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
This files has expired at 30-Jun-13
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
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
Questions 2 Answer
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 companys 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
Questions 3 Answer
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 companys 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
Questions 4 Answer
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
Questions 5 Answer
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 companys tax rate is 35 percent. The companys 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
Questions 6 Answer
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 This files has expired at 30-Jun-13
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 companys 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
Questions 7 Answer
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
companys financial statements to compare it with other companies in the industry? The amount
reported for the companys 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
Questions 8 Answer
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
Questions 9 Answer
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 companys financial statements in the first year of the
lease, which of the following is most accurate? The reduction in the companys:
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
Questions 10 Answer
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
companys 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
Questions 11 Answer
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
Questions 12 Answer
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
Questions 13 Answer
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 companys 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
Questions 14 Answer
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
Questions 15 Answer
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
Questions 16 Answer
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
Questions 17 Answer
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
Questions 18 Answer
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 companys 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
Questions 19 Answer
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
Questions 20 Answer
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
Questions 21 Answer
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
Questions 22 Answer
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
Questions 23 Answer
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
Questions 24 Answer
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
Questions 25 Answer
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
Questions 26 Answer
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
Questions 27 Answer
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
Questions 28 Answer
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 companys 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
Questions 29 Answer
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
Questions 30 Answer
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
Questions 31 Answer
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 companys marginal tax rate is 40 percent.
The companys 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
Questions 32 Answer
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 = w
d
r
d
(1 t) + w
p
r
p
+ w
e
r
e
= 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 companys 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
Questions 33 Answer
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
Questions 34 Answer
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
Questions 35 Answer
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 companys 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
Questions 36 Answer
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
Questions 37 Answer
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 members qualifications? The board member:
A. Has served on the board for 14 years.
B. Owns 1,000 shares of the corporations equity.
C. Has formerly served on the boards of several successful companies
77
Questions 38 Answer
Such long-term participation may enhance the individual board members 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
Questions 39 Answer
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
Questions 40 Answer
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 investors objectives is long term growth,
but the investor will need $30,000 by the end of the year to pay his sons college tuition and another
$10,000 by year end for his annual vacation. The investor is considering four alternative portfolios:
Using Roys safety first criterion which of the following alternative portfolios minimizes the probability
that the investors 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
Questions 41 Answer
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
Questions 42 Answer
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
Questions 43 Answer
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
Questions 44 Answer
The asset allocation decision explains about 90% of a funds 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 funds 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
Questions 45 Answer
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
Questions 46 Answer
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
Questions 47 Answer
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
Questions 48 Answer
The investment objective must be expressed in terms of both risk and return and current income from
dividends and interest represents only the investors 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
Questions 49 Answer
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
Questions 51 Answer
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
Questions 52 Equity
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
Questions 52 Answer
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
Questions 53 Equity
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
Questions 53 Answer
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
Questions 54 Equity
Metiu Metev, an analyst with Sofia Equity Researchers, has gathered the following information about
Balkan Steel Mills.
Current years 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
Questions 54 Answer
return and expected growth rate of dividends
V = OFCF1 / (WACC - g) = 5 (1.06) / (0.124 - 0.06) = 82.81
109
Questions 55 Equity
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
Questions 55 Answer
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
Questions 56 Equity
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 years 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
Questions 56 Answer
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
Questions 57 Answer
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
Questions 58 Answer
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 . 0 1
) 360 / 90 ( ) 045 . 0 04 . 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
Questions 59 Answer
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
Questions 60 Answer
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
Questions 61 Answer
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
Questions 62 Answer
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
Questions 63 Answer
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
Questions 64 Answer
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 bonds 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
Questions 65 Answer
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
Investors 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
Questions 66 Answer
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
Questions 67 Answer
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
Questions 68 Answer
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
Questions 69 Answer
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.

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Financial Statement Analysis

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