Equity Investment

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 Question 1

▪ All of the following are characteristics of a good market except

A. Information asymmetry
B. Price Continuity
C. Internal Efficiency

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 Solution 1

▪ A.
Characteristics of a good market include a) information symmetry b) price continuity c) internal efficiency.

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 Question 2

Cluster analysis groups companies:

A. Operating in the same region
B. Having correlated returns
C. In the same industry

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 Solution 2

▪ B
Cluster analysis is done by grouping companies whose past returns correlations are high

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 Question 3

▪ An investor buys 100 shares of a company at 50% margin for $42. The shares fall to $35 in the next
few days. What is his rate of return on the investment? Instead if the stock had risen to $50 what will
be his rate of return
A. -16.67%; 19.05%
B. -33.33%; 38.10%
C. -33.33%;19.05%

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 Solution 3

▪ B.
The cost of the purchase will be $42 * 100 = $4,200 since the investor has a 50% margin, his equity will
be $2,100. When the stock rises to $50. The value of his equity will be $2,900 giving him a return of
38.10%. If the stock falls to $35 his equity falls to $1,400 and he has a negative return of -33.33%.

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 Question 4

▪ The correlation between US Investment grade bonds and Emerging Markets and between S&P 500
and Russell 3000 is most likely

US Investment Grade vs. Emerging Markets

A. Low S&P 500 vs. Russell

B. Low 3000 Low
C. High High Low

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 Solution 4

▪ B.
The correlation between US Investment-grade bonds and the emerging markets is very low while the
correlation between S&P 500 and the Russell 3000 will be very high.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 9

 Question 5

▪ The most likely classification for the following indices will be

Price Index Weighted
Index
A. S&P 500
B. S&P 500 Dow Jones

C. Dow Jones Nikkei – DJ S&P

500

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 Solution 5

▪ C.
The Dow Jones is a price index while the S&P 500 is a value-weighted index

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 Question 6

▪ The price of stock XYZ fell from $100 to $20. Stock XYZ was a constituent of an index but after the
stock fall, its market cap reduced many folded and thus needed to be replaced in the index. Which of
the following must take place for company's XYZ to be replaced by company's ABC's stock?
A. Rebalancing
B. Reconstitution
C. Both Rebalancing and Reconstitution

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 Solution 6

▪ C.
Not only the constituents of the index must change, but their weights as well

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 Question 7

▪ An investor makes the following statement," While testing the weak-form of EMH the returns from a
trading rule must be calculated excluding any transaction charges because they tend to skew the
returns when the returns are negative."
A. Correct. Transaction costs increase the losses when the returns are negative.
B. Incorrect. Transaction costs involved in implementing the trading rule should be included.
C. Incorrect. Transaction costs are public information and they should be included in the calculations.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 14

 Solution 7

▪ B.
Transaction charges should be included while testing the weak-form hypothesis.

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 Question 8

▪ An investor who does not have access to superior analyst should least likely
A. Invest in mid cap stocks
B. Diversify the portfolio
C. Minimize transaction costs

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 Solution 8

▪ A.
An investor without superior analysis skills should diversify and minimize the transaction costs.

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 Question 9

▪ Corporate insiders, professional money managers and stock exchange specialists are most likely to
be tested for which form of the EMH
A. Strong-form Hypothesis
B. Semi-strong form Hypothesis
C. Weak form Hypothesis

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 Solution 9

▪ A.
▪ Corporate insiders, professional money managers, security analysts and stock exchange specialist
represent a group of investors who represent the strong-form of EMH. They have information which
might not be available to the lay investor and the means to act on it.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 19

 Question 10

Karen makes the following statement – "A stock with a relatively low PEG will experience above- average
rates of return as compared to a stock with relatively higher PEG ratio."
She also states that –"The risk-adjusted returns for smaller firms are greater than for larger firms." She is
most likely correct regarding

PEG Small-firm
ratio
Correct
A. Correct Incorrect
B. Incorrect Correct
C. Incorrect

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 Solution 10

▪ A.
Karen is correct regarding both the statements.

