SIMULACRO Nº1 (AM) – NIVEL 1

ETHICS:

Question #1
A member or candidate who rejects a disciplinary sanction proposed by the Professional Conduct Program:
A) may request an appeal to a hearing panel.
B) will be suspended from membership or participation in the CFA Program.
C) will typically not be subject to further disciplinary procedure unless a new investigation is initiated.
A member or candidate may accept a proposed disciplinary sanction or request an appeal to a hearing panel.
Reading 2

Question #2
Which of the following is NOT part of the CFA Institute Code of Ethics?
A) Competence.
B) Independent judgment.
C) Contractual provisions.
Contractual provisions are not part of the Code of Ethics.
Reading 2

Question #3
Jacob Allen, CFA, decides he could make more money if he started his own company. Which of the following steps
would NOT violate Standard IV(A), Loyalty to Employer?
A) Taking home his current employer's client lists, investment statements and marketing presentations.
B) Taking home the employer's buy lists.
C) Getting written permission from his employer to call the clients and solicit their business for his new firm.
If Jacob gets written permission from his employer to solicit their clients (not likely, obviously) he would not be violating
the Loyalty to Employer Standard.
Reading 3

Question #4
Gordon McKinney, CFA, works in the trust department of a bank. The bank's trust account holds a large block of a
particular company. McKinney learns that this company is going to buy back one million shares at a 15% premium to
the market price on a first-come-first-served basis. McKinney immediately tells his mother-in-law to tender her shares
but waits until the end of the day to tender the trust's shares. McKinney has most likely violated:
A) Standard II(A), Material Nonpublic Information.
B) Standard IV(A), Loyalty to Employer.
C) Standard VI(B), Priority of Transactions.
Standard VI(B), Priority of Transactions, applies. If an analyst decides to make a recommendation about the purchase
or sale of a security, he must give his customers or employer adequate opportunity to act on this recommendation
before acting on his own behalf. Personal transactions include those made for the member's own account and family
accounts. Here, McKinney violated Standard VI(B) by acting on his mother-in-law's behalf and then waiting until the
end of the day to act on his employer's behalf.
Explanations for other responses:
 Standard IV(A), Loyalty to Employer, does not apply. This standard concerns a member competing with his/her
employer (independent practice), for example a member who engages in outside consulting.
 Standard II(A), Material Nonpublic Information, does not apply. The question does not indicate that the information
is not public.
Reading 3

Question #5
Paul Salyer,a portfolio manager, is making a presentation to a prospective client. Paul says that as a new portfolio
manager, he made an average annual rate of return of 50% in the last two years at his previous firm and that based
on this, he can guarantee a 50% return to the client. Which of the following statements is in accordance with Standard
III(D), Performance Presentation?
A) Implying that he can guarantee a return.
B) Imputing his past performance to future performance.
C) Stating his past performance as long as it is fact.
There is no evidence that he's lying about his past performance. He is in violation for implying that he can guarantee
performance, for using short-term performance, and for imputing the manager's past performance to future
performance.
Reading 3.

Question #6
Which of the following activities will least likely constitute a violation of Standard IV(A), Loyalty?
A) Conspiracy to bring about a mass resignation of other employees.
B) Contacting your current clients and asking them to "come with you" when you resign from your current employer.
C) Consulting on your own time and obtaining written permission from your employer.
Consulting on your own time and obtaining written permission from your employer does not constitute a violation of
Standard IV(A).
Reading 3

Question #7
When using the CFA designation, which of the following is appropriate?
A) Jones CFA's, Inc.
B) "I am a CFA."
C) "I am a CFA charterholder."
The only appropriate use of the designation is "I am a CFA charterholder." You cannot use the designation as a noun
(as in "I am a CFA") and you cannot use the designation in the company name.
Reading 3

Question #8
Stephanie Orange, Level II CFA candidate, posts blogs for her exam study group three days after the exam to vent
her frustrations over the exam. However, to avoid disclosing what was actually on the exam, she only discusses topic
areas she thought would be on the exam that were not. She writes "...the topics selected were unnecessarily obscure.
Important items like FCF, DDM, and Residual Income were ignored completely..." Orange is most likely:
A) in violation of Standard VII(A) "the Code and Standards" for providing confidential information about the exam.
B) not in violation because the information about the actual exam contents was posted only after the conclusion of the
exam.
C) not in violation because the information was only about what was not on the exam.
Standard VII(A) Conduct as Participants in CFA Institute Programs prohibits members and candidates from providing
confidential information about the exam - even after the conclusion of the exam. Examples include broad topical areas
tested or not tested.
Reading 3

Question #9
An analyst finds a stock with historical returns that are not correlated with interest rate changes. The analyst writes a
report for his clients that have large allocations in fixed-income instruments and emphasizes the observed lack of
correlation. He feels the stock would be of little value to investors whose portfolios are comprised primarily of equities.
The clients with allocations of fixed income instruments are the only clients to see the report. According to Standard
V(B), Communication with Clients and Prospective Clients, the analyst has:
A) violated the article in the Standard concerning facts and opinions.
B) not violated the Standard.
C) violated the Standard concerning fair dealings with all clients.
Recommending a stock whose return is uncorrelated with interest rate changes is appropriate for the clients described
in the problem. Emphasizing the lack of correlation is appropriate as long as the analyst makes no guarantees
concerning the relationship in the future. Reporting historical correlation is a presentation of fact, and is not in
violation. The analyst is free to show the report only to investors for whom the investment is appropriate.
Reading 3

Question #10
Bill Fox, CFA, has been preparing a research report on New London Wire and Cable, one of his major investment
clients. He had completed much of his analysis and had planned on having his report typed and bound today.
Unfortunately, his briefcase was stolen while he ate breakfast, and he lost all his notes and working papers. The lost
materials included his notes from management interviews, conversations with suppliers and competitors, dates of
company visits, and his computer diskette containing much of his quantitative analysis. Fox's client needs this report
tomorrow. In a panic, Fox called New London's vice president of finance and was faxed a copy of the company's most
recent financial projections. Fox remembered that his own analysis showed that management's estimates were too
high. He did not remember the exact amount, so he revised New London's figures downward 10%. Fox also
incorporated some charts and graphs on New London from a research report he had received last week from a small
regional research firm and used some information from a Standard & Poor's reference work. With the help of his
secretary, a Xerox machine, and some creative word processing, Fox got the report done in time for the evening
Fedex pick up. On the way home from the office that night, Fox wondered if he had violated any CFA Institute
Standards of Professional Conduct. Fox has:
A) violated the requirement to have a reasonable basis for a recommendation, the prohibition against plagiarism, and
the requirement to maintain appropriate records.
B) violated none of the Standards.
C) violated the requirement to have a reasonable basis for a recommendation and the prohibition against plagiarism.
New London's report is potentially self serving, so Fox did not exercise diligence or have an adequate basis for his
recommendation. In addition, Fox did not acknowledge his source of the charts and graphs. Finally, he did not
maintain adequate records.
Reading 3

Question #11
A client calls his money manager and asks the manager to liquidate a large portion of his assets under management
for an emergency. The manager warns the client of the risk of selling many assets quickly but says that he will try to
get the client the best possible price. This is a violation of:
A) Standard V(A), Diligence and Reasonable Basis.
B) none of the Standards listed here.
C) Standard III(C), Suitability.
The money manager has done his duty. He has warned the client of the risk and made no explicit promises
concerning what he can and cannot do.
Reading 3

Question #12
Don Roberts, a CFA Institute member, resides in Country L, where the securities laws and regulations are less strict
than the CFA Institute Code and Standards. Roberts also does business in Country N, which has no securities laws or
regulations. Thus, Country N has no laws prohibiting the use of material nonpublic information. Roberts has clients in
both Country L and N. Country L's law states that the law of the locality where business is conducted governs.
According to CFA Institute Standards of Professional Conduct about the use of material nonpublic information,
Roberts may:
A) take investment action based on this information for clients in both Country N and Country L and for himself.
B) not take investment action on the basis of this information.
C) take investment action based on this information only for his clients in Country N but not for his clients in Country L
or himself.
Because applicable law states that the law of the locality where the business is conducted governs and local law is
less strict than the Code and Standards, the member must adhere to the Code and Standards. Standard II(A) prohibits
the use of material nonpublic information.
Reading 3

