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Free Test Prep CFA-Level-I Exam Questions (page: 22)

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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, calculate the value of a market-value weighted index at year-end and the one-year return on the price-weighted index. The beginning value for the market index is 100. (Note: The choices are listed in the order market-value weighted index value and price-weighted index percent return, respectively). Which of the following choices is closest to the correct answer?

  1. 10.6, 6.3.
  2. 110.6, -6.3.
  3. 110.6, 50.0.
  4. 10.6, 8.4.

Answer(s): B

Explanation:

Calculations are as follows:



First, we will calculate the value of the market-value weighted index at year-end, and then we will calculate the return on the price-weighted index.
Step 1: Calculate value of the market-weighted index at year-end:
Value of market-weighted index =
[(market capitalization year-end) / (market capitalization beginning of year)]* Beginning index value = (442,500 / 400,000) * 100 = 110.625, or approximately 110.6
Step 2: Calculate the one-year return on the price-weighted index:
First, we will calculate the price-weighted index value for both the beginning of year and end of year, then we will calculate the return percentage.
Value of price-weighted index beginning= (sum of stock per share prices beginning) / (number of stocks beginning)
= (10 + 50 + 100) / 3 =53.333
Value of price-weighted index end= (sum of stock per share prices end) / (number of stocks end) = (15 + 50 + 85) / 3 =50.0
One-Year Return = [(Index value year-end/ Index value beginning of year) -1]* 100 = [ 50.0 / 53.333) ­ 1] * 100 =-6.3%
Note:Your calculation may differ slightly due to rounding. Remember that the question asks you to select the closest choice.



Caleb Gold is studying for the Level 1 CFA examination with a fellow group of first year MBA students at the London School of Economics. During that night's study session, Stephan LeMond, the self-proclaimed group "leader," gives a short presentation on the forms of the efficient market hypothesis (EMH). As Gold listens, he hears LeMond make an obviously incorrect statement. He quickly speaks up, and identifies which of the following statements as INCORRECT?

  1. The weak-form EMH states that stock prices reflect current public market information and expectations.
  2. The semi-strong form EMH addresses market and non-market public information.
  3. The strong-form EMH assumes perfect markets.
  4. The weak-form EMH suggests that technical analysis will not provide excess returns while the semi-strong form suggests that fundamental analysis cannot achieve excess returns.

Answer(s): A

Explanation:

The weak-form EMH assumes the price of a security reflects all currently available historical information. Thus, the past price and volume of trading has no relationship with the future, hence technical analysis is not useful in achieving superior returns.
The other statements are true. The strong-form EMH states that stock prices reflect all types of information:
market, non-public market, and private. No group has monopolistic access to relevant information; thus no group can achieve excess returns. For these assumptions to hold, the strong-form assumes perfect markets ­ information is free and available to all.



Tamira Scott, CFA, manager of an index fund, needs to raise money soon (although not immediately) to pay taxes. Although she believes in the efficient market hypothesis (EMH), she remembers that there are a few anomalies she may take advantage of to earn higher returns. Which of the following actions is most unlikely to provide excess returns? Scott should purchase stocks in:

  1. companies with low price/earnings ratios and/or with high book to market ratios.
  2. companies that announce stock splits.
  3. companies not followed by analysts.
  4. mid-December, with the intent to sell in early January.

Answer(s): B

Explanation:

According to event studies of the semi-strong form of the EMH, stock splits do not have a short run or long run impact on returns. This finding supports the EMH.
The other choices are considered anomalies. That is, they reject the semi-strong form of the EMH, and suggest that investors can earn excess returns by exploiting these anomalies. The January anomaly (from a time-series test of the semi-strong EMH) suggests that investors can earn excess returns by buying stocks in December and selling them in the first week of January, due to tax-induced trading at year-end. Cross-sectional tests of the semi-strong form EMH have shown that low P/E stocks, stocks of firms neglected by analysts, and stocks of firms with high book to value ratios can produce superior returns.



Given the following estimated financial results, value the stock of Magic Holdings, Inc. using the infinite period dividend discount model (DDM).
Which of the following choices is closest to the value of Magic Holding Inc. stock? (Note: Carry calculations out to at least 3 decimals.)

  1. $44.64.
  2. $23.54.
  3. Unable to calculate stock value because ke < g.
  4. $109.27.

Answer(s): D

Explanation:

Here, we are given all the inputs we need. Use the following steps to calculate the value of the stock:
First, expand the infinite period DDM:
DDMformula: P0= D1/ (ke­ g)
D1
= (Earnings * Payout ratio) / average number of shares outstanding = ($200,000 * 0.625) / 50,000 = $2.50.
ke
= nominal risk free rate + [beta * (expected market return ­ nominal risk free rate)] Note: Nominal risk-free rate = (1 + real risk free rate) * (1 + expected inflation) ­ 1 =(1.035)*(1.040) ­ 1 = 0.0764, or 7.64%.
ke
= 7.64% + [1.8 * (13.0% - 7.64%)] = 0.17288.
g
= (retention rate * ROE)
Retention = (1 ­ Payout) = 1 ­ 0.625 = 0.375.
ROE = (net income/sales)*(sales/total assets)*(total assets/equity) = (200,000/1,000,000)*(1,000,000/750,000)*(750,000/500,000) = 0.40 g
= 0.375 * 0.40 = 0.15.
Then, calculate:P0= D1/ (ke­ g) = $2.50 / (0.17288 - 0.15) = 109.27.