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 Question 11

▪ Capital Markets are not always efficient. The least likely reason for a market to be fully efficient is
A. Cost of Information
B. Costs of Trading
C. Cost of Insider Information

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 Solution 11

▪ C.
The limitations for capital markets to be completely efficient are Cost of information Cost of trading and
Limits of arbitrage.

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 Question 12

Karen and Carl are arguing on the limitations of arbitrage opportunities. Karen states that arbitrageurs are
agents. They manage other people's money; hence they may be limited by their mandates and so may
not be able to take advantage of every arbitrage opportunity.
Carl states that arbitrageurs are never limited by the amount of capital that they can invest in a
mispricing. Both of them are most likely
A. Both the statements are correct
B. Only one statement is correct
C. Both the statements are incorrect

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 Solution 12

▪ B.
Arbitrageurs are limited by the amount of money that they can invest in an anomaly. In a rising market
investors want to take advantage of the available opportunity rather than searching for mispricing that
may give small returns.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 25

 Question 13

▪ Ashley Williams argues that in Neo-Classical growth theory the long-term growth rate of GDP
depends upon the savings rate. However Wayne Brady states that according to the neo-classical
theory the long-term level of GDP depends on the country's saving rate. Ashley and William are
respectively
▪ Ashley Wayne

A. Correct Incorrect
B. Incorrect Correct
C. Incorrect Incorrect

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 26

 Solution 13

▪ B.
The Neo-classical growth theory states that the long-term level of the GDP depends on the country's
saving rate but the growth rate of GDP is independent of the country's saving rate.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 27

 Question 14

▪ Zadobe Corp. has sustained modest but rapidly increasing growth rates. It also has shown high profit
margins as it has very few competitors in the industry. Bulsoft Inc. has high growth rates but these
rates are stagnating. It is also facing increased competition from new competitors and price cutting
due to increased capacity. Both the companies respectively are most likely in which stage of the
industry cycle.

Zadobe Corp Bulsoft Inc.

A. Mature Growth Decelerating
B. Rapid accelerating growth Market
growth maturity Mature
C. Pioneering stage stage

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 Solution 14

▪ B.
Zadobe is in a rapidly accelerating growth stage while Bulsoft is in a mature industry.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 29

 Question 15

▪ According to Porter if a company is maintaining industry leadership through cost cutting and low-cost
production. The company is most likely following which of the following competitive strategies
A. Cost leadership
B. Differentiation
C. Focus

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 Solution 15

▪ A.
A company following a cost-leader ship strategy is trying to capture the market share through cost-
cutting.

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 Question 16

▪ The following two statements most likely represent which of Porter's five forces that shape an
industry:
▪ Statement 1: Defense contractors require very specific components in their hardware. There are
very few companies who can provide the components with the required specifications.
▪ Statement 2: The brokerage industry is very competitive. New players are always entering the
industry and there are very low exit costs.

Statement 1 Statement 2
A. Supplier Competitors
Power Substitutes
B. Buyer's Power New Entrants
C. Supplier
Power

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 Solution 16

▪ C.
The defense industry is an example of supplier's power due to its stringent specifications. Statement 2
gives an example of the threat of new entrants to the profitability of incumbents in the industry.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 33

 Question 17

▪ An analyst states that, "A cyclical stock is a high beta stock while a cyclical company is greatly
influenced by the economy. These are generally commodity stocks." The analyst is most likely
A. Correct regarding both the statements
B. Correct regarding only one statement
C. Incorrect regarding both the statements

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 34

 Solution 17

▪ A.
Both the statements are correct.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 35

 Question 18

In the country of Silverland drug chains have grown at a very high rate for the last five years. However
during the last few quarters aggressive price cuts have reduced profit margins.
However the industry is expected to consolidate and prices are expected to stabilize. The industry is most
likely
A. Pioneering
B. Mature
C. Declining

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 36

 Solution 18

▪ B.
In a mature industry profits are squeezed and the industry is consolidating with stable prices.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 37

 Question 19

▪ The value of the preferred stock of Company A is $92.45. If the dividend is $7.5 per year. The
promised yield is closest to
A. 8.15%
B. 8.11%
C. 8.25%

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 38

 Solution 19

▪ B.
Promised Yield = Dividend / Price
= $7.5 / $92.45
= 8.11%.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 39

 Question 20

▪ Equity valuation can be approached through two techniques – Discounted Cash Flow and Relative
Valuation. The closest classification of the various techniques

DCF Relative Valuation

A. P/CF P/E
B. P/S PV of Operating
C. PV of FCFF CF P/BV

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 Solution 20

▪ C.
Free Cash Flow to the Firm is a DCF approach to valuation while Price to Book Value is a Relative
Valuation technique.

