CFA LeveL 1 Testbank

(64 questions with detailed solutions) Question 1: Subordinated debentures a) are also known as minor debentures. b) are a type of senior bond. c) are also known as senior debentures. d) posses a claim on the issuer that is subordinated to other debentures. e) posses a claim on the issuer that is above that of other debentures.

Question 2: The law of comparative advantage explains why a nation will benefit from trade when a) its trading partners are experiencing offsetting losses. b) it exports more than it imports. c) it exports goods for which it is a low-opportunity cost producer, while importing those for which it is a high-opportunity cost producer. d) it exports goods for which it is a high-opportunity cost producer, while importing those for which it is a low-opportunity cost producer.

Question 3: The ________ margin is generally about seventy-five percent of the amount of the ________ margin. a) variation; initial b) maintenance; initial c) initial; daily settlement d) initial; maintenance

Question 4: In the calculation of the arithmetic mean for grouped data, which value is used to represent all the values in a particular class? a) The lower limit of the class b) The upper limit of the class c) None of these answers

CFA L1 Testbank

d) The frequency of the class e) The cumulative frequency preceding the class

Question 5: Ameriscam, Inc. is considering the issuance of some junior subordinated debt. The Company's combined state/federal corporate tax rate is 30%, and the coupon on its outstanding senior debt is 7.55%. The proposed debt would pay an annual coupon. Very recently, Ameriscam has met with a corporate finance firm, who advised the Company that the pre-tax cost of a debt issuance would be 7.70%; Ameriscam's finance division mirrored these findings. A month earlier, a study in a popular financial magazine found that shareholder's require a 7.95% rate of return on similar investments. Which of the following represents the best answer for Ameriscam's estimated after-tax cost of debt for this proposed debt issuance? a) 5.39% b) The after-tax cost of debt cannot be determined from the information provided. c) 5.425% d) 5.285% e) 5.565%

Question 6: Which of the following equations correctly illustrates the calculation of the cost of equity using the Capital Asset Pricing Model? a) Risk-free rate of return + beta (expected return on the market - risk-free rate of return) b) None of these examples c) Annual dividend/current stock price * (1-tax rate) d) Risk-free rate of return * beta (expected return on the market - risk-free rate of return) e) beta (risk-free rate of return + beta (expected return on the market - risk-free rate of return) f) Risk-free rate of return + alpha (expected return on the market - risk-free rate of return)

CFA L1 Testbank

Question 7: The management of Clay Industries have adhered to the following capital structure: 40% debt, 45% common equity, and 15% perpetual preferred equity. The following information applies to the firm: Yield to maturity of outstanding long-term debt = 9.5% Expected return on the market = 14.5% Annual risk-free rate of return = 6.25% Historical Beta coefficient of Clay Industries Common Stock = 1.24 Annual preferred dividend = $1.75 Preferred stock net offering price = $28.50 Combined state/federal corporate tax rate = 35% Given this information, and using the Capital Asset Pricing Model to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for Clay Industries? a) The WACC for Clay Industries cannot be determined from the information provided. b) 8.54% c) 14.45% d) 12.14% e) 10.00% f) 10.81%

Question 8: In the presence of externalities, which of the following effects can occur? I. The market will over-allocate resources to the production of those goods which cause harmful externalities for which producers do not have to pay. II. The market will under-allocate resources to the production of those goods which have positive spill-over effects for the society in general. III. Externalities skew the demand and supply effects since some of the benefits and costs get ignored.

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a) I only b) II only c) III only d) I, II & III e) II & III f) I & III g) I & II

Question 9: The GDP deflator is used to: a) reduce the gross GDP to allow for net income earned abroad. b) adjust the gross GDP for net exports and depreciation. c) calculate the GDP in terms of base year currency value. d) calculate net GDP given gross GDP. e) none of these answers. Qu estion 10: Frictional unemployment refers to the unemployment due to: a) none of these answers. b) strikes caused by unionization. c) business downturn and falling profits. d) structural characteristics of the economy. e) constant changes in the economy.

Question 11: Which of the following is/are true? I. An increase in unemployment benefits will increase the rate of unemployment. II. Keeping the total number of people employed constant, an increase in the number of people working part-time will increase unemployment rate. III. "Discouraged workers" are not counted as part of the "unemployed" population or the labor force. a) II & II b) I, II & III c) I & II

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d) II only e) III only f) I & III g) I only

Question 12: When complying with Standard IV (B.3) Fair Dealing, there are certain points one should be sure to address when establishing compliance procedures. Which of the following points is NOT mentioned in the Standards of Practice Handbook? a) Disclose levels of service. b) Establish procedures for determining material change. c) Establish control over trading activity. d) Simultaneous dissemination. e) Publish personnel guidelines for predissemination. f) Limit the number of people involved. g) Be flexible on the time frame between decision and dissemination.

