CFA2020L1QbanksAnswers equity

Reading 36:: Market Organization and Structure Question #1 of 70 Question ID: 1205922 Equity securities most likely include: A) preferred stock and certi cates of deposit B) common stock and warrants C) commercial paper and repurchase agreements Explanation Common stock, preferred stock, and warrants are equity securities Certi cates of deposit, commercial paper, and repurchase agreements are debt securities (Study Session 12, Module 36.1, LOS 36.c) Question #2 of 70 Question ID: 1205973 A trading system that matches buyers and sellers based on price and time precedence is most likely a(n): A) brokered market B) order-driven market C) quote-driven market Explanation In an order-driven market, buy orders and sell orders are matched up by the exchange according to order matching rules In a quote-driven market, customers trade with dealers at bid and ask prices set by the dealers In a brokered market, brokers organize trades among their clients (Study Session 12, Module 36.3, LOS 36.j) Question #3 of 70 Question ID: 1205981 Peg Fisk, CFA, states that two of the objectives of market regulation which CFA Institute attempts to address are minimum standards of competence among investment professionals and ease of performance evaluation for investors Fisk is accurate with regard to: A) both of these objectives B) only one of these objectives C) neither of these objectives Explanation CFA Institute attempts to address both of these objectives of market regulation The CFA Program is part of the e ort to encourage minimum standards of competency among nance professionals Global Investment Performance Standards are part of the e ort to make performance evaluation easier for investors (Study Session 12, Module 36.3, LOS 36.l) Question #4 of 70 Question ID: 1205915 Which of the following conditions is most likely necessary for capital to be allocated to its most valuable uses? A) Investors are well informed about the risk and return of various investments B) Financial markets are frictionless (i.e., free of taxes or transactions costs) C) There are no barriers to the ow of complete information to the nancial markets Explanation Capital will ow to its most valuable uses if markets function well and investors are well informed about the risk and return characteristics of various investments Allocation of capital to its most valuable uses does not require that all investors have complete information or that nancial markets are frictionless (Study Session 12, Module 36.1, LOS 36.a) Question #5 of 70 Question ID: 1205920 Jorman Inc stock is cross-listed on exchanges in Tokyo and New York Jorman stock is best described as a: A) public security B) primary market security C) private security Explanation Jorman stock is a public security because it is traded on public exchanges that are subject to regulatory oversight A private security is a security that is not o ered for sale on a public exchange and is not subject to regulation Securities are issued in the primary market (i.e., initial public o erings) and subsequently trade in the secondary market (e.g., stock exchanges) (Study Session 12, Module 36.1, LOS 36.b) Question #6 of 70 An order to sell a security at the best price available is most likely a: A) market order B) stop order Question ID: 1205961 C) limit order Explanation A market order is an order to buy or sell a security immediately at the best available price A limit order is an order to buy at the speci ed limit price or lower, or to sell at the limit price or higher A stop order is an order to buy if the market price increases to the speci ed stop price, or to sell if the market price decreases to the stop price (Study Session 12, Module 36.3, LOS 36.h) Question #7 of 70 Question ID: 1205913 The main functions of the nancial system least likely include: A) preventing investors from generating abnormal pro ts by trading on information B) bringing together savers and borrowers C) allocating nancial resources to their most productive uses Explanation One of the purposes of the nancial system is to allow investors to trade on (public) information Other purposes of the nancial system include allocating nancial capital to its most productive uses, and bringing together those who wish to save with those who wish to borrow (Study Session 12, Module 