Answer aunderstanding balance sheets elaine henry and thomas

360
𝐷𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 , 𝑀𝑀𝑌 > 𝐷𝐵𝑌

𝐵𝐸𝑌 = 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒

𝐵𝐸𝑌 = 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒

𝐷𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

1. As a condition of his employment with an investment bank, Abasi Hasina, CFA, was required to sign an employment contract, including a non-compete clause restricting him from working for a competitor for three years after leaving the employer. After one year, Hasina quits his job for a comparable position with an investment bank in a country where non-compete clauses are illegal. Lawyers with whom he consulted prior to taking the new position determined the non- compete clause was a violation of human rights and thus illegal. Did Hasina most likely violate the CFA Institute Code of Ethics?

A.Yes
B.No, because the non-compete clause violates his human rights
C.No, because the non-compete clause is illegal in the new country of employment

2. Benefits of compliance with the CFA Institute Global Investment Performance Standards (GIPS®) least likely include:

A.strengthening of internal controls.

“Introduction to the Global Investment Performance Standards (GIPS®),” CFA Institute 2011 Modular Level I, Vol. 1, pp. 172–173
Study Session 1-3-a
Explain why the GIPS standards were created, what parties the GIPS standards apply to, and who is served by the standards.

C is correct because compliance with the GIPS standards does not eliminate the need for in-depth due diligence on the part of the investor.

B is correct because firms that claim compliance with the GIPS standards are responsible for their claim of compliance and for maintaining that compliance.

4. Mariam Musa, CFA, head of compliance at Dunfield Brokers, questions her colleague Omar Kassim, a CFA candidate and a research analyst, about his purchase of shares in a company for his own account immediately before he publishes a “buy” recommendation. He defends his actions by stating he has done nothing wrong because Dunfield does not have any personal trading policies in place. The CFA Institute Code of Ethics and Standards of Professional Conduct were most likely violated by:

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level I, Vol. 1, pp. 101–103, 131
Study Session 1-2-b
Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.

C is correct because both Musa and Kassim violated the Standards of Professional Conduct.

B.do nothing, until other analysts support her analysis.

C.recommend her clients sell their Green Run shares immediately.

6. Richard Cardinal, CFA, is the founder of Volcano Capital Research, an investment management firm whose sole activity is short selling. Cardinal seeks out companies whose stocks have had large price increases. Cardinal also pays several lobbying firms to update him immediately on any legislative or regulatory changes that may impact his target companies. Cardinal sells short those target companies he estimates are near the peak of their sales and earnings and that his sources identify as facing legal or regulatory challenges. Immediately after he sells a stock, Cardinal conducts a public relations campaign to disclose all of the negative information he has gathered on the company, even if the information is not yet public. Which of Cardinal’s following actions is least likely to be in violation of the CFA Institute Standards of Professional Conduct?

A.Selling stock short
B.Trading on information from lobbyists
C.Disclosing information about target companies

A.Fair Dealing
B.Communication with Clients
C.Diligence and Reasonable Basis

Answer = C

A.Suitability
B.Conflicts of Interest
C.Client Communication

Answer = A

B.this practice benefits all clients.

C.the long-standing client relationships are not disclosed.

C is correct because the analyst does not violate any of the Standards of Professional Conduct by having long-standing client relationships and generally is not required to disclose such
relationships. However, the analyst is not treating all clients fairly as required by Standard III (B) Fair Dealing when disseminating investment recommendations; disclosure of the relationship with long-standing clients is not the issue. The analyst has advantaged some clients over others by providing advance information, and all clients do not have a fair opportunity to act on the information within the draft report. Members and candidates may differentiate their services to clients, but different levels of service must not disadvantage or negatively affect clients.

