CFA L1 Equity

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Schweser Printable Exams

SchweserPro 2013 CFA Level I

Question 1 - 96343

Assume that the expected dividend growth rate (g) for a firm decreased from 5% to zero. Further, assume that the firm's cost of equity (k) and dividend payout ratio will maintain their historic levels. The firm's P/E ratio will most likely:

A) decrease.

B) become undefined.

C) increase.

Question 2 - 96305

Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75. Next year, they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for the foreseeable future. Investors require a 12% rate of return on Day.

Part 1) What is the approximate amount that an investor would be willing to pay today for the two years of abnormal dividends?

A) $1.62.

B) $1.55.

C) $1.83.

Part 2) What would an investor pay for Day and Associates today?

A) $20.71.

B) $24.03.

C) $18.65.

Question 3 - 96245

Assume that a stock paid a dividend of $1.50 last year. Next year, an investor believes that the dividend will be 20% higher and that the stock will be selling for $50 at year-end. Assume a beta of 2.0, a risk-free rate of 6%, and an expected market return of 15%. What is the value of the stock?

A) $41.77.

B) $45.00.

C) $40.32.

Question 4 - 96399

Which of the following is least likely an advantage of using price/sales (P/S) multiple?

A) P/S multiples provide a meaningful framework for evaluating distressed firms.

B) P/S multiples are more reliable because sales data cannot be distorted by management.

C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.

Question 5 - 96334

An analyst gathered the following data for the Parker Corp. for the year ended December 31, 2005:

EPS2005 = $1.75

Dividends2005 = $1.40

Beta Parker = 1.17

Long-term bond rate = 6.75%

Rate of return S&P500 = 12.00%

The firm has changed its dividend policy and now plans to pay out 60% of its earnings as dividends in the future. If the long-term growth rate in earnings and dividends is expected to be 5%, the appropriate price to earnings (P/E) ratio for Parker will be:

A) 7.60.

B) 9.14.

C) 7.98.

Question 6 - 96291

Use the following information and the multi-period dividend discount model to find the value of Computech’s common stock.

Last year’s dividend was $1.62.

The dividend is expected to grow at 12% for three years.

The growth rate of dividends after three years is expected to stabilize at 4%.

The required return for Computech’s common stock is 15%.

Which of the following statements about Computech's stock is least accurate?

A) At the end of two years, Computech's stock will sell for $20.64.

B) The dividend at the end of year three is expected to be $2.27.

C) Computech's stock is currently worth $17.46.

Question 7 - 140481

Starr Company is an asset management firm. Thomas Company is a manufacturer of apparel. Assuming these firms are representative of their industry groups, how are they best classified with regard to their sensitivity to the business cycle?

Starr Thomas

A) Cyclical Cyclical

B) Cyclical Non-cyclical

C) Non-cyclical Non-cyclical

Question 8 - 96352

A firm is expected to have four years of growth with a retention ratio of 100%. Afterwards the firm’s dividends are expected to grow 4% annually, and the dividend payout ratio will be set at 50%. If earnings per share (EPS) = $2.4 in year 5 and the required return on equity is 10%, what is the stock’s value today?

A) $13.66.

B) $30.00.

C) $20.00.

Question 9 - 96355

Calculate the value of a preferred stock that pays an annual dividend of $5.50 if the current market yield on AAA rated preferred stock is 75 basis points above the current T-Bond rate of 7%.

A) $42.63.

B) $78.57.

C) $70.97.

Question 10 - 88706

Food, beverage, and utility companies are examples of:

A) cyclical industries.

B) declining industries.

C) defensive industries.

Question 11 - 96292

Assume the following information for a stock:

Beta coefficient = 1.50

Risk-free rate = 6%

Expected rate of return on market = 14%

Dividend payout ratio = 30%

Expected dividend growth rate = 11%

The estimated earnings multiplier (P/E ratio) is closest to:

A) 3.33.

B) 10.00.

C) 4.29.

Question 12 - 96322

Using the one-year holding period and multiple-year holding period dividend discount model (DDM), calculate the change in value of the stock of Monster Burger Place under the following scenarios. First, assume that an investor holds the stock for only one year. Second, assume that the investor intends to hold the stock for two years. Information on the stock is as follows:

Last year’s dividend was $2.50 per share.

Dividends are projected to grow at a rate of 10.0% for each of the next two years.

Estimated stock price at the end of year 1 is $25 and at the end of year 2 is $30.

Nominal risk-free rate is 4.5%.

The required market return is 10.0%.

Beta is estimated at 1.0.

The value of the stock if held for one year and the value if held for two years are:

Year one Year two

A) $25.22 $35.25

B) $25.22 $29.80

C) $27.50 $35.25

Question 13 - 140478

With which of the following types of equity shares does the investor typically have the greatest voting power?

A) Participating preference shares.

B) Unsponsored depository receipts.

C) Common shares.

Question 14 - 96247

A firm has a profit margin of 10%, an asset turnover of 1.2, an equity multiplier of 1.3, and an earnings retention ratio of 0.5. What is the firm's internal growth rate?