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 Question 21

▪ Company A reinvests all of its retained earnings in the business. The company management
believes that this is the most appropriate source of funding as it keeps leverage low which can be
very beneficial in a cyclical industry. The least likely method of analyzing the company
A. Dividend Discount Model
B. Price to Earnings model
C. PV of Free CF to Equity

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 42

 Solution 21

▪ A.
DDM models are used for companies which make regular dividend payments with a fixed dividend payout
ratio.

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 Question 22

▪ Ashley an analyst with a broking firm makes the following statement," The relative valuation
technique is useful while comparing companies that are similar in terms of industry, size and risk.
However a DDM model can also be used for companies that do not pay dividends during a high
growth period, but otherwise pay regular dividends." She is most likely
A. Correct regarding the DDM model but incorrect regarding the relative valuation technique.
B. Correct regarding both the DDM model and the relative valuation technique.
C. Correct regarding the relative valuation technique but incorrect regarding the DDM model.

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 Solution 22

▪ C.
DDM models can only be used for companies with regular payout ratios.

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 Question 23

▪ Company A pays 50% of its earnings to its shareholders. Their ROE is 20% while the required rate of
return is 14%. Next year's earnings are $4. The value of their stock is closest to
A. 200
B. 50
C. 100

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 Solution 23

▪ B.
Constant growth rate(g) = ROE*Payout ratio = 0.20*0.5 = 0.10
Next Year's dividend (D1)= 4*.5 =2 Required rate (k)=14%
P = D1/(k-g)
= 2/(0.14-0.10)
= 50

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 47

 Question 24

An analyst has gathered some information about stock, which is provided below: Expected market
returns: 15%
Risk free rate: 8% Beta of the stock: 1.13
Current market price: Rs 75
9 month price target: Rs 87

Which of the following is most likely to be true about stock valuation?

A. Stock is undervalued
B. Stock is overvalued
C. Stock is fairly valued

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 Solution 24

▪ A.
Stock is undervalued
Ke=8%+1.13*(15%-8%)
= 15.9% for 1 year
Interest rate for 9 months = 15.9 *0.75 = 11.93% V0=87/1.1193
= 77.73

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 49

 Question 25

Which of the following statements is least accurate?

▪ Returns of defensive stocks have high correlation with returns of the market.
▪ Cyclical companies often have high business or financial risk.
▪ Value stocks are often characterized by low P/E ratios.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 50

 Solution 25

▪ A.
Defensive stocks don’t decline much when the overall market declines.

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 Question 26

▪ Analysis that seek to earn positive risk adjusted returns by using historic price and volume data is
most likely referred to as:
A. Technical Analysis
B. Fundamental Analysis
C. Combination of technical and fundamental analysis.

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 Solution 26

▪ A.
Technical analysis seeks to earn positive risk adjusted returns by using historic price and volume data.
Fundamental analysis is based on public information such as earnings and dividends.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 53

 Question 27

▪ Adtech Inc. paid a recent dividend of USD 0.5. It pays semi-annual dividends and these dividends
are expected to increase at 4% semi-annually. The required return on the stock is 12%. Which of the
following is most likely the present value of the stock assuming it will sell at USD 15 two years from
now:
A. USD 13.78
B. USD 11.88
C. USD 14.08

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 Solution 27

▪ A.
D1 = 0.5 × 1.04 = USD 0.52
D2 = 0.52 × 1.04 = USD 0.54
D3 = 0.54 × 1.04 = USD 0.56
D4 = 0.56 × 1.04 = USD 0.58
PV of dividends = 0.52/1.06 + 0.54/(1.06)2 + 0.56/(1.06)3 + 0.58/(1.06)4 = USD 1.90
PV of future price at the end of two years is 15/(1.06)4 = USD 11.88
Hence the present value of the stock as of today is 11.88 +1.90 = USD 13.78.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 55