36.1, LOS 36.a) Question #8 of 70 Question ID: 1205960 Austin Bruno, CFA, places a ll or kill, limit buy order at 92 for a stock Bruno's order speci es: A) validity and execution instructions B) execution and clearing instructions C) clearing and validity instructions Explanation Fill or kill is a validity instruction as it indicates when the order can be lled (i.e immediately or cancel the order) A limit buy order is an execution instruction as it indicates how the order should be lled (e.g buy at $92 or less) Clearing instructions indicate how to settle the trade (i.e., how and when to transfer the cash and the security) (Study Session 12, Module 36.3, LOS 36.g) Question #9 of 70 Question ID: 1205955 An investor purchased 725 shares of stock at $40 per share and posted initial margin of 60% He subsequently sold the shares at $50 per share Based only on this information, the investor's holding period return is closest to: A) 25% B) 20% C) 40% Explanation (50 – 40) / (40 × 0.6) = 41.67% (Study Session 12, Module 36.2, LOS 36.f) Question #10 of 70 Question ID: 1205962 Which of the following statements about securities markets is least accurate? A) Secondary markets, such as the over-the-counter (OTC) market, provide liquidity and price continuity B) Characteristics of a well-functioning securities market include: many buyers and sellers, low bidask spreads, timely information on price and volume of past transactions, and accurate i f i l dd d C) A limit buy order and a stop buy order are both placed below the current market price Explanation 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) operational e ciency (low transaction costs) informational e ciency (rapidly adjusting prices) (Study Session 12, Module 36.3, LOS 36.h) Question #11 of 70 Question ID: 1205952 An investor purchases 200 shares of Mertz, Inc on margin The shares are trading at $40 Initial and maintenance margins are 50% and 25% 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) 25% B) 50% C) 20% Explanation Pro t = 10,000 – 8,000 = 2,000 Return = 2,000 / 4,000 = 50% (Study Session 12, Module 36.2, LOS 36.f) Question #12 of 70 Question ID: 1205917 The "real assets" classi cation most likely includes: A) stocks B) bonds C) commodities Explanation Real assets include commodities, real estate, durable equipment, and other physical assets Bonds and stocks are classi ed as nancial assets (Study Session 12, Module 36.1, LOS 36.b) Question #13 of 70 Question ID: 1205941 Which of the following statements regarding margin accounts is most accurate? A) Maintenance margin refers to the amount of funds the investor can borrow B) The total equity in the margin account cannot fall below the initial margin requirement C) Margin accounts can be used to purchase securities by borrowing part of the purchase price Explanation Margin accounts are brokerage accounts that allow investors to borrow part of the purchase price from the broker (Study Session 12, Module 36.2, LOS 36.f) Question #14 of 70 A buy limit order is said to be "inside the market" when: A) the limit is between the best bid and the best ask B) it reaches the exchange oor and is entered in the limit book C) the limit is below the best bid Question ID: 1205963 Explanation A limit order with a limit price between the best bid and the best ask is said to be "inside the market" or "making a new market." A limit order that has not yet been executed is a "standing limit order." (Study Session 12, Module 36.3, LOS 36.h) Question #15 of 70 Question ID: 1205942 An investor bought a stock on margin The margin requirement was 60%, the current price of the stock is $80, and the stock price was $50 one year ago If margin interest is 5%, how much equity did the investor have in the investment at year-end? A) 73.8% B) 67.7% C) 60.6% Explanation Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1 Equity % = [Value – (margin debt + interest)] / Value $80 - $21 / $80 = 73.8% (Study Session 12, Module 36.2, LOS 36.f) Question #16 of 70 Question ID: 1205948 An investor buys 200 shares of ABC at the market price of $100 and posts the required initial margin of $8,000 The maintenance margin requirement is 25% At what share price will the investor's account balance be reduced to the maintenance margin level? A) $80 B) $112 C) $48 Explanation The initial margin