www.cfa-aficionado.cjb.net www.marbella.to/cfa-aficionado

641 Questions + Answers

of the

CFA EXAM

Level 1

Study Session : Equity

Introduction by the Author : Hi there, CFA fellows, here you are . You see , it doesnt need to be an expensive prep course to get first class preparation for the CFA exams. The following questions are original CFA AIMR questions and not just composed by prep course providers. They all come with a clear answer. In order to understand why the questions are commented by answer is correct / incorrect it is important to know that all questions have automatically been responded with the first (and only the first ) answer. Your CFA-Aficionado cfa-aficionado@softhome.net cfa-aficionado@flashmail.com And now , here we go Name the first step in estimating the expected value of an industry. * Estimate the expected payout ratio for the industry. * Estimate the earnings per share for the industry. * Estimate the sales per share for the industry. * Estimate the expected industry P/E ratio. * Estimate the expected growth in dividends for the industry. That answer is incorrect. Correct answer: Estimate the earnings per share for the industry. The second step of the two-step process is to estimate the expected industry P/E ratio. Multiplying the expected earnings per share by the expected earnings multiplier gives the expected ending value for the industry. ------------------------------ Assume the following information about a stock market series: Observed beginning value: 1677 Anticipated ending value: 1890 Expected dividends during the period: $16.36 Required rate of return: 19.50% Using this information, what is the expected rate of return for this index? (Assume a one-year holding period.) * 10.40%

* 14.79% * None of these answers is correct. * 12.14% * 11.73% That answer is incorrect. Correct answer: None of these answers is correct. The anticipated rate of return for this stock market series is found as 13.68%. Thus, none of these answers is correct. To calculate the expected rate of return for a stock market series, the following information must be known: The beginning value for the series, the anticipated ending value for the series, and the amount of any dividends and/or distributions during the period. Once this information has been determined, the expected return on a stock market index can be found by employing the following equation: {E(R) = [(EV - BV + Div) / BV]}. Where E(R) = the expected return on the stock market series, EV = the anticipated ending value for the series, BV = the observed beginning value for the series, and Div = the amount of any dividends paid during the period. In this example, all of the necessary information has been provided and the calculation of the expected return on this stock market series is found as follows: {E(R) = [$1890 - $1677 + $16.36] / 1677} = 13.68%. This is significantly less than the required rate of return. Assuming that both the ending value and dividend figure is accurate, investment in this stock market series is likely not warranted. ------------------------------ Which of the following are beliefs espoused by technical analysts? * Popularity of trading rules will eventually eliminate the value of the technique. * No one can consistently get new information and process it correctly and quickly. * All of these answers. * Fundamental analysts can only achieve superior returns if they obtain information before other investors. That answer is incorrect. Correct answer: All of these answers. Under the heading 'advantages of technical analysis': there is a discussion on how technical analysis relies more on tracking market movement than assimilating intrinsic market data, which is advantageous perhaps because there is too much data accumulating too fast too be any help in proficient forecasting. But technicians also recognize that new market tracking techniques have short shelf lives. ------------------------------ Milton Manufacturing has an outstanding issue of preferred stock that pays a $1.15 annual dividend. This dividend is not assumed to change in the future, and similar investments are currently warranting a 13.75% per year return. What is the value of Milton Manufacturing's preferred stock? Further, does this

value represent a perpetuity or a finite series of cash flows? * $33.33; finite series of cash flows * $10.99; perpetuity * $8.36; perpetuity * $10.99; finite series of cash flows * $8.36; finite series of cash flows That answer is incorrect. Correct answer: $8.36; perpetuity Preferred stock is commonly valued as a perpetuity using the following equation: {P0 = [d1 / k]} Where: P0 = the price of the preferred stock at time 0, d1 = the annual dividend at t = 1, and k = the required rate of return. In this example, the dividend is provided as an annual figure, so all of the necessary information has been given. The calculation of the value of this preferred stock is found as follows: {P0 = [$1.15 / 0.1375] = $8.36. 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. ------------------------------ When estimating change in sales for a market series, change in sales is regressed against change in ________. * Earnings * Nominal GNP * None of these answers * Revenues That answer is incorrect. Correct answer: Nominal GNP Regressing change in sales with change in GNP basically to find a relationship between GNP and sales, so that GNP growth rate can be used to estimate future sales changes. ------------------------------ Composite Software, Inc. is anticipated to experience temporary supernormal growth of 40% per year for the next two years. After this supernormal growth period has passed, the growth rate of Composite Software is anticipated to experience a two-year transition phase of 25% per year growth. Following this

transition phase, the growth rate of Composite Software is expected to stabilize at 15% annually. The Company currently pays a dividend of $0.10 per share, and the required rate of return is 18% per year. What is the value of Composite Software common stock? * $6.62 * $23.83 * $14.15 * $6.03 * None of these answers is correct. That answer is correct! To determine the value of a common stock experiencing temporary supernormal growth, use the following equation: {V = {[d0 * (1 + gs)^1] / k} + {[d1 * (1 + gs)^2} + ... {dn * (1 + gs)^n} + {[dn * (1 + gs)^n * (1 + gn] / (k - g)}/ (1 + k)^n}} Where: V = the value of common stock at t0, d0 = the dividend at t0, d1 = the dividend at t1, dn = the dividend at tn, gs = the supernormal rate of growth, gn = the normal rate of growth, n = the time period "n", and k = the required rate of return. In this example, there is a transitional growth period of two years, during which the growth rate of Composite Software is expected to grow at 25% annually. This period will follow the two-year supernormal growth period, and would be denoted as g subset t. The calculation of the value of this common stock is illustrated as follows: {V = {[$0.10 * (1.40)^1] / (1.18)} + {[$0.10 * (1.40)^2] / (1.18)^2} + {[$0.10 * (1.40)^2 * (1.25)^1] / (1.18)^3} + {[$0.10 * (1.40)^2 * (1.25)^2] / (1.18)^4} + {{[$0.10 * (1.40)^2 * (1.25)^2 * (1.15)^1]/ (0.18 - 0.15)}/ (1.18)^4} which can be deduced to the following series of discounted cash flows: {V = [$0.118644 + $0.140764 + $0.149115 + $0.15796 + $6.055146] = $6.62} ------------------------------ You have invested in a stock that has a dividend growth rate of 4%. It is expected to pay a dividend of $4 per share next year. You expect to sell the stock after 3 years, for a capital gain of about $6 per share. If your required rate of return is 8%, what price would you be ready to pay for the stock? * $75.04 * $18.98 * $14.18 * $15.47 That answer is correct! Be careful about the fact that $6 represents the capital gain on the stock, not the selling price. If you buy the stock for a price, P, then the problem has in effect told you that the cash flows from the stock are expected to be: $4 next year, $4 * 1.04 = $4.16 in year 2 and (P + $6 + $4 * 1.04^2) = $(P + 10.33) in year 3. The present value of these cash flows at a discount rate of 8% per year is equal to P and this equals