 Question 28

▪ Under which of the following cases will the value of the preferred stock be greater than the normal
stock if the required return on preferred stock is equal to the required return of normal stock:
A. When the growth rate of dividends is equal to 5%
B. When the growth rate of dividends is equal to -5%
C. When the growth rate of dividends is equal to 0

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 Solution 28

▪ B.
As per the Dividend Discount Model, value of preferred stock = D1/kp and the value of normal stock =
D1/(ke-g). Hence when the growth rate of dividends is greater than or equal to 0 the value of normal
stock will be greater than or equal to the value of the preferred stock respectively keeping the required
return on preferred stock is equal to the required return of normal stock. Only when the growth rate of
dividends is less than 0 will the value of the normal stock be less than the value of the preferred stock.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 57

 Question 29

▪ Westend Inc. paid a dividend of USD 1.5 in 2011, if the dividends are expected to increase at 5%
annually forever and the value of the stock using constant growth dividend discount valuation
technique is USD 25, what is the required rate of return of the equity:
A. 6.3%
B. 10.3%
C. 11.3%

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 58

 Solution 29

▪ C.
▪ ke=(D1/PV0)+gc = (1.575/25) + 0.05 = 0.113 or 11.3%.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 59

 Question 30

▪ Which of the following statements is most likely true regarding the constant growth dividend discount
model?
A. As the difference between ke and gc widens, the value of the stock falls
B. As the difference between ke and gc narrows, the value of the stock falls
C. Only large changes in the difference of ke and gc cause changes in the stock’s value

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 60

 Solution 30

▪ A.
Since the difference between ke and gc are in the denominator of the constant growth dividend discount
model, as the gap widens the value of the stock falls and vice versa. Even small changes the difference
of ke and gc cause large changes in the stock’s value.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 61

 Question 31

▪ Which of the following statements is least accurate?

A. Returns of defensive stocks have high correlation with returns of the market.
B. Cyclical companies often have high business or financial risk.
C. Value stocks are often characterized by low P/E ratios.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 62

 Solution 31

▪ A.
Defensive stocks don’t decline much when the overall market declines

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 Question 32

▪ If the current security prices fully reflect all publicly available information, be it security market and
non market information available to the public, which form of Efficient Market Hypothesis (EMH) is it
most likely to come under:
A. Weak form
B. Semi strong form
C. Strong form

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 Solution 32

▪ B.
If the current security prices fully reflect all publicly available information, be it security market and non
market information available to the public, it is called the semi strong form of Efficient Market Hypothesis
(EMH).

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 65

 Question 33

▪ Calculate the maximum amount an investor should pay for a stock which paid an Rs 90 dividend last
year and dividends are expected to grow at 6% forever. The risk free rate is 7%, expected market
return is 10% and beta of the stock is 1.1?
A. Rs 2219
B. Rs 2222
C. Rs 2250

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 66

 Solution 33

▪ A.
▪ Ke= 7%+1.1*(10%-7%) = 10.3%
▪ D1= 90*1.06 = 95.4
▪ V0 =95.4/(10.3%-6%) =2218.6

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 67

 Question 34

▪ Which of the following is stock’s P/E ratio based on the DDM?

A. (1-RR)/[k-RR(ROE)]
B. (1+RR)/[k-RR(ROE)]
C. (1+RR)/[k+RR(ROE)]
D. (1-RR)/[k+RR(ROE)]

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 68

 Solution 34

▪ A.
(1-RR)/[k-RR(ROE)]
The earnings multiplier model calculate P/E as follows: payout /( k – g) Substituting term, payout =1 –
RR, & g=ROE(RR)

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 69

 Question 35

▪ Which of the following is most likely the best substitute for calculating the enterprise value of a firm if
the market value of its debt is not available:
A. Market value of similar bonds
B. Book value of the bonds
C. Either market value of similar bonds or book value of the bonds

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 70

 Solution 35

▪ A.
Market value of similar bonds is the best substitute for calculating the enterprise value of a firm if the
market value of its debt is not available. Since book value may not be a good estimate if the firm and
market conditions have changed significantly since the time the bonds were issued.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 71

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