[ 2009 Mock Exam (PM) ] Equity Investments .Questions 79-90 face, accounting, investment, companies

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79. Which of the following is the least accurate rationale to justify the use of price-tobook value (P/B) ratio as a measure of relative valuation of companies or common stocks?

A. P/B is a useful measure of value for firms that are not expected to continue as a going concern.
B. Compared to P/E, the P/B ratio is not influenced by such accounting effects as expensing a capital investment as opposed to capitalizing it.
C. P/B is particularly appropriate to value companies primarily composed of liquid assets, for example, those in the financial services industry.

80. An analyst is creating a new stock market index that is not affected by stock splits.
The index the analyst is least likely to develop is:

A. unweighted.
B. price-weighted.
C. value-weighted.

81. An analyst gathers the following information about a company:

Common stock $1.50 par value – Authorized	5,000,000 shares
-- Issued	4,000,000 shares
Additional paid-in-capital	$20,000,000
Retained earnings	$5,000,000
Treasury stock (500,000 shares)	$10,000,000
Current price per share	$21

The price-to-book (P/B) ratio of the company is closest to:

A. 2.31.
B. 3.50.
C. 4.20.

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79. Which of the following is the least accurate rationale to justify the use of price-tobook value (P/B) ratio as a measure of relative valuation of companies or common stocks?

A. P/B is a useful measure of value for firms that are not expected to continue as a going concern.
B. Compared to P/E, the P/B ratio is not influenced by such accounting effects as expensing a capital investment as opposed to capitalizing it.
C. P/B is particularly appropriate to value companies primarily composed of liquid assets, for example, those in the financial services industry.

Answer: B
“Introduction to Price Multiples,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA, and Dennis W. McLeavey, CFA
2009 Modular Level I, Volume 5, pp. 188-190
Study Session 14-59-a
Discuss the rationales for, and the possible drawbacks to, the use of price to earnings
(P/E), price to book value (P/BV), price to sales (P/S), and price to cash flow (P/CF) in equity valuation.
It is incorrect to say that P/B correctly reflects a company’s value. The historical cost basis of assets in P/B ratio is a drawback, not a rationale for using it as a measure of relative valuation.

80. An analyst is creating a new stock market index that is not affected by stock splits.
The index the analyst is least likely to develop is:

A. unweighted.
B. price-weighted.
C. value-weighted.

Answer: B
“Security-Market Indexes,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp. 42-46
Study Session 13-53-a
Compare and contrast the characteristics of, and discuss the source and direction of bias exhibited by, each of the three predominant weighting schemes used in constructing stock market indexes, and compute a price-weighted, value-weighted and un-weighted index series for three stocks.
A price-weighted index, such as the Dow Jones Industrial Average, requires adjustment for stock splits. It is computed by summing the prices of individual stocks and dividing by a divisor that is adjusted for stock splits such that the index value is the same before and after the split.

81. An analyst gathers the following information about a company:

Common stock $1.50 par value – Authorized	5,000,000 shares
-- Issued	4,000,000 shares
Additional paid-in-capital	$20,000,000
Retained earnings	$5,000,000
Treasury stock (500,000 shares)	$10,000,000
Current price per share	$21

The price-to-book (P/B) ratio of the company is closest to:

A. 2.31.
B. 3.50.
C. 4.20.

Answer: B
“Introduction to Price Multiples,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA, and Dennis W. McLeavey, CFA
2009 Modular Level I, Volume 5, pp. 191-193
Study Session 14-59-b
Calculate and interpret P/E, P/BV, P/S, and P/CF.
Number of issued and outstanding shares = 4 m – 0.5 m = 3.5 m; (Issued – Treasury
Stock)
BV per share = 4m shares (1.50) + $20 m + $5 m - $10 m = $21 m / 3.5 m sh. = $6.00
Price-to-book value = $21 / $6.00 = 3.50

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82. A call market is least likely characterized as a market:

A. with bid-ask prices posted by dealers.
B. where buy-sell orders are cleared at a single equilibrium price.
C. with participation by a small number of active investors-traders.