Question 13: Which of the is/are false? I. A high p-value is necessary to reject a null hypothesis. II The higher the significance level, the greater is the chance that the null will be rejected when it is false. III. The higher the probability of Type II error, the higher is the chance of rejecting the null when it is false. a) II only b) I, II & III c) I only d) II & III e) I & II f) III only Question 14: Which of the following is/are true? I. A project's sunk costs are irrelevant to the decision of accepting or rejecting it. II. A project's incremental cash flows are not affected by interest expenses.

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III. Project rankings using incremental net income and incremental net cash flows can be different. a) III only b) I, II & III c) II only d) I only e) I & II f) II & III g) I & III

Question 15: Each trading nation can gain by specializing in producing those services for which it is a low-opportunity cost producer while trading for those things for which it is a high-opportunity cost producer. This statement best describes the implications of the ________. a) equation of exchange b) infant-industry argument c) law of comparative advantage d) free rider problem e) none of these answers

Question 16: A nation can gain from international tradewhen: I. the relative prices of the nation's products differ from those of other countries. II. it imports goods for which it is a high-opportunity cost producer while exporting goods it produces at low opportunity cost. a) Both statements are false. b) I is false, II is true. c) Both statements are true. d) I is true, II is false.

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Question 17: A trade policy that restricts the sale of foreign goods in the U.S. market will a) increase the nation's income since it protects domestic jobs. b) benefit producers in industries that export goods. c) diminish economic efficiency by allocating more resources to the areas of their relative comparative disadvantage. d) reduce the demand for U.S. export goods, since foreigners will be less able to buy our goods if they cannot sell to us.

Question 18: Indenture provisions a) are left to the bondholders to enforce. Indenture provisions include deferred call provisions, which allow the bondholder to swap the bond for a predetermined number of shares up to a certain time. After that time, the bondholder no longer has that right. b) are left to the bondholders to enforce. Indenture provisions include deferred call provisions, which allow the issuer to retire the issue up to a certain period of time. A deferred call provision is like a freely callable provision that is limited to only the first years of the issue. c) are left to the bondholders to enforce. In the case of provisions stipulating registered bonds, the bondholder must report any changes in address in order to receive interest and principal payments. Registered bonds are priced less than other bonds. d) are enforced by a trustee acting on behalf of the bondholders. Indenture provisions include call provisions, which allow the bondholder to swap the bond for a predetermined number of shares. Call provisions increase the price of the issue. e) are enforced by a trustee acting on behalf of the bondholders. Indenture provisions include noncallable provisions, which prohibit the issuer from retiring the issue before its maturity. Qu estion 19: The ________ hypothesis states that the shape of the yield curve results from the interest rate expectations of market participants. a) liquidity preference b) segmented market

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c) expectations d) none of these answers

Question 20: The promised yield to maturity a) measures the expected rate of return on a bond if it is held to maturity. b) measures the cash flow on a bond. c) is equal to the coupon rate. d) measures the current income on a bond. e) is the least widely used bond yield figure. Qu estion 21: In a price-taking market, if there is a sudden decrease in demand: I. the demand curve will move to the right. II. the supply curve will move to the left in the long run. III. prices will fall in the long run. a) I, II & III b) III only c) I only d) I & II e) I & III f) II & III g) II only h) none of these answers

Question 22: In a monopolistically competitive market in the long run, firms produce an output where: I. average total cost is minimized. II. average variable cost is minimized. III. price equals marginal cost. IV. marginal revenue equals marginal cost. a) II only

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b) III only c) IV only d) I only e) I, III & IV f) III & IV g) I, II & IV h) none of these answers

Question 23: A monopolist will tend to produce at a level of output where: I. the difference between total revenue and total costs is maximized. II. the average total cost is minimized. III. the marginal cost is minimized. IV. marginal revenue equals marginal cost. a) III & IV b) IV only c) III only d) II only e) I only f) I & IV g) I, III & IV h) none of these answers

Question 24: A portfolio manager is being evaluated against the rate of return required by CAPM. If the market portfolio used has been mis-identified, the manager's performance is most likely: a) the question is based on a false premise. Any well-diversified portfolio is a good proxy for the market portfolio. b) either over or under-estimated. c) overestimated. d) underestimated. e) none of these answers.

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Question 25: When a mature firm raises the dividend, signaling theory implies that its stock price ________. When a growth firm cuts the dividend, signaling theory implies that its stock price ________. a) will fall; may rise or fall b) will fall; will rise c) will rise; may rise or fall d) will rise; will fall e) none of these answers.

Question 26: The Residual Dividend Policy leads to: a) a highly unstable dividend policy. b) the firm maintaining a constant absolute amount of dividends. c) the firm maintaining a steady growth of dividends. d) the firm paying out a constant fraction of earnings as dividends. e) none of these answers.