Question #13
Standard V(B), Communication with Clients and Prospective Clients, least likely requires members to:
A) use reasonable judgment regarding the inclusion or exclusion of relevant factors in research reports.
B) disclose the general principles of investment processes used to analyze and select securities, and construct
portfolios.
C) make clear buy or sell recommendations on the securities covered in research reports.
There is no obligation to make buy or sell recommendations on securities that are covered by research reports.
Reading 3

Question #14
Lynne Jennings is a chemical industry research analyst for a large brokerage company. That industry is currently
seeing an increase in mergers and acquisitions. While flying through Chicago, Jennings sees several senior officers
who she knows are from the largest and fourth largest chemical companies walk into a conference room. She
concludes that negotiations for an acquisition might be taking place. Jennings:
A) may use this information to support an investment recommendation.
B) should inform her compliance officer that she has material nonpublic information on firms she covers.
C) may not act or cause others to act on this information.
The fact that the company officers met is not material nonpublic information. As long as she bases her investment
recommendation on her own independent research, Jennings will not violate any Standards if she uses this additional
information to support it.
Reading 3

Question #15
The investment-banking department of the XYZ Brokerage House often has information that would be of significant
use to the firm's brokerage clients. In order to conform to CFA Institute Standards of Professional Conduct, which of
the following policies should XYZ adopt?
According to Standard:
A) III(B), Fair Dealing, all clients should be informed of the information at the same time.
B) II(A), Material Nonpublic Information, XYZ should encourage their investment banking clients to publicly
disseminate this information.
C) II(A), Material Nonpublic Information, XYZ should establish physical and informational barriers within the firm to
prevent the exchange of information between the investment banking and the brokerage operations.
The physical and information barrier erected between departments to prevent communication of material nonpublic
information from one department to another is called a "firewall." Departments should be separated. For example, the
investment banking and corporate finance departments of a brokerage firm should be segregated from the sales and
research departments. Family member accounts who are also clients should be treated like any other client accounts
and should not be given special treatment or disadvantaged.
Reading 3

Question #16
Kim Lee is a research analyst at Superior Investments and is researching a biotech firm specializing in the analysis of
"mad cow" disease. While touring company facilities and meeting with management, she learns that they believe they
may have found a way to reverse the disease. Moreover, one manager conjectured, "Suppose that we reversed the
disease in someone who didn't even have it? We might then be able to boost that individual's IQ into the
stratosphere!" After returning to her office, Lee issues a research report describing the compound as an "IQ booster
with huge potential." This statement:
A) is reasonable given the information she was provided by the company.
B) lacks a reasonable and adequate basis in fact.
C) is allowable but only if quoted verbatim from her conversations with management.
Standard V(A) requires that a member have a "reasonable and adequate basis" before making an investment
recommendation. Extrapolating on the basis of the conjecture of one member of the management team, without
independent corroboration, is clearly in violation of this Standard. She is also in violation of Standard V(B) concerning
the use of reasonable judgment regarding what is included or excluded in a communication with a client or prospective
client.
Reading 3

Question #17
Which of the following statements about a GIPS-compliant firm's verification of GIPS compliance is most accurate?
Verification is:
A) optional, but if chosen it must be performed by an independent third party.
B) required, and may be performed by the firm's internal auditors.
C) required, and must be performed by an independent third party.
Verification of GIPS compliance is recommended but not required. If a firm chooses to obtain GIPS verification, it is
required to be performed by an independent third party.
Reading 4

Question #18
The section of the Global Investment Performance Standards (GIPS) that outlines defining the firm and documenting
firm policies and procedures is:
A) Presentation and Reporting.
B) Disclosures.
C) Fundamentals of Compliance.
According to Section 0, Fundamentals of Compliance, the definition of the firm is the foundation for firm-wide
compliance and creates boundaries in order to determine total firm assets.
Reading 6

QUANTITATIVE METHODS

Question #19
A major brokerage house is currently selling an investment product that offers an 8% rate of return, compounded
monthly. Based on this information, it follows that this investment has:
A) a stated rate of 0.830%.
B) a periodic interest rate of 0.667%.
C) an effective annual rate of 8.00%.
Periodic rate = 8.0 / 12 = 0.667. Stated rate is 8.0% and effective rate is 8.30%.
Reading 6

Question #20
Selmer Jones has just inherited some money and wants to set some of it aside for a vacation in Hawaii one year from
today. His bank will pay him 5% interest on any funds he deposits. In order to determine how much of the money must
be set aside and held for the trip, he should use the 5% as a:
A) required rate of return.
B) opportunity cost.
C) discount rate.
He needs to figure out how much the trip will cost in one year, and use the 5% as a discount rate to convert the future
cost to a present value. Thus, in this context the rate is best viewed as a discount rate.
Reading 6

Question #21
Which of the following statements regarding the money-weighted and time-weighted rates of return is least accurate?
A) The time-weighted rate of return is the standard in the investment management industry.
B) The money-weighted rate of return removes the effects of the timing of additions and withdrawals to a portfolio.
C) The time-weighted rate of return reflects the compound rate of growth of one unit of currency over a stated
measurement period.
The money-weighted return is actually highly sensitive to the timing and amount of withdrawals and additions to a
portfolio. The time-weighted return removes the effects of timing and amount of withdrawals to a portfolio and reflects
the compound rate of growth of $1 over a stated measurement period. Because the time-weighted rate of return
removes the effects of timing, it is the standard in the investment management industry.
Reading 6

Question #22
A T-bill with a face value of $100,000 and 140 days until maturity is selling for $98,000. What is the bank discount
yield?
A) 5.41%.
B) 5.14%.
C) 4.18%.
Actual discount is 2%, annualized discount is: 0.02(360 / 140) = 5.14%
Reading 7

Question #23
What is the seventh decile of the following data points?
81 84 91 97 102 108 110 112 115 121
128 135 138 141 142 147 153 155 159 162
A) 142.0.
B) 141.0.
C) 141.7.
The formula for determining quantiles is: Ly = (n + 1)(y) / (100). Here, we are looking for the seventh decile (70% of the
observations lie below) and the formula is: (21)(70) / (100) = 14.7. The seventh decile falls between 141.0 and 142.0,
the fourteenth and fifteenth numbers from the left. Since L is not a whole number, we interpolate as: 141.0 +
(0.70)(142.0 − 141.0) = 141.7.
Reading 8

Question #24
Given P(X = 2) = 0.3, P(X = 3) = 0.4, P(X = 4) = 0.3. What is the variance of X?
A) 3.0.
B) 0.3.
C) 0.6.
The variance is the sum of the squared deviations from the expected value weighted by the probability of each
outcome.
The expected value is E(X) = 0.3 × 2 + 0.4 × 3 + 0.3 × 4 = 3.
The variance is 0.3 × (2 − 3)2 + 0.4 × (3 − 3)2 + 0.3 × (4 − 3)2 = 0.6.
Reading 9

Question #25
For the task of arranging a given number of items without any sub-groups, this would require:
A) the labeling formula.
B) the permutation formula.
C) only the factorial function.
The factorial function, denoted n!, tells how many different ways n items can be arranged where all the items are
included.
Reading 9

Question #26
The following table shows the individual weightings and expected returns for the three stocks in an investor's portfolio:
Stock Weight E(RX)
V 0.40 12%
M 0.35 8%
S 0.25 5%
What is the expected return of this portfolio?
A) 9.05%.
B) 8.33%.
C) 8.85%.
To solve this problem, we need to use the formula for the expected return of a portfolio: E(R P) = w1E(R1) + w2E(R2) +
... + wnE(Rn)
Multiplying the weight of each asset by its expected return, then summing, produces: E(RP) = 0.40(12) + 0.35(8) +
0.25(5) = 8.85%.
Reading 9

Question #27
Joan Biggs, CFA, acquires a large database of past returns on a variety of assets. Biggs then draws random samples
of sets of returns from the database and analyzes the resulting distributions. Biggs is engaging in:
A) discrete analysis.
B) Monte Carlo simulation.
C) historical simulation.
This is a typical example of historical simulation.
Reading 10

Question #28
Which of the following statements about sample statistics is least accurate?
A) The z-statistic is used to test normally distributed data with a known variance, whether testing a large or a small
sample.
B) There is no sample statistic for non-normal distributions with unknown variance for either small or large samples.
C) The z-statistic is used for nonnormal distributions with known variance, but only for large samples.
There is no sample statistic for non-normal distributions with unknown variance for small samples, but the t-statistic is
used when the sample size is large.
Reading 11

Question #29
A study reports that from 2002 to 2004 the average return on growth stocks was twice as large as that of value stocks.
These results most likely reflect:
A) look-ahead bias.
B) time-period bias.
C) survivorship bias.
Time-period bias can result if the time period over which the data is gathered is either too short because the results
may reflect phenomenon specific to that time period, or if a change occurred during the time frame that would result in
two different return distributions. In this case the time period sampled is probably not large enough to draw any
conclusions about the long-term relative performance of value and growth stocks, even if the sample size within that
time period is large.