10.Colin Caldwell, CFA, is the chief investment officer of Northwest Mutual Fund, whose
investment objective is to invest in fixed income emerging market securities. Caldwell allocates the fund’s assets primarily to bonds of commodity producers in emerging markets and invests in a combination of several different investments to ensure an acceptable level of risk. The allocation is clearly disclosed in all fund communications. High volatility in the commodities markets at the start of the year makes Caldwell pessimistic about returns, so he shifts the fund into emerging market and U.S. government securities, positions he maintains at the end of the year. This change is noted in the next annual report to fund shareholders. Caldwell’s investment change least likely violated the CFA Institute Code of Ethics and Standards of Professional Conduct concerning:

“Guidance for Standards I-VII,” CFA Institute
2012 Modular Level I, Vol. 1, pp. 78–81, 116–117
Study Session 1-2-a
Demonstrate and explain the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity.

A is correct because the investment officer has invested in a combination of several different investments to ensure an acceptable level of risk rather than having all assets in a single investment, and he has sought a reasonable amount of diversification. However, the shift into emerging market and U.S. government securities was communicated to clients in the annual report and not on an ongoing basis, in violation of Standard V (B) Communication with Clients and Prospective Clients. Additionally, the investment officer has not followed the investment style previously communicated to fund investors (i.e., to invest in fixed income emerging market securities), specifically, when he invested in U.S. government securities, a violation of Standard III (C) Suitability.

CFA Institute Standards
2012 Modular Level I, Vol. 1, pp. 38, 71–72, 107–108, 116–117
Study Session 1-2-b
Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.

A is correct because the analyst has dealt fairly with all clients by sending them an e-mail and posting his rating change on the credit rating agency’s website when making material changes to his prior investment recommendation; therefore, he has not violated Standard III (B) Fair Dealing. Clients should be treated fairly when material changes in a member’s or candidate’s prior investment recommendations are disseminated, which has been done.

Answer = B

By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently registered CFA candidates and copying, posting to any website, e-mailing, distributing, and/or reprinting the mock exam for any purpose.

B.confirm the president’s diagnosis before publishing his research report.

C.encourage Red Ribbon Mining management to disclose the president’s medical condition.

14.Raymond Ortiz, CFA, provides investment advice to high-net-worth investors. Ortiz has just completed an analysis of Continental Wheat, a manufacturer of wheat-based food products. He rated the company a long-term hold for investors seeking growth and income. Ortiz’s analysis included a review of the company’s management team, financial data, pro forma financial positions, dividends and dividend policy, and a comparison of Continental with its competitors.

Although he does not tell anyone, five years ago, Ortiz worked for and managed the
commodities derivatives trading unit of Continental. As part of his compensation at Continental, he received stock, which he still owns. Based upon his research, Ortiz recommends Continental to clients who have a moderate risk tolerance. Two weeks later Continental announces its quarterly earnings are 30% less than a year ago. Consequently, shares of Continental drop by 50%. Ortiz most likely violated the CFA Institute Code of Ethics and Standards of Professional Conduct related to his stock:

CFA Institute Standards
2012 Modular Level I, Vol. 1, pp. 107–108, 123–126
Study Session 1-2-b
Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.

B is correct because there is a violation of Standard VI (A) Disclosure of Conflicts; the analyst worked for Continental and still has ties to the company in the form of his stock ownership.

CFA Institute Standards
2012 Modular Level I, Vol. 1, p. 8
Study Session 1-1-c
Explain the ethical responsibilities required by the Code and Standards, including the multiple sub-sections of each standard.

C.investment mandate.

Answer = B

B.non-solicitation agreement.

C.investment performance history.

18.Chan Liu, CFA, is the new research manager at the Pacific MicroCap Fund. Liu observed the following activities after she published a research report on a thinly traded micro cap stock that included a “buy” recommendation:
•Pacific traders purchased the stock for Pacific’s proprietary account and then purchased the same stock for all client accounts; and
•Pacific marketing department employees disseminated positive, but false, information about this stock in widely read Internet forums.

Liu notes the stock’s price increased more than 50% within a period of two days and was then sold for Pacific’s account. Which of the following steps is most appropriate for Liu to take to avoid violating the CFA Institute Code of Ethics and Standards of Professional Conduct?