A) 6.7%.

B) 7.8%.

C) 4.5%.

Question 15 - 96400

Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations?

A) The use of P/S multiples can miss problems associated with cost control.

B) It is difficult to capture the effects of changes in pricing policies using P/S ratios.

C) P/S multiples are more volatile than price-to-earnings (P/E) multiples.

Question 16 - 140483

The threat of substitute products is most likely to be low for a firm that:

A) produces a commodity product in an industry with significant unused capacity.

B) operates in a fragmented market with little unused capacity.

C) produces a differentiated product with high switching costs.

Question 17 - 96230

Which of the following statements about the constant growth dividend discount model (DDM) is least accurate?

A) For the constant growth DDM to work, the growth rate must exceed the required return on equity.

B) The constant growth DDM is used primarily for stable mature stocks.

C) In the constant growth DDM dividends are assumed to grow at a constant rate forever.

Question 18 - 96234

An analyst gathered the following data:

An earnings retention rate of 40%.

An ROE of 12%.

The stock's beta is 1.2.

The nominal risk free rate is 6%.

The expected market return is 11%.

Assuming next year's earnings will be $4 per share, the stock’s current value is closest to:

A) $26.67.

B) $33.32.

C) $45.45.

Question 19 - 96196

If a company can convince its suppliers to offer better terms on their products leading to a higher profit margin, the return on equity (ROE) will most likely:

A) increase and the stock price will decline.

B) decrease and the stock price will increase.

C) increase and the stock price will increase

Question 20 - 96331

An analyst gathered the following data for the Parker Corp. for the year ended December 31, 2005:

EPS2005 = $1.75

Dividends2005 = $1.40

Beta Parker = 1.17

Long-term bond rate = 6.75%

Rate of return S&P 500 = 12.00%

The firm is expected to continue their dividend policy in future. If the long-term growth rate in earnings and dividends is expected to be 6%, the forward P/E ratio for Parker Corp. will be:

A) 11.61.

B) 21.54.

C) 12.31.

Question 21 - 96327

Baker Computer earned $6.00 per share last year, has a retention ratio of 55%, and a return on equity (ROE) of 20%. Assuming their required rate of return is 15%, how much would an investor pay for Baker on the basis of the earnings multiplier model?

A) $40.00.

B) $173.90.

C) $74.93.

Question 22 - 96357

If a preferred stock that pays a $11.50 dividend is trading at $88.46, what is the market’s required rate of return for this security?

A) 11.76%.

B) 13.00%.

C) 7.69%.

Question 23 - 96221

An analyst has gathered the following data for Webco, Inc:

Retention = 40%

ROE = 25%

k = 14%

Using the infinite period, or constant growth, dividend discount model, calculate the price of Webco’s stock assuming that next years earnings will be $4.25.

A) $55.00.

B) $125.00.

C) $63.75.

Question 24 - 96140

A preferred stock’s dividend is $5 and the firm’s bonds currently yield 6.25%. The preferred shares are priced to yield 75 basis points below the bond yield. The price of the preferred is closest to:

A) $5.00.

B) $80.00.

C) $90.91.

Question 25 - 96183

An analyst gathered the following information about an industry. The industry beta is 0.9. The industry profit margin is 8%, the total asset turnover ratio is 1.5, and the leverage multiplier is 2. The dividend payout ratio of the industry is 50%. The risk-free rate is 7% and the expected market return is 15%. The industry P/E is closest to:

A) 22.73.

B) 12.00.

C) 14.20.

Question 26 - 96250

Given the following information, compute the implied dividend growth rate.

Profit margin = 10.0%

Total asset turnover = 2.0 times

Financial leverage = 1.5 times

Dividend payout ratio = 40.0%

A) 4.5%.

B) 12.0%.

C) 18.0%.

Question 27 - 96257

Utilizing the infinite period dividend discount model, all else held equal, if the required rate of return (Ke) decreases, the model yields a price that is:

A) reduced, due to increased spread between growth and required return.

B) reduced, due to the reduction in discount rate.

C) increased, due to a smaller spread between required return and growth.

Question 28 - 96186

Given the following estimated financial results, value the stock of FishnChips, Inc., using the infinite period dividend discount model (DDM).

Sales of $1,000,000.

Earnings of $150,000.

Total assets of $800,000.

Equity of $400,000.

Dividend payout ratio of 60.0%.

Average shares outstanding of 75,000.

Real risk free interest rate of 4.0%.

Expected inflation rate of 3.0%.

Expected market return of 13.0%.

Stock Beta at 2.1.

The per share value of FishnChips stock is approximately: (Note: Carry calculations out to at least 3 decimal places.)

A) $26.86.

B) Unable to calculate stock value because ke < g.

C) $17.91.

Question 29 - 96236

A firm has a return on equity (ROE) of 15% and a dividend payout rate of 80%. If last year's dividend was $0.80 and the required return on equity is 10%, what is the firm's estimated dividend growth rate and what is the current stock price?

