cfa level i revision day ii

CFA Level I Revision Class

• Financial Statement Analysis

• Corporate Finance

• Portfolio Management

• Equity investments

• Fixed income investments

• Alternative investments

2

Questions 1– Financial Statement Analysis

• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Which

of the following is least likely to be classified as a financial statement element?

A. Asset

B. Revenue

C. Net Income

3

Questions 1 – Answer

• Net income is not an element of the financial statements, but the net result of revenues less expenses.

The elements are: assets, liabilities, owners’ equity, revenue and expenses

4

Questions 2 – Financial Statement Analysis

• An analyst prepares common-size balance sheets for two companies operating in the same industry.

The analyst notes that both companies had the same proportion of current liabilities, long-term

liabilities, and shareholders’ equity and the following ratios:

The most reasonable conclusion is that, compared with P&G, HUL had a:

A. higher percentage of assets associated with inventory.

B. higher percentage of assets associated with accounts receivable.

C. lower percentage of assets associated with marketable securities

HUL P&G

Current Ratio 2.0 2.0

Cash Ratio 0.5 0.5

Quick Ratio 0.8 1.2

5


• The current ratio includes inventory but the quick ratio does not. (Current ratio is higher than quick ratio

and quick ratio is higher than cash ratio.) The quick ratio includes accounts receivable but the cash

ratio does not. The denominator for all three ratios is current liabilities, which are the same proportion

for both companies. The difference in ratios is therefore created by inventory and accounts receivable.

HUL has the higher percentage of inventory because the difference between the current ratio and

quick ratio is greater for that company. P&G had the higher percentage of accounts receivable

because the difference between the quick ratio and the cash ratio is greater for P&G.

6


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. At the

end of the year, a company sold equipment for $25,000 cash. The company paid $100,000 for the

equipment several years ago and had recorded accumulated depreciation of $60,000 at the time of its

sale. All else equal, the equipment sale will result in the company’s cash flow from:

A. Investing activities increasing by $25,000

B. Investing activities decreasing by $15,000

C. Operating activities being $10,000 less than net income

7


• The book value of the equipment at the time of sale is $100,000 - $60,000 = $40,000. The proceeds

are $25,000; therefore a loss of $15,000 is reported on the income statement. The loss reduces net

income, but it is a non-cash amount, so is added back to net income in the calculation of the cash from

operations. Therefore, cash from operations is higher than net income, not lower. The total amount of

the proceeds, $25,000, is the cash inflow from the transaction and is shown as a cash inflow from

investing activities.

8


• An analyst gathers the following annual information ($ millions) about a company that pays no

dividends and has no debt:

The company’s annual free cash flow to equity ($ millions) is closest to:

A. 53.1

B. 58.4

C. 65.3

Net income 48.5

Depreciation 18.2

Loss on sale of equipment 1.6

Decrease in accounts receivable 4.2

Increase in inventories 3.4

Increase in accounts payable 2.5

Capital expenditures 7.3

Proceeds from sale of stock 8.5

9


• Free cash flow to equity in a company without any debt is equal to cash flow from operations (CFO)

less capital expenditures. CFO = net income + depreciation + loss on sale of equipment + decrease in

accounts receivable – increase in inventories + increase in accounts payable. (The loss on sale of

equipment is added back when calculating CFO. It would have been deducted in the calculation of net

income but the loss is not the cash impact of the transaction (the proceeds received, if any, would be

the cash effect) and cash flows related to equipment transactions are investing activities, not operating

activities. CFO = 48.5 + 18.2 +1.6 + 4.2 – 3.4 +2.5 = $72.6 million $72.6 – $7.3 = $65.3 million free

cash flow to equity.

10


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. The

following information is available from the accounting records of a company as at 31 December 2008

(all figures in $ thousands):

The working capital for the company (in $ thousands) is closest to:

A. 64

B. 72

C. 176

Account $

Accounts payable 20

Accounts receivable 85

Bank loan, due on demand 44

Cash 12

Income taxes payable 8

Inventory 47

Investments accounted for by the equity method 112

Loan payable, due 30 June 30 2010 50

Deposits from customers for deliveries in 2009 8

11


Current Assets:

• Cash 12

• Accounts receivable 85

• Inventory 47

144

Current Liabilities

• Bank loan, due on demand 44

• Accounts payable 20

• Income taxes payable 8

• Deposits from customers for deliveries in 2009 8

80

• Working capital (CA – CL) 64.0

12


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A

company reports earnings before taxes of $900,000 for the year. The table below indicates selected

items which were included in earnings before taxes and their associated tax status.

The company’s tax rate is 35 percent. The company’s current income taxes payable (in $) is closest to:

A. 206,500

B. 308,000

C. 360,500

Included in determining Net Income Tax Status

Depreciation Expense $80,000 $90,000 allowed for tax purposes

Dividend Income $125,000 Dividends not taxable

Fine related to environmental

damage

$90,000 Not deductible for tax purposes

R&D Expenditures $50,000 $25,000 allowed for tax purposes

13


• Net income $900,000

• Add back book depreciation 80,000

• Deduct tax allowed depreciation (90,000)

• Deduct Dividend income (125,000)

• Add back Fine 90,000

• Add back book R&D 50,000

• Deduct tax allowed R&D (25,000)

• Earnings before taxes 880,000

• Current taxes payable 35% x $880,000=308,000

14


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. On 1

January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor

with the following terms:

The firm is reasonably assured of the collection of the lease payments. Which of the following best

describes the classification of the lease on the company’s financial statements for 2008?