requirement is $8,000 / (200 × $100) = 0.40 In a long stock position, the equation to determine the margin call price is: long = [(original price)(1 – initial margin %)] / [1 – maintenance margin %] = $100(1 – 0.4) / (1 – 0.25) = $80 Alternatively, the margin loan is (200 × $100) – $8,000 = $12,000 The minimum value of the long position that meets the maintenance margin requirement is $12,000 / (1 – 0.25) = $16,000 The share price at which the long position has this value is $16,000 / 200 = $80 (Study Session 12, Module 36.2, LOS 36.f) Question #17 of 70 Question ID: 1205969 Which of the following statements regarding primary and secondary markets is least accurate? A) Secondary market transactions occur between two investors and not involve the rm that originally issued the security B) New issues of government securities can be sold on the primary market C) Prevailing market prices are determined by primary market transactions and are used in pricing new issues Explanation Prevailing market prices are determined by the transactions that take place on the secondary market This information is used to determine the price of new issues sold on primary markets (Study Session 12, Module 36.3, LOS 36.i) Question #18 of 70 Question ID: 1205936 Mark Ritchie purchased, on margin, 200 shares of TMX Corp stock at a price of $35 per share The margin requirement was 50% The stock price has increased to $42 per share What is Ritchie's return on investment before commissions and interest if he decides to sell his TMX holdings now? A) 20% B) 10% C) 40% Explanation 200 shares × $35 = $7000 Initial Market Value $7000 × 50 = $3500 cash payment and $3500 borrowed The new market value of the stock after price increase is (200 × $42) = $8400 If Ritchie sold his holdings he would have $4900 ($8400 – $3500) left after the loan was paid So Ritchie's return on his original $3500 investment is: $4900/3500 – = 1.4 – 1.0 = 0.40 = 40% (Study Session 12, Module 36.2, LOS 36.f) Question #19 of 70 Question ID: 1205946 An investor buys 400 shares of a stock for $25 a share The initial margin requirement is 50%, and the maintenance margin requirement is 25% At what price would an investor receive a margin call? A) $30.00 B) $16.67 C) $21.88 Explanation Margin call trigger price = [25(1 - 0.5)] / (1 - 0.25) = 16.67 (Study Session 12, Module 36.2, LOS 36.f) Question #20 of 70 Question ID: 1205979 A market that directs capital to its most productive use is best described as: A) operationally e cient B) allocationally e cient C) informationally e cient Explanation Markets are said to be allocationally e cient when capital is directed to its most productive uses Operationally e cient markets are those that have low trading costs Informationally e cient markets are those in which security prices re ect all information associated with fundamental value in a timely fashion (Study Session 12, Module 36.3, LOS 36.k) Question #21 of 70 Question ID: 1205938 If an investor buys 100 shares of a $50 stock on margin when the initial margin requirement is 40%, how much money must she borrow from her broker? A) $2,000 B) $3,000 C) $4,000 Explanation An initial margin requirement of 40% would mean that the investor must put up 40% of the funds and brokerage rm may lend the 60% balance Therefore, for this example (100 shares) * ($50) = $5,000 total cost $5,000 * 0.60 = $3,000 (Study Session 12, Module 36.2, LOS 36.f) Question #22 of 70 A short seller: A) often also places a stop loss sell order B) loses if the price of the stock sold short decreases C) does not receive the dividends Question ID: 1205931 Explanation 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 (Study Session 12, Module 36.2, LOS 36.e) Question #23 of 70 Question ID: 1205971 Which of the following is a di erence between primary and secondary capital markets? A) Primary markets are where stocks trade while secondary markets are where bonds trade B) Secondary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while primary capital markets are where securities trade after their initial o ering C) Primary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while secondary capital markets are where securities trade after their initial o ering Explanation Bonds and stocks are traded on both the primary and secondary markets (Study Session 12, Module 