Dividend growth rate

Stock price

A) 12.00% $11.77

B) 3.00% $11.77

C) 3.00% $9.96

Question 30 - 96259

Assuming that a company's return on equity (ROE) is 12% and the required rate of return is 10%, which of the following would most likely cause the company's P/E ratio to rise?

A) The firm's ROE falls.

B) The firm's dividend payout rises.

C) The inflation rate falls.

Question 31 - 96262

If a company has a "0" earnings retention rate, the firm's P/E ratio will equal:

A) 1 / k

B) k + g

C) D/P + g

Question 32 - 96233

Use the following information to determine the value of River Gardens’ common stock:

Expected dividend payout ratio is 45%.

Expected dividend growth rate is 6.5%.

River Gardens’ required return is 12.4%.

Expected earnings per share next year are $3.25.

A) $30.12.

B) $24.80.

C) $27.25.

Question 33 - 96231

According to the earnings multiplier model, which of the following factors is the least important in estimating a stock’s price-to-earnings ratio? The:

A) estimated required rate of return on the stock.

B) historical dividend payout ratio.

C) expected dividend payout ratio.

Question 34 - 96301

An analyst gathered the following information about a company:

The stock is currently trading at $31.00 per share.

Estimated growth rate for the next three years is 25%.

Beginning in the year 4, the growth rate is expected to decline and stabilize at 8%.

The required return for this type of company is estimated at 15%.

The dividend in year 1 is estimated at $2.00.

The stock is undervalued by approximately:

A) $6.40.

B) $15.70.

C) $0.00.

Question 35 - 96258

A stock has the following elements: last year’s dividend = $1, next year’s dividend is 10% higher, the price will be $25 at year-end, the risk-free rate is 5%, the market premium is 5%, and the stock’s beta is 1.2.

Part 1) What happens to the price of the stock if the beta of the stock increases to 1.5? It will:

A) decrease.

B) increase.

C) remain unchanged.

Part 2) What will be the current price of the stock with a beta of 1.5?

A) $23.51.

B) $20.23.

C) $23.20.

Question 36 - 96201

Which of the following statements concerning security valuation is least accurate?

A) The best way to value a company with no current dividend but who is expected to pay dividends in three years is to use the temporary supernormal growth (multistage) model.

B) The best way to value a company with high and unsustainable growth that exceeds the required return is to use the temporary supernormal growth (multistage) model.

C) A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24.

Question 37 - 96209

Assuming the risk-free rate is 5% and the expected return on the market is 12%, what is the value of a stock with a beta of 1.5 that paid a $2 dividend last year if dividends are expected to grow at a 5% rate forever?

A) $12.50.

B) $20.00.

C) $17.50.

Question 38 - 96252

A firm will not pay dividends until four years from now. Starting in year four dividends will be $2.20 per share, the retention ratio will be 40%, and ROE will be 15%. If k = 10%, what should be the value of the stock?

A) $55.25.

B) $41.32.

C) $58.89.

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Schweser Printable Exams

SchweserPro 2013 CFA Level I

Question 1 - 131590

Equal weighting is the most common weighting methodology for indexes of which of the following types of assets?

A) Hedge funds.

B) Equities.

C) Fixed income securities.

Question 2 - 97618

Which of the following would provide evidence against the semistrong form of the efficient market theory?

A) Trend analysis is worthless in determining stock prices.

B) Low P/E stocks tend to have positive abnormal returns over the long run.

C) All investors have learned to exploit signals related to future performance.

Question 3 - 97401

An investor sold a stock short and is worried about rising prices. To protect himself from rising prices he would place a:

A) limit order to buy.

B) stop order to sell.

C) stop order to buy.

Question 4 - 97732

An investor purchases 200 shares of Merxx on margin. The shares are trading at $40. Initial and maintenance margins are 50% and 25%.

Part 1) If the investor sells the stock when the price rises to $50 at year-end, the return on the investment would be closest to:

A) 50.00%.

B) 25.00%.

C) 18.75%.

Part 2) If the company pays a dividend of $0.75, the return on the investment would be closest to:

A) 53.75%.

B) 39.55%.

C) 15.75%.

Question 5 - 97245

Which of the following statements about securities markets is least accurate?

A) Initial public offerings (IPOs) are sold in the secondary market.

B) A market that features low transactions costs is said to have operational efficiency.

C) In a continuous market, a security can trade any time the market is open.

Question 6 - 96525

Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to:

A) minimize systematic risk in the portfolio.

B) follow a strict buy and hold strategy.

C) achieve complete diversification of the portfolio.

Question 7 - 97651

The implication of efficient capital markets and a lack of superior analysts have led to the introduction of:

A) index funds.

B) balanced funds.

C) futures options.

Question 8 - 97144

An investor can profit from a stock price decline by:

A) selling short.

B) placing a stop buy order.

C) purchasing a call option.

Question 9 - 98176

Which of the following statements about securities markets is least accurate?

A) Characteristics of a well-functioning securities market include: many buyers and sellers willing to trade at below market price, low bid-ask spreads, timely information on price and volume of past transactions, and accurate information on supply and demand.

B) A limit buy order and a stop buy order are both placed below the current market price.