A. Operating lease

B. Sales type lease

C. Direct financing lease

Annual lease payment due 31 December $50,000

Lease term 5 years

Estimated useful life of the machine 6 years

Estimated salvage value of the machine $0

Carrying value (cost) of leased asset $150,000

Implied interest rate on lease 8%

15


• It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%) and the

asset is on its books at less than the present value of the lease payments ($199,635) (PMT = $50,000,

N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than the

present value of the lease payments.

16


• A company uses the LIFO inventory method, but most of the other companies in the same industry use

FIFO. Which of the following best describes one of the adjustments that would be made to the

company’s financial statements to compare it with other companies in the industry? The amount

reported for the company’s ending inventory should be:

A. Increased by the ending balance in its LIFO reserve.

B. Decreased by the ending balance in its LIFO reserve.

C. Increased by the change in its LIFO reserve for that period.

17


• LIFO Reserve = FIFO Inventory – LIFO Inventory Adding the ending balance in the LIFO reserve to the

LIFO inventory would equal the ending balance for inventory on a FIFO basis.

18


• An analyst gathers the following information about a company:

Using the treasury stock method, the number of incremental shares used to compute diluted earnings

per share is closest to:

A. 4,000.

B. 16,000.

C. 20,000.

Average market price per share of common stock during the year $50

Exercise price per share for options on 50,000 common shares $60

Exercise price per share for warrants on 20,000 common shares $40

19


• Diluted EPS is calculated using the treasury stock method that considers what would be the effect if

the options or warrants had been exercised. Only options or warrants that are in-the-money are

included, as out-of-the-money options would not be exercised. Therefore only the warrants are dilutive:

their exercise price is below the average market price of the stock. Using the treasury stock method,

the number of new shares issued on exercise is reduced by the number of shares that could be

purchased with the cash received upon exercise of the warrants: 20,000($40) = $800,000 in proceeds.

$800,000 / $50 = 16,000 shares treasury stock. Incremental shares using the treasury stock method =

20,000 – 16,000 = 4,000.

20


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. At the

beginning of the year, a lessee company enters into a new lease agreement that is correctly classified

as a finance lease, with the following terms:

With respect to the effect of the lease on the company’s financial statements in the first year of the

lease, which of the following is most accurate? The reduction in the company’s:

A. Pretax income is $72,096.

B. Cash flow from financing is $56,742.

C. Cash flow from operations is $72,096.

Annual lease payments due at the end of the year $100,000

Lease term 5 years

Appropriate discount rate 12%

Depreciation method straight-line basis

Estimated salvage value $0

21


• The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original

PV is $43,257.31 and represents the interest component of the payment in the first year. The

difference between the annual payment and the interest is the amortization of the lease obligation

included in cash flow from financing. $100,000 – 43,257.31 = $56,742.69. Depreciation is $360,477.62

/ 5 or $72,095.52 so the total reduction in pretax income would be interest plus depreciation or

$115,352.83. Cash flow from operations would be reduced by the amount of the interest only because

the depreciation would be added back to determine cash flow from operations.

22



company using the LIFO inventory method reports a LIFO reserve at year-end of $85,000, which is

$20,000 lower than the prior year. If the company had used FIFO instead of LIFO in that year, the

company’s financial statements would have reported:

A. A lower cost of goods sold, but a higher inventory balance.

B. A higher cost of goods sold, but a lower inventory balance.

C. Both a higher cost of goods sold and a higher inventory balance.

23


• The negative change in the LIFO reserve would increase the cost of goods sold under FIFO compared

to LIFO. FIFO COGS = LIFO COGS – Change in LIFO reserve. The LIFO reserve has a positive

balance so that FIFO inventory would be higher than LIFO inventory. FIFO inventory = LIFO inventory

+ LIFO reserve.

24


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. An

analyst gathers the following information about a company:

The bonds were issued at par and can be converted into 300,000 common shares. All securities were

outstanding for the entire year. Diluted earnings per share is closest to:

A. $1.05.

B. $1.26.

C. $1.36.

Shares of common stock outstanding 1,000,000

Net income for the year $1,500,000

Par value of convertible bonds with a 4 percent coupon rate $10,000,000

Par value of cumulative preferred stock with a 7 percent dividend rate $2,000,000

Tax rate 30%

25


• Dividends of $140,000 (0.07 x 2,000,000) should be deducted from net income to determine the

amount available to common shareholders: $1,360,000 = (1,500,000 – 140,000). Basic EPS would be

$1,360,000 / 1,000,000 or $1.36 per share. Diluted EPS would consider the convertible bonds if they

were dilutive. Interest on the bonds is $400,000 and the after-tax amount add back to net income is

$400,000 (1-.30) = $280,000. Diluted EPS, assuming conversion, is ($1,360,000 + 280,000) /

(1,000,000 +300,000) = 1,640,000/1,300,000= $1.26 per share. The bonds are dilutive.

26


• When the financial statements materially depart from accounting standards and are not fairly

presented, the audit opinion would be a(n):

A. Adverse opinion.

B. Qualified opinion.

C. Disclaimer of opinion.

27


• An adverse opinion occurs when the financial statements materially depart from accounting standards

and are not fairly presented. A qualified opinion is one in which there is some limitation or exception to

accounting standards.