83. The annual report of a company as at the end of its first year of its operation contains the following data:

Common stock $0.50 par value – Authorized (2,500,000 shares)	$ 1,250,000
– Issued (2,000,000 shares)	$ 1,000,000
Additional paid-in-capital	$10,000,000
Retained earnings	$ 4,000,000
Current price per share	$30

The company’s ending inventories using LIFO are valued at $1,500,000 and a footnote to financial statements reports inventories valued using FIFO would be $1,900,000. The company’s tax rate is 30 percent. The FIFO adjusted price-to-book value of the company is closest to:

A. 3.93.
B. 4.00.
C. 4.08.

84. An analyst gathers the following data about a company with a double-digit growth rate that is expected to continue for three more years:

Current year’s dividend per share

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82. A call market is least likely characterized as a market:

A. with bid-ask prices posted by dealers.
B. where buy-sell orders are cleared at a single equilibrium price.
C. with participation by a small number of active investors-traders.

Answer: A
“Organizing and Functioning of Securities Markets,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp. 14-15
Study Session 13-52-c
Distinguish between call and continuous markets.
In a call market traders/investors indicate their bids and asks for stocks and they are not posted by dealers. Also, a call market is not a dealer or quote-driven market.

83. The annual report of a company as at the end of its first year of its operation contains the following data:

Common stock $0.50 par value – Authorized (2,500,000 shares)	$ 1,250,000
– Issued (2,000,000 shares)	$ 1,000,000
Additional paid-in-capital	$10,000,000
Retained earnings	$ 4,000,000
Current price per share	$30

The company’s ending inventories using LIFO are valued at $1,500,000 and a footnote to financial statements reports inventories valued using FIFO would be $1,900,000. The company’s tax rate is 30 percent. The FIFO adjusted price-to-book value of the company is closest to:

A. 3.93.
B. 4.00.
C. 4.08.

Answer: A
“Introduction to Price Multiples,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA, and Dennis W. McLeavey, CFA
2009 Modular Level I, Volume 5, pp. 194-196
Study Session 14-59-b
Calculate and interpret P/E, P/BV, P/S, and P/CF.
Inventory Adjustment = $400,000 x 0.70 = $280,000: (FIFO – LIFO values) x (1-Tax rate)
BV per share = $1 m + $10 m + $4 m + $0.28 m = $15.28 / 2 m sh. = $7.64.
Price-to-book value = $30 / $7.64 = 3.93

84. An analyst gathers the following data about a company with a double-digit growth rate that is expected to continue for three more years:

Current year’s dividend per share

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85. An equity fund manager gathers the following data in order to assess the investment potential of a company and its stock:

	Company	Industry Average
Weighted average cost of capital (WACC)	14%	12%
Return on Assets (ROA)	20%	15%
Dividend Yield	0 %	1.2%
Consensus estimate of stock’s value	$53	N/A
Current price of company’s stock	$50	N/A

Based on the above information, which of the following statements most accurately describes the company and its stock? The company is a:

A. growth company and its stock is a growth stock.
B. growth company and its stock is a speculative stock.
C. speculative company and its stock is a growth stock.

86. Free cash flow to equity is most accurately described as operating free cash flow adjusted for:

A. only interest payments to debt holders.
B. payments to both debt holders (interest and principal) and preferred stockholders.
C. both interest and principal payments to debt holders, but not payments to preferred stockholders.

87. Assuming efficient markets and a lack of access to superior analysts, which of the following is the least important activity in managing portfolios?

A. Minimizing total transaction costs.
B. Diversifying completely on a global basis.
C. Paying close attention to the monetary policy environment.

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85. An equity fund manager gathers the following data in order to assess the investment potential of a company and its stock:

	Company	Industry Average
Weighted average cost of capital (WACC)	14%	12%
Return on Assets (ROA)	20%	15%
Dividend Yield	0 %	1.2%
Consensus estimate of stock’s value	$53	N/A
Current price of company’s stock	$50	N/A

Based on the above information, which of the following statements most accurately describes the company and its stock? The company is a:

A. growth company and its stock is a growth stock.
B. growth company and its stock is a speculative stock.
C. speculative company and its stock is a growth stock.

Answer: A
“Company Analysis and Valuation,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp.160-162
Study Session 14-58-a
Differentiate between 1) a growth company and a growth stock, 2) a defensive company and a defensive stock, 3) a cyclical company and a cyclical stock, 4) a speculative company and a speculative stock, and 5) a value stock and a growth stock.
The company is a growth company since the spread between ROA and WACC is larger than the industry average and its dividend yield is 0% compared to the industry average of 1.2%. The company’s stock is a growth stock considering its undervaluation.
A speculative stock, on the other hand, would be overvalued.