C) Secondary markets, such as the over-the-counter (OTC) market, provide liquidity and price continuity.

Question 10 - 97693

An investor buys 200 shares of ABC at the market price of $100 on full margin. The initial margin requirement is 40% and the maintenance margin requirement is 25%.

If the shares of stock later sold for $200 per share, what is the rate of return on the margin transaction?

A) 400%.

B) 100%.

C) 250%.

Question 11 - 97079

A short seller:

A) often also places a stop loss sell order.

B) does not receive the dividends.

C) loses if the price of the stock sold short decreases.

Question 12 - 98233

The table below lists information on price per share and shares outstanding for three companies–Lair Enterprises, Kurlew, Inc., and Mowe, Ltd.

As of Beginning of Year As of End of Year

Stock Price Per Share ($) # Shares Outstanding Price Per Share ($) # Shares Outstanding

Lair 15 10,000 10 10,000

Kurlew 45 5,000 60 5,000

Mowe 90 500 110 500

Part 1) Assume that at the beginning of the year, the value of the market-weighted index was 100. The one-year return on the market-cap weighted index is closest to:

A) 30.0%.

B) 13.33%.

C) 8.33%.

Part 2) If the stocks in the table above are used to create a stock market index, it is least likely that:

A) a price-weighted index will have a downward bias compared to a value-weighted index.

B) a 5% change in the price of Kurlew would have a greater impact on a value-weighted index than a 5% change in the prices of either Lair or Mowe.

C) an investor creating a price-weighted index using these three stocks would need to rebalance his portfolio at year-end to reflect the price changes.

Question 13 - 98143

Which of the following statements concerning market efficiency is least accurate?

A) If weak-form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long-run.

B) Tests of the semi-strong form of the EMH require that security returns be risk-adjusted using a market model.

C) Market efficiency assumes that individual market participants correctly estimate asset prices.

Question 14 - 98189

With regard to stock market indexes, it is least likely that:

A) a market-cap weighted index must be adjusted for stock splits but not for dividends.

B) the use of price weighting versus market value weighting produces a downward bias on the index.

C) buying 100 shares of each stock in a price-weighted index will result in a portfolio that tracks the index quite well.

Question 15 - 96741

Assume 100 shares purchased at $75/share with an initial margin of 50%.

Part 1) The initial cost to the investor is:

A) $7,500.

B) $0.

C) $3,750.

Part 2) Now, assume that the stock rose to $112.50. The return on investment to the investor is:

A) 50%.

B) 100%.

C) 200%.

Question 16 - 98222

Use the data below to determine which of the statements is most accurate?

As of December 31

Company Stock Price Shares Outstanding

A $25 20,000

B $50 20,000

C $100 10,000

A) A 100% increase in the stock price of Company A will have a smaller impact on the price-weighted index than a 100% increase in the stock price of Company C.

B) For a given percentage change in the stock price, Company A will have a greater impact on the market-cap weighted index than Companies B or C.

C) For a given percentage change in the stock price, Company B will have less of an impact on the market-cap weighted index as Company C.

Question 17 - 98057

Which of the following statements about market efficiency is least accurate?

A) The strong-form EMH assumes cost free availability of all information, both public and private.

B) The weak-form EMH suggests that fundamental analysis will not provide excess returns while the semi-strong form suggests that technical analysis cannot achieve excess returns.

C) The semi-strong form EMH addresses market and non-market public information.

Schweser Printable Answers - Equity 2

Question 1 - #96343

A)

The P/E ratio may be defined as: Payout ratio / (k - g), so if k is constant and g goes to zero, the P/E will decrease.

This question tested from Session 14, Reading 51, LOS h.

Question 2 - #96305

Part 1) B) $1.55.

First find the abnormal dividends and then discount them back to the present. $0.75 × 1.25 = $0.9375 × 0.95 = $0.89. D1 = $0.9375; D2 = $0.89. At this point you can use the cash flow keys with CF0 = 0, CF1 = $0.9375 and CF2 = $0.89. Compute for NPV with I/Y = 12. NPV = $1.547. Alternatively, you can put the dividends in as future values, solve for present values and add the two together.

This question tested from Session 14, Reading 51, LOS e.

Part 2) A)

Here we find P2 using the constant growth dividend discount model. P2 = $0.89 × 1.08 / (0.12 – 0.08) = $24.03. Discount that back to the present at 12% for 2 periods and add it to the answer in the previous question. N = 2; I/Y = 12; PMT = 0; FV = $24.03; CPT &rarr PV = $19.16. Add $1.55 (the present value of the abnormal dividends) to $19.16 and you get $20.71.


Question 3 - #96245

A)

Using the Capital Asset Pricing Model, we can determine the discount rate equal to 0.06 + 2(0.15 – 0.06) = 0.24. The dividends next year are expected to be $1.50 × 1.2 = $1.80. The present value of the future stock price and the future dividend are determined by discounting the expected cash flows at the discount rate of 24%: (50 + 1.8) / 1.24 = $41.77.


Question 4 - #96399

B) P/S multiples are more reliable because sales data cannot be distorted by management.

Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions. However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can influence reported sales.

This question tested from Session 14, Reading 51, LOS k.

Question 5 - #96334

A)

Required rate of return on equity will be 12.89% = 6.75% + 1.17(12.00% - 6.75).

P/E Ratio = 0.60 / (0.1289 - 0.0500) = 7.60.


Question 6 - #96291

C) Computech's stock is currently worth $17.46.

The dividends for years 1, 2, and 3 are expected to be ($1.62)(1.12) = $1.81; ($1.81)(1.12) = $2.03; and ($2.03)(1.12) = $2.27. At the end of year 2, the stock should sell for $2.27 / (0.15 – 0.04) = $20.64. The stock should sell currently for ($20.64 + $2.03) / (1.15)

2 + ($1.81) / (1.15) = $18.71.


Question 7 - #140481

A)

Asset management firms are classified in the financial services industry group. Apparel manufacturers are classified in the consumer discretionary industry group. Financial services and consumer discretionary are cyclical industry groups.

This question tested from Session 14, Reading 50, LOS c.

Question 8 - #96352

A)

Dividend in year 5 = (EPS)(payout ratio) = 2.4 × 0.5 = 1.2

P4 = 1.2 / (0.1 − 0.04) = 1.2 / 0.06 = $20

P0 = PV (P4) = $20 / (1.10)4 = $13.66


Question 9 - #96355

C) $70.97.

kpreferred = base yield + risk premium = 0.07 + 0.0075 = 0.0775

ValuePreferred = Dividend / kpreferred

Value = 5.50 / 0.0775 = $70.97

This question tested from Session 14, Reading 51, LOS d.


C) defensive industries.

Food, beverage, and utility companies provide basic necessities of life and are considered to be defensive industries. In a recession, the demand for their products will not fall as much as for some of the other industry groups.

This question tested from Session 14, Reading 50, LOS b.


C) 4.29.

P/E = D/E1 / (k − g)

D/E1 = Dividend payout ratio = 0.3

g = 0.11

k = 6 + (1.5)(14 − 6) = 18%

P/E = 0.3 / (0.18 − 0.11) = 0.3 / 0.07 = 4.29



B)

$25.22 $29.80

First, we need to calculate the required rate of return. When a stock’s beta equals 1, the required return is equal to the market return, or 10.0%. Thus, ke = 0.10. Alternative: Using the capital asset pricing model (CAPM), ke = Rf + Beta * (Rm – Rf) = 4.5% + 1 * (10.0% - 4.5%) = 4.5% + 5.5% = 10.0%.

Next, we need to calculate the dividends for years 1 and 2.

D1 = D0 * (1 + g) = 2.50 * (1.10) = 2.75 D2 = D1 * (1 + g) = 2.75 * (1.10) = 3.03

Then, we use the one-year holding period DDM to calculate the present value of the expected stock cash flows (assuming the one-year hold).

P0 = [D1/ (1 + ke)] + [P1 / (1 + ke)] = [$2.75 / (1.10)] + [$25.0 / (1.10)] = $25.22. Shortcut: since the growth rate in dividends, g, was equal to ke, the present value of next year’s dividend is equal to last year’s dividend.

Finally, we use the multi-period DDM to calculate the return for the stock if held for two years.

P0 = [D1/ (1 + ke)] + [D2/ (1 + ke)2] +

[P2 / (1 + ke)

2] = [$2.75 / (1.10)] + [$3.03 / (1.10)

2] + [$30.0 / (1.10)

2] = $29.80.

Note: since the growth rate in dividends, g, was equal to ke, the present value of next year’s dividend is equal to last year’s dividend (for periods 1 and 2). Thus, a quick calculation would be 2.5 * 2 + $30.00 / (1.10)

2 = 29.80.


Question 13 - #140478

C) Common shares.

While common shares have voting rights, preference shares typically do not. With unsponsored depository receipts, the depository bank retains the right to vote the shares.

This question tested from Session 14, Reading 49, LOS b.


B) 7.8%.

ROE = (Net Income / Sales)(Sales / Total Assets)(Total Assets / Total Equity)

ROE = (0.1)(1.2)(1.3) = 0.156

g = (retention ratio)(ROE) = 0.5(0.156) = 0.078 or 7.8%



A)

Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful framework for evaluating effects of pricing changes on firm value.

This question tested from Session 14, Reading 51, LOS g.

Question 16 - #140483

C) produces a differentiated product with high switching costs.

The threat of competition from substitute products is likely to be low for a firm that produces a differentiated product with high switching costs. Unused capacity and low industry concentration (a fragmented market) tend to intensify rivalry among industry competitors but are not directly related to the threat of substitute products.

This question tested from Session 14, Reading 50, LOS f.


A)

Dividends grow at constant rate forever.

Constant growth DDM is used for mature firms.

k must be greater than g.



B) $33.32.

