CFA Prep Test L1

1. An example of an expense classification by function is:

Cost of goods sold

Interest expense.

Tax expense.

Cost of goods sold is a classification by function. The other two expenses represent classifications by nature.

Explanation

Cost of goods sold is a classification by function. The other two expenses represent classifications by nature.

2. An analyst gathered the price‐earnings ratios (P/E) for the firms in the S&P 500 and then ranked the firms from highest to lowest P/E. She then assigned the number 1 to the group with the lowest P/E ratios, the number 2 to the group with the second lowest P/E ratios, and so on. The measurement scale used by the analyst is best described as:

Ratio

Ordinal.

Interval.

Ordinal scale involves sorting data into categories based on some characteristic such as larger to smaller

Explanation

Ordinal scale involves sorting data into categories based on some characteristic such as larger to smaller

3. Oligopolistic pricing strategy most likely results in a demand curve that is:

Kinked.

Vertical.

Horizontal

The oligopolist faces two different demand structures, one for price increases and another for price decreases. Competitors will lower prices to match a price reduction, but will not match a price increase. The result is a kinked demand curve.

Explanation

The oligopolist faces two different demand structures, one for price increases and another for price decreases. Competitors will lower prices to match a price reduction, but will not match a price increase. The result is a kinked demand curve.

4. Assume U.S. GAAP applies unless otherwise noted. All else equal, the net profit marginfor a company will be highest if, for new depreciable assets, that company uses:

High salvage value estimates and long average lives.

High salvage value estimates and short average lives

Low salvage value estimates and long average lives.

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.

Explanation

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.

5. Apex Consignment sells items over the internet for individuals on a consignment basis. Apex receives the items from the owner, lists them for sale on the internet, and receives a 25 percent commission for any items sold. Apex collects the full amount from the buyer and pays the net amount after commission to the owner. Unsold items are returned to the owner after 90 days. During 2006, Apex had the following information: 􀂾 Total sales price of items sold during 2006 on consignment was €2,000,000, How much revenue should Apex report on its 2006 income statement?

€500,000.

€.2,000,000

€1,500,000.

Apex is not the owner of the goods and should only report its net commission as revenue. C is the amount paid to the owners. B is the total amount collected on behalf of the owners.

Explanation

Apex is not the owner of the goods and should only report its net commission as revenue. C is the amount paid to the owners. B is the total amount collected on behalf of the owners.

6. Two‐dimensional demand and supply curves are drawn under which of the following assumptions?

All variables but own price and quantity are held constant.

All variables but quantity are held constant.

Own price is held constant.

in order to draw demand and supply curves, own price and own quantity must be allowed to
vary. However, all other variables are held constant to focus on the relation of own price with
quantity.

Explanation

in order to draw demand and supply curves, own price and own quantity must be allowed to
vary. However, all other variables are held constant to focus on the relation of own price with
quantity.

7. A portfolio manager entered into a swap with a dealer. The swap's notional principal is$100 million, payments are to be made semiannually, and the swap allows netting ofpayments. The dealer agrees to pay a fixed annual rate of 4 percent while the assetmanager agrees to pay the return on a stock index. The index value at initiation of theswap is 280. If the value of the stock index six months after initiation of the swap is 250,the payment from the dealer to the asset manager would be closest to:

$13 million.

$9 million.

$2 million.

The loss on the stock index means that the dealer must also pay the negative amount to the asset manager in addition to the fixed rate on the notional principal. The amount that the dealer would pay is approximately $13 million: ($100,000,000) (0.04) / 2 = $2,000,000 for the fixed payment.
The negative return on the stock index computed as follows is (250/280) ‐ 1 = ‐0.1071, for a dollar payment of ‐0.1071(100,000,000j = $10,714.286 for the stock index. The dealer must pay roughly $2 million plus $11 million.

Explanation

The loss on the stock index means that the dealer must also pay the negative amount to the asset manager in addition to the fixed rate on the notional principal. The amount that the dealer would pay is approximately $13 million: ($100,000,000) (0.04) / 2 = $2,000,000 for the fixed payment.
The negative return on the stock index computed as follows is (250/280) ‐ 1 = ‐0.1071, for a dollar payment of ‐0.1071(100,000,000j = $10,714.286 for the stock index. The dealer must pay roughly $2 million plus $11 million.