28



company acquires a manufacturing facility in which it will produce toxic chemicals. The cost of the

facility (exclusive of the underlying land) is $25 million and it is expected to provide a 10-year useful

life, after which time the company will demolish the building and restore the underlying land. The cost

of this restoration and cleanup is estimated to be $3 million at that time. The facility will be amortized

on a straight-line basis. The company’s discount rate associated with this obligation is 6.25 percent.

The total expense that will be recorded in the first year associated with the asset retirement obligation

on this property is closest to:

A. $163,618.

B. $224,945.

C. $265,879.

29


• The PV of the future cleanup costs = 1,636,183 (FV = 3,000,000; N = 10; I/Y = 6.25; PMT = 0; CPT

PV). The firm will record asset retirement costs of $1,636,183 as part of the cost of the property and a

corresponding ARO liability of $1,636,183. The asset retirement costs will be amortized at the same

rate as the property (10 years, straight-line) and an accretion expense representing the change in the

ARO liability will also arise.

Depreciation Expense: 1/10 x 1,636,183 =163,618

Accretion Expense 6.25% x 1,636,183=102,261

Total Expense 265,879

30


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. On 1

January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor

with the following terms:

• The firm is reasonably assured of the collection of the lease payments.

The total affect on 2008 pre-tax income for the lessor from this lease is closest to:

A. $32,143.

B. $75,000.

C. $82,519.

Annual lease payment due 31 December $75,000

Lease term 6 years

Estimated useful life of the machine 7 years

Estimated salvage value of the machine $0

Carrying value (cost) of leased asset $300,000

Implied interest rate on lease 7%

31


• This is a sales type lease: the lease period covers more than 75% of its useful life (6/7=85.7%) and the

asset is on its books at less than the present value of the lease payments ($357,490) (PMT = $75,000,

N=6, i=7%). The firm must have acquired or manufactured the asset if it is recorded at less than the

present value of the lease payments.

The income in the first year will therefore consist of the gross profit on the sale (357,490-

300,000)=57,490 plus interest revenue from financing the lease = 25,024

Year Start Balance Interest Payment End Balance

1 357,490 7%x357,490=25,024 75,000 357,490-(75,000-25,024)=307,514

Total income = 57,490 + 25,024 = 82,514

32


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.

Compared to the completed contract method of revenue recognition, will the percentage of completion

method most likely result in higher:

Total assets Liabilities

A. No No

B. No Yes

C. Yes No

33


• Compared to the completed contract method, the percentage of completion method will most likely

result in higher total assets, reflecting the accrual of gross profit during the contract period and lower

liabilities, as the higher level of construction in progress provides a larger offset to advance billings

34


• An analyst has calculate the following ratios for Marico Ltd.

– Number of days of receivables 48

– Number of days of inventory 37

– Number of days of payables 28

The operating cycle and cash conversion cycle respectively for Marico are closet to:

operating cycle cash conversion cycle

A. 57 days 57 days

B. 57 days 85 days

C. 85 days 85 days

35


• The operating cycle = no of days of inventory + no of days of receivables =48+37= 85

• The cash conversion cycle = no of days of inventory + no of days of receivables – no of days of

payables= 48 + 37 -28= 57

36



adjustment to operating income for the effects of a change in LIFO reserves will most likely be required

if the change in LIFO reserve is the result of:

A. Price declines

B. A decrease in the number of units held in inventory

C. An increase in the number of units held in inventory

37


• The reason that a LIFO reserve might decline during a given period and evaluate the implications of

such decline for financial analysis. A liquidation of LIFO inventory produces unsustainable profit

margins.

38


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. During

inflationary periods, a company’s reported net income is least likely to be overstated relative to the

economic income if the company depreciates fixes assets using:

A. Accelerated depreciation and long average lives

B. Accelerated depreciation and short average lives

C. Straight line depreciation and long average lives

39


• During inflationary periods, the difference between historic costs and replacement value becomes

greater; using accelerated depreciation and short average lives will produce reported net income that

is closer to economic income.

40


• An analyst made the appropriate adjustments to the financial statements of retail companies that are

lessees using a substantial number of operating leases. Compared to ratios computed from the

unadjusted statements, the ratios computed from the adjusted statements would most likely be higher

for:

A. A. the debt-equity ratio but not the interest coverage ratio.

B. The interest coverage ratio but not the debt-equity ratio.

C. Both the debt-equity ratio and the interest coverage ratio.

41


• The adjustments for operating leases would increase the amount of total debt in the debt-equity ratio,

thus increasing the ratio; the estimated lease interest expense would lower the interest coverage ratio

42



analyst gathered the following data for four profitable companies operating in the same industry:

If the applicable corporate income tax rate is decreased and nothing else changes, which company will

most likely experience the largest decrease in reported equity?

A. Company A

B. Company B

C. Company C

Company Deferred tax assets Deferred tax liability

A $50,000 $200,000

B $300,000 $400,000

C $85,000 $50,000

D $170,000 $115,000

43


• In the case of a tax rate decrease, the greatest reduction in reported equity would go to the firm with

the largest net deferred tax asset. The net deferred tax asset for Company 4 is $55,000($170,000 -

$115,000), which is the largest of the group.

44


• The Regional Bank of Australia receives interest income on the loans it has outstanding. Durango

Manufacturing Inc. also receives interest income on some surplus funds they currently have invested in

corporate bonds. For each company, respectively, the interest income they receive would be classified

as which type of business activity for financial reporting purposes?