P = 4/1.08 + 4.16/1.08^2 + (P + 10.33)/1.08^3 = P/1.08^3 + 15.47. Solving for P gives P = 15.47/(1 - 1/1.08^3) = $75.04 ------------------------------ Which of the following is the correct order of the steps (from first to last) of the top-down, three-step approach to valuation? * Analysis of the economy and security markets, analysis of alternative industries, and analysis of individual firms and stocks * Analysis of alternative countries and regions, analysis of the economy and security markets, and analysis of individual firms and stocks. * Analysis of the economy and security markets, analysis of alternative countries, and analysis of individual firms and stocks * Analysis of alternative industries, analysis of the economy and security markets, and analysis of individual firms and stocks That answer is correct! Analysis of alternative countries and regions is considered part of analysis of the economy and security markets. The steps follow a top-down approach, with the most general category (the economy) followed by more specific areas (industries and then individual firms). ------------------------------ Consider the following annual growth forecasts for a common stock: Growth in years 1-2 = 30% Growth in years 3-4 = 20% Growth after year 4 = 15% Assuming that the last dividend was $0.80 per share, and the required rate of return is 17.5% per year, what is the value of this common stock? * $50.87 * $43.59 * $58.12 * $47.05 * None of these answers is correct. * $61.78 That answer is correct! To determine the value of a common stock experiencing temporary supernormal growth, use the following equation: {V = {[d0 * (1 + gs)^1] / k} + {[d1 * (1 + gs)^2} + ... {dn * (1 + gs)^n} + {[dn * (1 + gs)^n * (1 + gn] / (k - g)}/ (1 + k)^n}} Where: V = the value of common stock at t0, d0 = the dividend at t0, d1 = the dividend at t1, dn = the

dividend at tn, gs = the supernormal rate of growth, gn = the normal rate of growth, n = the time period "n", and k = the required rate of return. In this example, there is a transitional growth period of two years, during which the growth rate of Composite Software is expected to grow at 25% annually. This period will follow the two-year supernormal growth period, and would be denoted as g subset t. The calculation of the value of this common stock is illustrated as follows: {V = {[$0.80 * (1.30)^1] / (1.175)^1} + {[$0.80 * (1.30)^2] / (1.175)^2} + {[$0.80 * (1.30)^2 * (1.20)^1] / (1.175)^3} + {[$0.80 * (1.30)^2 * (1.20)^2] / (1.175)^4} + {{[$0.80 * (1.30)^2 * (1.20)^2 * (1.15)^1]/ (0.175 - 0.15)}/ (1.175)^4} which can be deduced to the following: {V = [$0.885106 + $0.979267 + $1.000102 + $1.021381 + $46.98352] = $50.87} ------------------------------ Technicians believe that a high confidence index is * a bullish sign. * indicative of an approaching trough. * an unimportant sign. * indicative of an approaching peak. * a bearish sign. That answer is correct! 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. A high index value is thus viewed as a bullish sign. ------------------------------ The resistance level of a stock is the price at which the technician expects: * the stock price to break out of the falling trend channel. * a substantial supply of the stock. * a substantial demand for the stock. * an unstable trading volume. That answer is incorrect. Correct answer: a substantial supply of the stock. The resistance level can be thought of as a temporary ceiling on the stock price in the sense that if the price rises above this level, additional supply from investors trying to cash in will depress the price below the resistance level.

------------------------------ You have a 15-year bond that pays $500 every 6 months. The face value is $10,000. The required rate of return is 10. What is the bond's value? * $10,000 * $8,435 * $12,000 * none of these answers That answer is correct! Present value of interest payments at 10%: $500 x 15.3725 = $7,686 Present value of principal payment at 10%: $10,000 x .2314 = 2,314 $7,686 + 2,314 = 10,000 ------------------------------ Which of the following is an assumption of technical analysis? * Supply and demand is governed by both rational and irrational factors. * All of these choices are assumptions of technical analysis. * Changes in the market value of any good are determined solely by supply and demand fluctuations. * Securities markets are weak-form inefficient. * Securities prices move in identifiable trends. That answer is incorrect. Correct answer: All of these choices are assumptions of technical analysis. Technical analysis is primarily grounded on three major assumptions - (1.) the market value of any good is determined solely by supply and demand, (2.) supply and demand fluctuations are caused by both rational and irrational factors, and (3.) the prices of individual securities and securities markets move in trends, i.e. securities markets "price-in" information slowly. The third assumption of technical analysis negates any belief in the weak form efficient market hypothesis, which assumes that past performance data cannot be used to predict securities prices, and that the securities markets "price-in" information instantly. This "incongruence" with all forms of the EMH is cited as the greatest criticism of technical analysis. ------------------------------ You are going to hold a stock for an infinite amount of time. The current dividend is $1 per share and is expected to grow at 10% a year. Your long run required rate of return is 13%. Using the infinite period dividend discount model calculate the value of the stock. * $40.01 * $27.25 * none of these answers * $38.89

That answer is incorrect. Correct answer: none of these answers g = .10 k = .13 Dividend = 1.10 x $1.00 V = 1.10/(.13 - .10) = $36.67 ------------------------------ Given that the beginning value on a stock is $530, expected earnings are $50, the dividend payout ratio is 40%, and the required rate of return is 14%, what is the minimum expected ending value of the stock that makes it a profitable investment? * $611.20 * $584.20 * $591.20 * $604.20 * Not enough information That answer is incorrect. Correct answer: $584.20 Expected dividends equal 50 x 0.4 = $20. In order for a stock to be a good investment, its rate of return should be equal to or greater than the required rate of return. The minimum ending value that would make the stock investment in this question profitable is given by the equation (P2 + D) / P1 = 1 + k, where P2 is the ending value, P1 is the beginning value, D is the expected dividend, and k is the required rate return. Rearranging this yield P2 = ((k + 1) x P1) - D. In this question, the minimum ending value is (1.14 x 530) - 20 = $584.20. ------------------------------ Assume the following information about a publicly traded automobile manufacturer: Revenue: $16,000,000 Cash flow: $1,700,000 Net worth per share: $14.55 Current stock price: $30.25 per share Number of common shares outstanding: 1,300,000 Using this information, what are the price-to-sales, price-to-book, and price-to-cash flow ratios, respectively? * The answer cannot entirely be calculated from the information provided. * None of these answers is correct. * 1.18, 2.08, 23.13 * 2.46, 0.48, 23.21 * 2.46, 2.08, 23.13 * 1.18, 2.08, 23.13 That answer is incorrect.

Correct answer: 2.46, 2.08, 23.13 To calculate the price-to-sales ratio, divide the market price of a common stock by its sales-per share figure. The equation for the price-to-sales ratio is as follows: Price-to-sales ratio = [P0 / sales per share]. Incorporating the given information into this equation will yield the following: Price-to-sales ratio = [$30.25 / ($16,000,000 / 1,300,000)] = 2.4578 The calculation of the price-to-book ratio involves dividing the market price of a common stock by its net worth per share. The equation for the price-to-book ratio is as follows: Price-to-book ratio = [P0 / net worth per share]. Where: net worth per share = (total assets - total liabilities) / # of common shares outstanding. In this example, the net worth figure has been converted to a per-share basis, and the calculation of the price-to-book ratio is straightforward: Price-to-book ratio = ($30.35 / $14.55) = 2.0859 The calculation of the price-to-cash flow ratio involves dividing the market price of a common stock by the cash-flow-per-share figure. The calculation of the price-to-cash flow ratio is as follows: Price-to-cash flow = (P0 / cash flow per share) Incorporating the given information into this equation will yield the following: Price-to-cash flow = [$30.35 / (1,700,000 / 1,300,000)] = 23.132 ------------------------------ A firm issues debt to repurchase equity and at the same time, experiences an increase in its profit margin. All else equal, using the Dividend Discount Model, its stock price ________. * is not affected * increases * decreases * insufficient information given That answer is incorrect. Correct answer: increases Intuitively, it should be clear that the stock price rises since the profit margin has gone up and at the same time, the percentage of equity holders has gone down. To see this mathematically, note that the duPont system gives ROE = Profit margin * Total Asset Turnover * Financial Leverage. In the present case, the ROE increases since profit margin and Financial Leverage have both increased. The dividend growth rate, g, equals ROE*(1 - payout ratio). Hence, as ROE increases, the dividend growth rate increases with a constant payout ratio. In the Dividend Discount Model, the stock price increases as the dividend growth rate increases, all else equal.