86. Free cash flow to equity is most accurately described as operating free cash flow adjusted for:

A. only interest payments to debt holders.
B. payments to both debt holders (interest and principal) and preferred stockholders.
C. both interest and principal payments to debt holders, but not payments to preferred stockholders.

Answer: B
“Understanding the Cash Flow Statement,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn, CFA
2009 Modular Level I, Volume 3, pp. 279-280
“An Introduction to Security Valuation,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, p. 135
Study Session 8-34-i, 14-56-g
Explain and calculate free cash flow to the firm, free cash flow to equity, and other cash flow ratios.
Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends.
Free cash flow to equity is derived after adjusting the operating free cash flow for payments to debt holders (interest and principal) as well as preferred stockholders.

87. Assuming efficient markets and a lack of access to superior analysts, which of the following is the least important activity in managing portfolios?

A. Minimizing total transaction costs.
B. Diversifying completely on a global basis.
C. Paying close attention to the monetary policy environment.

Answer: C
“Efficient Capital Markets,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp. 87-89
Study Session 13-54-c
Explain the implications of stock market efficiency for technical analysis, fundamental analysis, the portfolio management process, the role of the portfolio manager, and the rationale for investing in index funds.
In efficient markets and without access to superior analysts, portfolio management calls for minimizing the transaction costs and diversifying completely on a global basis. Paying attention to the monetary policy and evaluating its implications for portfolio management is appropriate for portfolio managers with access to superior analysts.

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88. An analyst gathers the following data about a company in order to estimate its price/earnings (P/E) ratio.

Expected dividend payout ratio	40%
Return on equity	15%
Required rate of return	12%
Stock’s current market price	$75

The P/E ratio is closest to:

A. 6.7 x.
B. 13.3 x.
C. 20.0 x.

89. For growth companies which of the following components of ROE is most likely to decline first?

A. Profit margin.
B. Financial leverage.
C. Total assets turnover.

90. Which of the following is least likely included in the assumptions of an informationally efficient securities market?

A. A large number of profit-maximizing participants analyze and value securities.
B. New information regarding securities comes to the market in a predictable manner.
C. Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.

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88. An analyst gathers the following data about a company in order to estimate its price/earnings (P/E) ratio.

Expected dividend payout ratio	40%
Return on equity	15%
Required rate of return	12%
Stock’s current market price	$75

The P/E ratio is closest to:

A. 6.7 x.
B. 13.3 x.
C. 20.0 x.

Answer: B
“An Introduction to Security Valuation,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, p. 137, 146-147
Study Session 14-56-d, g
Show how to use the DDM to develop an earnings multiplier model, and explain the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio.
Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends.
Growth rate = g = RR x ROE = (1 - 0.40) x 15 = 9%; P/E1 = D1/E1 ÷ (k - g) = 0.40 ÷ (0.12 - 0.09) = 13.33

89. For growth companies which of the following components of ROE is most likely to decline first?

A. Profit margin.
B. Financial leverage.
C. Total assets turnover.

Answer: A
“Financial Analysis Techniques,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn
2009 Modular Level I, Volume 3, pp. 520-525
“An Introduction to Security Valuation,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp. 146-147
Study Session 10-39-e, 14-56-e
Demonstrate the application of and interpret changes in the component parts of the
DuPont analysis (the decomposition of return on equity).
Estimate the dividend growth rate, given the components of the required return on equity and incorporating the earnings retention rate and current stock price.
For growth companies profit margin is one of the first ratios to decline due to increased competition and forced price cuttings.

90. Which of the following is least likely included in the assumptions of an informationally efficient securities market?

A. A large number of profit-maximizing participants analyze and value securities.
B. New information regarding securities comes to the market in a predictable manner.
C. Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.

Answer: B
“Efficient Capital Markets,” Frank K. Reilly, CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, p. 62-63
Study Session 13-54-a
Define an efficient capital market and describe and contrast the three forms of the efficient market hypothesis (EMH).
The assumption that the new information comes to the market in a predictable manner is an inaccurate statement. The correct assumption is that the new information comes to the market in a random fashion.

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