One component company in a price-weighted stock index executes a 2-for-1 stock split, with no change in the company's total market capitalization. All else equal, immediately after the split:

The index level is unaffected, because the index divisor is recalculated to offset the drop in that stock's price

CFA Level I Equity Investments Practice Questions

Question 1
A stock has a required return of 10%, an expected long-term dividend growth rate of 6%, and an expected dividend payout ratio of 40%. Using the Gordon growth model, what is the stock's justified leading (forward) P/E ratio?
- A. 10.0x
- B. 6.67x
- C. 4.0x
- D. 16.0x
Show answer and explanation
Correct answer: A. 10.0x
The justified leading P/E from the Gordon growth model is: Payout ratio / (r − g) = 0.40 / (0.10 − 0.06) = 0.40 / 0.04 = 10.0x. This shows how a valuation multiple can be derived directly from fundamentals: payout policy, required return, and growth.
- A. Justified leading P/E = payout ratio / (r-g) = 0.40 / (0.10-0.06) = 0.40/0.04 = 10.0x.
- B. 6.67x results from dividing the payout ratio by g alone (0.40/0.06) rather than by the correct (r-g) spread of 4%.
- C. 4.0x mistakes the (r-g) spread itself, 4%, for the P/E multiple, rather than dividing the payout ratio by that spread.
- D. 16.0x overstates the multiple beyond what the correct payout-ratio-over-spread calculation supports given the modest 4-point gap between required return and growth.
Question 2
An operating company has $500 million market capitalization, $120 million interest-bearing debt, $30 million preferred equity, $10 million noncontrolling interest, and $40 million excess cash. Its annual EBITDA is $100 million. What EV/EBITDA multiple is implied?
- A. 6.2x.
- B. 5.8x.
- C. 4.6x.
- D. 7.0x.
Show answer and explanation
Correct answer: A. 6.2x.
Enterprise value = market cap + debt + preferred + noncontrolling interest - excess cash = 500 + 120 + 30 + 10 - 40 = $620 million. EV/EBITDA = 620/100 = 6.2x.
- A. EV of $620 million divided by EBITDA of $100 million is 6.2x.
- B. This omits preferred equity and noncontrolling interest from enterprise value.
- C. This omits debt, preferred and noncontrolling interest, effectively using equity less cash.
- D. This adds excess cash instead of subtracting it.
Question 3
A company has a sustainable ROE of 15%, a dividend payout ratio of 40%, and shareholders require a 12% return. Using the fundamental (Gordon growth-based) justified leading P/E formula, the justified P0/E1 multiple is closest to:
- A. 13.33x
- B. 14.53x
- C. 3.33x
- D. 6.67x
Show answer and explanation
Correct answer: A. 13.33x
Retention ratio b = 1 − 0.40 = 0.60, so g = b × ROE = 0.60 × 0.15 = 9%. Justified leading P/E = payout ratio / (r − g) = 0.40 / (0.12 − 0.09) = 13.33x. B (14.53x) results from applying the trailing P/E formula, which grows the payout by (1+g), instead of the leading formula the question asks for. C (3.33x) comes from forgetting to net out growth (0.40/0.12). D (6.67x) comes from mistakenly discounting at ROE instead of the required return r (0.40/(0.15−0.09)).
- A. g = ROE x (1-payout) = 15% x 0.60 = 9%; justified leading P0/E1 = payout/(r-g) = 0.40/(0.12-0.09) = 0.40/0.03 = 13.33x.
- B. 14.53x equals payout x (1+g)/(r-g) = 0.40 x 1.09/0.03, which is the justified trailing (P0/E0) multiple, not the leading (P0/E1) multiple the question asks for.
- C. 3.33x equals payout/r (0.40/0.12), mistakenly dividing by the full required return alone and ignoring the growth-rate adjustment in the denominator.
- D. 6.67x results from miscalculating growth as ROE x payout (15% x 0.40 = 6%) instead of ROE x (1-payout), understating growth and overstating the (r-g) spread.
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Question 4
One component company in a price-weighted stock index executes a 2-for-1 stock split, with no change in the company's total market capitalization. All else equal, immediately after the split:
- A. The index level rises immediately, because the number of the company's shares outstanding doubles
- B. The index provider must remove the stock and replace it with a different company
- C. The stock's weight in the index increases, requiring the divisor to be adjusted upward
- D. The index level is unaffected, because the index divisor is recalculated to offset the drop in that stock's price
Show answer and explanation
Correct answer: D. The index level is unaffected, because the index divisor is recalculated to offset the drop in that stock's price
In a price-weighted index, a component's stock split lowers that stock's price per share (here, roughly by half), which would otherwise distort the index level even though nothing economically changed. To neutralize this, index providers recalculate the divisor immediately so the index level is unaffected by the mechanical price change from the split.
- A. Incorrect — shares outstanding doubling does not, by itself, change the price-weighted index level; the divisor absorbs the price change.
- B. Incorrect — stock splits are routine and do not trigger removal from an index; the divisor mechanism handles them.
- C. Incorrect — a split lowers, not raises, the stock's per-share price and thus its weight in a price-weighted index.
- D. Correct — the divisor is recalculated specifically to keep the index level unchanged when a split alone (with no economic change) occurs.

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