------------------------------ A junior financial analyst with Churn Brothers brokerage has been instructed to value shares of Intelligent Semiconductor, a diversified technology company. A senior analyst at Churn Brothers has provided the following information: The required rate of return on equity is 15% per year The senior analyst has predicted that shares of Intelligent will sell at a multiple of 25 times predicted free cash flow to equity in four years. The estimated free cash flows for each of the next four years are: Year 1: $15,000,000 Year 2: $18,500,000 Year 3: $21,000,000 Year 4: $35,000,000 Intelligent Semiconductor has 1,000,000 shares of common stock outstanding. Using this information, what is the value per share of Intelligent Semiconductor according to the free cash flow to equity model? * $65.81 * $561.13 * $56.67 * $650.34 * The answer cannot be calculated from the information provided. * None of these answers is correct. That answer is incorrect. Correct answer: $561.13 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: ($15,000,000 / 1.15) / 1,000,000 shares outstanding = $13.04 Year 2: [$18,500,000 / (1.15)(1.15)] / 1,000,000 shares outstanding = $13.99 Year 3: [$21,000,000 / (1.15)(1.15)(1.15)] / 1,000,000 shares outstanding = $13.81 Year 4: [$35,000,000 / (1.15)(1.15)(1.15)(1.15)] / 1,000,000 shares outstanding = $20.01 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 4: 25 times. Imputing this information into the terminal cash flow equation will yield the following: {[25 * ($35,000,000 / 1,000,000 shares outstanding)] / [(1.15) (1.15)(1.15)(1.15)]} = $500.28. Adding the answers from step 1 to the final year cash flow will yield the following: Value of Intelligent Semiconductor = [$13.04 + $13.99 + $13.81 + $20.01 + $500.28] = $561.13 per share. ------------------------------ You are going to hold a stock for 3 years. It is estimated to pay dividends of $1.10, $1.20 and $1.35. The estimated sale price at the end of the holding period is $34. Using the dividend discount model, calculate the value of the stock if your required rate of return is 14%. * $25.75 * $33.01 * $33.43 * $25.86 That answer is correct! The main idea is to find the present value of each dividend (keeping in mind that they have different payout dates) and the PV of the sales price. The calculation is as follows: $1.10/1.14 + $1.20/(1.14 x 1.14) + $35.35/(1.14 x 1.14 x 1.14) = $25.75. ------------------------------ The Dow Theory * is widely used today. * was invented in the 1960s. * was invented in the early 19th century. * was one of the first theories of technical analysis. That answer is incorrect. Correct answer: was one of the first theories of technical analysis. The Dow Theory was invented in the late 19th century by Charles Dow, publisher of the Wall Street Journal. It postulated that there were three types of price movements over time: major trends, intermediate trends, and short-term movements. These three types of trends interacted with one another, and identifying and isolating them individually would lead to profit opportunities. ------------------------------ The P/E ratio is not determined by

* the required rate of return. * the expected dividend payout ratio. * the expected growth rate of dividends for the stock. * the financial leverage ratio. That answer is incorrect. Correct answer: the financial leverage ratio. Using the dividend discount model, the price of a stock is equal to D / (k - g), where D is the expected dividend, k is the required rate of return, and g is the expected growth rate of dividends for the stock. Dividing both sides of the equation by expected earnings (E) yields P/E = (D/E) / (k - g), where D/E is the expected dividend payout ratio. Thus, the P/E ratio is determined by the expected dividend payout ratio, the required rate of return, and the expected growth rate of dividends for the stock. Financial leverage does not help determine P/E ratio. ------------------------------ 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. * II only * III only * I only * III & IV * I & IV * I & II * IV only That answer is incorrect. Correct answer: I only 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). ------------------------------ The confidence index is equal to the ratio of * the yield on 10 top-grade corporate bonds divided by the yield on the Dow Jones average of 40 bonds, multiplied by 100. * the yield on the Dow Jones average of 40 bonds divided by the average yield on 10 top-grade corporate

bonds, multiplied by 100. * the expected return on the S&P 500 divided by the yield on 10 top-grade corporate bonds, multiplied by 100. * the yield on the Dow Jones average of 40 stocks divided by the expected return on the S&P 500. * the expected return on the S&P 500 divided by the yield on the Dow Jones average of 40 stocks. That answer is correct! 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. ------------------------------ Which of the following is the preferred method of return calculation in the investment management industry? * Time-weighted rate of return * Dollar-weighted rate of return * Internal rate of return * None of these answers is correct. * Asset-weighted rate of return That answer is correct! 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. ------------------------------ What would be indicative of a high-growth industry? * A relatively low payout ratio. * A relatively high debt-to-equity ratio. * All of these answers are correct. * A relatively low return on assets ratio. * A relatively low return on equity ratio. * None of these answers. That answer is correct! In order to sustain a high rate of growth in earnings and dividends, a firm will need financing and if a large cash dividend is paid, it gives up one source of financing. The result being low payout of dividends for these high-growth companies.

------------------------------ If the spread between the required rate of return on a stock and the dividend growth rate decreases, the price of the stock: * is not affected. * decreases. * is not affected or increases. * increases. That answer is incorrect. Correct answer: increases. In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). When k - g decreases, all else equal, the stock price rises. ------------------------------ Which is a measure of a stockholder's return? * Return on Equity * Debt to Equity Ratio * Dividend Yield * Return on Assets * Payout Ratio That answer is incorrect. Correct answer: Dividend Yield 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. ------------------------------ 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. * I & II * I only * III only * II only

That answer is correct! 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. ------------------------------ 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: * decrease by 50%. * decrease by 15%. * increase by 30%. * decrease by 35%. That answer is incorrect. Correct answer: decrease by 35%. 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. ------------------------------ 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? * 11.8% * 12.3% * 14.8% * Not enough information * 6.9% * 9.3% That answer is correct! 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%

------------------------------ 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? * $18.99 * $45.54 * The answer cannot be calculated from the information provided. * None of these answers is correct. * $31.26 * $26.31 That answer is incorrect. Correct answer: $26.31 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. ------------------------------ Which of the following factors is an underlying assumption of technical analysis? * Supply and demand is driven by rational and irrational behavior. * The actual shifts in supply and demand cannot be observed in market behavior. * Prices move randomly. * Prices are not determined by supply and demand. That answer is correct! Supply and demand is driven by rational and irrational behavior. ------------------------------ Mary Short is a retail investor. During the course of the last several weeks, Ms. Short has been examining shares of Tellcorr Industries, a large telecommunications firm. In her examination, Mary has determined that Tellcorr's $1.05 per share dividend is anticipated to grow 20% annually. Assuming that Mary can sell her shares of Tellcorr for $70 per share at the end of three years, and that her required rate of return is 22% per year, what is the value of Tellcorr's common stock? * $41.60 * $39.98 * None of these answers is correct. * $59.23 * $63.44 That answer is correct! The Multiple Holding Period form of the Dividend Discount Model takes the following form: {V = {[d1 / (1 + k)] + [d2 / (1 + k)^2] + ....[dn / (1 + k)^n] + [Pn / (1 + k)^n]} Where: V = the price of the common stock at t0, d1 = the annual dividend at t1 (this is found by multiplying the annual dividend at t0 by (1 + the anticipated growth rate), d2 = the annual dividend at t2 (this is found by multiplying the dividend at t1 by (1 + the anticipated growth rate), k = the required rate of return, n = period "n", and Pn = the sale price of the common stock at time "n". In this example, time "n" is the third year, as this is the end horizon for Mary's holding period. Had the investor in this example forecasted selling the shares at the end of the 10th year, then "n" would be the tenth year.