Question 27: The allocation of shares in oversubscribed IPOs to investment managers for their personal account is a perk that is most clearly a violation of Standard ________. a) II (B) - Professional Misconduct b) IV (B.8) - Disclosure of Referral Fees c) IV (A.3) - Independence and Objectivity d) IV (B.6) - Prohibition against Misrepresentation e) None of these answers

Question 28: According to the AIMR-Performance Presentation Standards, ________ must be used when calculating investment performance. a) benchmark b) asset-weighted return c) total return d) aggregate return

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CFA L1 Testbank

Question 29: When a shortage of a good is present, then a) only an increase in production will eliminate the shortage. b) price must be controlled to avoid rationing. c) nonprice factors, such as quality deterioration, play a greater role in the allocation process unless the price is permitted to rise. d) the amount demanded will be greater than the amount supplied at all prices except the existing price.

Question 30: Suppose apple juice and orange juice are substitutes. If an increase in the supply of apples reduces the price of apple juice and a cold spell damages orange groves in Florida, which of the following will necessarily result in the market for orange juice? a) The quantity of orange juice sold goes up, while the price of orange juice may go either up or down. b) The price of orange juice declines, while the quantity of orange juice sold declines. c) The price of orange juice increases, while the quantity of orange juice sold declines. d) The quantity of orange juice sold goes down, while the price of orange juice may go either up or down.

Question 31: Andrea, a portfolio manager for XYZ Investment Management Company, a registered investment organization that advises investment companies and private accounts, was promoted to that position three years ago. Bates, her supervisor, is responsible for reviewing Andrea's portfolio account transactions and her required monthly reports of personal stock transactions. Andrea has been using Jonelli, a broker, almost exclusively for portfolio account brokerage transactions. For securities in which Jonelli's firm makes a market, Jonelli has been giving Andrea lower prices for personal purchases and higher prices for personal sales than Jonelli gives to Andrea's portfolio accounts and other investors. Andrea has been filing monthly reports with Bates only for those months in which she has no personal transactions, which is about every fourth month. Which of the following applies/apply? I. Andrea violated the Code and Standards in that she failed to disclose to her employer her personal transactions.

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II. Andrea violated the Code and Standards by breaching her fiduciary duty to her clients. III. Bates violated the Code and Standards by failing to enforce reasonable procedures for supervising and monitoring Andrea in Andrea's trading for her own account. a) III only b) II only c) I, II and III d) I and III only e) II and III only f) I and II only g) I only

Question 32: A profit maximizing business will tend to produce at a level of output where: I. The difference between total revenue and total costs is maximized. II. Marginal revenue equals marginal cost. III. The marginal cost is minimized. IV. The total cost is minimized. a) I, II, III & IV b) III & IV c) IV only d) I only e) I & II f) II only g) III only

Question 33: The opportunity costs of a project refer to: a) the costs that would be incurred in one or more of mutually exclusive projects that are rejected in favor of the project selected. b) the costs incurred due to the effects of the project on the firm's other projects at hand. c) the costs already incurred in developing the project.

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CFA L1 Testbank

d) none of these answers.

Question 34: Supply curves tend to be: A . less elastic in the long run because firms have time to enter or leave the industry. B . perfectly elastic in the long run because consumer demand will have time enough to adjust fully to changes in supply. C . more elastic in the long run because firms have time to enter or leave the industry. D . perfectly inelastic in the long run because the law of scarcity imposes absolute limits upon production. Qu estion 35: The major difference between accounting profit and economic profit is that: A . accounting profit does not consider the opportunity cost of the firm's equity capital, and therefore, it generally overstates economic profit. B . accounting profit is based on opportunity costs, whereas economic profit is based on market transactions. C . accounting profit generally understates the level of economic profit, because it includes interest expense. D . explicit and implicit costs are included in accounting profit, but only explicit costs are included in economic profit. Qu estion 36: Which one of the following accurately describes a major difference between a purely competitive firm and a monopolistic firm? A . The monopolistic firm is a price searcher, and the competitive firm is a price taker. B . The monopolistic firm maximizes price charged, and the competitive firm maximizes profit. C . The monopolistic firm will maximize profits, and the competitive firm cannot, because profits are driven down to zero in the long run. D . The monopolistic firm maximizes profit, and the competitive firm minimizes costs. Qu estion 37: Which one of the following statements about an oligopolistic firm is true? An oligopolistic firm:

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CFA L1 Testbank

A . will consider the potential response of its rivals when making business decisions. B . is likely to be formed when barriers to entry are low. C . is likely to be formed when the minimum-cost output is only a small portion of the market output. D . will seldom use product quality as a competitive weapon. Qu estion 38: Which of the following statements about price searchers in markets with low entry barriers and price takers is true? I. Neither price searchers nor price takers can earn long-run economic profits because barriers to entry are low. II. Both price searchers and price takers are motivated to develop and adopt new costreducing procedures and techniques because lower costs will mean higher short-run profits. III. Price searchers and price takers respond to changing demand conditions in similar ways. A . II and III only. B . I and III only. C . I only. D . I, II, and III.