8. A futures trader goes long one futures contract at $450. The settlement price one daybefore expiration is $500. On expiration day, the futures is trading at $505. The mostlikely way the futures trader will lock in her profits on expiration is:

Takes delivery of the underlying asset and pays the expiration settlement price to the short.

Close out the futures position by selling the futures contract at $505.

Takes delivery of the underlying asset and pay $500 to the short.

To lock in profits if possible sell the futures contract at the price of the expiration day.

Explanation

To lock in profits if possible sell the futures contract at the price of the expiration day.

9. A U.S. investor has purchased a tax-exempt 5-year municipal bond at a yield of 3.86%, which is 100 basis points less than the yield on a 5-year option-free U.S. Treasury. If the investor's marginal tax rate is 32%, then the taxable-equivalent yield and the yield ratio are closest to:

Taxable Equivalent Yield	Yield Ratio
2.62	0.79
2.62	1.26
5.68	0.79
5.68	1.26

5.68, 1.26

5.68, 0.79

2.62, 0.79

compute, compare, and contrast the various yield spread measures;
compute the after-tax yield of a taxable security and the tax-equivalent yield
of a tax-exempt security
Taxable equivalent yield = (tax-exempt yield) / (1 - marginal tax rate) =
3.86 / (1 - 0.32) = 5.68%
Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) =
3.86 / (3.86 + 100bp) = 3.86 / 4.86 = 0.79

Explanation

compute, compare, and contrast the various yield spread measures;
compute the after-tax yield of a taxable security and the tax-equivalent yield
of a tax-exempt security
Taxable equivalent yield = (tax-exempt yield) / (1 - marginal tax rate) =
3.86 / (1 - 0.32) = 5.68%
Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) =
3.86 / (3.86 + 100bp) = 3.86 / 4.86 = 0.79

10. An analyst is reviewing a corporate bond with the following couponstructure:Coupon rate = 20% ‐ 2 * (10 year Treasury rate)This corporate bond is most appropriately classified as a(n):

Deferred coupon bond.

Inverse floater.

Step‐up note.

Inverse floaters are issues whose coupon rate moves in the opposite direction from the
reference rate.
The coupon formula for an inverse floater is:
Coupon rate = K ‐ I. × (Reference rate)
where K and L are values specified in the prospectus.

Explanation

Inverse floaters are issues whose coupon rate moves in the opposite direction from the
reference rate.
The coupon formula for an inverse floater is:
Coupon rate = K ‐ I. × (Reference rate)
where K and L are values specified in the prospectus.

11. When an analyst is unsure of the underlying population distribution, which of the following is least likely to increase the reliability of parameter estimates?

Use of point estimates rather than confidence intervals

Increase in the sample size

Use of the t‐distribution rather than the normal distribution to establish confidence intervals

Point estimates are not as reliable as confidence interval estimates. A conservative approach to confidence intervals relies on the t‐distribution rather than the normal distribution, and use of the t‐distribution will increase the reliability of the confidence interval. Increasing the sample size increases the reliability of the confidence interval.

Explanation

Point estimates are not as reliable as confidence interval estimates. A conservative approach to confidence intervals relies on the t‐distribution rather than the normal distribution, and use of the t‐distribution will increase the reliability of the confidence interval. Increasing the sample size increases the reliability of the confidence interval.

12. Alexandra Zagoreos, CFA, is the head of a government pension plan. Whenever Zagoreos hires amoney management firm to work with the pension plan, she finalizes the deal over dinner at a nice restaurant. At these meals, Zagoreos also arranges for the money manager to provide her payments equal to 10% of the management fee the manager receives from the pension plan. Zagoreos keeps half of the payments for her own use and distributes the remainder as cash incentives to a handful of her most trusted staff. Zagoreos least likely violated which of the following CFA Institute Code of Ethics and Standards of Professional Conduct?

Referral fees.

Loyalty, Prudence and Care.

Additional Compensation Arrangements.

As the money should not be accepted without receiving written consent from all parties involved, therefore Zagoreos is in violation of Standard IV (B) Additional Compensation Arrangements. However, there is no indication that the member has received compensation, consideration, or benefit received from, or paid to, others for the recommendation of products or services and therefore has not violated Standard VI (6) Referral Fees.

Explanation

As the money should not be accepted without receiving written consent from all parties involved, therefore Zagoreos is in violation of Standard IV (B) Additional Compensation Arrangements. However, there is no indication that the member has received compensation, consideration, or benefit received from, or paid to, others for the recommendation of products or services and therefore has not violated Standard VI (6) Referral Fees.