Now that the formality of expressing the equation for this form of the DDM has been carried through, we can move toward a calculation of the value of this common stock. In this example, all of the necessary information has been provided, and the calculation of the value of this retail stock is as follows: {V = [($1.05 * 1.20) / (1 + 0.22)^] + [($1.26 * 1.20) / (1 + 0.22)^2] + [($1.512 * 1.20) / (1 + 0.22)^3] + [$70 / (1 + 0.22)^3]} which can be further broken down into the following: {V = [$1.032787 + $1.015856 + $0.999203+ $38.549482] = $41.60} ------------------------------ Which of the following represents a "contrary opinion" technical indicator? * Mutual fund cash position. * Diffusion Index. * T-Bill-Eurodollar Yield Spread. * None of these answers is correct. * Short sales by specialists. * The Confidence Index. That answer is correct! Of the choices listed, only "mutual fund cash positions" represents a contrarian technical indicator. Technical analysts often believe that the majority of market participants are incorrect in their opinions about market direction and valuation, especially during periods preceding market peaks and troughs. This style of thinking is often referred to as "contrary opinion" technical analysis. The mutual fund cash position is a contrary opinion technical indicator because contrarian technical analysts believe that mutual funds will be wrong in their forecasts of market direction. Technical analysts often use mutual funds as a proxy for institutional investors, and believe that the mutual fund cash position provides important insight into the sentiment of institutional investors. Specifically, these technical analysts believe that a high mutual fund cash position, which indicates that mutual funds are bearish on the market, is actually a signal of an impending upward move in stock prices. Conversely, a low mutual fund cash position is viewed as bearish by contrarian technical analysts. The intuition behind this opinion is relatively straightforward - a low mutual fund cash position indicates a low amount of buying power within mutual funds, i.e. there is less money available to support stock prices. Several studies have examined the cash ratio's ability to predict market cycles and have determined its usefulness is less than that implied by the technical analyst community. The Confidence Index is a measure of yield spreads between high-grade corporate bonds and the yields on average corporate bonds. The Diffusion Index measures the breadth of the market, and is found by taking the total volume of advancing shares plus one-half of the issues unchanged, divided by the total number of issues traded. The ratio of short sales by specialists is used by technical analysts to track the opinions of the "smart money," and the yield spread between T-Bills and Eurodollars is used to measure international sentiment and confidence. The T-Bill-Eurodollar Yield Spread is another example of a "smart money" technical indicator. ------------------------------

Which of the following does not affect the growth rate of earnings and dividends of a stock? * Changes in the dividend payout ratio * Changes in the return on equity (ROE) * Changes in the risk premium * Changes in the earnings retention rate That answer is incorrect. Correct answer: Changes in the risk premium The growth rate is equal to the retention rate multiplied by the ROE. The retention rate is itself equal to one minus the dividend payout ratio. Changes in the risk premium affect the required rate of return on a stock. Changes in all these variables are used in the direction of change approach to estimate the earnings multiplier. ------------------------------ The ratio of upside-downside volume is equal to * the number of downticks in the stock market divided by the number of upticks. * the total volume of increasing stocks plus half the volume of unchanged stocks, divided by the total volume of decreasing stocks. * the number of stocks increasing divided by the number of stocks decreasing. * the total volume of increasing stocks divided by the total volume of decreasing stocks. That answer is incorrect. Correct answer: the total volume of increasing stocks divided by the total volume of decreasing stocks. Technical analysts may use the ratio of upside-downside volume as an indicator of short-term momentum for the market. They feel that a ratio value of 1.50 or more indicates that the market is overbought, while a ratio of 0.70 or less indicates that the market is oversold. ------------------------------ If the moving average of past stock prices has been above the current price, this indicates * that the stock price has been declining. * that the stock price has been increasing. * an approaching market peak. * probable market instability. That answer is correct! A 50-day moving average, for example, would be equal to the average stock price for the past 50 days. In order for this average to be consistently above the current price, the current price must be going through a general decline that is dragging it below the moving average, which takes longer to adjust to falling prices.

------------------------------ Which of the following are assumptions of the dividend discount model? * No inflation * All of these answers * The required rate of return is greater than the growth rate * Earnings will not be negative That answer is incorrect. Correct answer: The required rate of return is greater than the growth rate The assumptions of the Dividend Discount Model are: (1) Dividends grow at a constant rate; (2) The constant growth rate will continue for an infinite period; (3) The required rate of return is greater than the growth rate. ------------------------------ The P/E ratio is not determined by * the ROE. * the expected dividend growth rate for the stock. * the expected dividend payout ratio. * the required rate of return on the stock. That answer is correct! 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). This equation shows that the P/E ratio is determined by the expected dividend payout ratio (D1/E), k, and g. ROE does not help determine the P/E ratio. ------------------------------ Closed end funds sell * none of these answers. * at a price equal to its NAV. * at a premium over its NAV. * at a discount from its NAV. That answer is incorrect. Correct answer: at a discount from its NAV. Historically, the market price of a closed end fund has been 5 to 20 percent below the NAV of the fund.

------------------------------ At which stage in an industry life cycle would profit margins most likely be at their highest? * mature growth * pioneering development * rapid accelerating growth * deceleration of growth and decline * stabilization and market maturity That answer is incorrect. Correct answer: rapid accelerating growth In this stage, there are a limited of number of firms for the product/service and demand is very high enabling the firm to experience high markups. ------------------------------ Which of the following is an advantage of technical analysis? * It explains why investors are buying and selling. * It involves adjusting for accounting problems. * It only incorporates economic reasoning. * It is quick and easy. That answer is incorrect. Correct answer: It is quick and easy. Technical Analysis is viewed as less vigorous than fundamental analysis. ------------------------------ Historically, the earnings per share (EPS) figure for a stock market series has been less volatile than the earnings multiplier for the same series. Which of the following best characterizes the primary reason for the greater volatility experienced by the earnings multiplier? Choose the best answer. * The price/earnings figure experiences a tax leveraging effect that is not passed on to the EPS figure. * The EPS figure is less volatile due to accounting manipulations and the malleability of international and domestic accounting standards including GAAP. * The earnings multiplier is more sensitive to changes in dividend policies than is the EPS figure. * None of these answers is correct. * The price/earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate. * The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking."

That answer is incorrect. Correct answer: The price/earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate. The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following: 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. As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure. ------------------------------ If a stock has an expected dividend payout ratio of 50%, a required rate of return of 13% and an expected dividend growth rate of 10%, what is the P/E ratio? * 10 * 12.5 * None of these answers * 8.5 That answer is incorrect. Correct answer: None of these answers 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/(.13-.10) = 16.7 ------------------------------ Given that the beginning value of a stock is $120, the ending value is $110, earnings are $40, and the retention rate of earnings is 0.6, what is the rate of return on the stock over this period? * 6% * 5.7% * 5% * -8.3% * Not enough information.