Regional Bank of Australia Durango

A. Operating activity Operating activity

B. Operating activity Investing activity

C. Investing activity Operating activity

45


• For a bank, lending money and earning interest on it is an operating activity; but for a manufacturing

company, they are not in the business of lending or investing money and the interest they receive

would be more correctly classified as an investing activity.

46



a period of declining prices, a company using the LIFO inventory method instead of FIFO would most

likely report:

A. Lower current assets and higher gross income.

B. Higher current assets and lower gross income.

C. Higher current assets and higher gross income.

47


• If prices were declining, using LIFO would match the lower (most recent) costs with current sales.

Costs of goods sold would be lower with LIFO and gross profit (income) would be higher compared to

using FIFO. Lower cost of goods sold means inventory balances, consisting of older, higher-priced

items, would be higher using LIFO, increasing current assets relative to FIFO.

48


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Most

of the differences among companies with respect to quality of earnings are addressed when

companies are compared using:

A. Price to cash flow ratios but not price to earnings ratios.

B. Price to earnings ratios but not price to cash flow ratios.

C. Either price to cash flow ratios or price to earnings ratios.

49


• Most quality of earnings differences between companies (use of aggressive versus conservative

accounting methods) are not likely to be a problem when using P/CF ratios, but are a problem when

using P/E ratios

50



company's cash conversion cycle is most likely to decrease if that company experiences a(n):

A. Increase in the payables turnover ratio.

B. Decrease in the inventory turnover ratio.

C. Increase in the receivables turnover ratio.

51


• An increase in receivables turnover would indicate that receivables were outstanding for a shorter

period of time, decreasing the cash conversion cycle.

52


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. If a

company has a current ratio of 2.0, that company's repayment of $150,000 in short-term borrowing

obtained from a bank would most likely decrease:

A. The company's cash flow from operations, but not the company's current ratio.

B. Both the company's current ratio and the company's cash flow from operations.

C. Neither the company's current ratio nor the company's cash flow from Operations.

53


• The current ratio is above 1.0, so the payment of short-term borrowing would increase the current ratio;

it would reduce both the numerator and denominator by the same amount. The repayment of short-

term debt would reduce cash flow from financing, not cash flow from operations.

54



late December 2009 Jayco Publishing Inc. acquired a small competitor, Max's Magazines. In the

evaluation of the acquisition it was determined that the customer lists of Max's Magazines had a fair

value of $50,000. Jayco Publishing had spent $15,000 during the year updating and maintaining its

own customer lists. What is the correct amount and asset account that will be recorded by Popular

Publishing for the year-ended December 31, 2009, related to customer lists?

A. $50,000 identifiable intangible asset

B. $65,000 identifiable intangible asset

C. $50,000 unidentifiable intangible asset

55


• The purchased customer list is an identifiable intangible because it can be sold separately from the

company and it would be recorded at its fair market value, the amount paid for it in the acquisition,

$50,000. The amount spent by Popular on its own lists, $15,000, would have to be expensed because

internally generated intangibles are not capitalized.

56


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Which

of the following factors is an analyst least likely to consider when determining if a company's deferred

tax liabilities should be treated as a liability or equity?

A. The expectation that temporary differences will reverse.

B. The use of accelerated depreciation methods for tax purposes.

C. The average discount rate of liabilities.

57


• The classification of deferred taxes as liabilities or equity depends on the likelihood, or expectation, of

reversal. For growing firms and those using accelerated methods of depreciation, the temporary

differences tend not to reverse. If the analyst determined the deferred tax liabilities were likely to

reverse, and hence should be classified as liabilities, then it would be appropriate to discount them at

the company’s average discount rate. But the discount rate is not a factor in determining if reversal is

likely.

58


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. All

else equal, the net profit margin for a company will be highest if, for new depreciable assets, that

company uses:

A. High salvage value estimates and long average lives.

B. Low salvage value estimates and short average lives.

C. High salvage value estimates and short average lives.

59


• A high salvage value estimate reduces the depreciable base and thus depreciation expense; long

average lives reduce the annual depreciation expense for any given depreciable base. The

combination of the two would result in the lowest depreciation expense, which leads to the highest net

income and profit margins.

60


• Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Bains

Corporation uses the LIFO inventory method, but most of the other companies in Bains's industry use

FIFO. Which of the following best describes one of the adjustments that would be made to Bains's

financial statements to compare that company with other companies in the industry? To adjust

Greene's ending inventory to the FIFO method, the amount reported for Greene's ending inventory

should be:

A. Increased by the ending balance in Greene's LIFO reserve.

B. Decreased by the ending balance in Greene's LIFO reserve.

C. Increased by the change in Greene's LIFO reserve for that period.

61


• Adding the ending balance in the LIFO reserve to the LIFO inventory would equal the ending balance

for inventory on a FIFO basis.

62

Questions 31 – Corporate Finance

• A large corporation accepts a project which generates no revenue and has a negative net present

value. The project most likely is classified in which of the following categories?

A. Replacement project.

B. New product or service.

C. Regulatory or environmental project.

63


• Regulatory, safety, and environmental projects are often mandated by governmental agencies. They

may generate no revenue and might not be undertaken by a company maximizing its own private

interests. For example, a corporation may be required to install equipment to meet a regulatory

standard, and the cost of satisfying the standard is born by the corporation. In this case, the

corporation selects the lowest cost alternative that meets the requirement, i.e., the alternative with the

least negative net present value.