13. A company, which prepares its financial statements in accordance with IFRS uses the revaluation model to value land. At the end of the current year the value of the land has increased and will be adjusted on the balance sheet. Which of the following statements is most accurate? In the current period the revaluation of the land will:

Increase return on assets.

Increase return on sales

Decrease the debt to equity ratio.

The increase in the value of the land bypasses the income statement and goes directly to a revaluation surplus account in equity. Equity increases thereby decreasing the debt to equity ratio.

Explanation

The increase in the value of the land bypasses the income statement and goes directly to a revaluation surplus account in equity. Equity increases thereby decreasing the debt to equity ratio.

14. Which of the following least likely describes an unstable market equilibrium ?

The supply curve is less steeply sloped than the demand curve.

Excess supply will tend to drive prices down.

Prices that differ from equilibrium values tend to move further away from equilibrium.

An unstable market equilibrium is characterized by prices that tend to move further away from equilibrium. This means that any deviation from the equilibrium price will result in prices moving even further away from the equilibrium value. In contrast, excess supply tends to drive prices down towards equilibrium, which is the opposite of what an unstable market equilibrium would exhibit. Therefore, excess supply driving prices down is the least likely description of an unstable market equilibrium.

Explanation

An unstable market equilibrium is characterized by prices that tend to move further away from equilibrium. This means that any deviation from the equilibrium price will result in prices moving even further away from the equilibrium value. In contrast, excess supply tends to drive prices down towards equilibrium, which is the opposite of what an unstable market equilibrium would exhibit. Therefore, excess supply driving prices down is the least likely description of an unstable market equilibrium.

15. Which of the following is most likely a reason for using asset‐based valuation?

The company has a relatively high level of intangible assets

The analyst is valuing a privately held company.

The market values of assets and liabilities are different from the balance sheet values.

Asset‐based valuations are most often used when an analyst is valuing private enterprises. Both
B and C are considerations in asset‐based valuation but are more likely to be reasons to avoid
that valuation model rather than reasons to use it.

Explanation

Asset‐based valuations are most often used when an analyst is valuing private enterprises. Both
B and C are considerations in asset‐based valuation but are more likely to be reasons to avoid
that valuation model rather than reasons to use it.

16. Markowitz portfolio theory is most accurately described as including an assumption that:

Risk is measured by the range of expected returns.

Investor utility curves demonstrate diminishing marginal utility of wealth.

Investors have the ability to borrow or lend at the risk‐free rate of return.

MPT assumes investors maximize one‐period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth. http://en.wikipedia.org/wiki/Modern_portfolio_theory

Explanation

MPT assumes investors maximize one‐period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth. http://en.wikipedia.org/wiki/Modern_portfolio_theory

17. In principle and in practice, rent ceilings are most likely to:

Prevent the housing market from operating in the social interest.

Be efficient.

Be fair.

In principle and in practice rent ceilings are inefficient and unfair. They prevent the housing market from operating in the social interest.

Explanation

In principle and in practice rent ceilings are inefficient and unfair. They prevent the housing market from operating in the social interest.

18. Which of the following statements best illustrates the difference between a Giffen good and a Veblen good?

The substitution effect for each is in opposite directions.

The Veblen good alone has a positively sloped demand curve.

The Giffen good alone is an inferior good.

Veblen goods are not inferior goods, whereas Giffen goods are. An increase in income for
consumers of a Veblen good leads to an increase in the quantity purchased at each price. The
opposite is true for a Giffen good.

Explanation

Veblen goods are not inferior goods, whereas Giffen goods are. An increase in income for
consumers of a Veblen good leads to an increase in the quantity purchased at each price. The
opposite is true for a Giffen good.

19. Degree of operating leverage is best described as a measure of the sensitivity of:

Fixed operating costs to changes in variable costs.

Net earnings to changes in sales.

Operating earnings to changes in the number of units produced and sold.

The degree of operating leverage is the elasticity of operating earnings with respect to the number of units produced and sold. As an elasticity, the degree of operating leverage measures the sensitivity of operating earnings to a change in the number of units produced and sold.

Explanation

The degree of operating leverage is the elasticity of operating earnings with respect to the number of units produced and sold. As an elasticity, the degree of operating leverage measures the sensitivity of operating earnings to a change in the number of units produced and sold.