Look-ahead bias occurs when the analyst uses historical data that was not publicly available at the time being studied.
Survivorship bias is a form of sample selection bias in which the observations in the sample are biased because the
elements of the sample that survived until the sample was taken are different than the elements that dropped out of
the population.
Reading 11

Question #30
George Appleton believes that the average return on equity in the amusement industry, µ, is greater than 10%. What
is the null (H0) and alternative (Ha) hypothesis for his study?
A) H0: > 0.10 versus Ha: ≤ 0.10.
B) H0: ≤ 0.10 versus Ha: > 0.10.
C) H0: > 0.10 versus Ha: < 0.10.
The alternative hypothesis is determined by the theory or the belief. The researcher specifies the null as the
hypothesis that he wishes to reject (in favor of the alternative). Note that this is a one-sided alternative because of the
"greater than" belief.
Reading 12

Question #31
A p-value of 0.02% means that a researcher:
A) can reject the null hypothesis at the 5% significance level but cannot reject at the 1% significance level.
B) can reject the null hypothesis at both the 5% and 1% significance levels.
C) cannot reject the null hypothesis at either the 5% or 1% significance levels.
A p-value of 0.02% means that the smallest significance level at which the hypothesis can be rejected is 0.0002,
which is smaller than 0.05 or 0.01. Therefore the null hypothesis can be rejected at both the 5% and 1% significance
levels.
Reading 12

Question #32
In a test of the mean of a population, if the population variance is:
A) known, a z-distributed test statistic is appropriate.
B) known, a t-distributed test statistic is appropriate.
C) unknown, a z-distributed test statistic is appropriate.
If the population sampled has a known variance, the z-test is the correct test to use. In general, a t-test is used to test
the mean of a population when the population variance is unknown. Note that in special cases when the sample is
extremely large, the z-test may be used in place of the t-test, but the t-test is considered to be the test of choice when
the population variance is unknown.
Reading 12

Question #33
An inverse head and shoulders pattern most likely indicates:
A) the continuation of a downtrend.
B) the reversal of a downtrend.
C) the reversal of an uptrend.
Inverse head and shoulders patterns typically occur after downtrends and indicate that the trend is going to reverse.
Reading 13

ECONOMICS

Question #34
Other things equal, an increase in the price of a good will increase:
A) quantity demanded.
B) quantity supplied.
C) neither quantity supplied nor quantity demanded.
Producers of a good are typically willing to supply a greater quantity of a good when its price increases.
Reading 14

Question #35
The most likely cause for a shift in the supply curve for coffee is a change in the:
A) price of tea.
B) price of coffee.
C) wages of coffee harvesters.
The supply curve shifts in response to a change in the cost of inputs, such as the wages for coffee harvesters. A
change in the price of the product is a movement along the supply curve, not a shift in the curve. A change in the price
of a substitute would more likely influence the demand curve, not the supply curve.
Reading 14

Question #36
With respect to utility theory, the substitution effect for a decrease in the price of a good:
A) will increase consumption of the good.
B) will decrease consumption of the good.
C) may increase or decrease consumption of the good.
In utility theory, if the price of one good decreases, the substitution effect causes consumption of that good to
increase.
Reading 14

Question #37
Which of the following factors of production is least likely to be fixed in the short run?
A) Labor.
B) Technology.
C) Plant size.
Labor is typically assumed to be variable in the short run.
Reading 14

Question #38
The kinked demand model assumes that below the current price, the demand curve becomes:
A) more elastic because competitors will decrease their prices.
B) less elastic because competitors will not decrease their prices.
C) less elastic because competitors will decrease their prices.
The kinked demand model of oligopoly behavior assumes that a firm's competitors will not match a price increase, but
will match the price of a competitor that offers a lower price. The result is a demand curve that is more elastic above
the current price, but less elastic below it.
Reading 15

Question #39
Which of the following statements regarding a monopolist is most accurate?
A) A monopolist will charge the highest price for which he can sell his product.
B) A monopolist, like any other profit-maximizing firm, will sell at the output level where marginal revenue equals
marginal cost.
C) A monopolist will maximize the average profit per unit sold.
The demand curve for monopolists slopes downward to the right reflecting the fact that a higher price results in lower
demand. Monopolists maximize profits by expanding output until marginal revenue equals marginal cost.
Reading 15

Question #40
If money wages increase, other things equal, the most likely result is a:
A) short-run recessionary gap.
B) short-run inflationary gap.
C) long-run inflationary gap.
An increase in the wage rate decreases short-run aggregate supply, leading to a short-run recessionary gap.
Reading 16

Question #41
As an economic expansion approaches its peak, the economy is most likely to show:
A) a decrease in inventory levels.
B) an increase in the inventory-to-sales ratio.
C) accelerating sales growth.
As the economy approaches its peak, sales growth begins to slow, unsold inventories begin to accumulate, and the
inventory-to-sales ratio increases.
Reading 17

Question #42
The Fisher effect describes a nominal interest rate as the:
A) expected inflation rate plus the real interest rate.
B) actual inflation rate less the real interest rate.
C) expected inflation rate less the real interest rate.
The Fisher effect states that a nominal interest rate is equal to the real interest rate plus the expected inflation rate.
Reading 18

Question #43
Which of the following statements regarding money demand and supply is least accurate?
A) The supply of money is determined by the monetary authority and is not affected by changes in interest rates.
B) The supply curve for money is vertical.
C) As the Fed reduces the money supply, short-term interest rates decrease.
As the Fed reduces the money supply, short-term interest rates increase. The other statements concerning the
demand and supply for money are true.
Reading 18

Question #44
The table below outlines the possible tradeoffs of producing units of cloth and corn for both Country A and Country B.
Country A Country B
Units of Cloth Units of Corn Units of Cloth Units of Corn
0 4 0 8
6 3 8 6
14 0 16 0
Which scenario best describes the effects of trade between the countries?
A) Both countries would gain if Country A traded cloth for Country B's corn.
B) Both countries would gain if Country A traded corn for Country B's cloth.
C) Country B would not gain from trade, because it has an absolute advantage in the production of both goods.
If Country B devotes all of its resources to producing corn, it will make 8 units while, under the same circumstances,
Country A will make 4 units. Therefore, Country B is twice as productive with respect to corn as Country A. Country B
can also produce more cloth (16 units) in relation to Country A (14 units) supposing all resources are used for cloth.
However, rather than being twice as productive as was the case for corn, it is only slightly more productive. Therefore,
Country B has a comparative advantage in corn, and thus should specialize in its production, while Country A should
specialize in the production of cloth.
Reading 19

Question #45
Which of the following would least likely be a participant in the forward market?
A) Arbitrageurs.
B) Traders.
C) Long-term investors.
Forward contracts are for 30, 90, 180, and 360-day periods and would, therefore, be considered short-term investment
choices. Other participants in the forward market are hedgers who use forward contracts to protect the home currency
value of foreign currency denominated assets on their balance sheets over the life of the contracts involved.
Reading 20

FINANCIAL REPORTING & ANALYSIS

Question #46
The step in the financial statement analysis framework that includes making any appropriate adjustments to the
financial statements and calculating ratios is best described as:
A) analyzing and interpreting the data.
B) gathering the data.
C) processing the data.