64


• An analyst gathers the following information about the capital structure and before-tax component

costs for a company. The company’s marginal tax rate is 40 percent.

The company’s weighted average cost of capital (WACC) is closest to:

A. 8.55%.

B. 9.95%.

C. 10.80%

Capital Component Book Value (,000) Market Value (,000) Component Cost

Debt $100 $80 8%

Preferred stock $20 $20 10%

Common stock $100 $200 12%

65


• Because the target capital weights are not given, market value weights are used to compute the

WACC. The market value weights for debt, preferred stock and equity are 0.2667, 0.0667, and 0.6667

respectively.

WACC = wd × rd × (1 – t) + wp × rp + we × re

= 0.2667 × 8% × (1 – 0.4) + 0.0667 × 10% + 0.6667 × 12% = 9.95%

66


• A company is considering issuing a 10-year, option-free, semiannual coupon bond with a 9 percent

coupon rate. The bond is expected to sell at 95 percent of par value. If the company’s marginal tax rate

is 30 percent, then the after-tax cost of debt is closest to:

A. 6.30%.

B. 6.86%.

C. 9.80%.

67


• Using a financial calculator: N = 20, PMT = 45, PV = –950, FV = 1000; solve for I/Y = 4.90%. The

annual yield is twice the semiannual yield = 4.90% × 2 = 9.80%. The after-tax cost of debt = annual

yield × (1 – t) = 9.80% × (1 – 0.30) = 6.86%

68


• An analyst gathers the following information about a company and the market:

Using the dividend discount model approach, the cost of common equity for the company is closest to:

A. 16.0%.

B. 16.5%.

C. 17.2%.

Current market price per share of common stock €32.00

Most recent dividend per share paid on common stock €2.40

Expected dividend payout rate 40%

Expected return on equity (ROE) 15%

Beta for the common stock 1.5

Expected return on the market portfolio 12%

Risk-free rate of return 4%

69


• According to the dividend discount model approach, the cost of common equity is equal to the dividend

yield plus the growth rate. In this case, the growth rate is the earnings retention rate times the

expected ROE or (1 – dividend payout rate) × expected ROE = 1 – 0.4) × 15% = 9%. The expected

dividend = 2.40 × (1 + 0.09) = 2.616. The expected dividend yield = 2.616 / 32 = 8.175%. The cost of

common equity = 8.175% + 9.0% ≈ 17.2%.

70


• Which of the following is least likely classified as a takeover defense?

A. Greenmail.

B. Cumulative voting.

C. Golden parachutes.

71


• The ability to use cumulative voting enables shareowners to vote in a manner that enhances the

likelihood that their interests are represented on the board. It is a valuable shareowner right.

72


• An analyst gathers the following information about the cost and availability of raising various amounts

of new debt and equity capital for a company:

The company’s target capital structure is 60 percent equity and 40 percent debt. If the company raises

€9.5 million in new financing, the marginal cost of capital is closest to:

A. 9.8%.

B. 10.6%.

C. 11.0%.

Amount of New debt (in mn) Cost of debt (after tax) Amount of new equity (in

millions)

Cost of equity

≤ €4.0 4% ≤ €5.0 13%

> €4.0 5% > €5.0 15%

73


• The break-points for debt and equity are €10 million (€4.0 million / 0.40) and €8.33 million (€5.0 million

/ 0.60), respectively. The cost of debt and equity if the firm raises €9.5 million in new financing will be

4% and 15%, respectively, because €9.5 million is below the debt breakpoint and above the equity

breakpoint. The marginal cost of capital = 0.40 × 4% + 0.60 × 15% = 10.6%.

74


• A company is offered trade credit terms of 2/10, net 45. The implicit cost of failing to take the discount

and instead paying the account in 45 days is closest to:

A. 21.28%.

B. 23.10%.

C. 23.45%.

75


• The cost of trade credit if paid on day 45 = (1 + 2 / 98)365/35 – 1 = 23.45%.

76


• Regarding corporate governance, which of the following most likely would be a reason for concern

when evaluating an independent board member’s qualifications? The board member:

A. Has served on the board for 14 years.

B. Owns 1,000 shares of the corporation’s equity.

C. Has formerly served on the boards of several successful companies

77


• Such long-term participation may enhance the individual board member’s knowledge of the company,

but it also may cause the board member to develop a cooperative relationship with management that

could impair his/her willingness to act in the best interests of shareowners.

78


• For two mutually exclusive capital projects with normal cash flows, the NPV and IRR methods will

most likely produce conflicting rankings when the:

A. Cost of capital is equal to the crossover rate.

B. Cost of capital is less than the crossover rate.

C. Cost of capital is greater than the crossover rate.

79


• The NPV and IRR methods lead to conflicting decisions when the cost of capital is less than the

crossover rate

80


• A company that sells ice cream is evaluating an expansion of its production facilities to allow the

company to also produce frozen yogurt. The expansion project is based on a marketing study that

concluded producing frozen yogurt would increase the company's ice cream sales because of an

increase in brand awareness. Should an analyst include the cash flows associated with the expected

increase in ice cream sales in the calculation of the project's net present value (NPV)?

A. No, because the projected increase in ice cream sales is an opportunity cost.

B. Yes, because the project's NPV will be overstated if the cash flows associated with the projected increase

in ice cream sales are not included.

C. Yes, because the project's NPV will be understated if the cash flows associated with the projected

increase in ice cream sales are not included.