Question 39: Which one of the following factors is most likely to cause a nation's currency to depreciate on the foreign exchange market? A. An increase in domestic real interest rates B. An increase in the nation's domestic rate of inflation. C. An increase in the inflation rates of the nation's trading partners D. A decrease in the nation's domestic rate of inflation Qu estion 40: How would an unanticipated shift to a more expansionary monetary policy in the United States typically affect the demand for foreign currencies in the United States and the value of the U.S. dollar? Demand for Foreign Exchange A. Increase B. Increase Foreign Currencies Value of the Dollar Decrease No change

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CFA L1 Testbank

C. Decrease D. No change

Increase Decrease

Question 41: The law of comparative advantage suggests that: I. specialization and exchange will permit trading partners to maximize their joint output. II. a nation can gain from trade even when it has an absolute disadvantage in the production of all goods. III. a nation cannot gain from trade when its trading partners are low-wage countries. A. II and III only. B. I and II only. C. II only. D. I only.

Question 42: If the exchange rate value of the British pound goes from US$1.80 to US$1.60, then: A. the pound has depreciated, and the British will find U.S. goods cheaper. B. the pound has appreciated, and the British will find U.S. goods cheaper. C. the pound has appreciated, and the British will find U.S. goods more expensive. D. the pound has depreciated, and the British will find U.S. goods more expensive.

Question 43: Under a system of fixed exchange rates, a nation experiencing an excess of imports over exports can try to remedy this situation by: A . applying an expansionary macroeconomic policy to drive prices up and interest rates down. B . adopting tariffs and quotas. C . reducing its income from investments abroad. D . building up its reserves of foreign currencies and reserve balances with the International Monetary Fund.

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CFA L1 Testbank

Question 44: Security market indexes are used: I. II. as benchmarks for portfolio performance. to construct index funds.

III. as inputs for technical analysis. IV. to determine systematic risk. A . III and IV only. B . II and III only. C . I, II, III, and IV. D . I and II only. Qu estion 45: The divisor for the Dow Jones Industrial Average (DJIA) is most likely to decrease when a stock in the DJIA: A . is removed and replaced. B . has a stock split. C . has a reverse split. D . pays a cash dividend. Qu estion 46: To maintain a fair and orderly market, stock exchange specialists in the United States are expected to: A . neither buy nor sell against the market, regardless of market trends. B . sell against the market when the market is definitely rising but are not expected to buy against the market when the market is definitely declining. C . buy against the market when the market is definitely declining and are expected to sell against the market when the market is definitely rising. D . buy against the market when the market is definitely declining but are not expected to sell against the market when the market is definitely rising. Qu estion 47: Direct trading of securities between two parties with no broker intermediary occurs in: A . the "third market." B . the "fourth market."

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CFA L1 Testbank

C . a listed exchange market. D . over-the counter trading.

Question 48: When analyzing a company's leverage and liquidity, an analyst should treat deferred tax liabilities on a company's balance sheet: A . as long-term debt. B . as short-term debt. C . as equity. D . on a case-by-case basis. Qu estion 49: Which of the following describes how issuing zero-coupon bonds affects a company's financial statements? A . Company net income is overstated every year until maturity. B . Cash flow from financing increases during the year of issuance. C . Cash flow from investing decrease during the year of maturity. D . Cash flow from operations decreases for the life of the bond.

Question 50:

Jones Company plans to lease a computer from Gray Computing

Services. The lease will be a 10-year capital lease with annual payments of $2,400 plus a guarantee of a residual value of $4,000 at the end of the lease. The present value of the lease discounted at the appropriate interest rate of 9 percent is $17,000. Jones Company uses the straight-line depreciation method. In the first year, the reported lease expense will be: A . $3,230 B . $1,700 C . $2,830 D . $2,400 Qu estion 51: Accounting standards are best described as: A . the state of the art presentation of the science of accounting.

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CFA L1 Testbank

B . directed toward measuring the quality of stewardship. C . the result of a political process among groups with diverse interests. D . presentation standards mandated by the U.S. Securities and Exchange Commission. Qu estion 52: Which of the following actions will decrease current net income? A . Using the percentage-of-completion method instead of the completed-contract method B . Capitalizing rather than expensing, a purchase C . Changing from the LIFO method to the FIFO method in periods of rising prices D . Reclassification of a marketable security that has had a permanent decrease in value from current to noncurrent Qu estion 53: Tenley Cafe (TC) estimates a customer has a 1 in 100,000 chance of getting food poisoning. TC serves 25,000 customers each year. The cost to TC of a food poisoning case might range from a free meal to a large damage award. Which of the following statements about a loss contingency for TC is true? A . TC must recognize a loss contingency, because a food poisoning case is expected to occur every fourth year. B . TC must not recognize a loss contingency, because no food poisoning has occurred. C . TC must recognize a loss contingency equal to the expected value of the loss. D . TC must recognize a loss contingency based on the industry average. Qu estion 54: All of the following treatments are allowed under U.S. generally accepted accounting principles EXCEPT: A . treating a 40 percent stock distribution as a stock dividend. B . charging appropriated retained earnings to recognize the outcome of a court case. C . carrying Treasury stock at the repurchase price. D . a company that issued $100 par value preferred stock now selling in the market at $80 should carry that stock on the balance sheet at $100.