Ted McGovern works in the economics branch of a government bank regulator. When he arrives at work this morning and checks his voicemail, he has a message from the Regional Director asking him to calculate the expected rate of return for a stock market series. More detailed information will be forthcoming in an e-mail. Fortunately, McGovern still has his CFA Program study guides in his office and finds the correct formulas. McGovern logs on to the computer network and downloads an attachment that contains the following estimates:
Overall Assumptions:
Index Estimates ­ Bull Market:
Index Estimates ­ Bear Market:
The expected return on the index is closest to:

  1. 67.4%.
  2. 39.4%.
  3. 30.8%.
  4. 98.2%.

Answer(s): C

Explanation:

To calculate the expected index return, we need to calculate the expected return for the bull market and the expected return for the bear market. Then, we will use the given probabilities of each scenario to calculate the expected index return. Note: All amounts are in millions of $ unless noted otherwise.
BULL MARKET
BEAR MARKET
EXPECTED VALUE OF INDEX
= 0.35 * 110% + 0.65 * -11.8% =30.83%



Daniel Tipton and Jesse Torrez are first-year MBA students at the Haas School of Business. Torrez has an economics background, but Tipton's background is in music. To help Tipton study one of the main tenets of competition theory, Torrez creates the following question and asks Tipton to identify the statement that is most inconsistent with Porter's five forces. Which statement should Tipton select?

  1. Supplier power is higher when there are only a few suppliers to an industry.
  2. To sustain above average returns on invested capital, firms should strive for economies of scale.
  3. Porter's five forces are: rivalry among current competitors, economies of scale, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers.
  4. Rivalry increases when firms of equal size compete within an industry.

Answer(s): C

Explanation:

Porter's five forces are: rivalry among current competitors, threat of new entrants, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers. Economies of scale are a way to lessen the threat of new entrants, but are not the only way to discourage competition. Companies can also have barriers to entry such as regulation or high start up capital. The other choices are true.



Consider the following information for Magical Interactions, Inc. Based on the assumptions above, which of the following statements is TRUE?

  1. The stock is undervalued.
  2. If the earnings retention rate increases, the value of the stock will increase (all else equal).
  3. If management can increase the EBITDA ratio by only 1.0%, the stock will be properly priced (all else equal).
  4. If inflation expectations decrease, the value of the stock will increase (all else equal).

Answer(s): D

Explanation:

The expected inflation rate is a component of ke (through the nominal risk free rate). ke is one component of the P/E ratio and can be represented by the following: nominal risk free rate + stock risk premium, where nominal risk free rate = [(1 + real risk free rate) * (1 + expected inflation rate)] ­ 1.
The other statements are false. To determine the stock over/under valuation, we need to calculate both the P/E ratio and the EPS.
The P/E ratio = Dividend Payout Ratio / (ke­ g),
EPS = [(Per share Sales Estimate) * (EBITDA%) ­ D (per share) ­ I (per share)] * (1 - t) = [($150 * 0.18) - $15 - $10] * (1 ­ 0.35) = $1.30
Value of stock = EPS * P/E = 7.14 * $1.30 =$9.30
Since the market value of the stock is greater than the estimated value, the stock is overvalued.
An increase in earnings retention will likely decrease the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay dividends (absent tax concerns). Investors will likely value the company lower if it retains a higher percentage of earnings.
If management increases EBITDA by 1.0%,the stock will be undervalued.
EPS = [($150 * 0.19) - $15 - $10] * (1 ­ 0.35) = $2.28
Value of stock = EPS * P/E = 7.14 * $2.28 = approximately$16.30, which is greater than the market value.
Note: the EBITDA % that equates to the market price is approximately 18.5%, or a 0.5% increase. Small changes in EBITDA% have a large impact on the EPS and thus on the estimated stock value.



Assume an investor makes the following investments:
During year one, the stock paid a $5.00 per share dividend. In year 2, the stock paid a $7.50 per share dividend. The investor's required return is 35.0 percent.
The dollar-weighted return is:

  1. 48.9%.
  2. 16.1%.
  3. 46.5%.
  4. 102.4%.

Answer(s): A

Explanation:

To calculate the dollar-weighted return:
Step 1: Determine the timing and sign (inflow, outflow) of the cash flows Purchase share 2, $75.00 outflow
Received dividend from share 2, $7.50 inflow
Sell share 1, $100.00 inflow,
Sell share 2, $100.00 inflow.
Step 2: Calculate the net cash flows for each year (all amounts in $) Step 3: Use your financial calculator to solve for IRR (or use trial and error)






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