81


• The increase in ice cream sales (externality) should be treated as an incremental cash flow and should

be included in the analysis of the project's net present value

82


• An investor currently has a portfolio valued at $700,000. the investor’s objectives is long term growth,

but the investor will need $30,000 by the end of the year to pay his son’s college tuition and another

$10,000 by year end for his annual vacation. The investor is considering four alternative portfolios:

Using Roy’s safety first criterion which of the following alternative portfolios minimizes the probability

that the investor’s portfolio will have a value lower than $700,000 at year end.

A. Portfolio 1

B. Portfolio 2

C. Portfolio 3

Portfolio Expected return Standard deviation of returns

1 8% 10%

2 10% 13%

3 14% 22%

4 18% 35%

83


• The investor requires minimum return of 40,000/700,000=5.71%. The highest safety first ratio is

associated with portfolio 3. (14%-5,71%)/22%= 0.3768

84


• Which of the following is least likely to concern an investor that is evaluating a corporation's

shareowner rights provisions?

A. Shareowners may nominate board members.

B. Shareowners must attend the annual meeting to vote their shares.

C. Shares held by the founding family have supernormal voting rights.

85


• The ability to nominate one or more individuals to the board can prevent erosion of shareowner value.

Shareowners may be able to force the board or management to take steps to address shareowner

concerns.

86


• Two mutually exclusive projects have conventional cash flows, but one project has a larger NPV while

the other project has a higher IRR. Which of the following is least likely responsible for this conflict?

A. Timing of the projects' cash flows.

B. Size of the projects' initial investments.

C. Risk of the projects as reflected in the required rate of return.

87


• Conflicting decision rules based on the NPV and IRR methods are related to the reinvestment rate

assumption, the timing of the cash flows, or the scale of the projects. Differing required rates of return

are not related to conflicting NPV and IRR decisions.

88

Questions 44 – Portfolio Management

• Over time, the major source of investment return and risk can most likely be attributed to:

A. Stock selection.

B. Asset allocation.

C. Risk management.

89


• The asset allocation decision explains about 90% of a fund’s returns over time. Across al funds, asset

allocation explains an average of 40% of the variation in fund returns, and slightly more than 100% of

the average fund’s level of return.

90


• An analyst has gathered monthly returns for two stock indexes A and B:

The covariance between Index A and Index B is closest to:

A. 10.37.

B. 13.82.

C. 19.64.

Month Returns for Index A Returns for Index B

1 -6.4% -6.2%

2 6.6% 19.0%

3 12.9% -7.7%

4 3.2% 4.0%

91


• Calculation of the covariance proceeds as follows:

1) Compute the average for each index: Index A = (-6.4 + 6.6 + 12.9+3.2)/4 = 4.08 Index B = (-6.2 +

19.0 - 7.7 + 4)/4 = 2.28

2) Compute the following sum: (-6.4-4.08) × (-6.2-2.28) + (6.6-4.08) × (19.0-2.28) + (12.9-4.08) × (-7.7-

2.28) + (3.2-4.08) × (4.0-2.28) = 41.47

3) Divide the sum found in 2) by number of observation minus one = 41.47/(4-1) =13.82

92


• Which of the following statements about portfolio risk and diversification is least accurate?

A. Unsystematic risk can be substantially reduced by diversification

B. Systematic risk can be eliminated by holding securities in a well diversified international portfolio

C. Diversification results form combining securities that have less than perfect positive correlation between

their returns to reduce portfolio risks

93


• Systematic risk cannot be eliminated by diversification. Diversification benefits will occur any time

security returns have less than perfect positive correlations.

94


• Portfolios located to the right of the market portfolio on the capital market line are:

A. Lending portfolios.

B. Low-risk portfolios.

C. Borrowing portfolios.

95


• The only way an investor can achieve a portfolio to the right of the market portfolio is to borrow at the

risk-free rate and invest the proceeds in the market portfolio; 100% of the investor's wealth plus the

borrowed funds are invested in the market portfolio.

96


• Regarding an individual's investment policy statement, which of the following is least appropriate as

the investment objective? The portfolio seeks:

A. 12% annual returns with above-average market risk.

B. To match the performance and risk characteristics of the S&P 500 Index.

C. Long-term capital appreciation with market risk comparable to the MSCI EAFE Index.

97


• The investment objective must be expressed in terms of both risk and return and current income from

dividends and interest represents only the investor’s return objective. It does not include any reference

to risk tolerance or risk limits as provided in the other alternatives.

98


• Which of the following statements about the relation between covariance and correlation is least

accurate? If the covariance of returns between two assets is positive, the correlation coefficient for

those two assets:

A. Could be a negative number.

B. Could indicate a strong positive relation if both return series were stable.

C. Could indicate a weak positive relation if both return series were volatile.

99


• If the covariance of returns between two assets is a positive number, the correlation coefficient for

those two assets cannot be negative. The correlation coefficient is equal to the covariance

standardized by the product of the individual standard deviations (which are always positive).

100


• An analyst gathered the following information about two common stocks:

Variance of returns for the Libby Company = 15.5

Variance of returns for the Metromedia Company = 22.3

Covariance between returns of Libby Company and Metromedia Company = 8.65

The correlation coefficient between returns for the two common stocks is closest to:

A. 0.558

B. 0.388

C. 0.465

101

Questions 51 – Equity

• The four firms in the Internet search engine industry have the following market shares.