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CFA L1 Testbank

Question 55: A corporation wants to increase its current ratio from the present level of 1.5 before it ends its fiscal year. The action having the desired effect is: A . writing down impaired assets. B . paying current payables from cash. C . delaying the next payroll. D . selling current marketable securities for cash at their book value. Qu estion 56: Which of the following ratios are components of a firm's return on equity within the traditional DuPont system? I. Net income to net sales. II. Net annual sales to average receivables. III. Sales to total assets. IV. Total assets to common equity. A . III and IV only. B . I and III only. C . II and IV only. D . I, III, and IV only. Qu estion 57: All of the following appear on a U.S. corporation's financial statements but are not reported on its tax return EXCEPT: A . amortization of goodwill. B . interest income on tax-exempt bonds. C . interest income from investment in U.S. Treasury bonds. D . premium paid on officers' life insurance. Qu estion 58: Which of the following statements about deferred taxes is true? Deferred taxes: A . that arise from depreciation of a particular asset will ultimately reduce to zero as the item is depreciated. B . are not found on the liability side of the balance sheet.

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CFA L1 Testbank

C . result from permanent differences between taxable and reported earnings. D . will decrease only when a cash payment is made. Qu estion 59: White Company has a net temporary difference between tax and book income of $90 million, resulting in deferred taxes of $30.6 million. Under Statement of Financial Accounting Standards 96, an increase in the tax rate would have which of the following impacts on deferred taxes and net income? Deferred / Income Taxes A . Increase Decrease B . Increase No effect C . No effect No effect D . No effect Decrease

Question 60: During a period of rising prices, the financial statements of a firm using FIFO reporting instead of LIFO reporting would show: A . higher total assets and lower net income. B . lower total assets and higher net income. C . higher total assets and higher net income. D . lower total assets and lower net income. Qu estion 61: Compared with firms that expense costs, firms that capitalize costs can be expected to report: A . lower asset levels and lower equity levels. B . lower asset levels and higher equity levels. C . higher asset levels and lower equity levels. D . higher asset levels and higher equity levels. Qu estion 62: Which of the following statements about the balance sheet or income statement is true? A . Classification of marketable securities as current or noncurrent by management is

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CFA L1 Testbank

likely to affect income. B . During inflation, LIFO tends to overstate the current ratio. C . LIFO inventory accounting is less likely to facilitate management of income than FIFO accounting. D . Non-equity marketable securities are carried at lower-of-cost-or-market, except where industry practice differs. Qu estion 63: Which of the following actions will decrease current net income? A . Using the percentage-of-completion method instead of the completed-contract method B . Capitalizing rather than expensing, a purchase C . Changing from the LIFO method to the FIFO method in periods of rising prices D . Reclassification of a marketable security that has had a permanent decrease in value from current to noncurrent Qu estion 64: For a capitalized lease, the implicit interest rate of a lessor is equal to the: A . interest rate that equates the fair market value of leased equipment to the present value of the lease payments. B . weighted average after-tax cost of capital of the lessor. C . interest rate that equates the fair market value of leased equipment to the sum of the present value of the lease payments and the residual value. D . weighted average before-tax cost of capital of the lessor.

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ANSWERS Answer 1: d Rational: Subordinated (junior) debentures hold a claim on the income and assets of the issuer that is subordinated to that of other debentures. As such, they are not quite as secure for the bondholder as other debentures are. Answer 2: c Rational: The law of comparative advantage implies that trading partners can be made better off if each specializes in the production of goods for which it is a low opportunity cost producer and trades for those goods for which it is a high opportunity cost producer. A nation benefits from trade because it imports high opportunity cost goods and produces low opportunity cost goods. As a result, there is greater output overall and each nation is at least as well off as under no trade. With international trade, each country can gain by specializing in the production of goods that it can produce economically and using the proceeds to import goods that would be expensive to produce domestically. Answer 3: b Rational: When the value of the initial margin on deposit with the broker reaches a certain level, called the maintenance margin, the trader is required to replenish the margin, bringing it back to its initial level. Answer 4: c Rational: The value that you would use is the midpoint of a particular class. This will be the average of the upper and lower limits of the class. Answer 5: a Rationale: Remember that in calculating the after-tax cost of debt for new debt issues, the MARGINAL cost of issuing new debt is the most relevant measure. In this example, the marginal cost of debt is given as 7.70%, and the after-tax cost of debt capital is found by multiplying (1 - corporate tax rate) by this figure. Specifically, the calculation of the after-tax cost of debt for Ameriscam is as follows: {pre-tax cost of issuing new debt 7.70% * [1-combined state/federal tax rate 30%]} = 5.39%. While the coupon rate on the firm's outstanding senior debt is often used as a proxy, this number is significantly inferior to the use of marginal figures. What is relevant in this example is the cost of new debt, and this can best be approximated by using the marginal cost of a new debt issue. Often, in capital budgeting and related corporate finance decisions, the only available figures are related to the cost and yield of outstanding debt, and in