The financial statement analysis framework consists of six steps:

1. State the objective and context. Determine what questions the analysis is meant to answer, the form in which it
needs to be presented, and what resources and how much time are available to perform the analysis.
2. Gather data. Acquire the company's financial statements and other relevant data on its industry and the economy.
Ask questions of the company's management, suppliers, and customers, and visit company sites.
3. Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios. Prepare exhibits
such as graphs and common-size balance sheets.
4. Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what
conclusions or recommendations the information supports.
5. Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure
the report and its dissemination comply with the Code and Standards that relate to investment analysis and
recommendations.
6. Update the analysis. Repeat these steps periodically and change the conclusions or recommendations when
necessary.
Reading 21

Question #47
Which of the following statements about financial reporting standards is least accurate? Reporting standards:
A) ensure that the information is "useful to a wide range of users."
B) are disclosed on Form 8K by publicly traded firms in the United States.
C) narrow the range within which management estimates can be seen as reasonable.
Reporting standards ensure that the information is "useful to a wide range of users," including security analysts, by
making financial statements comparable to one another and narrowing the range within which management's
estimates can be seen as reasonable. Securities & Exchange Commission Form 8K addresses acquisitions,
divestitures, etc. and not reporting standards.
Reading 23

Question #48
According to the Financial Accounting Standards Board, what is the appropriate balance sheet treatment for available-
for-sale securities and where are the unrealized gains and losses reported?
Balance sheet Unrealized gains and losses
A) Fair value Net income
B) Fair value Other comprehensive income
C) Amortized cost Other comprehensive income
Available-for-sale securities are reported on the balance sheet at fair value. The unrealized gains and losses bypass
the income statement and are reported as a component of stockholders' equity as a part of other comprehensive
income.
Reading 24

Question #49
Where in the financial statements should a firm recognize the unrealized gains and losses on cash flow hedging
derivatives and the unrealized gains and losses on available-for-sale securities?
Cash flow hedging derivatives Available-for-sale securities
A) Other comprehensive income Other comprehensive income
B) Net income Other comprehensive income
C) Other comprehensive income Net income
Unrealized gains and losses from cash flow hedging derivatives and unrealized gains and losses from available-for-
sale securities are not recognized in the income statement; rather, they are both recognized as a component of
stockholders' equity as a part of other comprehensive income.
Reading 24

Question #50
Jerry Krome, CFA, is an equity analyst. The head of research at Krome's firm composes a memo that contains the
following statements:
 To the extent that management has discretion over the firm's revenue recognition, an analyst should consider
policies that recognize revenue later to be more conservative than policies that recognize revenue sooner.
 When comparing the performance of companies, an analyst can use the information in the financial statement
disclosures to adjust the financial statements for differences in revenue recognition policies.
With regard to the implications of revenue recognition policies for financial analysis, Krome should agree with:
A) neither of these statements.
B) only one of these statements.
C) both of these statements.
Because revenue recognition often relies on judgment and estimates from management, it is not always possible to
calculate the appropriate adjustments that would account for the differences between companies' revenue recognition
policies. An analyst should use the policies disclosed in companies' financial statement footnotes to understand the
degree to which their revenue recognition is conservative or aggressive. In general, recognizing revenue sooner is
considered aggressive and recognizing revenue later is considered conservative.
Reading 24

Question #51
Which of the following statements regarding basic and diluted EPS is least accurate?
A) Dilutive securities decrease EPS if they are exercised or converted to common stock.
B) A simple capital structure contains no potentially dilutive securities.
C) Antidilutive securities decrease EPS if they are exercised or converted.
Antidilutive securities increase EPS if exercised or converted to common stock.
Reading 24

Question #52
The following information is for Trotters Diversified as of year-end:
 Average common shares outstanding of 5.0 million.
 Average market price for common stock of $35.00 per share.
 Net income of $9.0 million.
 Common stock dividends paid of $1.2 million.
 Tax rate of 40%.
 500,000 shares of cumulative convertible preferred stock with $30 par value and 10% dividend. Each preferred
share is convertible into 5 common shares. Preferred dividends of $1.5 million were paid.
 10,000 convertible $1,000 par bonds with a 6.0% coupon, each convertible into 8 shares of common stock.
 400,000 stock options with an exercise price of $32.00 per share.
 All of these securities were outstanding for the full year.
Diluted EPS for Trotters Diversified is closest to:
A) $1.23.
B) $1.19.
C) $1.50.
Only the options and convertible preferred stock are dilutive. First, calculate basic EPS to use as a benchmark to
determine dilutive capital components.
Basic EPS = (net income - preferred dividends) / weighted average common shares outstanding = (9.0 - 1.5) / 5.0 =
$1.50.
Next, check for dilution.
 The stock options are dilutive because the exercise price is less than the average stock price. There is no
numerator impact from the options. The denominator impact = # options - [(# options × exercise price) / average
stock price)] = 400,000 - [(400,000 × 32) / 35] = 34,286 or 0.034 million.
 To check whether the convertible preferred stock is dilutive we need to determine whether it decreases EPS. To
the numerator, we add back the preferred dividend. The denominator impact = (# preferred shares × conversion
rate) = 500,000 × 5 = 2,500,000, or 2.5 million. Then, EPS = (9.0 - 1.5 + 1.5) / (5.0 + 2.5) = $1.20. Thus the
convertible preferred stock is dilutive.
 To check whether the convertible bonds are dilutive we need to determine whether they decrease EPS. To the
numerator, we add back the after-tax impact of the coupon, or (face value × coupon × (1 − t)), or (10,000 bonds ×
1,000 par × 0.06 coupon × 0.6 ) = 360,000, or $0.360 million. The denominator impact = (# convertible bonds ×
conversion rate) = 10,000 × 8 = 80,000, or 0.080 million. Then, EPS = (9.0 - 1.5 + 0.360) / (5.0 + 0.080) = $1.55.
Thus the bonds are antidilutive.
Finally, calculate diluted EPS:
Diluted EPS = (9.0 - 1.5 + 1.5) / (5.0 + 2.5 + 0.034) = $1.1946.
Reading 24

Question #53
Liabilities are best described as:
A) obligations that are expected to require a future outflow of resources.
B) resources that are expected to provide future benefits.
C) residual ownership interest.
Liabilities are obligations resulting from past events that are expected to require a future outflow of resources.
Reading 25

Question #54
Which of the following should be classified as cash flows from investing (CFI) by Elegant, Inc., which reports under
U.S. GAAP?
A) Interest received by Elegant, Inc. on a bond Elegant, Inc. purchased from an outside investor.
B) Dividends received by Elegant, Inc. from an investment in another firm.
C) Elegant's payment to purchase equipment to be used in its business.
Purchases of equipment are considered to be cash flows from investing. Interest paid or received and dividends
received are considered to be cash flows from operations under U.S. GAAP.
Reading 26

Question #55
Noncurrent assets on the balance sheet are most closely linked to which part of the cash flow statement?
A) Financing cash flows.
B) Investing cash flows.
C) Operating cash flows.
Investing cash flows are most closely linked with a firm's noncurrent assets. For example, purchases and sales of
property, plant, and equipment are classified as investing cash flows.
Reading 26

Question #56
Would an increase in net profit margin or in the firm's dividend payout ratio increase a firm's sustainable growth rate?
Net profit margin Dividend payout ratio
A) Yes Yes
B) No No
C) Yes No
The sustainable growth rate is equal to ROE multiplied by the retention rate. According to the Dupont formula, an
increase in net profit margin will result in higher ROE. Thus, an increase in net profit margin will result in a higher
growth rate. The retention rate is equal to 1 minus the dividend payout ratio. Thus, an increase in the dividend payout
ratio will lower the retention rate and lower the growth rate.
Reading 27

Question #57
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004
Cash 500 450
Accounts Receivable 600 660
Inventory 500 550
Total CA 1300 1660
Plant, prop. Equip 1000 1250
Total Assets 2600 2,910

Liabilities
Accounts Payable 500 550
Long term debt 700 1102
Total liabilities 1200 1652

Equity
Common Stock 400 538
Retained Earnings 1000 720
Total Liabilities & Equity 2600 2,910

Income Statement
Sales 3000
Cost of Goods Sold (1000)
Gross Profit 2000
SG&A 500
Interest Expense 151
EBT 1349
Taxes (30%) 405
Net Income 944
What is the average receivables collection period?
A) 80.3 days.
B) 60.6 days.
C) 76.7 days.
Average collection period = 365 / receivables turnover
Receivables turnover = sales / average receivables = 3,000 / 630 = 4.76
Average receivables collection period = 365 / 4.76 = 76.65
Reading 27