36.3, LOS 36.i) Question #24 of 70 Question ID: 1205944 An investor purchases stock on 25% initial margin, posting $10 of the original stock price of $40 as equity The position has a required maintenance margin of 20% The investor later sells the stock for $45 Ignoring transaction costs and margin loan interest, which of the following statements is most accurate? A) Leverage ratio is 3:1 B) Margin call price is $36 C) Return on investment is 50% Explanation Return on invested equity is ($45 – $40) / $10 = 50% The leverage ratio is purchase price / equity = $40 / $10 = Margin call price is $40 × [(1 – 0.25) / (1 – 0.20)] = $37.50 (Study Session 12, Module 36.2, LOS 36.f) Question #25 of 70 Question ID: 1205916 Markets for nancial assets with maturities of one year or less are best characterized as: A) capital markets B) money markets C) primary markets Explanation "Money markets" generally refers to markets for debt securities maturing in one year or less Capital markets refer to markets for equities and for debt securities with maturities greater than one year Primary markets are the markets for newly issued securities (Study Session 12, Module 36.1, LOS 36.b) Question #26 of 70 Question ID: 1205956 A trader pays $100 per share to buy 500 shares of a non-dividend-paying rm The purchase is done on margin, and the leverage ratio at purchase is 3.0X Three months later, the trader sells the shares for $90 per share Ignoring transaction costs and interest paid on the margin loan, the trader's 3-month return was closest to: A) –10% B) –40% C) –30% Explanation With a leverage ratio of and a 10% decrease in share value, the investor's return is × –10% = –30% (Study Session 12, Module 36.2, LOS 36.f) Question #27 of 70 Question ID: 1205958 An order placed to protect a short position is called a: A) stop loss sell B) stop loss buy C) protective call Explanation A short position pro ts from declines in stock price and experiences losses as the price rises A stop loss buy is a limit order that is placed above the market price When the stock price reaches the stop price, the limit order is executed curtailing further loses (Study Session 12, Module 36.3, LOS 36.g) Question #28 of 70 Question ID: 1205976 Free cash ow to equity represents a rm's capacity to pay future dividends A free cash ow to equity model estimates the rm's FCFE for future periods and values the stock as the present value of the rm's future FCFE per share (Study Session 13, Module 41.2, LOS 41.e) Question #107 of 140 Question ID: 1206137 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 is estimated at $2.00 The stock is undervalued by approximately: A) $15.70 B) $0.00 C) $6.40 Explanation The high "supernormal" growth in the rst three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and nite dividend growth models (DDM) to value the stock Step 1: Determine the dividend stream through year 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 (using D4) P3 = D4 / (ke – g) = $3.38 / (0.15 – 0.08) = $48.29 Step 3: Calculate the PV of each cash ow stream at ke = 15%, and sum the cash ows Note: We suggest you clear the nancial 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 ows = 37.44 Thus, the stock is undervalued by 37.44 – 31.00 = approximately 6.40 Note: Future values are entered in a nancial calculator as negatives to ensure that the PV result is positive It does not mean that the cash ows are negative Also, your calculations may di er slightly due to rounding Remember that the question asks you to select the closest answer (Study Session 13, Module 41.1, LOS 41.a) Question #108 of 140 Question ID: 1206206 A rm has a pro t 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 rm's internal growth rate? A) 4.5% B) 7.8% C) 6.7% Explanation 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% (Study Session 13, Module 41.2, LOS 41.g) Question #109 of 140 Question ID: 1206266 An asset-based valuation model is most appropriate for a company that: A) has a high proportion of intangible assets among its total assets B) is likely to be liquidated C) is expected to remain pro table for the foreseeable future Explanation For companies that are likely to be liquidated, the asset-based approach may be the most appropriate value as the assets may be worth more to another entity Asset-based valuation models