Dividend payout = 1 − earnings retention rate = 1 − 0.4 = 0.6

RS = Rf + β(RM − Rf) = 0.06 + 1.2(0.11 − 0.06) = 0.12

g = (retention rate)(ROE) = (0.4)(0.12) = 0.048

D1 = E1 × payout ratio = $4.00 × 0.60 = $2.40

Price = D1 / (k – g) = $2.40 / (0.12 – 0.048) = $33.32



C) increase and the stock price will increase

Better supplier terms lead to increased profitability. Better profit margins lead to an increase in ROE. This leads to an increase in the dividend growth rate. The difference between the cost of equity and the dividend growth rate will decline, causing the stock price to increase.



A)

The required rate of return on equity for Parker will be 12.89% = 6.75% + 1.17(12.00% − 6.75%) and the firm pays 80% (1.40 / 1.75) of its earnings as dividends.

Forward P/E ratio = 0.80 / (0.1289 - 0.0600) = 11.61

Where r = required rate of return on equity, gn = growth rate in dividends (forever).



C) $74.93.

g = Retention × ROE = (0.55) × (0.2) = 0.11

P0/E1 = 0.45 / (0.15 − 0.11) = 11.25

Next year's earnings E1 = E0 × (1 + g) = (6.00) × (1.11) = $6.66

P0 = 11.25($6.66) = $74.93



B) 13.00%.

From the formula: ValuePreferred Stock = D / kp, we derive kp = D / ValuePreferred Stock = 11.50 / 88.46 = 0.1300, or 13.00%.



C) $63.75.

g = (ROE)(RR) = (0.25)(0.4) = 10%

V = D1 / (k – g)

D1 = 4.25 (1 − 0.4) = 2.55

G = 0.10

K – g = 0.14 − 0.10 = 0.04

V = 2.55 / 0.04 = 63.75



C) $90.91.

Preferred stock yield (Kp) = bond yield – 0.75% = 6.25% − 0.75% = 5.5%

Value = dividend / Kp = $5 / 0.055 = $90.91.



A)

Using the CAPM: ki = 7% + 0.9(0.15 − 0.07) = 14.2%.

Using the DuPont equation: ROE = 8% × 1.5 × 2 = 24%.

g = retention ratio × ROE = 0.50 × 24% = 12%.

P/E = 0.5/(0.142 − 0.12) = 22.73.



C) 18.0%.

Retention ratio equals 1 – 0.40, or 0.60. Return on equity equals (10.0%)(2.0)(1.5) = 30.0%. Dividend growth rate equals (0.60)(30.0%) = 18.0%.



C) increased, due to a smaller spread between required return and growth.

The denominator of the single-stage DDM is the spread between required return Ke, and expected growth rate, g. The smaller the denominator, all else held equal, the larger the computed value.



A)

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: DDM formula: P0 = D1 / (ke – g)

D1 = (Earnings × Payout ratio) / average number of shares outstanding = ($150,000 × 0.60) / 75,000 = $1.20 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 = (1.04)×(1.03) – 1 = 0.0712, or 7.12%. ke = 7.12% + [2.1 × (13.0% − 7.12%)] = 0.19468 g = (retention rate × ROE) Retention = (1 – Payout) = 1 – 0.60 = 0.40. ROE = (net income / sales)(sales / total assets)(total assets / equity) = (150,000 / 1,000,000)(1,000,000 / 800,000)(800,000 / 400,000) = 0.375 g = 0.375 × 0.40 = 0.15

Then, calculate: P0 = D1 / (ke – g) = $1.20 / (0.19468 − 0.15) = 26.86.



B)

3.00% $11.77

The expected growth rate of dividends is the retention rate (RR) times the return on the equity portion of new investments (ROE), g = (RR)(ROE). The retention rate is 1 minus the payout rate. RR = (1 - 0.80) = 0.20. g = (0.20)(0.15)= 3.00%.

The value of the stock will be the dividend paid next year divided by the required rate of return minus the growth rate. Next year's dividend is $0.80 × 1.03 = $0.824. So the value is 0.824 / (.10 - 0.03) = 0.824 / 0.07 = $11.77



C) The inflation rate falls.

Decrease in the expected inflation rate. The expected inflation rate is a component of ke (through the nominal risk free rate). ke 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.

If the rate of inflation decreases, the nominal risk free rate will decrease. ke will decrease. The spread between ke and g, or the P/E denominator, will decrease. P/E ratio will increase.

(An increase in the stock risk premium would have the opposite effect.)

Decrease in ROE: ROE is a component of g. As g decreases, the spread between ke and g, or the P/E denominator, will increase, and the P/E ratio will decrease.

Increase in dividend payout/reduction in earnings retention. In this case, an increase in the dividend payout will likely decrease the P/E ratio because a decrease in earnings retention will likely lower 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 higher rate on new projects than the rate required by the market (ROE> ke), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.



A)

P/E = div payout ratio / (k − g)

where g = (retention rate)(ROE) = (0)(ROE) = 0

Dividend payout = 1 − retention ratio = 1 − 0 = 1

P/E = 1 / (k − 0) = 1 / k



B) $24.80.

First, estimate the price to earnings (P/E) ratio as: (0.45) / (0.124 – 0.065) = 7.63. Then, multiply the expected earnings by the estimated P/E ratio: ($3.25)(7.63) = $24.80.