20. An economic forecasting firm has estimated the following equation from historical databased on the neoclassical growth model:Potential output growth = 1.5 + 0.72 X Growth of labor + 0.28 X Growth of capitalThe intercept (1.5) in this equation is best interpreted as:

The long‐run sustainable growth rate.

Above trend historical growth that is unlikely to be sustained.

The growth rate of total factor productivity.

The estimated equation is the standard Solow growth accounting equation. The intercept is the growth rate of total factor productivity.

Explanation

The estimated equation is the standard Solow growth accounting equation. The intercept is the growth rate of total factor productivity.

21. The following information is available about a manufacturing company: $ million Cost of ending inventory computed using FIFO 4.3 Net realizable value 4.1 Current replacement cost 3.8 Compared to U.S. GAAP, the company's gross profit ($ millions) computed under IFRS is most likely:

The same

0.3 lower

0.3 higher

Under IFRS, the inventory would be written down to its net realizable value ($4.1 million) whereas, under U.S. GAAP, market is defined as current replacement cost and hence would be written down to its current replacement cost ($3.8). The larger closing inventory value under IFRS will reduce the amount charged to the cost of goods sold, as compared to U.S. GAAP, and result in a higher gross profit of $0.3 million.

Explanation

Under IFRS, the inventory would be written down to its net realizable value ($4.1 million) whereas, under U.S. GAAP, market is defined as current replacement cost and hence would be written down to its current replacement cost ($3.8). The larger closing inventory value under IFRS will reduce the amount charged to the cost of goods sold, as compared to U.S. GAAP, and result in a higher gross profit of $0.3 million.

22. In the Ricardian trade model, a country captures more of the gains from trade if:

The terms of trade are closer to its partner's autarkic prices than to its autarkic prices.

The terms of trade are closer to its autarkic prices than to its partner's autarkic prices.

It produces all products while its trade partner specializes in one good.

A country gains if trade increases the price of its exports relative to its imports as compared to its
autarkic prices, i.e. the final terms of trade are more favorable than its autarkic prices. If the
relative price of exports and imports remains the same after trade opens, then the country will
consume the same basket of goods before and after trade opens, and it gains nothing from the
ability to trade. In that case, its trade partner will capture all of the gains. Of course, the opposite
is true if the roles are reversed. More generally, a country captures more of the gains from trade
the more the final terms of trade differ from its autarkic prices.

Explanation

A country gains if trade increases the price of its exports relative to its imports as compared to its
autarkic prices, i.e. the final terms of trade are more favorable than its autarkic prices. If the
relative price of exports and imports remains the same after trade opens, then the country will
consume the same basket of goods before and after trade opens, and it gains nothing from the
ability to trade. In that case, its trade partner will capture all of the gains. Of course, the opposite
is true if the roles are reversed. More generally, a country captures more of the gains from trade
the more the final terms of trade differ from its autarkic prices.

23. If the distribution of the population from which the samples are drawn is positivelyskewed, and given that the sample size is large, the sampling distribution of the samplemeans is most likely:

To have a mean smaller than the mean of the entire population.

To have a variance equal to that of the entire population.

Approximately normally distributed.

The central limit theorem establishes that the sampling distribution of sample means will be approximately normal, will have a mean equal to the population mean, and will have a variance equal to the population variance divided by the sample size.

Explanation

The central limit theorem establishes that the sampling distribution of sample means will be approximately normal, will have a mean equal to the population mean, and will have a variance equal to the population variance divided by the sample size.

24. Calculate the 2009 return on equity (ROE) of a stable company using the following data: Total sales £2,500,000, Net income £2,000,000, Beginning of year total assets £50,000,000, Beginning of year total liabilities £35,000,000, Shares outstanding at end of 2009 1,000,000, Price per share at the end of 2009 £20.

13.3%

10.0%

16.7%

A company's ROE is calculated as (NIt/BVEt‐1). For 2009, the BVEt‐1 is equal to the beginning total assets minus the beginning total liabilities, which equals &50,000,000 ‐ f 35,000,000 =
£15,000,000. Therefore, ROE200=9 £2,000,000/£ 15,000,000= 13.3%.

Explanation

A company's ROE is calculated as (NIt/BVEt‐1). For 2009, the BVEt‐1 is equal to the beginning total assets minus the beginning total liabilities, which equals &50,000,000 ‐ f 35,000,000 =
£15,000,000. Therefore, ROE200=9 £2,000,000/£ 15,000,000= 13.3%.