Company Market Share

Gigloo 50%

Ohooho 25%

MySearch 15%

Foxnet 10%

The Herfindahl Index and the "Equivalent Number" of firms in this industry, respectively, are closest to:

The Herfindahl Index "Equivalent Number" of firms

A. 0.345 4

B. 0.345 2.9

C. 0.478 2.09

102


• Herfindahl Index = 0.52 + 0.252 + 0.152 + 0.12 = 0.25 + 0.0625 + 0.0225 + 0.01 = 0.345

• “Equivalent Number” of firms = 1 / 0.345 = 2.8986 ≈ 2.90

103


• Chu Wang, CFA, gathered the following data to estimate the implied growth rate of dividends for

Shenghai Toys Co. to use as an input for valuing the company's common stock.

Return on Assets 10%

Profit Margin 5%

Total Assists CNY 50 million

Debt Ration 40%

Payout Ration 25%

Wang's estimate of Shenghai Toys' implied growth rate would be closest to:

A. 6.25%.

B. 12.50%.

C. 18.75%.

104


• g = RR x ROE

RR = (1 – Payout Ratio) = 1 – 0.25 = 0.75

Financial Leverage = TA / Equity

Debt = TA x Debt Ratio = CNY 50 m x 0.4 = CNY 20 m

Equity = CNY 50 m – CNY 20 m = CNY 30 m

ROE = ROA x Financial Leverage; ROE = 10% x (50/30) = 16.67%

g = 0.75 x 16.67 = 12.50%

105


• Strongsville Fabricators Inc. uses the FIFO method of inventory valuation. Assuming a rising costs

environment and other factors held constant, Strongsville's price-to earnings and price-to-book

multiples relative to those for another company that uses the LIFO method of inventory valuation would

be:

P/E multiple P/B multiple

A. Overstated Understated

B. Understated Overstated

C. Understated Understated

106


• In a rising costs environment, FIFO would result in higher earnings, higher ending inventory, as well as

higher book value of equity. Thus, both P/E and P/BV tend to be understated relative to a comparable

firm that uses LIFO method.

107


• Metiu Metev, an analyst with Sofia Equity Researchers, has gathered the following information about

Balkan Steel Mills.

Current year’s operating free cash flow BGN 5 million

Cost of equity capital 15%

Weighted average cost of capital 12.40%

Estimated long-term growth rate 6%

Given this information, Metev's best estimate of BSM's intrinsic value (in BGN millions) would be

closest to:

A. 58.89 million.

B. 78.13 million.

C. 82.81 million.

108


• return and expected growth rate of dividends

V = OFCF1 / (WACC - g) = 5 (1.06) / (0.124 - 0.06) = 82.81

109


• An equity investment in a producer firm would be more attractive at what levels of the bargaining

power of buyers and suppliers, respectively?

Bargaining power of buyers Bargaining power of suppliers

A. Low Low

B. Low High

C. High Low

110


• At high levels of the bargaining power of both buyers and suppliers, the producer would potentially

experience a squeeze on profits and profit margins. Therefore, equity investments in producer firms

with low levels of bargaining power of both buyers and sellers tend to be more attractive.

111


• Geo Telecommunications Inc. is a fast growing company with a double-digit growth rate that is

expected to continue for three more years. In his pursuit of valuing the company's stock, Dimiter

Nenkov, a freelance equity analyst, has compiled the following data about the company:

Current year’s free cash flow to equity €20 million

Growth rate in free cash flow during the next three years 30% in years 1 and 2, 20% in year 3

Growth rate in free cash flow for year 4 and beyond 8%

Weighted average cost of capital 12%

Cost of equity capital 15%

Number of outstanding shares 50 million

Based on the above information, Nenkov's best estimate of the value per share for Geo

Telecommunications would be closest to:

A. € 9.72.

B. € 10.13.

C. € 17.17.

112


Time period FCFE PVIF@15% Present Value

1 20 x 1.30 = 26.0 0.8696 € 22.61

2 20 x 1.302 = 33.8 0.7561 € 25.56

3 20 x 1.302 x 1.20 = 40.56 0.6575 € 26.67

4 & beyond V3 = (40.56 x 1.08) / (0.15 – 0.08) = 625.78 0.6575 €411.46

Value of Equity €486.30

Value per share = Value of Equity / # of outstanding shares € 9.72

113

Questions 57 – Fixed income

• The party making the fixed-rate payment under a swap contract could also have to make the variable

payment on that contract if the payments are related to a(n):

A. Equity swap.

B. Currency swap.

C. Interest rate swap.

114


• If the value of the index on which the swap is based declines, the resulting negative return would have

to be paid by the party making the fixed-rate payment. This characteristic is one of the distinguishing

features of equity swaps.

115


• An investor goes long an FRA that expires in 30 days for which the underlying is 90-day LIBOR for a

notional of $10 million. A dealer quotes this instrument at 4.5%. At expiration, 60-day LIBOR is 3.5%

and 90-day LIBOR is 4%. The payment made at expiration is closest to:

A. $12,376 from the investor to the dealer.

B. $12,376 from the dealer to the investor.

C. $16,570 from the investor to the dealer.

116


• The underlying of an FRA is an interest payment. The investor is long the rate and will benefit if rates

increase. Since rates decreased, the investor must pay the dealer:

376,12$)360/90(04.01

)360/90()045.004.0(000,000,10$

117


• If interest rates are expected to decline, an investor can earn a higher coupon interest rate by

purchasing a(n):

A. Callable bond.

B. Inverse floater.

C. Floater with a cap.

118


• Inverse floaters have a coupon formula such that the coupon rate increases when the reference rate

decreases and decreases when reference rate increases. The coupon rate moves in the opposite

direction from the change in the reference rate.