B) historical dividend payout ratio.

P/E = (D1/E1)/(k - g)

where: D1/E1 = the expected dividend payout ratio k = estimated required rate of return on the stock g = expected growth rate of dividends for the stock

The P/E is most sensitive to movements in the denominator.



A)

The high “supernormal” growth in the first three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and finite dividend growth models (DDM) to value the stock.

Step 1: Determine the dividend stream through year 4

D1 = $2.00 (given) D2 = D1 × (1 + g) = 2.00 × (1.25) = $2.50 D3 = D2 × (1 + g) = $2.50 × (1.25) = $3.13 D4 = D3 × (1 + g) = $3.13 × (1.08) = $3.38

Step 2: Calculate the value of the stock at the end of year 3 (using D4)

P3 = D4 / (ke – g) = $3.38 / (0.15 – 0.08) = $48.29

Step 3: Calculate the PV of each cash flow stream at ke = 15%, and sum the cash flows. Note: We suggest you clear the financial calculator memory registers before calculating the value. The present value of:

D1 = 1.74 = 2.00 / (1.15)1, or FV = -2.00, N = 1, I/Y = 15, PV = 1.74

D2 = 1.89 = 2.50 / (1.15)2, or FV = -2.50, N = 2, I/Y = 15, PV = 1.89

D3 = 2.06 = 3.13 / (1.15)3, or FV = -3.13, N = 3, I/Y = 15, PV = 2.06

P3 = 31.75 = 48.29 / (1.15)3, or FV = -48.29, N = 3, I/Y = 15, PV = 31.75

Sum of cash flows = 37.44. Thus, the stock is undervalued by 37.44 – 31.00 = approximately 6.40.

Note: Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that the question asks you to select the closest answer.

This question tested from Session 14, Reading 51, LOS a.


Part 1) A)

When the beta of a stock increases, its required return will increase. The increase in the discount rate leads to a decrease in the PV of the future cash flows.


Part 2) C) $23.20.

k = 5 + 1.5(5) = 12.5% P0 = (1.1 / 1.125) + (25 / 1.125) = $23.20



C) A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24.

A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on new investment of 12%, and a 15% required return is worth $20.64. The growth rate is (1 – 0.40) × 0.12 = 7.2%. The expected dividend is then ($1.50)(1.072) = $1.61. The value is then (1.61) / (0.15 – 0.072) = $20.64.



B) $20.00.

P0 = D1 / (k − g)

Rs = Rf + β(RM − Rf) = 0.05 + 1.5(0.12 − 0.05) = 0.155

D1 = D0(1 + g) = 2 × (1.05) = 2.10

P0 = 2.10 / (0.155 − 0.05) = $20.00



B) $41.32.

g = ROE × retention ratio = ROE × b = 15 × 0.4 = 6%

Based on the growth rate we can calculate the expected price in year 3:

P3 = D4 / (k − g) = 2.2 / (0.10 − 0.06) = $55

The stock value today is: P0 = PV (55) at 10% for 3 periods = $41.32


Schweser Printable Answers - Equity 1

Test ID#: 12


A)

Most hedge fund indexes are equal-weighted. Equity and fixed income indexes are predominately market capitalization weighted.

This question tested from Session 13, Reading 47, LOS k.

Question 2 - #97618

B) Low P/E stocks tend to have positive abnormal returns over the long run.

P/E information is publicly available information and therefore this test relates to the semistrong-form EMH. Trend analysis is based on historical information and therefore relates to the weak-form EMH. In an efficient market one would expect 50% of pension fund managers to do better than average and 50% of pension fund managers to do worse than average. If all investors exploit the same information no excess returns are possible.


Question 3 - #97401

C) stop order to buy.

A limit order to buy is placed below the current market price.

A limit order to sell is placed above the current market price.

A stop (loss) order to buy is placed above the current market price.

A stop (loss) order to sell is placed below the current market price.

A stop order becomes a market order if the price is hit.

This question tested from Session 13, Reading 46, LOS g.

Question 4 - #97732

Part 1) A)

Profit = 10,000 – 8,000 = 2,000 Return = 2,000 / 4,000 = 50%


Part 2) A)

Dividends income = (0.75) × (200) = $150 Profit = 10,000 – 8,000 + 150 = 2,150 Return = 2,150 / 4,000 = 53.75%


Question 5 - #97245

A)

IPOs are sold in the primary market.

This question tested from Session 13, Reading 46, LOS i.

Question 6 - #96525

C) achieve complete diversification of the portfolio.

In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client’s needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.


Question 7 - #97651

A)

An index fund is designed to duplicate the composition of a specific index series or market segment. There is a strong argument suggesting that portfolio managers cannot beat the market after fees, therefore an index fund should be used to try to match the market.

This question tested from Session 13, Reading 48, LOS a.

Question 8 - #97144

A)

Short selling provides a way for an investor to profit from a stock price decline. In order to sell short, the broker borrows the security and then sells it for the short seller. Later, if the investor can replace the borrowed securities by repurchasing them at a lower price, then the investor will profit from the transaction.