Question #58
A company that uses the LIFO inventory cost method records the following purchases and sales for an accounting
period:
Beginning inventory, July 1: $5,000, 10 units
July 8: Purchase of $2,600 (5 units)
July 12: Sale of $2,200 (4 units)
July 15: Purchase of $2,800 (5 units)
July 21: Sale of $1,680 (3 units)
The company's cost of goods sold using a perpetual inventory system is:
A) $3,500.
B) $3,760.
C) $3,780.
With a perpetual inventory system, units purchased and sold are recorded in inventory in the order that the purchases
and sales occur. Cost of goods sold for the July 12 sale uses 4 of the units purchased on July 8: 4 × ($2,600 / 5) =
$2,080. Cost of goods sold for the July 21 sale uses 3 of the units purchased on July 15: 3 × ($2,800 / 5) = $1,680.
COGS = $2,080 + $1,680 = $3,760.
Reading 28

Question #59
Given the following inventory data about a firm:
 Beginning inventory 20 units at $50/unit
 Purchased 10 units at $45/unit
 Purchased 35 units at $55/unit
 Purchased 20 units at $65/unit
 Sold 60 units at $80/unit
What is the inventory value at the end of the period using first in, first out (FIFO)?
A) $1,575.
B) $3,100.
C) $3,475.
Ending inventory equals 20 + 10 + 35 + 20 − 60 = 25 of last units purchased in inventory.
(20 units)($65/unit) + (5 units)($55/unit) = $1,300 + $275 = $1,575
Reading 28

Question #60
La Crosse Partners LLC has a franchise agreement with Arnolds Crispy Fry that expires in seven years, but is
renewable at each expiration date for a nominal fee. If the franchise agreement is initially valued at $60,000:
A) amortization expense in the first year will be one-seventh of $60,000.
B) amortization expense in the sixth year will be zero.
C) an accelerated amortization method is more appropriate than the straight-line method.
Because the franchise agreement is renewable for a nominal fee, it is treated as an intangible asset with an indefinite
life and therefore not amortized but tested for impairment regularly.
Reading 29

Question #61
Which of the following statements regarding capitalizing versus expensing costs is least accurate?
A) Capitalization results in higher profitability initially.
B) Cash flow from investing is higher with expensing than with capitalization.
C) Total cash flow is higher with capitalization than expensing.
Total cash flow is higher with capitalization than expensing is least accurate because total cash flow would be the
same under both methods, not considering tax implications.
Reading 29

Question #62
A firm purchased a piece of equipment for $6,000 with the following information provided:
 Revenue will increase by $15,000 per year.
 The equipment has a 3-year life expectancy and no salvage value.
 The firm's tax rate is 30%.
 Straight-line depreciation is used for financial reporting and double declining is used for tax purposes.
What will the firm report for deferred taxes on the balance sheet for years 1 and 2?
Year 1 Year 2
A) $3,300 $4,100
B) $600 $400
C) $3,900 $3,900
Using DDB:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Dep. 4,000 1,333
Taxable Inc 11,000 13,667
Taxes Pay 3,300 4,100
Using SL:
Yr. 1 Yr. 2
Revenue 15,000 15,000
Dep. 2,000 2,000
Pretax Inc 13,000 13,000
Tax Exp 3,900 3,900
Deferred taxes year 1 = 3,900 - 3,300 = 600
Deferred taxes year 2 = 3,900 - 4,100 + previously deferred taxes = -200 + 600 = 400
Reading 30

Question #63
A health care company purchased a new MRI machine on 1/1/X3. At year-end the company recorded straight-line
depreciation expense of $75,000 for book purposes and accelerated depreciation expense of $94,000 for tax
purposes. Management estimates warranty expense related to corrective eye surgeries performed in 20X3 to be
$250,000. Actual warranty expenses of $100,000 were incurred in 20X3 related to surgeries performed in 20X2. The
company's tax rate for the current year was 35%, but a tax rate of 37% has been enacted into law and will apply in
future periods. Assuming these are the only relevant entries for deferred taxes, the company's recorded changes in
deferred tax assets and liabilities on 12/31/X3 are closest to:
DTA DTL
A) $52,500 $6,650
B) $55,500 $6,650
C) $55,500 $7,030
DTL = (tax depreciation - financial statement depreciation) × future tax rate
= ($94,000 - $75,000) × 37% = $7,030.
DTA = (estimated warranty expense − actual warranty expense) × future tax rate
= ($250,000 − $100,000) × 37% = $55,500.
Reading 30

Question #64
A company purchased a new pizza oven for $12,676. It will work for 5 years and has no salvage value. The tax rate is
41%, and annual revenues are constant at $7,192. For financial reporting, the straight-line depreciation method is
used, but for tax purposes depreciation is 35% of original cost in years 1 and 2 and the remaining 30% in Year 3. For
this question ignore all expenses other than depreciation.
What is the deferred tax liability as of the end of year three?
A) $1,029.
B) $780.
C) $2,079.
For tax purposes the machine is 100% depreciated at the end of year three, while for financial reporting it is only 60%
depreciated.
The difference in depreciation is $12,676 × (1.00 − 0.60) = $5,070.
Deferred tax liability = difference in depreciation × tax rate = $5,070 × 0.41 = $2,079.
Reading 30
Question #65
Compared to a finance lease, an operating lease is most likely to be favored when:
A) at the end of the lease, the lessee may be better able to sell the asset than the lessor.
B) the lessee has bond covenants relating to financial policies.
C) management compensation is not based on returns on invested capital.
If the lessee has bond covenants (e.g., debt-to-equity ratio) relating to its financial policies that it must follow, it is best
to have an operating lease due to the fact that the operating lease will keep the asset off of the balance sheet resulting
in less liabilities.
Reading 31

Question #66
A firm is more solvent if it has:
A) high leverage and coverage ratios.
B) low leverage ratios and high coverage ratios.
C) low leverage and coverage ratios.
Low leverage ratios suggest the firm has relatively little debt compared to its equity and assets. High coverage ratios
suggest the firm generates enough earnings to meet its interest payments.
Reading 31

Question #67
A debt covenant is most likely to restrict a firm from:
A) decreasing its common dividends.
B) issuing new common shares.
C) repurchasing common shares.
Debt covenants exist to protect creditors. Repurchasing common shares is a use of cash that rewards equity investors
but might harm creditors by reducing the firm's solvency. Decreasing dividends or issuing new shares would increase
the cash available to repay creditors.
Reading 31

Question #68
With regard to the goal of neutrality in financial reporting, accounting standards related to research costs and litigation
losses should be viewed as:
A) promoting neutral financial reporting.
B) biased toward aggressive financial reporting.
C) biased toward conservative financial reporting.
Some accounting principles, such as IFRS and U.S. GAAP standards for expensing research costs and recognizing
probable litigation losses, reflect conservatism rather than neutrality, in that they require earlier recognition of probable
losses and later recognition of probable gains.
Reading 32

Question #69
To adjust for operating leases before calculating financial statement ratios, what value should an analyst add to a
firm's liabilities?
A) Difference between present values of lease payments and the asset's future earnings.
B) Present value of future operating lease payments.
C) Sum of future operating lease obligations.
Before calculating ratios involving liabilities, an analyst should estimate the present value of operating lease
obligations and add this value to the firm's liabilities.
Reading 33

CORPORATE FINANCE

Question #70
The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed
marketing study for the new product and the possible increase in the sales of a related product made by Axis are best
described (respectively) as:
A) opportunity cost; externality.
B) sunk cost; externality.
C) externality; cannibalization.
The study is a sunk cost, and the possible increase in sales of a related product is an example of a positive
externality.
Reading 35

Question #71
A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and
$30 million in new common stock. The before-tax required return on debt is 9% and the required return for equity is
14%. If the company is in the 40% tax bracket, the marginal weighted average cost of capital is closest to:
A) 9.0%.
B) 10.0%
C) 10.6%.
(0.4)(9%)(1 - 0.4) + (0.6)(14%) = 10.56%
Reading 36