not work well for companies that have large amounts of intangible assets Because asset-based valuation is not forwardlooking, an asset-based approach may underestimate the value of companies that are expected to be pro table (Study Session 13, Module 41.3, LOS 41.l) Question #110 of 140 Question ID: 1206193 A company has just paid a $2.00 dividend per share and dividends are expected to grow at a rate of 6% inde nitely If the required return is 13%, what is the value of the stock today? A) $34.16 B) $30.29 C) $32.25 Explanation P0 = D1 / (k - g) = 2.12 / (0.13 - 0.06) = $30.29 (Study Session 13, Module 41.2, LOS 41.g) Question #111 of 140 Question ID: 1206269 One advantage of price/sales (P/S) multiples over price to earnings (P/E) and price-to-book value (PBV) multiples is that: A) P/S can be used for distressed rms B) P/S is easier to calculate C) Regression shows a strong relationship between stock prices and sales Explanation Unlike the PBV and P/E multiples, which can become negative and not meaningful, the price/sales multiple is meaningful even for distressed rms (that may have negative earnings or book value) (Study Session 13, Module 41.3, LOS 41.m) Question #112 of 140 Question ID: 1206222 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 di cult to capture the e ects of changes in pricing policies using P/S ratios C) P/S multiples are more volatile than price-to-earnings (P/E) multiples Explanation Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled rms 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 e ects of pricing changes on rm value (Study Session 13, Module 41.3, LOS 41.i) Question #113 of 140 Question ID: 1206236 Assuming all other factors remain unchanged, which of the following would most likely lead to a decrease in the market P/E ratio? A) A rise in the stock risk premium B) A decline in the risk-free rate C) An increase in the dividend payout ratio Explanation P/E = (1 - RR)/(k - g) To lower P/E: RR increases, g decreases and or k increases Both a decline in the RF rate and a decline in the rate of in ation will reduce k An increase in the stock's risk premium will increase k (Study Session 13, Module 41.3, LOS 41.j) Question #114 of 140 Question ID: 1206176 Use the following information on Brown Partners, Inc to compute the current stock price Dividend just paid = $6.10 Expected dividend growth rate = 4% Expected stock price in one year = $60 Risk-free rate = 3% Risk premium on the stock = 12% A) $57.70 B) $59.55 C) $57.48 Explanation The current stock price is equal to (D1 + P1) / (1 + ke) D1 equals $6.10(1.04) = $6.34 The equity discount rate is 3% + 12% = 15% Therefore the current stock price is ($6.34 + $60)/(1.15) = $57.70 (Study Session 13, Module 41.2, LOS 41.g) Question #115 of 140 Question ID: 1206270 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 rms B) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis C) P/S multiples are more reliable because sales data cannot be distorted by management Explanation Accounting data on sales is used to calculate the P/S multiple The P/S multiple is thought to be more reliable because sales gures are not as easy to manipulate as the earnings and book value, both of which are signi cantly a ected by accounting conventions However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can in uence reported sales (Study Session 13, Module 41.3, LOS 41.m) Question #116 of 140 Question ID: 1206160 A company has 6% preferred stock outstanding with a par value of $100 The required return on the preferred is 8% What is the value of the preferred stock? A) $92.59 B) $100.00 C) $75.00 Explanation The annual dividend on the preferred is $100(.06) = $6.00 The value of the preferred is $6.00/0.08 = $75.00 (Study Session 13, Module 41.2, LOS 41.f) Question #117 of 140 Question ID: 1206142 The free cash ow to equity model is best described as a(n): A) single-factor model B) enterprise value model C) present value model Explanation The free cash ow to equity model is one type of present value model or discounted cash ow model It estimates a stock's value as the present value of cash available to common shareholders The enterprise value model is an example of a multiplier model (Study Session 13, Module 41.1, LOS 41.b) Question #118 of 140 Question ID: 1206178 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) $45.00 