CFA Equity Investments 1 — Questions and Answers
Question 1: The Gordon Growth Model (Dividend Discount Model) assumes which of the following conditions?
- Dividends grow at a variable rate over time
- Dividends grow at a constant rate indefinitely (Correct answer)
- The stock pays no dividends
- The required return equals the dividend growth rate
Correct answer: Dividends grow at a constant rate indefinitely
The Gordon Growth Model requires dividends to grow at a constant rate g in perpetuity, with the required return r greater than g.
Question 2: Which equity valuation multiple is most appropriate when comparing companies with different capital structures?
- Price-to-Earnings (P/E)
- Price-to-Book (P/B)
- EV/EBITDA (Correct answer)
- Dividend Yield
Correct answer: EV/EBITDA
EV/EBITDA is capital structure-neutral because enterprise value and EBITDA are both pre-debt measures, making it the best cross-company multiple when leverage differs.
Question 3: A company has an ROE of 15% and a dividend payout ratio of 40%. Its sustainable growth rate is:
- 6%
- 9% (Correct answer)
- 15%
- 40%
Correct answer: 9%
Sustainable growth rate = ROE × retention ratio = 15% × (1 – 0.40) = 15% × 0.60 = 9%.
Question 4: A stock trading at a P/E of 25 with an earnings growth rate of 20% has a PEG ratio of:
- 0.80
- 1.25 (Correct answer)
- 2.00
- 5.00
Correct answer: 1.25
PEG ratio = P/E ÷ earnings growth rate = 25 ÷ 20 = 1.25; a PEG below 1 is often considered undervalued relative to growth.
Question 5: In the context of the CFA curriculum, free cash flow to equity (FCFE) is best described as:
- Operating cash flow minus capital expenditures
- Cash flow available to equity holders after meeting all financial obligations and capex needs (Correct answer)
- Net income plus depreciation minus changes in working capital
- EBITDA minus interest expense and taxes
Correct answer: Cash flow available to equity holders after meeting all financial obligations and capex needs
FCFE = CFO – Capex + net borrowing, representing cash available to equity holders after all obligations including debt service.
Question 6: Which of the following best describes a market that is weak-form efficient?
- Past prices cannot be used to predict future prices (Correct answer)
- Public information is already reflected in stock prices
- All information including insider data is reflected in prices
- Technical analysis can consistently generate excess returns
Correct answer: Past prices cannot be used to predict future prices
Weak-form efficiency means all historical price and volume information is already reflected in current prices, so technical analysis cannot generate consistent excess returns.
CFA Equity Investments 1
The Gordon Growth Model (Dividend Discount Model) assumes which of the following conditions?