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these instances, using the cost of outstanding debt is very appropriate. However, in this example, using the cost of existing debt does not yield the best possible answer. Answer 6: a Rationale: The Capital Asset Pricing Model is an important and widely used tool within the field of finance, and it is imperative for the CFA candidate to have a fundamental understanding of both the methodology and the applications of this approach. Of the six choices listed, only 1 represents a recognized financial equation, and this is the CAPM. The other choices are largely fictitious. Answer 7: f Rationale: The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the Bond-Yield-plus-Risk-Premium approach. In this example, you are required to calculate the cost of equity using the Capital Asset Pricing Model (CAPM), which is illustrated as follows: {risk-free rate + beta(expected return on the market ?risk-free rate)}. Using this model, the cost of common equity can be found as 16.48%. The cost of perpetual preferred stock can be found by dividing the annual dividend by the net offering price, which is illustrated in this case as follows: {$1.75/28.50} = 6.14%. The after-tax cost of debt can be found by taking the yield to maturity on the firms outstanding longterm debt (9.5%), and multiplying this figure by (1 ?annual tax rate 35%) = 6.175%. Incorporating all of these figures into the WACC equation gives a Weighted Average Cost of Capital of 10.807% Answer 8: d Rationale: Harmful externalities which impose collateral costs on producers serve to reduce the level of productive activity. However, if producers are not charged for these costs on society, then their supply curve will be to the right of that which would prevail if the costs had to be borne by them. This would lead to an over-allocation of production assets to such activities. On the other hand, if the benefits of positive externalities accrue to the society in general but not to the actual purchasers of the goods in particular, then non-paying customers enjoy some of the gains without actually paying for the costs. This reduces

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the demand that would otherwise prevail if all the benefits were to accrue to paying customers. Consequently, the production of the goods in question will be lower than that which maximizes efficiency. Answer 9: c Rationale: The GDP deflator is used to calculate real GDP from nominal GDP by adjusting appropriately for inflation. For this, a base year is arbitrarily selected and all values are expressed in terms of the base year currency value (e.g. 1990 U.S. dollars). This is done by dividing the nominal GDP by the GDP deflator. The result indicates the GDP in terms of the purchasing power which prevailed in the base year. Answer 10: e Rationale: Frictional employment arises due to a mismatch between what employers know and what job-seekers are looking for. Specifically, employers do not known about all the available workers and their qualifications while job-seekers are not fully aware of the available job opportunities matching their interests and skills. This leads to a longer job placement time and also causes a higher employee turnover due to job mismatches. The resulting contribution to the unemployment rate is called "Frictional unemployment" and changes in the economy are the primary cause of it. Answer 11: f Rationale: "Discouraged workers" are those who are no longer seeking employment, though they would accept it if it were offered to them. For this reason, they are not considered part of the labor force and hence, not "unemployed" (only people in the labor force can be "unemployed.") An increase in unemployment benefits decreases the opportunity cost of staying unemployed. This tends to increase the time workers remain unemployed, increasing the unemployment rate. Even if a person works part-time, he is considered fully employed while compiling the employment statistics. Therefore, II is not true. Answer 12: g Rationale: Members have an obligation to ensure that their firms establish compliance procedures requiring all employees who disseminate investment recommendations or actions to

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treat clients fairly. The number of people privy to an investment recommendation should be limited. The amount of time that lapses between the decision and the dissemination of the recommendation should be shortened. Guidelines must be established to prohibit persons who have prior knowledge from discussing a pending recommendation. Trading activities should be monitored and controlled. Procedures should be established to determine whether a change in an investment recommendation is considered material. The organization should disclose to firms whether or not it offers two or more levels of service to clients for the same or different fees. Answer 13: b Rationale: You can think of the p-value as the maximum probability that the null hypothesis is true despite observing the value of the test statistic that you have in the sample at hand. Thus, the lower the p-value, the greater is your confidence in rejecting the null hypothesis. The significance level represents an upper bound on the probability that the null hypothesis is true given the observed sample and the testing procedure. Hence, if you reject the null at the 5% significance level, for e.g., then the probability that the null is true despite your statistical evidence to the contrary could be as high as 5% (but no more, under the assumptions of the test). A Type II error refers to the event that we will fail to reject the null when it is false. The higher the probability of a Type II error, the lower the chance of rejecting the null when it is false. Answer 14: b Rationale: Incremental cash flows of a project are the cash flows that occur if and only if the project is undertaken. Since the effects of debt financing are taken into account through the discount rate used to discount the project cash flows, interest payments are ignored while estimating the project's cash flows. Therefore, a project's incremental cash flows are not affected by interest expenses. Sunk costs represent expenses that have already been incurred or committed to. Therefore, they should not be allowed to affect future decisions.

