[ 2009 Mock Exam (AM) ] Equity Investments .Questions 79-90 face, commission, registered, following

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79. In securities exchange markets, a member who executes stop loss or stop buy orders when the specified price occurs is most likely a:

A. specialist.
B. registered trader.
C. commission broker.

80. An analyst gathers the following data for a company to estimate the expected growth rate of dividends and use it as an input for valuing the company’s common stock.

Return on Assets	10%
rofit Margin	5 %
Financial Leverage	1.67
ayout Ratio	25%

The company’s expected growth rate is closest to:

A. 4.2%.
B. 6.3%.
C. 12.5%.

81. Which of the following statements about the short sale of a stock is least accurate?

A. The short seller must pay any dividends due to the lender of shares.
B. A stop buy order would enable a short seller to minimize potential losses.
C. Short sales involve time limits for returning the shares borrowed to the lender.

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79. In securities exchange markets, a member who executes stop loss or stop buy orders when the specified price occurs is most likely a:

A. specialist.
B. registered trader.
C. commission broker.

Answer: A
“Organization and Functioning of Securities Markets,” Frank K. Reilly CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 24-26, 29
Study Session 13-52-e Compare and contrast major characteristics of exchange markets including exchange membership, types of orders, and market markers. The specialists (market makers) have two major functions. They act as brokers to match buy and sell orders, including special (stop loss or stop buy) orders.

80. An analyst gathers the following data for a company to estimate the expected growth rate of dividends and use it as an input for valuing the company’s common stock.

Return on Assets	10%
rofit Margin	5 %
Financial Leverage	1.67
ayout Ratio	25%

The company’s expected growth rate is closest to:

A. 4.2%.
B. 6.3%.
C. 12.5%.

Answer: C
“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 14-56-f, g
Estimate the dividend growth rate, given the components of the required return on equity and incorporating the earnings retention rate and current stock price.
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.
g = RR x ROE; RR = (1 – Payout Ratio) = 1 – 0.25 = 0.75
ROE = ROA x Financial Leverage; ROE = 10% x 1.67 = 16.67%; g = 0.75 x 16.67 = 12.5%

81. Which of the following statements about the short sale of a stock is least accurate?

A. The short seller must pay any dividends due to the lender of shares.
B. A stop buy order would enable a short seller to minimize potential losses.
C. Short sales involve time limits for returning the shares borrowed to the lender.

Answer: C
“Organization and Functioning of Securities Markets,” Frank K. Reilly CFA, and Keith C. Brown, CFA
2009 Modular Level I, Volume 5, pp. 25-26
Study Session13-52-f
Describe the process of selling a stock short and discuss an investor’s likely motivation for selling short.
A short sale has no time limit, the other two statements are correct.

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82. An analyst gathers the following data to determine the attractiveness of the company’s common stock:

Dividends per share in 2002	$2
Dividends per share in 2008	$3
Expected return on the market	17%
Expected nominal risk-free return	9%
Stock’s beta	1.8
Stock’s market price as of 1 January 2009	$19

Using the constant growth dividend discount model, the stock’s intrinsic value is closest to:

A. $12.82.
B. $18.29.
C. $19.57.

83. Value Line Index, an unweighted index, uses which of the following methods in the computation of the holding period returns of underlying stocks?

A. Geometric mean.
B. Arithmetic mean.
C. Value-weighted mean.

84. The behavior of investors who put more money into a failure that they feel responsible for, rather than into a success, is most accurately described as:

A. escalation bias.
B. confirmation bias.
C. overconfidence bias.

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82. An analyst gathers the following data to determine the attractiveness of the company’s common stock:

Dividends per share in 2002	$2
Dividends per share in 2008	$3
Expected return on the market	17%
Expected nominal risk-free return	9%
Stock’s beta	1.8
Stock’s market price as of 1 January 2009	$19

Using the constant growth dividend discount model, the stock’s intrinsic value is closest to:

A. $12.82.
B. $18.29.
C. $19.57.

Answer: C
“The Time Value of Money” Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA 2009 Modular Level I, Volume 1, p. 199
“An Introduction to Asset Pricing Models,” Frank K. Reilly, CFA and Keith C.
Brown, CFA 2009 Modular Level I, Volume 4, pp. 260-261; “An Introduction to Security Valuation,” Frank K. Reilly CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 130-131
Study Session 1-5-e; 12-51-e; 14-56-c Draw a time line, and solve time value of money applications (for example, mortgages and savings for college tuition or retirement).
Calculate, using the SML, the expected return on a security, and evaluate whether the security is overvalued, undervalued, or properly valued. Calculate and interpret the value both of a preferred stock and a common stock using the dividend discount model (DDM). g = growth rate of dividends: [(3/2)1/6] - 1= 7%; Alternatively, PV = 2, FV = -3 n= 6, compute I/Y; k = 9 + 1.8 (17 – 9) = 23.4% V = 3(1.07) / (0.234-0.07) = 19.57

83. Value Line Index, an unweighted index, uses which of the following methods in the computation of the holding period returns of underlying stocks?

A. Geometric mean.
B. Arithmetic mean.
C. Value-weighted mean.

Answer: A
“Security-Market Indexes,” Frank K. Reilly CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 44-46
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.
The Value Line Index, an un-weighted index, uses the geometric mean return approach.