Question 9 - #98176

B) A limit buy order and a stop buy order are both placed below the current market price.

A limit buy is placed below the current market price, but a stop buy order is placed above the current market price (stop buy orders are often placed to protect a short sale from a rising market).

The other choices are true. A well-functioning securities market includes the following characteristics:

timely and accurate information on price and volume of past transactions. timely and accurate information on the supply and demand for current transactions. liquidity (as indicated by low bid-ask spreads). marketability. price continuity. depth (many buyers and sellers willing to transact above and below the current price). operational efficiency (low transaction costs). informational efficiency (rapidly adjusting prices).



C) 250%.

One quick (and less than intensive) way to calculate the answer to this on the examination (and it is very important to save time on the examination) is to first calculate the return if all cash, then calculate the margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the margin return.

Calculations:

Step 1: Calculate All Cash Return:

Cash Return % = [(Ending Value / Beginning Equity Position) – 1] × 100

= [(($200 × 200) / ($100 × 200)) – 1] × 100 = 100%

Step 2: Calculate Leverage Factor:

Leverage Factor = 1 / Initial Margin % = 1 / 0.40 = 2.50

Step 3: Calculate Margin Return:

Margin Transaction Return = All cash return × Leverage Factor = 100% × 2.50 = 250%

Note: You can verify the margin return as follows:

Margin Return % = [((Ending Value − Loan Payoff) / Beginning Equity Position) – 1] × 100

= [(([$200 × 200] – [$100 × 200 × 0.60]) / ($100 × 0.40 × 200)) – 1] × 100

= [ ((40,000 − 12,000) / 8,000) − 1] × 100 = 250%



B) does not receive the dividends.

The short seller pays all dividends to the lender, loses if stock prices rise, and is required to post a margin account. A short seller often places a stop buy order to protect the short sale position from a rising market.



Part 1) C) 8.33%.

Expand the table as follows:

As of Beginning of Year 1

As of End of Year 1

Stock Price Per

Share (in $)

# Shares Outstanding

Market Capitalization (in $)

Price Per Share (in $)

# Shares Outstanding

Market Capitalization (in $)

Lair 15 10,000 150,000 10 10,000 100,000

Kurlew 45 5,000 225,000 60 5,000 300,000

Mowe 90 500 45,000 110 500 55,000

Total 150

420,000 170

455,000

First, we will calculate the year-end market-cap weighted index value, then we will calculate the return percentage.

Value of market-cap weighted index = [(market capitalizationyear-end) / (market capitalizationbeginning of year)] × Beginning index value = (455,000 / 420,000) × 100 = 108.33

One-Year Return = [(Index valueyear-end / Index valuebeginning of year) − 1] × 100 = [(108.33 / 100) − 1] × 100 = 8.33%.


Part 2) C) an investor creating a price-weighted index using these three stocks would need to rebalance his portfolio at year-end to reflect the price changes.

A price-weighted index assumes that the investor holds an equal number of shares of each stock in the index. Since the number of stocks did not change, the investor would not need to change his holdings.

The other statements are true. A market value weighted index is most influenced by the stock with the largest market capitalization (Kurlew) and does not need to be adjusted for stock splits. A price-weighted index has a built-in downward bias because of the impact of stock splits. After a stock split, the denominator is adjusted downward to keep the index at

the same level as before the split. Since high-growth companies tend to announce stock splits more frequently than low-growth companies, the larger, more successful firms lose influence on the index.



C) Market efficiency assumes that individual market participants correctly estimate asset prices.

Market efficiency does not assume that individual market participants correctly estimate asset prices, but does assume that their estimates are unbiased. That is, some agents will over-estimate and some will under-estimate, but they will be correct, on average.



A)

A price-weighted index needs to be adjusted for stock splits, but a market-cap weighted index does not. Neither type of index considers dividend income unless it is designed as a total return index.

Price weighting produces a downward bias compared to market weighting because firms that split their stocks (which tend to be the more successful firms) decrease in weight within a price-weighted index. The returns on a price-weighted index can be matched by purchasing a portfolio with an equal number of shares of each stock in the index.



Part 1) C) $3,750.

$75/share × 100 shares = $7,500

50% margin means investor only pays ½ of the $7,500

= $3,750.


Part 2) B) 100%.

(market value – initial own investment – margin loan repayment)/initial equity =($11,250 – $3,750 – $3,750) / $3,750 = 100%. (Assuming no interest on the call loan and no transactions fees.)



A)

A 100% change in the stock price of Company C will have a larger impact than a 100% change in either stocks A or B on the price-weighted index. A price-weighted index adds together the market price of each stock in the index and then divides this total by the number of stocks in the index. The price-weighted index assumes you purchase one share of each stock represented in the index. The price-weighted index is influenced most by given percentage changes in the higher priced stocks.



B) The weak-form EMH suggests that fundamental analysis will not provide excess returns while the semi-strong form suggests that technical analysis cannot achieve excess returns.

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. 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 choices are correct. 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.

Documents

CFA L1 Equity