Question #72
A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate of 9%. The
firm's beta is 1.125, the risk-free rate is 6%, and the expected return in the market is 14%. Assume the firm is at their
optimal capital structure and the firm's tax rate is 40%. What is the firm's weighted average cost of capital (WACC)?
A) 7.8%.
B) 8.6%.
C) 5.4%.
CAPM = RE = RF + B(RM − RF) = 0.06 + (1.125)(0.14 − 0.06) = 0.15
WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)
V = 100 + 300 = 400
WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078
Reading 36

Question #73
When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:
A) equity earns higher return than debt.
B) the interest on debt is tax deductible.
C) equity is risky.
Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only
interest expense is deductible for corporate taxes.
Reading 36

Question #74
Sinclair Construction Company's Board of Directors is considering repurchasing $30,000,000 worth of common stock.
Sinclair assumes that the stock can be repurchased at the market price of $50 per share. After much discussion
Sinclair decides to borrow $30 million that it will use to repurchase shares. Sinclair's Chief Executive Officer (CEO)
has compiled the following information regarding the repurchase of the firm's common stock:
 Share price at the time of buyback = $50
 Shares outstanding before buyback = 30,600,000
 EPS before buyback = $3.33
 Earnings yield = $3.33 / $50 = 6.7%
 After-tax cost of borrowing = 8.0%
 Planned buyback = 600,000 shares
Based on the information above, Sinclair's earnings per share (EPS) after the repurchase of its common stock will
be closest to:
A) $3.23.
B) $3.18.
C) $3.32.
Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the 8.0% after-tax cost of borrowing is greater than the 6.7% earnings yield (E/P) of the shares, the share
repurchase reduces Sinclair's EPS.
Reading 38

Question #75
Which of the following shows the key dividend dates in their proper sequence?
A) Ex-dividend date, holder-of-record date, declaration date, payment date.
B) Declaration date, ex-dividend date, holder-of-record date, payment date.
C) Declaration date, holder-of-record date, ex-dividend date, payment date.
The board of directors announce the amount of the dividend, the holder-of-record date, and payment date. The ex-
dividend date is two business days prior to the holder-of-record date, giving the firm time to identify the rightful owner
of the dividends.
Reading 38

Question #76
Which of the following statements related to corporate governance is least accurate?
A) It is desirable for the chairman of the board to be the firm's current CEO or former CEO.
B) It is desirable for board members to have board experience with other boards.
C) Board members should not have any material relationships with the firm's advisers, auditors, and their families.
The willingness of independent board members to express opinions that are not aligned with managements' may be
impaired when the chairman is the firm's current CEO or a former CEO.
Reading 40

Question #77
A critical corporate governance issue is ensuring that the board and its members have the requisite experience
needed to properly govern the firm for the shareholders' benefit. When considering board member qualifications,
investors and shareholders should consider whether board members can act with care and competence as a result of
their experience with all of the following EXCEPT:
A) technologies, products, services which the firm offers.
B) legal issues.
C) the competitive landscape the firm faces.
Knowledge of the firm's competitive landscape is likely beyond what a board member should have intimate knowledge
about. The other items are all issues a board member should be knowledgeable about. Other issues board
members should have experience with include financial operations, accounting and auditing topics, and business risks
the firm faces.
Reading 40

PORTFOLIO MANAGEMENT

Question #78
Which of the following institutional investors is most likely to have low liquidity needs?
A) Defined benefit pension plan.
B) Property insurance company.
C) Bank.
A defined benefit pension plan has less need for liquidity than a bank or a property and casualty insurance company.
Banks have high liquidity needs because assets may have to be sold quickly if depositors withdraw their funds.
Property and casualty insurance companies need to keep liquid assets to meet claims as they arise.
Reading 40

Question #79
Question ID: 414948
Which of the following would be assessed first in a top-down valuation approach?
A) Industry risks.
B) Fiscal policy.
C) Industry return on equity (ROE).
In the top-down valuation approach, the investor should analyze macroeconomic influences first, then industry
influences, and then company influences. Fiscal policy, as part of the macroeconomic landscape, should be analyzed
first.
Reading 40

Question #80
Risk management within an organization should most appropriately consider:
A) interactions among different risks.
B) financial risks independently of non-financial risks.
C) internal risks independently of external risks.
The various financial and non-financial risks interact in many ways. A risk management process should consider these
interactions among risks rather than treating them each in isolation.
Reading 41

Question #81
Which of the following statements about portfolio diversification is CORRECT?
A) When a risk-averse investor is confronted with two investment opportunities having the same expected return, the
investor will take the opportunity with the lower risk.
B) The efficient frontier represents individual securities.
C) As the correlation coefficient moves from +1 to zero, the potential for diversification diminishes.
The other statements are false. The lower the correlation coefficient; the greater the potential for diversification.
Efficient portfolios lie on the efficient frontier.
Reading 42

Question #82
A measure of how well the returns of two risky assets move together is the:
A) standard deviation.
B) range.
C) covariance.
This is a correct description of covariance. A positive covariance means the returns of the two securities move in the
same direction. A negative covariance means that the returns of two securities move in opposite directions. A zero
covariance means there is no relationship between the behaviors of two stocks. The magnitude of the covariance
depends on the magnitude of the individual stock's standard deviations and the relationship between their co-
movements. The covariance is an absolute measure of movement and is measured in return units squared.
Reading 42

Question #83
Which one of the following portfolios cannot lie on the efficient frontier?
Portfolio Expected Return Standard Deviation
A 20% 35%
B 11% 13%
C 8% 10%
D 8% 9%
A) Portfolio A.
B) Portfolio D.
C) Portfolio C.
Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.
Reading 42

Question #84
The market portfolio in Capital Market Theory is determined by:
A) a line tangent to the efficient frontier, drawn from any point on the expected return axis.
B) a line tangent to the efficient frontier, drawn from the risk-free rate of return.
C) the intersection of the efficient frontier and the investor's highest utility curve.
The Capital Market Line is a straight line drawn from the risk-free rate of return (on the Y axis) through the market
portfolio. The market portfolio is determined as where that straight line is exactly tangent to the efficient frontier.
Reading 43

Question #85
Luis Green is an investor who uses the security market line to determine whether securities are properly valued. He is
evaluating the stocks of two companies, Mia Shoes and Video Systems. The stock of Mia Shoes is currently trading at
$15 per share, and the stock of Video Systems is currently trading at $18 per share. Green expects the prices of both
stocks to increase by $2 in a year. Neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems
has a beta of (-0.30). If the market return is 15% and the risk-free rate is 8%, which trading strategy will Green
employ?
Mia Shoes Video Systems
A) Sell Buy
B) Buy Buy
C) Buy Sell
The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast return is $2/$15 = 13.3%. The
stock is overvalued and the investor should sell it. The required return for Video Systems is 0.08 - 0.3 × (0.15-0.08) =
5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.
Reading 43

Question #86
An analyst collected the following data for three possible investments.
Stock Price Today Forecast Price* Dividend Beta
Alpha 25 31 2 1.6
Omega 105 110 1 1.2
Lambda 10 10.80 0 0.5
*Expected price one year from today.
The expected return on the market is 12% and the risk-free rate is 4%. Assuming that capital markets are in
equilibrium, what is the required return for Omega?
A) 1.2%.
B) 13.6%.
C) 17.4%.
RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, Rf = risk-free rate, and (RMarket − Rf) =
market premium
RRStock = 4 + (12 − 4) × 1.2 = 4 + 9.6 = 13.6%.
Reading 43

EQUITY

Question #87
Which of the following statements regarding primary and secondary markets is least accurate?
A) New issues of government securities can be sold on the primary market.
B) Secondary market transactions occur between two investors and do not involve the firm that originally issued the
security.
C) Prevailing market prices are determined by primary market transactions and are used in pricing new issues.
Prevailing market prices are determined by the transactions that take place on the secondary market. This information
is used to determine the price of new issues sold on primary markets.
Reading 45

Question #88
Markets for financial assets with maturities of one year or less are best characterized as:
A) primary markets.
B) money markets.
C) capital markets.
"Money markets" generally refers to markets for debt securities maturing in one year or less. Capital markets refer to
markets for equities and for debt securities with maturities greater than one year. Primary markets are the markets for
newly issued securities.
Reading 45