84. The behavior of investors who put more money into a failure that they feel responsible for, rather than into a success, is most accurately described as:

A. escalation bias.
B. confirmation bias.
C. overconfidence bias.

Answer: A
“Efficient Capital Markets,” Frank K. Reilly, CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 83-84
Study Session 13-54-d Define behavioral finance and describe overconfidence bias, confirmation bias, and escalation bias.
Escalation bias refers to the investor behavior of putting more money into a failure that they feel responsible for rather than into a success. This leads to the practice of “averaging down” by viewing the additional purchase as a “bargain” rather than considering the initial purchase as a mistake and selling the stock.

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85. An analyst gathers the following data about a company:

Stock price	$40
Stock’s required return	12%
Consensus estimate of next year’s dividend	$2.00
Company’s return on equity	10%

Using the dividend discount model, the company’s dividend payout ratio is closest to:

A. 5%.
B. 30%.
C. 70%.

86. Which of the following attributes is least likely to be associated with the characteristics of a well functioning securities market?

A. Market depth.
B. Wide bid-ask spreads.
C. Rapid adjustment of prices to new information.

87. The best description of the measure of cash flow to use when estimating the total value of a firm is the operating free cash flow:

A. prior to interest payments on debt.
B. prior to interest payments on debt but after deducting funds needed for capital expenditures.
C. after adjustment for payments to debt holders, but before dividend payments to common stockholders.

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85. An analyst gathers the following data about a company:

Stock price	$40
Stock’s required return	12%
Consensus estimate of next year’s dividend	$2.00
Company’s return on equity	10%

Using the dividend discount model, the company’s dividend payout ratio is closest to:

A. 5%.
B. 30%.
C. 70%.

Answer: B
“An Introduction to Security Valuation: Part II,” Frank K. Reilly, CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 130, 146
Study Session 14-56- c, g
Calculate and interpret the value both of a preferred stock and a common stock using the dividend discount model (DDM). 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.
=/ (k – g); $40 = $2 / (0.12 - g); g = 7%; g = ROE x RR;
RR = 7 / 10 = 0.70; Payout Ratio = 1 – RR = 1 – 0.70 = 0.30 = 30%.

86. Which of the following attributes is least likely to be associated with the characteristics of a well functioning securities market?

A. Market depth.
B. Wide bid-ask spreads.
C. Rapid adjustment of prices to new information.

Answer: B
“Organization and Functioning of Securities Markets,” Frank K. Reilly, CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 6-7
Study Session 13-52-a Describe the characteristics of a well-functioning securities market.
Wide bid-ask spreads is not a characteristic of a well functioning market.

87. The best description of the measure of cash flow to use when estimating the total value of a firm is the operating free cash flow:

A. prior to interest payments on debt.
B. prior to interest payments on debt but after deducting funds needed for capital expenditures.
C. after adjustment for payments to debt holders, but before dividend payments to common 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, pp. 134-135
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.
The appropriate cash flow for estimating the total value of a firm is the operating free cash flow prior to interest payments on debt but after deducting funds needed for capital expenditures.

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88. Which of the following is the least likely source of unreliability of a pricing anomaly?

A. Data mining.
B. Arbitrage activity.
C. Nonsynchronous trading.

89. The best characterization of the strong-form of efficient market hypothesis (EMH) with respect to the information set is that it encompasses:

A. both weak-form and semistrong-form hypotheses.
B. neither weak-form nor semistrong-form hypothesis.
C. the semistrong-form but not the weak-form hypothesis.

90. Among a company’s price to earnings (P/E), price to sales (P/S), and price to cash flow (P/CF) ratios, it is most accurate to state that P/E ratios are generally more stable from period to period than:

A. P/S ratios but not P/CF ratios.
B. P/CF ratios but not P/S ratios.
C. neither P/S ratios nor P/CF ratios.

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88. Which of the following is the least likely source of unreliability of a pricing anomaly?

A. Data mining.
B. Arbitrage activity.
C. Nonsynchronous trading.

Answer: B
“Market Efficiency and Anomalies,” Vijay Singal, CFA 2009 Modular Level I, Volume 5, pp. 100-104
Study Session 13-55-c Explain why an apparent anomaly may be justified and describe the common biases that distort testing for mispricings.
Arbitrage activity is not a source of unreliability of an anomaly. Arbitrageurs attempt to take advantage of an anomaly and are not a source of its unreliability.

89. The best characterization of the strong-form of efficient market hypothesis (EMH) with respect to the information set is that it encompasses:

A. both weak-form and semistrong-form hypotheses.
B. neither weak-form nor semistrong-form hypothesis.
C. the semistrong-form but not the weak-form hypothesis.

Answer: A
“Efficient Capital Markets,” Frank K. Reilly CFA, and Keith C. Brown, CFA 2009 Modular Level I, Volume 5, pp. 63-6
Study Session 13-54-a Define an efficient capital market and describe and contrast the three forms of the efficient market hypothesis (EMH).
The difference among the three forms of the EMH revolves around the information set included in each. The weak form includes public market information, the semistrong form includes all public information, and the strong form includes all public and private information. The strong form EMH encompasses both the weak-from and the semistrong form EMH.

90. Among a company’s price to earnings (P/E), price to sales (P/S), and price to cash flow (P/CF) ratios, it is most accurate to state that P/E ratios are generally more stable from period to period than:

A. P/S ratios but not P/CF ratios.
B. P/CF ratios but not P/S ratios.
C. neither P/S ratios nor P/CF ratios.

Answer: C
“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. 182-188, 196-201
Study Session 14-59-a, b
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.
Calculate and interpret P/E, P/BV, P/S, and P/CF.
Both sales and cash flow tend to be more stable than earnings, making the multiples based on sales and cash flow more stable than those based on EPS.

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