119


• All else equal, an increase in expected yield volatility is most likely to result in an increase in the price

of a(n):

A. Putable bond.

B. Callable bond.

C. Option-free bond selling at a discount to par.

120


• An increase in expected yield volatility increases the price of the embedded put option. The price of a

putable bond will increase because the price of the putable bond is equal to an option-free bond plus

the put option.

121


• An analyst determined that if interest rates increase 120 basis points the price of a bond would be

$89.70, but if interest rates decrease 120 basis points the price of that bond would be $99.30. If the

initial price of the bond is $95.40, the approximate percentage price change for a 100 basis point

change in yield is closest to:

A. 2.5%.

B. 4.2%.

C. 8.4%.

122


• The formula for calculating the duration of a bond (estimated percentage price change for a 100 basis

point change in yield) is:

= Price if yields decline - price if yields increase / 2(initial price)(change in yield in decimal)

= 99.3 - 89.7 / 2 (95.4)0.0120 = 4.19287.

123


• A portfolio manager is considering investing a portion of her fixed income portfolio in a security whose

cash flows are dependent on an underlying pool of mortgages. The portfolio consists of Treasury

bonds, corporate bonds and Ginnie Mae pass-through's. The security being considered is Tranche B

of a collateralized mortgage obligation (CMO). The underlying collateral is a Ginnie Mae pass-through

security. The rules of the CMO state that Tranche A is the first to receive monthly principal. By

investing in Tranche B of the CMO, the portfolio manager will most likely reduce portfolio:

A. Credit risk

B. Sovereign risk.

C. Prepayment risk.

124


• Adding Tranche B of the CMO to the portfolio will most likely reduce prepayment. A passthrough

security, such as a Ginnie Mae, can be prepaid as the underlying loans pay off principal, i.e., they are

exposed to prepayment risk. On the other hand, the tranches in a CMO will be paid off sequentially,

i.e., Tranche A then Tranche B. Tranche B has less prepayment risk than the underlying passthrough

securities.

125


• An analyst determines that an 10% option free bond maturing in 205 would experience a 2% change in

price if market interest rates rise by 50 basis points. If market rates instead fall by 50 basis points then

the price of the bond would increase by?

A. Exactly 2%

B. Less than 2%

C. More than 2%

126


• The bond is option free and will therefore exhibit positive convexity. an equal cange in rates will

produce greater percentage gain when rates decrease then the percentage loss produced when rates

increases.

127


• According to the market segmentation theory an upward sloping yield curve is most likely due to:

A. Investor expectations that short term interest rates will rise in the future

B. Different levels of supply and demand for short term & long term funds’

C. An increasing yield premium required by investors for bearing interest rate risks

128


• The market segmentation theory asserts that the supply and demand for funds determine the interest

rates for each maturity sector

129


• A fixed income portfolio manager owns a $5mn par value noncallable bond. The bond’s duration is 5.6

and currnet market value is $5,125,000. the dollar duration of the bond is closet to:

A. $280,000

B. $287,000

C. $700,000

130


• Dollar duration= 5.6*0.01*5,125,000 = $287,000

131

Questions 66 – Alternative investments

• A real estate investment has the following characteristics:

Annual rental income $1,800,000

Annual operating expenses $1,200,000

Available mortgage rate 6%

Financing percentage 90%

Required rate of return 15%

Estimated holding period 5 years

Investor’s tax rate 25%

Based on the income approach, the value of the investment is closest to:

A. $4,000,000.

B. $5,455,000.

C. $6,133,000.

132


• Using the income approach:

($1,800,000 - $1,200,000) / 0.15 = $4,000,000

133


• An investor would most likely expect commodities to have correlations with traditional stock or bond

investments and inflation that are:

Correlation with traditional Correlation with inflation

stock or bond investments

A. Positive Negative

B. Negative Positive

C. Negative Negative

134


• A primary motivation for an investment in commodities, commodity derivatives, commodity-linked

bonds, and commodity-linked equity are the diversification benefits provided due to the negative return

correlation with other assets and the positive correlation with inflation.

135


• Which of the following statements is least accurate with respect to the advantages of open end

exchange traded fund (ETF)?

A. Provide for more immediate reinvestment of dividends than do index mutual funds

B. Provide a more cost effective way for large institutions to invest in emerging marjets

C. Provide lower exposure to capital gains distribution taxes than do traditional mutual funds

136


• Some sectors and international ETFs have large bid ask spreads and substantial expense ratios

compared to managed portfolios, which may provide a more cost efficient alternative to ETF

137


• Hedge funds that contain infrequently traded assets would most likely exhibit a downward bias with

respect to:

A. Measured risk but not correlations with conventional equity investments

B. Correlations with conventional equity investments but not measured risk

C. Both measured risk and correlations with conventional equity investments

138


• The presence of infrequently traded assets leads to smoothed pricing that induces a significant

downward bias to the measured risk of the assets as well as the correlations of returns with

conventional equity and fixed income returns.

cfa level i revision day ii

Documents

cash ratio

quick ratio

income statement

cash inflow

financial statement

higher percentage of

higher percentage of

answer net income