Question #89
The providers of the Smith 30 Stock Index remove Jones Company from the index because it has been acquired by
another firm, and replace it with Johnson Company. This change in the index is best described as an example of:
A) rebalancing.
B) reconstitution.
C) redefinition.
Reconstitution refers to changing the securities that make up an index. Reconstitution of an index is required if one of
its constituent securities goes out of existence (for example, a maturing bond or an expiring futures contract) or no
longer meets the requirements to be included in the index.
Reading 46

Question #90
What is the price-weighted index of the following three stocks?
As of December 31, 2001
Company Stock Price Shares Outstanding
A $50 10,000
B $35 20,000
C $110 30,000
A) 75.
B) 65.
C) 80.
The price-weighted index equals [(50 + 35 + 110) / 3] = 65.
Reading 46

Question #91
The measure of an asset's value that can most likely be determined without estimation is its:
A) fundamental value.
B) market value.
C) intrinsic value.
The current price of a traded asset is its market value. An asset's intrinsic or fundamental value is the price a rational
investor with complete information about the asset would pay for it.
Reading 47

Question #92
Pearl River Heavy Industries shows the following information in its financial statements:
Total Assets HK$146,000,000
Total Liabilities HK$87,000,000
Net Income HK$27,000,000
Price per Share HK$312
Shares Outstanding 200,000
The equity securities of Pearl River have a:
A) market value of HK$146,000,000.
B) book value of HK$62,400,000.
C) book value of HK$59,000,000.
Book value = Total assets − total liabilities = 146,000,000 − 87,000,000 = HK$59,000,000
Market value of equity = Market price per share × shares outstanding = HK$312 × 200,000 = HK$62,400,000
Reading 48

Question #93
The experience curve, which illustrates the cost per unit relative to output:
A) slopes downward.
B) slopes upward in the early years and downward in the later years.
C) slopes upward.
The experience curve, which shows the cost per unit relative to output, slopes downward because of increases in
productivity and economies of scale, especially in industries with high fixed costs.
Reading 49

Question #94
A stock has the following elements: last year's dividend = $1, next year's dividend is 10% higher, the price will be $25
at year-end, the risk-free rate is 5%, the market risk premium is 5%, and the stock's beta is 1.5. The stock's price
is closest to:
A) $23.50.
B) $23.20.
C) $20.20.
Cost of equity capital = 5% + 1.5(5%) = 12.5%
P0 = (1.1 / 1.125) + (25 / 1.125) = $23.20.
Reading 50

Question #95
Given the following information, compute price/book value.
 Book value of assets = $550,000
 Total sales = $200,000
 Net income = $20,000
 Dividend payout ratio = 30%
 Operating cash flow = $40,000
 Price per share = $100
 Shares outstanding = 1000
 Book value of liabilities = $500,000
A) 2.0X.
B) 2.5X.
C) 5.5X.
Book value of equity = $550,000 - $500,000 = $50,000
Market value of equity = ($100)(1000) = $100,000
Price/Book = $100,000/$50,000 = 2.0X
Reading 50

Question #96
An analyst gathered the following information about a company:
 The stock is currently trading at $31.00 per share.
 Estimated growth rate for the next three years is 25%.
 Beginning in the year 4, the growth rate is expected to decline and stabilize at 8%.
 The required return for this type of company is estimated at 15%.
 The dividend in year 1 is estimated at $2.00.
The stock is undervalued by approximately:
A) $15.70.
B) $6.40.
C) $0.00.
The high "supernormal" growth in the first three years and the decrease in growth thereafter signals that we should
use a combination of the multi-period and finite dividend growth models (DDM) to value the stock.
Step 1: Determine the dividend stream through year 4
 D1 = $2.00 (given)
 D2 = D1 × (1 + g) = 2.00 × (1.25) = $2.50
 D3 = D2 × (1 + g) = $2.50 × (1.25) = $3.13
 D4 = D3 × (1 + g) = $3.13 × (1.08) = $3.38
Step 2: Calculate the value of the stock at the end of year 3 (using D 4)
 P3 = D4 / (ke - g) = $3.38 / (0.15 - 0.08) = $48.29
Step 3: Calculate the PV of each cash flow stream at ke = 15%, and sum the cash flows. Note: We suggest you clear
the financial calculator memory registers before calculating the value. The present value of:
 D1 = 1.74 = 2.00 / (1.15)1, or FV = -2.00, N = 1, I/Y = 15, PV = 1.74
 D2 = 1.89 = 2.50 / (1.15)2, or FV = -2.50, N = 2, I/Y = 15, PV = 1.89
 D3 = 2.06 = 3.13 / (1.15)3, or FV = -3.13, N = 3, I/Y = 15, PV = 2.06
 P3 = 31.75 = 48.29 / (1.15)3, or FV = -48.29, N = 3, I/Y = 15, PV = 31.75
 Sum of cash flows = 37.44.
 Thus, the stock is undervalued by 37.44 - 31.00 = approximately 6.40.
Note: Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does
not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that
the question asks you to select the closest answer.
Reading 50

Question #97
What is the value of a preferred stock that is expected to pay a $5.00 annual dividend per year forever if similar risk
securities are now yielding 8%?
A) $62.50.
B) $60.00.
C) $40.00.
$5.00/0.08 = $62.50.
Reading 50

Question #98
Given the following estimated financial results for the next period, value the stock of FishnChips, Inc., using the infinite
period dividend discount model (DDM).
 Sales of $1,000,000.
 Earnings of $150,000.
 Total assets of $800,000.
 Equity of $400,000.
 Dividend payout ratio of 60.0%.
 Average shares outstanding of 75,000.
 Real risk free interest rate of 4.0%.
 Expected inflation rate of 3.0%.
 Expected market return of 13.0%.
 Stock Beta at 2.1.
The per share value of FishnChips stock is approximately: (Note: Carry calculations out to at least 3 decimal places.)
A) $30.89.
B) $26.86.
C) $17.91.
Here, we are given all the inputs we need. Use the following steps to calculate the value of the stock:
First, expand the infinite period DDM:
DDM formula: P0 = D1 / (ke - g)
D1 = (Earnings × Payout ratio) / average number of shares outstanding
= ($150,000 × 0.60) / 75,000 = $1.20
ke = nominal risk free rate + [beta × (expected market return - nominal risk free rate)]
Note: Nominal risk-free rate = (1 + real risk free rate) × (1 + expected inflation) - 1
= (1.04)× (1.03) - 1 = 0.0712, or 7.12%.
ke = 7.12% + [2.1 × (13.0% − 7.12%)] = 0.19468
G = (retention rate × ROE)
 Retention = (1 - Payout) = 1 - 0.60 = 0.40.
ROE = (net income / sales)(sales / total assets)(total assets / equity)
= (150,000 / 1,000,000)(1,000,000 / 800,000)(800,000 / 400,000)
= 0.375
G = 0.375 × 0.40 = 0.15
Then, calculate: P0 = D1 / (ke - g) = $1.20 / (0.19468 − 0.15) = 26.86.
Reading 50

FIXED INCOME

Question #99
Which of the following entities play a critical role in the ability to create a securitized bond with a higher credit rating
than the corporation?
A) Investment banks.
B) Rating agencies.
C) Special purpose entities.
Special purpose entities (SPEs), buy the assets from the corporation. The SPE separates the assets used as
collateral from the corporation that is seeking financing. This shields the assets from other creditors.
Reading 51

Question #100
A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at
112.16. What is the dollar amount of the semi-annual coupon payment?
A) $425.00.
B) $212.50.
C) $238.33.
The dollar amount of the coupon payment is computed as follows:
Coupon in $ = $5,000 × 0.085 / 2 = $212.50
Reading 51

Question #101
Which of the following embedded options in a fixed income security can be exercised by the issuer?
A) Call option.
B) Conversion option.
C) Put option.
Securities with embedded call options may be called by the issuer. An embedded put option gives the bondholder the
right to sell (put) the security back to the issuer. A conversion option gives the bondholder the right to exchange the
security for the issuer's common stock.
Reading 51