25. Rachel Kelly, 24 years old, is planning for retirement. Kelly's annual consumption expenditures are currently $30,000. She assumes her consumption expenditures will increase with the rate of inflation, and she expects the average inflation rate is 3% until she retires at the age of 68.Given a life expectancy of 93 years and constant expenditures in retirement, the amount Kelly must accumulate by her retirement date, assuming an 8% rate of return on her retirement account, is closest to:

$423,000.

$1,552,000.

$1,176,000.

(68-24=44) so she has 44 years to retire. The annual expense will go to 30,000×(1.03^44) =110143.57. Since her expenditure is constant after she retires and she expect to live 25 years more till the age of 93. Using BAii calculator: PMT=‐110,143.57 ，FV=0，T=25，I/Y=8， CPT PV=1,175,758.

Explanation

(68-24=44) so she has 44 years to retire. The annual expense will go to 30,000×(1.03^44) =110143.57. Since her expenditure is constant after she retires and she expect to live 25 years more till the age of 93. Using BAii calculator: PMT=‐110,143.57 ，FV=0，T=25，I/Y=8， CPT PV=1,175,758.

26. Compared to its market‐value‐weighted counterpart, a fundamentally weighted indexwill least likely have a:

Contrarian “effect.”

Value tilt.

Momentum “effect.”

Momentum “effect” is a characteristic of a market‐value‐weighted index, not a fundamentally
weighted index.

Explanation

Momentum “effect” is a characteristic of a market‐value‐weighted index, not a fundamentally
weighted index.

27. The initial measurement of goodwill is most likely affected by:

The fair value of the acquirer's assets and liabilities.

The acquired company's book value.

An acquisition's purchase price.

The initial measurement of goodwill is most likely affected by the fair value of the acquirer's assets and liabilities. This is because goodwill is calculated as the difference between the purchase price of an acquisition and the fair value of the identifiable net assets acquired. The fair value of the acquirer's assets and liabilities is important in determining the overall value of the acquisition and therefore impacts the calculation of goodwill. The acquired company's book value and the acquisition's purchase price may also play a role in the calculation, but the fair value of the acquirer's assets and liabilities is the most likely factor to affect the initial measurement of goodwill.

Explanation

The initial measurement of goodwill is most likely affected by the fair value of the acquirer's assets and liabilities. This is because goodwill is calculated as the difference between the purchase price of an acquisition and the fair value of the identifiable net assets acquired. The fair value of the acquirer's assets and liabilities is important in determining the overall value of the acquisition and therefore impacts the calculation of goodwill. The acquired company's book value and the acquisition's purchase price may also play a role in the calculation, but the fair value of the acquirer's assets and liabilities is the most likely factor to affect the initial measurement of goodwill.

28. Which of the following is an appropriate method of computing free cash flow to thefirm?

Deduct both after‐tax interest payments and capital expenditures from operating cashflows.

Add operating cash flows to capital expenditures and deduct after‐tax interest payments.

Add operating cash flows to after‐tax interest payments and deduct capital expenditures.

Free cash flow to the firm can be computed as operating cash flows plus after‐tax interest
expense less capital expenditures.

Explanation

Free cash flow to the firm can be computed as operating cash flows plus after‐tax interest
expense less capital expenditures.

29. A per‐unit tax on items sold that is paid by the seller will most likely result in the:

Demand curve shifting vertically upward

Demand curve shifting vertically downward.

Supply curve shifting vertically upward.

The lowest acceptable price to the supplier at any given quantity must now increase because part of the price is paid as a per‐unit tax. Thus, the supply curve shifts upward.

Explanation

The lowest acceptable price to the supplier at any given quantity must now increase because part of the price is paid as a per‐unit tax. Thus, the supply curve shifts upward.

30. All else equal, if the elasticity of demand and the elasticity of supply both increase, which of the following is most likely?

Consumer surplus will increase and producer surplus will increase

Consumer surplus will decrease and producer surplus will decrease.

Consumer surplus will decrease and producer surplus will increase.

If both the elasticity of demand and elasticity of supply increase, both the demand curve and the supply curve will become more horizontal. The space between the curves to the left of the equilibrium quantity will become smaller and both consumer and producer surplus will decrease.

Explanation

If both the elasticity of demand and elasticity of supply increase, both the demand curve and the supply curve will become more horizontal. The space between the curves to the left of the equilibrium quantity will become smaller and both consumer and producer surplus will decrease.