B) $41.77 C) $40.32 Explanation 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 ows at the discount rate of 24%: (50 + 1.8) / 1.24 = $41.77 (Study Session 13, Module 41.2, LOS 41.g) Question #119 of 140 Question ID: 1206190 Assume that at the end of the next year, Company A will pay a $2.00 dividend per share, an increase from the current dividend of $1.50 per share After that, the dividend is expected to increase at a constant rate of 5% If an investor requires a 12% return on the stock, what is the value of the stock? A) $30.00 B) $28.57 C) $31.78 Explanation P0 = D1 / k – g D1 = $2 g = 0.05 k = 0.12 P0 = / 0.12 – 0.05 = / 0.07 = $28.57 (Study Session 13, Module 41.2, LOS 41.g) Question #120 of 140 Question ID: 1206149 Which of the following shows the dividend payment chronology in its proper sequence? A) Ex-dividend date, holder-of-record date, declaration date, payment date B) Declaration date, ex-dividend date, holder-of-record date, payment date C) Declaration date, holder-of-record date, ex-dividend date, payment date Explanation The dividend payment chronology begins with the declaration of a dividend by the board of directors The ex-dividend date occurs one or two business days before the holder-of-record date (Study Session 13, Module 41.1, LOS 41.d) Question #121 of 140 Question ID: 1206138 If an analyst estimates the intrinsic value for a security that is di erent from its market value, the analyst should most likely take an investment position based on this di erence if: A) the security lacks a liquid market and trades infrequently B) many analysts independently evaluate the security C) the model used is not highly sensitive to its input values Explanation In general, an analyst can be more dent about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a pro t within the investment horizon even if the analyst's estimate of intrinsic value is correct (Study Session 13, Module 41.1, LOS 41.a) Question #122 of 140 Question ID: 1206264 Gwangwa Gold, a South African gold producer, has as its primary asset a mine which is shown on the balance sheet with a value of R100 million An analyst estimates the market value of this mine to be 90% of book value The company's balance sheet shows other assets of R20 million and liabilities of R40 million, and the analyst feels that the book value of these items re ects their market values Using the asset-based valuation approach, what should the analyst estimate the value of the company to be? A) R110 million B) R80 million C) R70 million Explanation Market value of assets = 0.9(R100 million) + R20 million = R110 million Market value of liabilities = R40 million Estimated net value of company = R110 million – R40 million = R70 million (Study Session 13, Module 41.3, LOS 41.l) Question #123 of 140 Question ID: 1206173 An analyst has gathered the following data for Webco, Inc: Retention = 40% ROE = 25% k = 14% Using the in nite period, or constant growth, dividend discount model, calculate the price of Webco's stock assuming that next years earnings will be $4.25 A) $125.00 B) $55.00 C) $63.75 Explanation 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 (Study Session 13, Module 41.2, LOS 41.g) Question #124 of 140 Question ID: 1206243 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) $33.32 B) $45.45 C) $26.67 Explanation Dividend payout = – earnings retention rate = – 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 (Study Session 13, Module 41.3, LOS 41.j) Question #125 of 140 Question ID: 1206253 Use the following data to analyze a stock's price earnings ratio (P/E ratio): The stock's beta is 1.2 The dividend payout ratio is 60% The stock's expected growth rate is 7% The risk free rate is 6% and the expected rate of return on the market is 13% Using the dividend discount model, the expected P/E ratio of the stock is closest to: A) 8.1 B) 5.4 C) 10.0 Explanation k = ER = Rf + Beta(RM – Rf) = 0.06 + (1.2)(0.13 – 0.06) = 0.144 Dividend payout ratio = 0.60 P/E = div payout / (k – g) = 0.6 / (0.144 – 0.07) = 8.1 (Study Session 13, Module 41.3, LOS 41.j) Question #126 of 140 Question ID: 1206225 Which of the following is least likely a reason the price to cash ow (P/CF) model has grown in popularity? A) CFs are more easily estimated than future dividends B) CFs are used