Question #102
Assume a city issues a $5 million bond to build a new arena. The bond pays 8% semiannual interest and will mature
in 10 years. Current interest rates are 9%. What is the present value of this bond and what will the bond's value be in
seven years from today?
Present Value Value in 7 Years from Today
A) 4,674,802 4,871,053
B) 4,674,802 4,931,276
C) 5,339,758 4,871,053
Present Value:
Since the current interest rate is above the coupon rate the bond will be issued at a discount. FV = $5,000,000; N =
20; PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,674,802
Value in 7 Years:
Since the current interest rate is above the coupon rate the bond will be issued at a discount. FV = $5,000,000; N = 6;
PMT = (0.04)(5 million) = $200,000; I/Y = 4.5; CPT → PV = -$4,871,053
Reading 53

Question #103
The one-year spot rate is 5% and the two-year spot rate is 6.5%. What is the one-year forward rate starting one year
from now?
A) 5.00%.
B) 8.02%.
C) 7.87%.
The forward rate is computed as follows:
One-year forward rate = 1.0652 / 1.05 - 1 = 8.02%
Reading 53

Question #104
An interpolated spread (I-spread) for a bond is a yield spread relative to:
A) risk-free bond yields.
B) swap rates.
C) benchmark spot rates.
Spreads relative to swap rates are referred to as Interpolated or I-spreads.
Reading 53

Question #105
A 20-year, 9% semi-annual coupon bond selling for $1,000 offers a yield to maturity of:
A) 10%.
B) 11%.
C) 9%.
N = (20 × 2) = 40
pmt = 90/2 = 45
PV = -1000
FV = 1000
cpt i = 4.5× 2 = 9%
Reading 53

Question #106
What is the value of a 10-year, semi-annual, 8% coupon bond with a $1,000 face value if similar bonds are now
yielding 10%?
A) $1,000.00.
B) $875.38.
C) $1,373.87.
Using the financial calculator: N = 10 × 2 = 20; PMT = $80/2 = $40; I/Y = 10/2 = 5%; FV = $1,000; Compute the bond's
value PV = $875.38.
Reading 53

Question #107
A sequential-pay CMO has two tranches. Principal is paid to Tranche S until it is paid off, after which principal is paid
to Tranche R. Compared to Tranche R, Tranche S has:
A) more contraction risk and less extension risk.
B) more contraction risk and more extension risk.
C) less contraction risk and more extension risk.
In a sequential-pay CMO the short tranche, which receives principal payments and prepayments first, has more
contraction risk, while the tranche that receives principal payments and prepayments last has more extension risk.
Reading 54

Question #108
Which of the following classes of asset-backed securities typically includes a lockout period?
A) Auto loan ABS.
B) Credit card ABS.
C) Non-agency residential MBS.
Credit card ABS typically have a lockout period during which principal payments by credit card borrowers are used to
purchase additional credit card debt, rather than paid out to the ABS holders.
Reading 54

Question #109
Senior subordinated bonds have a priority of claims over:
A) subordinated bonds.
B) first lien debt.
C) secured bonds.
First lien loans and secure bonds are senior to any unsecured debt. Senior subordinated debt is senior to
subordinated debt.
Reading 56

Question #110
What is the most likely effect on yield spreads when demand for bonds is high and supply of bonds is low?
A) Yield spreads are likely to narrow.
B) Yield spreads are likely to widen.
C) The effect on yield spreads will depend on whether supply or demand is the stronger influence.
Credit spreads tend to narrow in times of high demand for bonds and widen in times of low demand for bonds. Credit
spreads tend to widen under excess supply conditions, such as large issuance in a short period of time, and narrow
when supply is low.
Reading 56

DERIVATIVES

Question #111
A similarity of margin accounts for both equities and futures is that for both:
A) interest is charged on the margin loan balance.
B) additional payment is required if margin falls below the maintenance margin.
C) the value of the security is the collateral for the loan.
Both futures accounts and equity margin accounts have minimum margin requirements that, if violated, require the
deposit of additional funds. There is no loan in a futures account; the margin deposit is a performance guarantee. The
seller does not receive the margin deposit in futures trades. The seller must also deposit margin in order to open a
position.
Reading 57

Question #112
Which of the following statements about forward contracts is least accurate?
A) The long promises to purchase the asset.
B) Both parties to a forward contract have potential default risk.
C) A forward contract can be exercised at any time.
Forward contracts typically require a purchase/sale of the asset on the expiration/delivery date specified in the
contract. The other statements are true.
Reading 57

Question #113
One of the principal characteristics of swaps is that swaps:
A) are standardized derivative instruments.
B) are highly regulated over-the-counter agreements.
C) may be likened to a series of forward contracts.
A swap agreement often requires that both parties agree to a series of transactions. Each transaction is similar to a
forward contract, where a party is paying a fixed price to offset the risk associated with an unknown future value.
Swaps are over-the-counter agreements but are not highly regulated. One of the benefits of swaps is that they can be
customized to fit the needs of the counterparties. Thus, they are not standardized.
Reading 58

Question #114
Which of the following statements about long positions in put and call options is most accurate? Profits from a long
call:
A) are positively correlated with the stock price and the profits from a long put are negatively correlated with the stock
price.
B) are negatively correlated with the stock price and the profits from a long put are positively correlated with the stock
price.
C) and a long put are positively correlated with the stock price.
For a call, the buyer's (or the long position's) potential gain is unlimited. The call option is in-the-money when the stock
price (S) exceeds the strike price (X). Thus, the buyer's profits are positively correlated with the stock price. For a put,
the buyer's (or the long position's) potential gain is equal to the strike price less the premium. A put option is in-the-
money when X > S. Thus, a put buyer wants a high exercise price and a low stock price. Thus, the buyer's profits are
negatively correlated with the stock price.
Reading 58

Question #115
Donner Foliette holds stock in Hamilton Properties, which is currently trading at $25.70 per share. On the advice of
this investment advisor, he conducts a covered call transaction at a strike price of $30 and at a premium of $3.50. The
advisor drew the following graph to help explain the transaction.
Which of the following statements about this transaction is least accurate?
A) The call buyer paid $3.50 for the right to any gain above $30.
B) Foliette believes the stock will appreciate significantly in the near future.
C) If the stock price falls to $23, Foliette will gain $0.80 per share.
One reason for an investor to conduct a covered call transaction is that he believes that the stock's upside potential is
limited and he wants to collect some option premiums. The call writer thus trades the stock's upside potential for the
premium. An investor is less likely to write a covered call if he believes the stock's upside potential is significant
because he would be giving up the expected gains if the stock is called away.
The information about Foliette's gains is correct. If the stock price decreases to $23.70, Foliette can realize a gain of
$0.80 if he sells the stock ($23.0 value − $25.70 + $3.50 premium).
Reading 59

Question #116
An investor buys a call option that has an option premium of $5 and a strike price of $22.50. The current market price
of the stock is $25.75. At expiration, the value of the stock is $23.00. The net profit/loss of the call position
is closest to:
A) -$4.50.
B) $4.50.
C) -$5.00.
The option is in-the-money by $0.50 ($23.00 - $22.50). The investor paid $5.00 for the call option, thus the net loss is -
$4.50 ($0.50 - $5.00).
Reading 59

ALTERNATIVE INVESTMENTS

Question #117
Which of the following will result from futures prices for a particular commodity being in contango?
A) Negative collateral yield.
B) Positive current yield.
C) Negative roll yield.
A positive roll yield results from a backwardated market, whereas a negative yield is produced in a contango market.
In backwardated (contango) markets, futures prices are lower (higher) than spot prices.
Reading 60

Question #118
Historical data on returns of assets valued with appraisal methods are most likely to exhibit:
A) overstated correlations with other asset classes.
B) downward-biased Sharpe measures.
C) smoothing.
Appraisal methods tend to produce smoothed return patterns understate standard deviations of returns. This causes
correlations with other asset classes to be understated and Sharpe ratios to be biased upward.
Reading 60

Question #119
Categories of alternative investments least likely include:
A) hedge funds.
B) real estate.
C) currencies.
Categories of alternative investments include hedge funds, private equity, real estate, commodities, and other non-
traditional assets such as collectibles or patents.
Reading 60

Question #120
Compared to traditional investments, alternative investments are most likely to be more:
A) transparent.
B) liquid.
C) leveraged.
Alternative investments tend to use more leverage and are typically less liquid and less transparent than traditional
investments.
Reading 60