV

  E.

  I and IV

  F.

  I and II

  G.

  IV only

  Correct Answer: C

  Dividend Discount Model assumes a constant growth in dividends but does not require the payout ratio to be constant. Also, it is applicable only when the constant growth rate is lower than the expected rate of return (It does not preclude the growth rate from exceeding the expected rate of return over some periods. However, in that case, the formula that arises from the assumption of constant growth rate cannot be used).