That answer is incorrect. Correct answer: 5% The dividend payout ratio is equal to one minus the retention rate (1 - 0.6 = 0.4). Dividends are equal to the dividend payout ratio multiplied by earnings (0.4 x 40 = $16). The rate of return is equal to the ending price plus the dividend payments, divided by the beginning price, minus one. In this question, the rate of return is [(110 + 16)/ 120] - 1 = 0.05 = 5%. ------------------------------ An fundamental analyst with Street Brothers asset management is considering shares of Polynomial Software Solutions, Inc., for possible investment. In her analysis, this investor has determined the following information: The Company currently pays a $2.20 per share dividend, and this dividend is anticipated to grow at 13% annually. Additionally, the investor has assumed that she will be able to sell the stock for $125 per share at the end of four years. Similar investments have warranted a 15.25% per year required rate of return. What is the value of Polynomial Software Solutions? * $79.23 * $110.64 * $71.89 * $122.16 * The Multiple Holding Period DDM will produce a nonsensical answer for this stock. That answer is correct! The Multiple Holding Period form of the Dividend Discount Model takes the following form: {V = {[d1 / (1 + k)] + [d2 / (1 + k)^2] + ....[dn / (1 + k)^n] + [Pn / (1 + k)^n]} Where: V = the price of the common stock at t0, d1 = the annual dividend at t1 (this is found by multiplying the annual dividend at t0 by (1 + the anticipated growth rate), d2 = the annual dividend at t2 (this is found by multiplying the dividend at t1 by (1 + the anticipated growth rate), k = the required rate of return, n = period "n", and Pn = the sale price of the common stock at time "n". In this example, time "n" is the fourth year, as this is the end horizon for this investors holding period. Had the investor in this example forecasted selling the shares at the end of the 10th year, then "n" would be the tenth year. Now that the formality of expressing the equation for this form of the DDM has been carried through, we can move toward a calculation of the value of this common stock. In this example, all of the necessary information has been provided, and the calculation of the value of this retail stock is as follows: {V = [($2.20 * 1.13) / (1 + 0.1525)^1] + [($2.486 * 1.13) / (1 + 0.1525)^2] + [($2.80918 * 1.13) / (1 + 0.1525)^3] + [($3.174373 * 1.13) / (1 + 0.1525)^4] + [$125 / (1 + 0.1525)^4]} which breaks down into the following: {V = [$2.15705 + $2.114938 + $2.073649 + $2.033165 + $70.851048] = $79.23 ------------------------------

Which statement is not true? * Within industries, firms tend to have similar capital structures. * Most ratios vary across time within a given industry. * The higher proportion of debt, the higher the return on equity ratio will be. * The lower the dividend yield, the greater the anticipated price appreciation. * High P/E ratios tend to go with high payout ratios. * The higher the payout ratio in a given industry, the more important dividends are to shareholders. That answer is incorrect. Correct answer: High P/E ratios tend to go with high payout ratios. High P/E ratios tend to go with low payout ratios as both of these measures are associated with higher growth rates. Remember that low payout ratios are common for high-growth companies as they give up a paying large dividends to finance their firm. ------------------------------ Joe Wellworth, an oil analyst with Smith, Kleen and Beetchnutty institutional brokerage, is trying to determine an appropriate earnings multiplier for the natural gas industry. In his research, Mr. Wellworth has examined the relationship between the earnings multiplier of the natural gas industry and the Price-to-Earnings ratio of the Standard & Poors 500. Using a time series analysis, Joe examines the trend in the relationship between the natural gas industry and the overall market and uses this information to estimate the appropriate earnings multiplier for the natural gas industry. Which of the following best characterizes this method of estimating the earnings multiplier of an industry? Choose the best answer. * Correlation analysis * Microanalysis * The bottom-up approach * Macroanalysis * Time series analysis That answer is incorrect. Correct answer: Macroanalysis The answer called for in this example is macroanalysis. This method involves an examination of the relationship between the earnings multiplier of a stock market series and the earnings multiplier of the overall market. For example, an individual projecting an earnings multiplier for a software index using macroanalysis would begin by examining the relationship between the P/E ratio of the software index and the P/E ratio of a broad market index such as the Standard & Poors 500. Both historical trends and point estimates would be examined, and from this information, a projection of the earnings multiplier for the stock market series is deduced. This is precisely the process illustrated in this example. This is contrasted by microanalysis, which involves an examination of the components of the earnings multiplier, including the anticipated growth rate of dividends, the required rate of return, and the dividend payout ratio. Once these variables have been examined, both from the perspective of trend analysis and point estimation, a value for the earnings multiplier is deduced.

The bottom-up approach is used in the investment selection process, and involves identifying superior investments by first examining companies, rather than beginning with an examination of macroeconomic cycles and influence. Time series analysis, while materially correct, does not represent the best possible answer. ------------------------------ A technical analyst with Bullfighter.com, a noted investment research firm, has been examining the U.S. securities markets, and believes that the market is technically "overbought." Which of the following technical indicators would this analyst likely use to support his opinion? Choose the best answer. * The Block Uptick-Downtick Ratio has declined below 0.70. * All of these choices indicate an "overbought" condition. * The Diffusion Index has increased significantly. * The Block Uptick-Downtick Ratio has advanced beyond 1.1. * The CBOE Put/Call Ratio has declined to 0.50. That answer is incorrect. Correct answer: The Block Uptick-Downtick Ratio has advanced beyond 1.1. The Block Uptick-Downtick Ratio is used by technical analysts to gauge institutional investment activity by measuring the percentage of block trades which result in an uptick versus the block trades which are executed on a downtick. The idea behind this ratio is the belief that a block buyer would initiate an "uptick", or a bid up in the securities' price, and a block seller would initiate a "downtick," or a bid down in the securities' price. Technical analysts view a decline in the Block Uptick-Downtick Ratio below 0.70 as an indication of an oversold condition, and an increase in the Block Uptick-Downtick Ratio above 1.10 as indicative of an overbought condition. The "Diffusion Index" is a measure of market breadth, and is defined as [(# of advancing issues + 1/2 # of issues unchanged) / # of issues traded]. An increase in the diffusion index is indicative of an increase in advancing issues relative to declining issues. The CBOE Put/Call Ratio is a contrarian technical indicator used to gauge the sentiment of investment professionals, and a ratio greater than 50% is viewed by contrarian technical analysts as overtly bullish. Finally, contrarian technical analysts would view a large increase in the amount of futures traders who express bullish sentiment on stock index futures as a bearish signal. The % of issues trading below their 200-day moving average is frequently cited by technical analysts as a measure of oversold and overbought market conditions. Specifically, technical analysts see the market as "overbought" when 80% of issues are trading above their 200-day moving average, and consider a market "oversold" when 80% of issues are trading under their 200-day moving average. ------------------------------ Technical analysts may view a decline in credit balances as * a bullish sign. * a bearish sign. * the result of low mutual fund cash positions. * a sign indicating a short-term, transient bull market.

That answer is incorrect. Correct answer: a bearish sign. A credit balance results when an investor sells stocks and deposits the proceeds with his broker. Technical analysts view a decline in credit balances as a decrease in a pool of potential buying power. For this reason, such a decline is viewed as a bearish sign. ------------------------------ A market strategist with Churn Brothers Brokerage is trying to determine the earnings multiplier of an equity index comprised of grocery stores, and has gathered the following information: g: 6.00% per year k: 8.50% per year EPS: $3.35 D0: $1.20 Using this information, what is earnings multiplier for this equity index? Further, assuming that the grocery business is a mature industry, and that the economy is experiencing stable growth, is this earnings multiple realistic? * None of these answers is correct. * 4.21, this multiple is too low * 5.97, this multiple is too low * 130, this multiple is much too high * 15.67, this multiple is likely realistic * 14.33, this multiple is likely realistic That answer is incorrect. Correct answer: 14.33, this multiple is likely realistic To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/E = [(D1 / E1) / (k-g) Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends. In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following: P/E of a stock market series = [($1.20*1.06 / ($3.35*1.06)) / (0.085 - 0.06)] = 14.33 This earnings multiple is appropriate for lower growth industries, such as the grocery business, which has historically grown in the mid-to-high single digits for much of the last decade. Consider the fact that the P/E ratio is a proxy for future growth. Firms in the automobile, basic materials, or other mature industries, which are expected to grow slowly, are characterized by lower earnings multiples and higher dividend payout ratios. Firms in the software, networking, biotechnology, and other high-growth industries, are typically characterized by high earnings multiples and low dividend payout ratios. What is happening here is that investors are giving up current income (i.e. dividends) in the hopes of rapid earnings growth (i.e. greatly increased EPS in the future).