extensively in valuation models C) CFs are generally more di cult to manipulate than earnings Explanation CFs are not easier to estimate than dividends (Study Session 13, Module 41.3, LOS 41.i) Question #127 of 140 Question ID: 1206189 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) $74.93 B) $40.00 C) $173.90 Explanation 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 (Study Session 13, Module 41.2, LOS 41.g) Question #128 of 140 Question ID: 1206230 According to the earnings multiplier model, a stock's P/E ratio (P0/E1) is a ected by all of the following EXCEPT the: A) required return on equity B) expected dividend payout ratio C) expected stock price in one year Explanation According to the earnings multiplier model, the P/E ratio is equal to P0/E1 = (D1/E1)/(ke - g) Thus, the P/E ratio is determined by: The expected dividend payout ratio (D1/E1) The required rate of return on the stock (ke) The expected growth rate of dividends (g) (Study Session 13, Module 41.3, LOS 41.j) Question #129 of 140 Question ID: 1206273 An argument against using the price-to-sales (P/S) valuation approach is that: A) sales gures are not as easy to manipulate or distort as earnings per share (EPS) and book value B) P/S ratios not express di erences in cost structures across companies C) P/S ratios are not as volatile as price-to-earnings (P/E) multiples Explanation P/S ratios not express di erences in cost structures across companies Both remaining responses are advantages of the P/S ratios, not disadvantages (Study Session 13, Module 41.3, LOS 41.m) Question #130 of 140 Question ID: 1206249 All else equal, the price-to-earnings (P/E) ratio of a stable rm will increase if the: A) dividend payout is decreased B) ROE is increased C) long-term growth rate is decreased Explanation The increase in growth rate will increase the P/E ratio of a stable rm and growth rate can be calculated by the formula g = ROE × retention ratio All else being equal an increase in ROE will therefore increase the P/E ratio Note that decreasing the dividend payout ratio and decreasing the long term growth rate will both serve to decrease the P/E ratio (Study Session 13, Module 41.3, LOS 41.j) Question #131 of 140 Question ID: 1206168 Use the following information and the dividend discount model to nd the value of GoFlower, Inc.'s, common stock Last year's dividend was $3.10 per share The growth rate in dividends is estimated to be 10% forever The return on the market is expected to be 12% The risk-free rate is 4% GoFlower's beta is 1.1 A) $34.95 B) $26.64 C) $121.79 Explanation The required return for GoFlower is 0.04 + 1.1(0.12 – 0.04) = 0.128 or 12.8% The expect dividend is ($3.10) (1.10) = $3.41 GoFlower's common stock is then valued using the in nite period dividend discount model (DDM) as ($3.41) / (0.128 – 0.10) = $121.79 (Study Session 13, Module 41.2, LOS 41.g) Question #132 of 140 The rationale for using dividend discount models to value equity is that the: A) model works well for the nite period of time over which dividends are paid B) intrinsic value of a stock is the present value of its future dividends C) inputs are easily estimated and the model’s estimates are robust Explanation Question ID: 1206152 The rationale for dividend discount models is that the fundamental or intrinsic value of a stock is the present value of all its future dividends Dividend discount models can be applied to either a nite or in nite stream of dividends There are many ways to calculate the inputs and the estimated stock values may vary signi cantly with small changes in the inputs (Study Session 13, Module 41.2, LOS 41.e) Question #133 of 140 Question ID: 1206267 Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate? A) Dividend forecasts are less reliable than estimates of other inputs B) The model is most in uenced by the estimates of "k" and "g." C) The variables "k" and "g" are easy to forecast Explanation The relationship between "k" and "g" is critical - small changes in the di erence between these two variables results in large value uctuations (Study Session 13, Module 41.3, LOS 41.m) Question #134 of 140 Question ID: 1206241 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 Explanation 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 (Study Session 13, Module 41.3, LOS 41.j) Question #135 of 