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Finally, since income includes non-cash items, the discounting of income numbers can distort the project rankings based on cash flows. In capital budgeting, annual cash flows, not accounting income, are used to evaluate a project. Answer 15: c Rationale: The law of comparative advantage implies that trading partners can be made better off if each specializes in the production of goods for which it is a low opportunity cost producer and trades for those goods for which it is a high opportunity cost producer. This will minimize the cost of production and leads to maximum output. Answer 16: c Rationale: Both of these statements are true. The law of comparative advantage implies that trading partners can be made better off if each specializes in the production of goods for which it is a low opportunity cost producer and trades for those goods for which it is a high opportunity cost producer. This situation will lead to a minimization of costs and a maximization of output. There must be differences in the relative prices of products across countries in order for this comparative advantage to be realized. This is because the price of a good reflects the production costs. If all production costs were equal across countries then there would be no incentive to trade since each country can produce with equal efficiency. Answer 17: c Rationale: Trade restrictions promote inefficiency because they send the wrong signals to producers when foreigners can produce the good more cheaply. Under an import restricting policy, domestic producers of this good will be able to sell more of their output at a higher price (reduced foreign supply will cause the price of the good to rise domestically). This encourages domestic production of the good (in which the producers do not have a comparative advantage). Thus, the consequence of the trade restriction was a reallocation of the nation's resources toward the production of goods in which it does not have a comparative advantage. If there was a comparative advantage in the good, the country would not have imported it in the first place. Answer 18: e

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Rationale: Indenture provisions specify the issuer's legal requirements. They are enforced by a trustee (usually a bank) acting on the behalf of the bondholders. A freely callable provision allows the issuer to retire the issue at any time. A deferred call provision allows the issuer to retire the issue after a certain amount of time. A noncallable provision prohibits the issuer from retiring the issue prior to its maturity. Answer 19: c Rationale: According to the expectation hypothesis: the shape of the yield curve results from the interest rate expectations of market participants. In essence this means that a long-term interest rate has a term structure which involves a series of intermediate and long-term interest rates, each of which is a reflection of the geometric average of current and expected 1-year interest rates. Answer 21: a Rationale: The promised yield to maturity (YTM) is the most widely used bond yield figure because it can indicate the fully compounded rate of return on a bond to an investor who purchases it at the market price. The promised yield to maturity will equal the actual realized yield if the investor holds the bond to maturity, and if he reinvests the interest income from the bond into investments that earn the same YTM rate. Answer 21: g Rationale: In the question, you can be easily be misled into selecting the supply curve will move to the left in the long run and prices will fall in the long run. The two important points to note are that this is a price-taking market and you have to distinguish between short-term vs. long-term effects. In a price-taking market, there are a large number of competitors producing the same, non-differentiated good. Hence, price has already been driven down to the level where economic profits are zero i.e. where the price is just high enough to cover the average total costs. Thus, in the long run, prices cannot go any lower in the long run without a fundamental change in production techniques or resource prices. In the short run, the sudden decrease in demand moves the demand curve to the left but the supply curve does not move. This causes the price of the good to fall in the short run, causing economic losses to the firms. In response, some of the firms will leave the market over time and the supply of the good at any given price will diminish. This will move the supply curve to the left,

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CFA L1 Testbank

raising the price of the good. A new equilibrium will be reached in the long run with a fewer number of firms surviving in the market and the price rising back to the level where the economic profits equal zero. In the extreme case where demand drops so much that only a handful of firms can survive in the market, the market will get transformed from a price-taking market to an oligopoly or a monopoly. You should remember from this example that price need not fall in the long run when demand falls, since you have to account for movements not only in the demand curve but also in the supply curve. Answer 22: c Rationale: Remember that in competitive markets, economic profits are zero in the long run and hence, the equilibrium point is where the price equals average total cost. The demand curve facing a monopolistically competitive producer is downward sloping (and not horizontal, as is the case in a price-taking market). Therefore, the equilibrium point corresponds to the quantity where the slope of the ATC curve is negative, implying that the equilibrium output is less than the quantity at which the average total cost is minimized. Therefore, neither I nor II can be true. Since IV is the profit maximizing condition which holds in all markets (except oligopolies), IV is the only correct choice. Answer 23: f Rationale: A monopolistic firm will try to maximize profits. Profits equal total revenue minus total costs (which include both implicit and explicit costs). Hence, maximizing profit means the same thing as maximizing the difference between total revenues and total costs. This is also the same as producing at a level where marginal revenue equals marginal cost. When the additional cost of producing one more unit is less than the revenue that can be obtained by selling that unit, a producer will want to produce that additional unit and vice versa. This automatically implies that profits are maximized when marginal revenue equals marginal cost. Answer 24: c Rationale: This question requires an understanding of what the market portfolio means in the CAPM. The true market portfolio is the one that consists of all the risky assets traded in the entire investment universe available, not just stocks and bonds. It also is the tangency portfolio, having the highest excess-reward-to-risk ratio amongst all portfolios consisting of purely risky assets.