A complete understanding of this relationship is absolutely crucial, and as a Level 1 candidate, I encourage you to examine this relationship further if you are not completely comfortable with the P/E ratio, its components and the relationships between them, and the implications of the earnings multiplier across different industries. Indeed, the P/E ratio is a valuable tool, one which can provide significant information about the growth prospects priced into a common stock. ------------------------------ Analytics Software Incorporated currently pays 20% of its earnings in dividends and the Company has a steady growth rate of 25% per year. Assuming a 27.5% per year required rate of return, what is the appropriate earnings multiplier for Analytics Software? * The answer cannot be determined from the information provided. * 16 * 18 * 22 * 8 * 9 That answer is incorrect. Correct answer: 8 To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula: P/E = [(d1 / e1) / (k - g)] Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate. In this example, all of the necessary information has been provided, and the calculation of the earnings multiplier is as follows: P/E = [0.20 / (0.275 - 0.25)] = 8 This multiplier is likely low for a software firm growing at 25% annually. An analyst examining shares of Analytics Software would likely take this disparity into account in his or her analysis. Perhaps the use of the Infinite Period DDM to determine an earnings multiplier for this company is unrealistic. Perhaps valuing this company in accordance to anticipated free cash flows would provide a more realistic measure of value. ------------------------------ Which of the following is not an advantage of technical analysis? * It does not involve adjusting for accounting problems. * It tells when to buy and sell not why investors are buying and selling. * It only incorporates economic reasoning. * It is quick and easy.

That answer is incorrect. Correct answer: It only incorporates economic reasoning. It incorporates economic and psychological reasoning. ------------------------------ Which of the following is NOT typically true for a firm which has adopted the low-cost competitive strategy? * The firm will enjoy above-average rates of return only if its price premium based on its differentiation exceeds the extra cost of being unique. * None of these answers. * All of these answers. * The firm seeks to differentiate itself based on its distribution system, through some unique marketing approach, or by providing an important service to its customers. * The firm seeks to identify itself as unique in its industry in an area that is important to buyers. That answer is incorrect. Correct answer: All of these answers. The above are all true for a company that has adopted the differentiation strategy. With the low-cost strategy, the firm is determined to become the low-cost producer and, hence, the cost leader in the industry. Cost advantage might include economies of scale, proprietary technology, or preferential access to raw materials. The objective is to charge less for the product or service but still enjoy higher profit margins and returns on capital. ------------------------------ If the spread between the required rate of return and the anticipated dividend growth rate were to decrease significantly and suddenly while the remaining components of the P/E ratio were to remain unchanged, which of the following would likely occur? Further, a decrease in the retention rate would lead to what effect on the earnings multiplier, holding both k and g constant? * The earnings multiplier would increase; the earnings multiplier would increase. * The earnings multiplier would decrease; the earnings multiplier would decrease. * The earnings multiplier would increase; the earnings multiplier would either increase or decrease depending on the firm's ROE compared to its cost of capital. * The earnings multiplier would increase; the earnings multiplier would decrease. * The earnings multiplier would decrease; the earnings multiplier would increase. That answer is correct! Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following: {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. As the spread between k and g narrows, the earnings multiplier figure will increase. Indeed, the earnings multiplier is very sensitive to changes in the spread between k and g, and this is the primary reason for the greater relative volatility of the P/E ratio versus the EPS figure for a stock market series. A decrease in the retention rate will lead to an increase in the earnings multiplier figure, holding everything else equal. Remember that the retention rate is simply (1 - dividend payout ratio). So, a decline in the retention rate is analogous to an increase in the dividend payout ratio. An increase in the dividend payout ratio, holding everything else equal, will lead to an increase in the earnings multiplier figure. ------------------------------ Jim, an investment manager with Smith, Kleen & Associates, is in the process of determining the annualized return for a client portfolio. Jim uses a specific three-step process to determine this annualized return, which is detailed as follows: Step 1: Jim prices the portfolio immediately prior to any significant addition or withdrawal of funds. The portfolio is broken into specific subperiods based on the dates of cash inflows and outflows. The product of the subperiods is 10 years. Step 2: Jim calculates the holding period return of the portfolio for each subperiod. Step 3: Jim calculates the geometric mean of the annual returns. This calculation is used as the annual portfolio return measure. Which of the following best describes the final calculation produced by Jim? * Dollar-weighted rate of return * Time-weighted rate of return * Modified Internal Rate of Return * Annualized holding period return * Geometrical rate of return * Asset-weighted rate of return That answer is incorrect. Correct answer: Time-weighted rate of return The process illustrated in this example is the calculation of the time-weighted rate of return. This method of calculating portfolio returns is superior in many respects to the dollar-weighted rate of return, which is also known as the IRR. The reason for this relative superiority is the fact that the time-weighted rate of return is not sensitive to portfolio additions or withdrawals. So said, the time-weighted rate of return is more popular in the field of investment management. While "annualized holding period return" is a tempting choice, it does not represent the best possible answer. "Geometrical rate of return" could refer to several return measures, but not the time-weighted rate of return.

------------------------------ Which of the following is not an assumption of technical analysis? * Securities markets are weak-form efficient. * Changes in the market value of any good are determined solely by supply and demand fluctuations. * Securities prices exhibit identifiable patterns. * Supply and demand is governed by both rational and irrational factors. * More than one of these answers is correct. * Securities prices move in identifiable trends. That answer is correct! Technical analysis is primarily grounded on three major assumptions - (1.) the market value of any good is determined solely by supply and demand, (2.) supply and demand fluctuations are caused by both rational and irrational factors, and (3.) the prices of individual securities and securities markets move in trends, i.e. securities markets "price-in" information slowly. The third assumption of technical analysis negates any belief in the Weak Form Efficient Market Hypothesis, which assumes that past performance data cannot be used to predict securities prices, and that the securities markets "price-in" information instantly. This "incongruence" with all forms of the EMH is cited as the greatest criticism of technical analysis. ------------------------------ When studying industry analysis, which would be of most importance when concentrating on financial performance? * all of these would be important * financial leverage * components of return on equity * return on total capital * return on foreign investments That answer is correct! These are all factors in financial performance when studying industry analysis. ------------------------------ The current dividend yield on a stock A is 3.2%. The stock has a required rate of return of 9%. If the firm just paid a dividend of $1.65, what's the expected dividend for next year, assuming a constant growth rate? * $2.01 * $1.89 * $1.75 * $1.83 That answer is incorrect. Correct answer:

$1.75 The dividend yield, defined as the expected dividend next period divided by current price, equals D1/Po, in standard notation. Using the Dividend Discount Model, this is equal to k - g. With k = 9%, we get 3.2% = 9% - g. Therefore, g = 5.8%. The expected dividend next year is then equal to 1.65 * 1.058 = $1.75. ------------------------------ The estimate of ________ combined with the firm's retention rate will indicate its growth potential. * ROE * assets * ROA * current ratio * equity That answer is correct! The estimate of ROE combined with the firm's retention rate will indicate its growth potential. ------------------------------ Consider the following information about a natural gas driller: Next annual dividend: $1.18 Earnings per share next year: $4.60 Anticipated growth rate: 12.5% per year Required rate of return: 15% per year What is the expected earnings multiplier for this utility company? * 12.46 * 10.26 * 53.10 * 15.59 * 47.20 * None of these answers is correct. That answer is incorrect. Correct answer: 10.26 To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula: P/E = [(d1 / e1) / (k - g)] Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate. In this example, all of the necessary information has been provided, but some rearranging is necessary.