140 Question ID: 1206254 A stock has a required rate of return of 15%, a constant growth rate of 10%, and a dividend payout ratio of 45% The stock's price-earnings ratio should be: A) 9.0 times B) 4.5 times C) 3.0 times Explanation P/E = D/E1/ (k - g) D/E1 = Dividend Payout Ratio = 0.45 k = 0.15 g = 0.10 P/E = 0.45 / (0.15 - 0.10)  = 0.45 / 0.05 = (Study Session 13, Module 41.3, LOS 41.j) Question #136 of 140 Question ID: 1206195 Bybee is expected to have a temporary supernormal growth period and then level o to a "normal," sustainable growth rate forever The supernormal growth is expected to be 25 percent for years, 20 percent for one year and then level o to a normal growth rate of percent forever The market requires a 14 percent return on the company and the company last paid a $2.00 dividend What would the market be willing to pay for the stock today? A) $52.68 B) $67.50 C) $47.09 Explanation First, nd the future dividends at the supernormal growth rate(s) Next, use the in nite period dividend discount model to nd the expected price after the supernormal growth period ends Third, nd the present value of the cash ow stream D1 = 2.00 (1.25) = 2.50 (1.25) = D2 = 3.125 (1.20) = D3 = 3.75 P2 = 3.75/(0.14 - 0.08) = 62.50 N = 1; I/Y = 14; FV = 2.50; compute PV = 2.19 N = 2; I/Y = 14; FV = 3.125; compute PV = 2.40 N = 2; I/Y = 14; FV = 62.50; compute PV = 48.09 Now sum the PV's: 2.19 + 2.40 + 48.09 = $52.68 (Study Session 13, Module 41.2, LOS 41.g) Question #137 of 140 Question ID: 1206256 The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding Sales are $4,000 and the book value of the rm is $10,000 What is the price/sales ratio of XYZ, Inc.? A) 0.010 B) 4.000 C) 10.000 Explanation The price/sales ratio is (price per share)/(sales per share) = (40)/(4,000/1,000) = 10.0 Alternatively, the price/sales ratio may be thought of as the market value of the company divided by its sales, or (40 × 1,000)/4,000, or 10.0 again (Study Session 13, Module 41.3, LOS 41.j) Question #138 of 140 Question ID: 1206233 An analyst gathered the following information about an industry The industry beta is 0.9 The industry pro t margin is 8%, the total asset turnover ratio is 1.5, and the leverage multiplier is 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) 12.00 B) 22.73 C) 14.20 Explanation Using the CAPM: ki = 7% + 0.9(0.15 – 0.07) = 14.2% Using the DuPont equation: ROE = 8% × 1.5 × = 24% g = retention ratio × ROE = 0.50 × 24% = 12% P/E = 0.5/(0.142 – 0.12) = 22.73 (Study Session 13, Module 41.3, LOS 41.j) Question #139 of 140 Question ID: 1206246 A company currently has a required return on equity of 14% and an ROE of 12% All else equal, if there is an increase in a rm's dividend payout ratio, the stock's value will most likely: A) either increase or decrease B) decrease C) increase Explanation Increase in dividend payout/reduction in earnings retention In this case, an increase in the dividend payout will likely increase the P/E ratio because a decrease in earnings retention will likely increase the P/E ratio The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay out earnings rather than investing in lower-yield projects Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would rise, as investors will value the company higher if it retains a lower percentage of earnings (Study Session 13, Module 41.3, LOS 41.j) Question #140 of 140 Question ID: 1206240 Which of the following is NOT a determinant of the expected price/earnings (P/E) ratio? A) Expected dividend payout ratio (D/E) B) Expected growth rate in dividends (g) C) Average debt to capital ratio (D/C) Explanation The P/E ratio is determined by payout ratio D/E, required return Ke, and expected growth g (Study Session 13, Module 41.3, LOS 41.j) ... margin account C) equity represented in the margin account at any time Explanation Margin is the amount of equity in the account at a given time Initial margin is the amount of equity required... Return on investment is 50% Explanation Return on invested equity is ($45 – $40) / $10 = 50% The leverage ratio is purchase price / equity = $40 / $10 = Margin call price is $40 × [(1 – 0.25)... A) amount of borrowed funds in the transactions B) minimum amount of equity required of the investor C) minimum amount of equity required of the investor Margin Call Action a deposit must be