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As such, any proxy used for the true market portfolio will give an estimated market premium lower than the true market risk premium. Since the premium is underestimated, the required rate of return expected from the portfolio manager will be underestimated. Thus, his/her performance will be deemed better than it would actually be against the true market portfolio. Effectively, his performance will be overestimated. Answer 25: c Rationale: The signaling theory is properly applicable only to mature firms that have had stable dividend policies because in its pure form, the theory regards dividend changes as signals of management's forecasts of future earnings. Such an assumption is not fully justifiable for young, growth firms, which may cut dividends simply to supply retained earnings capital for expansion projects, without any signaling about the firm's future earnings prospects. Indeed, many growth firms pay no dividend at all for quite some time without an adverse effect on their stock prices. Hence, the increase in the dividend of a mature firm is taken as a signal by investors under the signaling hypothesis - that the management's forecasts of future earnings are quite favorable, leading to a rise in the stock price. On the other hand, for a growth firm, such a signaling conclusion does not necessarily hold. Answer 26: a Rationale: Under the Residual Dividend Policy, a firm first determines the amount of capital it requires for sufficiently profitable projects. It then uses retained earnings to supply equity capital and raises debt in the proper amount to maintain the target capital structure. If any earnings are left over after this, they are paid out as dividends. If not, the firm will not only not pay any dividends but also issues new equity for financing. Thus, the amount of dividends paid out can swing wildly from one year to the next, based on the current business conditions and future growth prospects. Answer 27: c Rationale & Reference: External sources may try to influence the investment process by offering analysts and portfolio managers a variety of perks. Corporations may be seeking expanded research coverage; issuers and underwriters may wish to promote new

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securities offerings; brokers typically want to increase commission business. The perks may include gifts, invitations to lavish functions, tickets and so on. One type of perk that has gained particular notoriety is the allocation of shares in oversubscribed IPOs to investment managers for their personal accounts. This practice is a violation under Standard IV (A.3). Answer 28: c Rationale & Reference: Total return, including realized and unrealized gains plus income, must be used when calculating investment performance. Portfolios must not be switched from one composite to another unless documented changes in client guidelines make switching appropriate. This is a requirement for calculation of returns. Answer 29: c Rationale & Reference: There are two ways to raise price: the first is to increase the nominal price of a good while holding quality constant. The second way to raise price is to maintain nominal price while reducing quality. This is what happens when there is a price ceiling which precipitates a shortage: since producers are not able to raise price they implicitly raise price by allowing the quality of the good to decline. Answer 30: d Rationale & Reference: An inward shift of the supply curve for orange juice will cause the equilibrium to occur at a higher price and lower output. However, there is another factor to consider: the supply of apples increased, causing the price of apple juice to decline. This will cause the demand for orange juice to shift inward, since apple and orange juice are substitutes. The inward shift of the demand curve for orange juice implies that the price of the new equilibrium for orange juice may either go up or down. It is indeterminate without knowing the specifics of the demand and supply. Answer 31: c Rationale: This question involves three Standards. Andrea, the portfolio manager, has been obtaining lower prices for her personal securities transactions than she gets for her clients, which is a violation of Standard IV (B.1), Fiduciary Duties. In addition, she violated Standard II (B), Professional Misconduct, by failing to adhere to company policy and hiding her personal transactions from her firm. Andrea's supervisor, Bates, violated Standard III (E), Responsibilities of Supervisors, by failing to enforce the procedures for reporting personal trading. Therefore, Statements I, II and III are all correct.

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CFA L1 Testbank

Answer 32: e Rationale: Profits equal total revenue minus total costs (which include both implicit and explicit costs). Hence, maximizing profit means the same thing as maximizing the difference between total revenues and total costs. This is also the same as producing at a level where marginal revenue equals marginal cost. When the additional cost of producing one more unit is less than the revenue that can be obtained by selling that unit, a producer will want to produce that additional unit and vice versa. This automatically implies that profits are maximized when marginal revenue equals marginal cost. Answer 33: d Rationale: The cash flows that could be earned if the assets were not used for the project but elsewhere are known as "opportunity costs." None of the given choices fits this definition. Note that the costs already incurred in developing the project are called "sunk costs," the costs incurred due to the effects of the project on the firm's other projects at hand are "externality" or "spill-over" costs. "The costs that would be incurred in one or more of mutually exclusive projects that are rejected in favor of the project selected" looks tempting but is not an opportunity cost. Answer 34) the industry. Answer 35) A*. accounting profit does not consider the opportunity cost of the firm's C*. more elastic in the long run because firms have time to enter or leave

equity capital, and therefore, it generally overstates economic profit. Answer 36) a price taker. Answer 37) decisions. Answer 38) D . I, II, and III. A . will consider the potential response of its rivals when making business A . The monopolistic firm is a price searcher, and the competitive firm is

39) B*. An increase in the nation's domestic rate of inflation. 40) A*. Increase Decrease 41) B*. I and II only.

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CFA L1 Testbank

42)

D*. the pound has depreciated, and the British will find U.S. goods more

expensive. 43) B*. adopting tariffs and quotas. 44) 45) 46) 47) 48) 49) 50) 51) 52) 53) 54) 55) 56) 57) 58) 59) 60) 61) 62) 63) 64) C B C B D B C C D B B B*. D*. C*. A*. A*. C D A D C

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CFA L1 Testbank