Specifically, the dividend payout ratio must be determined. This figure is found as follows: Dividend payout ratio = [$1.18 / $4.60] = 0.256522, or 25.65% Now that the dividend payout ratio has been determined, we can solve for the appropriate earnings multiplier. The calculation of this figure is found as follows: P/E = [0.2565 / (0.15 - 0.125)] = 10.26 In generally favorable economic conditions, this is a pretty realistic multiple for an average natural gas drilling company. ------------------------------ The ________ gives an estimate for the spread between the required rate of return and the expected growth of dividends. * none of these answers * dividend yield * P/E ratio * yield-to-maturity That answer is incorrect. Correct answer: dividend yield The dividend yield gives an estimate for the spread between the required rate of return and the expected growth of dividends. ------------------------------ A high short interest ratio would be interpreted by technical analysts as * a sign of coming market instability. * irrelevant. * bearish. * bullish. * indicative of an approaching market peak. That answer is incorrect. Correct answer: bullish. The short interest ratio is equal to the outstanding short interest divided by the average daily volume of trading on the exchange. A high ratio is interpreted as bullish because a larger relative short interest is indicative of a high potential demand for stock from those who have sold short but not yet covered their sales. ------------------------------

What is the value of a preferred stock with a par value of $150, an annual dividend equal to 15% of par value, and a required rate of return of 12%? * $150.00 * $187.50 * Not enough information * $123.49 * 230.54 That answer is incorrect. Correct answer: $187.50 The value of a preferred stock is the present value of its dividends, which is equal to the annual dividend divided by the required rate of return. In this question, the annual dividend is equal to 150 x .15 = $22.5, and the preferred stock is worth $22.5/0.12 = $187.50 ------------------------------ The risk premium * causes differences in the required rate of return among alternate types of investments. * causes differences in required rates of return among alternate types of investments and among investments of the same type. * can be less than zero. * causes differences in the required rate of return among investments of the same type. That answer is incorrect. Correct answer: causes differences in required rates of return among alternate types of investments and among investments of the same type. Every investment has its own risk premium, which may change over time. The required rate of return on any security is equal to the risk-free rate of return plus the risk premium on that security. Because the lowest possible required rate of return on any investment is the risk-free rate of return, the risk premium cannot be less than zero. ------------------------------ Using the microanalysis approach to estimating a company's earnings multiplier, the multiplier is based on: I. the dividend payout ratio II. the required rate of return III. the company's relationship to the industry IV. the rate of growth V. the estimated earnings per share VI. the company's relationship to the market * III, VI

* I, II, III, IV, V * I, II, IV * I, II, III * II, III, IV That answer is incorrect. Correct answer: I, II, IV The earnings multiplier, under the microanalysis approach, is estimated based on its three components: the dividend payout ratio, the required rate of return, and the rate of growth. Under the Macroanalysis approach, it is estimated from the relationships among the firm, its industry and the market. The estimates derived from each approach are resolved to settle on one estimate. ------------------------------ There are two popular methods for estimating the earnings multiplier for an industry or a stock market series, which of the following correctly lists these two techniques? * Discounted cash flow estimation, regression analysis. * The direction of change and the specific estimate approach. * Microanalysis and Macroanalysis. * The top-down and the bottom-up approach. * Scenario Analysis, Monte Carlo Simulation. * More than one of these answers is correct. That answer is incorrect. Correct answer: More than one of these answers is correct. More than one of these answers is correct. Specifically, the "direction of change" and the "specific estimate" are methods of forecasting the earnings multiplier of a stock market series and "microanalysis" and "macroanalysis" are used to forecast the earnings multiplier for an industry. When estimating the earnings multiplier for an industry, there are two common methods - the "direction of change" and the "specific estimate" approaches. The direction of change approach begins with the present earnings multiplier for a stock market series and seeks to estimate both the amount and direction of any change based upon changes in the components of the P/E ratio - the required rate of return, the anticipated growth rate of dividends, and the dividend payout ratio. This approach is contrasted by the specific estimate approach, which involves the estimation of a specific value for the earnings multiplier based on a series of projections for values of the components of the earnings multiplier components. When using this approach, analysts commonly confine their estimates to a series of scenarios, typically a best case, worst case, and base case scenario. There are two common methods for estimating the earnings multiplier for an industry - macroanalysis and microanalysis. Macroanalysis involves an examination of the relationship between the earnings multiplier for an industry and the earnings multiplier for the market. Microanalysis involves an estimation of the specific variables that influence the earnings multiplier, including the required rate of return, the estimated growth rate, and the dividend payout ratio. While the top down and bottom up method are similar to Macroanalysis and Microanalysis, respectively, they do not represent the best possible answer. Specifically, the top-down and bottom up approaches are typically used to identify investment opportunities, not for the estimation of an industry earnings multiplier.

------------------------------ The short-interest ratio is equal to * the outstanding short interest on an exchange divided by the daily volume of trading on the exchange. A low short-interest ratio would be interpreted by technical analysts as a bearish sign, because of the small potential demand for stocks by those who have sold short by not yet covered their sales. * the outstanding short interest on an exchange divided by the daily volume of trading on the exchange. A high short-interest ratio would be interpreted by technical analysts as a bearish sign, because a large amount of short sales indicates investors' expectations of declining share prices. * the outstanding short interest on an exchange divided by the market capitalization of shares on the exchange. A low short-interest ratio would be interpreted by technical analysts as a bullish sign, because a small amount of short sales indicates investors' expectations of rising share prices. * the outstanding short interest on an exchange divided by the number of long positions held. A high short-interest ratio would be interpreted by technical analysts as a bullish sign, because of the large potential demand for stocks by those who have sold short but not yet covered their sales. That answer is correct! Technical analysts interpret the short-interest ratio contrary to initial intuition. Because short sales reflect investors' expectations of declining share prices, a large amount of short sales might be taken as a bearish sign. But technical analysts prefer to focus on the potential demand for shares that short sales create. Once an investor has sold short a stock, he will eventually have to repurchase it to cover his position. ------------------------------ You have a stock that you are holding for one year. It has an estimated dividend payout of $1.10 and an expected sale price of $22. Using the dividend discount model, calculate the value of the stock if your required rate of return is 14%. * $23.10 * $20.26 * $22 * not enough information to calculate it That answer is incorrect. Correct answer: $20.26 Bring both dividend and expected sale price to present value and sum the two: V = $1.10/1.14 + $22.00/1.14 = $20.26 ------------------------------ A market strategist for Churn Brothers Brokerage is trying to determine an EPS figure for a stock market series. In her analysis, this portfolio manager has determined the following:

1. Regressing sales for the series against Nominal GDP, the sales figure for the index has been estimated at: $26.44. 2. Analyzing capacity utilization rates, foreign competition, rates of inflation and unit labor costs, the operating profit margin for the series has been determined to be 28%. 3. Creating a time series based upon inputs such as levels of capital expenditures and PP&E turnover, next year's depreciation-per-share has been determined to be: $1.89. 4. Creating a time series based upon levels of debt outstanding and prevailing debt yields, the interest expense for next year is determined to be: $0.94 per share. 5. Coordinating his research with a legislative consultant, the corporate tax rate for this series has been estimated at: 36% Using this information, what is the EPS figure for this stock market series? * The answer cannot be determined from the information provided. * $3.87 * None of these answers is correct. * $3.18 * $4.82 * $2.93 That answer is incorrect. Correct answer: $2.93 All of the necessary information has been provided in this example. To determine the EPS for a stock market series, the following steps are necessary: Step 1: Estimate sales-per-share for the series: Step 2: Estimate operating profit margin for the series Step 3: Estimate the depreciation-per-share for next year Step 4: Estimate the interest expense-per-share for the next year Step 5: Estimate next year's corporate tax rate Once these five steps have been completed, the calculation of EPS for a stock market series is found by the following: EPS = [(Sales per share * Operating profit margin) - Depreciation-per-share - Interest Expense] * (1 - Corporate Tax Rate) The calculation of EPS for this stock market series is shown as follows: EPS = [($26.44 * 0.28) - $1.89 - $0.94] * (1 - 0.36) = $2.93 ------------------------------ The estimated ________ is applied to the estimated ________ to arrive at estimated future values of a company's share. * earnings multiplier, earnings per share * dividend payout ratio, expected growth rate less the required rate of return

* dividend payout ratio, required rated of return less the expected growth rate That answer is correct! Estimated earnings multiplier x Estimated earnings per share = Estimated future value of the share. ------------------------------ A fundamental analyst is examining the perpetual preferred stock of a large telecom company. The preferred stock is expected to pay a quarterly dividend of $0.55, and the required rate of return is 11.75% per year. At what price would this preferred stock be fairly valued? * $16.44 * The answer cannot be calculated from the information provided. * $18.20 * None of these answers is correct. * $18.72 * $21.14 That answer is incorrect. Correct answer: $18.72 Assuming that the quarterly dividend is to remain unchanged forever allows us to use the standard perpetuity model, which is illustrated as follows: Value of preferred stock = {Annual dividend / required rate of return} In this example, we are given the quarterly dividend, which must be multiplied be annualized in order to be imputed into the perpetuity valuation equation. So said, a quarterly dividend of $0.55 translates into a yearly dividend of $2.20. Incorporating this yearly dividend into the perpetuity valuation model will result in the following: Value of preferred stock = {$2.20 / 0.1175} = $18.72 ------------------------------ A large net advance on an advance-decline series in a rising market would be viewed by technicians as * a bullish signal. * a sign of caution. * indicative of an uneven market. * irrelevant. That answer is correct! The large net advance means that considerably more stocks advanced than declined in the series, meaning that the general market rise is broadly based and extends to most of the stocks. This would be viewed as a bullish sign.

------------------------------ Which of the following is a method of assessing country risk? * Delphi technique * Simulation analysis * Monte Carlo simulation * Scenario Analysis * None of these answers is correct. * Darden case method * More than one of these answers is correct. That answer is correct! The Delphi technique is a popular method of assessing country risk, and involves the collection of several independent opinions the appropriate countries risk premium to be applied to the country under examination. In the Delphi technique, a group of experts are asked to quantify the country risk of a particular nation, without any input from other experts. By limiting any group discussion, the Delphi technique seeks to provide a realistic quantification of the country risk premium. "Simulation analysis," "Monte Carlo simulation," and "scenario analysis," are techniques designed to measure stand-alone risk. The "Darden case method" is largely a fictitious term. ------------------------------ Given that the expected dividend payout ratio is 0.34, the expected net profit margin is 0.16, the expected total asset turnover is 0.94, the expected return on capital is 0.24, and the expected financial leverage multiplier is 1.13, what is the expected growth rate of the firm? * 19% * 11% * 6% * 4% * Not enough information * 13% That answer is incorrect. Correct answer: 11% The expected growth rate of the firm is equal to the expected retention rate multiplied by the expected return on equity. The return on equity is equal to the expected net profit margin multiplied by the expected total asset turnover multiplied by the expected financial leverage multiplier (0.16 x 0.94 x 1.13 = 0.17). The expected retention rate is equal to 1 minus the expected dividend payout ratio (1 - 0.34 = 0.66). In this question, the expected growth rate is equal to 0.66 x 0.17 = 0.11 = 11% ------------------------------

When the relative strength of a stock with respect to an index is increasing, the stock is * keeping pace with the chosen index. * all of these answers are possible. * doing better than the chosen index. * worse than the chosen index. That answer is incorrect. Correct answer: doing better than the chosen index. The Relative Strength of a stock relative to an index equals the ratio of the stock price to the index price. Hence, if the relative strength is increasing, it indicates that the stock is doing better in price appreciation than the index. ------------------------------ Given the following information, what would the expected industry rate of return equal? Retention rate = 80% Net earnings estimate = $15.00/share Multiple estimate = 22 Current earnings = $13.95/share Current multiple = 21 * 12.8% * 12.2% * 13.7% * 14.0% * 11.9% That answer is incorrect. Correct answer: 13.7% Expected industry return = (Index estimate - Current index + Dividend) / Current index = (330 - 292.95 + $3.00) / 292.95 = 13.7% Index estimate = $15.00 x 22 = 330 Current index = $13.95 x 21 = 292.95 Dividend = (1 - .80) x $15.00 = $3.00 ------------------------------ Given that the risk-free rate of return is 6%, what is the value of a riskless zero-coupon bond with which the principal payment is $10,000 in 15 years? * $5,733 * $4,173 * $5,929 * $6,841

* $7,126 * Not enough information That answer is incorrect. Correct answer: $4,173 The value of a zero-coupon bond is equal to the present value of its principal payment. The required rate of return on a riskless bond is the risk-free rate of return. Using appendix C in the book by Reilly & Brown, the present value of the bond is $10,000 x 0.4173 = $4,173, or $10,000/(1.06^15). ------------------------------ Given the following information, what would the expected industry rate of return equal? Dividend payout = 30% Net earnings estimate = $12.62/share Multiple estimate = 19 Current earnings index = 225.50 * 8.5% * 9.0% * 8.0% * 7.5% * 10.0% That answer is incorrect. Correct answer: 8.0% Expected industry return = (Index estimate - Current index + Dividend) / Current index = (239.78 - 225.50 + $3.79) / 225.50 = 8.0% Index estimate = $12.62 x 19 = 239.78 Dividend = .30 x $12.62 = $3.79 ------------------------------ Which of the following best describes the primary reason for the greater volatility of the earnings multiplier of a stock market series compared to the earnings per share (EPS) for the same series? Choose the best answer. * The price/earnings ratio is less insulated from accounting distortions than is the EPS figure.; i.e. it is harder to "normalize." * None of these answers is correct. * The EPS figure is subject to a deleveraging effect caused by changes in the capital structure. * The earnings multiplier is more sensitive to changes in the spread between the required return and growth. * The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking." * The price/earnings ratio is more sensitive to increases in a companies dividends.

That answer is incorrect. Correct answer: The earnings multiplier is more sensitive to changes in the spread between the required return and growth. The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following: 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. As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier figure for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure. ------------------------------ Given that the P/E ratio on a common stock is 15, the expected dividend payout ratio is 0.6, and the required rate of return is 19%, what is the dividend growth rate? * 13.4% * 9% * 12.8% * Not enough information * 15% That answer is incorrect. Correct answer: 15% 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. The earnings multiplier model goes a step further by dividing both sides of the infinite period Dividend Discount Model equation by expected earnings during the next 12 months, yielding P/E = (D1/E) / (k - g). Rearranging this results in g = k - (D1/E) / (P/E). In this question, the dividend growth rate is equal to 0.19 - 0.6/15 = 0.15 = 15% ------------------------------ The situation of monopsony is most closely affiliated with which of Porter's Five Forces of industry competition? * Bargaining power of suppliers * Rivalry among existing firms * Threat of substitute products

* Bargaining power of buyers * Threat of new entrants That answer is incorrect. Correct answer: Bargaining power of buyers A monopsony exists when there is only one buyer for a product or service. This is contrasted by a monopoly, where there are many buyers and only one seller. Monopsony is most closely characterized by the bargaining power of buyers, as the sole buyer has much power in influencing prices. If there exists only one buyer for an industry or company's product, the bargaining power of suppliers will be small. This will lead to increased competition in the industry. While monopsony is a rare situation, it nonetheless occurs. For example, certain automobile parts are purchased only by one of the large auto manufacturers. These automobile manufacturers have tremendous pricing power from their suppliers, to many of which they are the only customer. ------------------------------ A portfolio manager with an independent money management firm has been examining a stock market series and is trying to determine an appropriate EPS figure for the series. In her research, this portfolio manager has determined the following information: 1. Regressing sales for the series against Nominal GDP, the sales figure for the index has been estimated at: $19.85. 2. Analyzing capacity utilization rates, foreign competition, rates of inflation and unit labor costs, the operating profit margin for the series has been determined to be 31%. 3. Creating a time series based upon inputs such as levels