A is correct because certain staff at Liu’s employer appear to be engaged in front running, a violation of Standard VI (B) Priority of Transactions, and market manipulation, a violation of Standard II (B) Market Manipulation. If Liu observes these violations without taking steps to notify her employer, she will be in violation of Standard I (A) Knowledge of the Law. Liu should know that the conduct observed is likely a violation of applicable laws, rules, and regulations and is a violation of the CFA Institute Code and Standards. Her first step, therefore, should be to attempt to stop the behavior by bringing it to the attention of the employer through a
supervisor or the firm’s compliance department. Inaction may be construed as participation or assistance in the illegal or unethical conduct.

	Prior probabilities
	25%
	55%
EPS are less than consensus	20%

Several days before releasing its earnings statement, the company announces a cut in its dividend. Given this information, the analyst revises his opinion regarding the likelihood that the company will have EPS below the consensus estimate. He estimates the likelihoods the company will cut the dividend given that EPS exceed/meet/fall below consensus as reported below.

A.24%.
B.72%.
C.85%.

Answer = B

+ P(Cut div│EPS below) × P(EPS below)
= 0.05 × 0.25 + 0.10 × 0.55 + 0.85 × 0.20 = 0.2375.

Then update the probability of EPS falling below the consensus as:
P(EPS below│Cut div) = [P(Cut div│EPS below) ÷ P(Cut div)] × P(EPS below) = [0.85 ÷ 0.2375] × 0.20 = 0.71579 ~ 72%.

Answer = A

“Sampling and Estimation,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E.

	0	1	2	3	4
Cash flow (€)	–12,500	2,000	4,000	5,000	2,000

The appropriate discount rate to use in evaluating the project is 8%. The NPV (in €) of the project is closest to:

Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI).

A is correct. Enter the given cash flows and the given discount rate into a financial calculator and solve for NPV. CF0 = –12,500, CF1 = 2,000, CF2 = 4,000, CF3 = 5,000, CF4 = 2,000, i = 8%. Compute PV. The NPV is –1,780.

B.10.0%.
C.10.8%.

Answer = C

Portfolio	Mean return on the portfolio (%)
A	10	20
B	18	15
C	6	3

“Statistical Concepts and Market Returns,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle
2012 Modular Level I, Vol. 1, pp. 396–399
Study Session 2-7-i
Calculate and interpret the coefficient of variation and the Sharpe ratio.

B is correct. The Sharpe ratio is defined as Sp = (𝑅𝑝 − 𝑅𝐹)/𝑠𝑝.

C.P(B│A).

Answer = A

A.4%.

B.8%.

26.When considering two mutually exclusive capital budgeting projects with conflicting rankings (one has the higher positive NPV, the other has a higher IRR), the most appropriateconclusion is to choose the project with the:

A.higher IRR.

Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI).

Explain NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods.

B.resistance.

C.change in polarity.

A.7.97%.
B.8.15%.
C.8.63%.

Answer = B

Assuming that the variances of the underlying populations are equal, the pooled estimate of the sample variance is 2,678.05. The t-test statistic appropriate to test the hypothesis that the two population means are equal is closest to:

𝑡 = �𝑋1 − 𝑋2� − (µ1 − µ2) 0.5 �𝑠𝑝2 𝑛1 + 𝑠𝑝2 𝑛2�

where

	2	(25−1)452+ (18−1)602
𝑡 =	𝑠𝑝 =	25 + 18−2	= 2678.04878
𝑡 =	0.5= 0.9377�2678.04878 25 + 2678.04878 18 �

“Common Probability Distributions,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle
2012 Modular Level I, Vol. 1, p. 516
Study Session 3-9-m
Define the standard normal distribution, explain how to standardize a random variable, and calculate and interpret probabilities using the standard normal distribution.

A is correct. There are two steps in standardizing a random variable X: Subtract the mean of X from X, and then divide that result by the standard deviation of X.

Runkle
2012 Modular Level I, Vol. 1, pp. 290–292
Study Session 2-5-e, f
Calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows.

Demonstrate the use of a time line in modeling and solving time value of money problems.

B.a head and shoulders.

C.an inverse head and shoulders.

33.Consumer surplus is best described as:

A.always less than or equal to zero.

B is correct. Consumer surplus arises when one pays less for a good than the maximum price that she or he was willing to pay for it. Consumer surplus is the value (or marginal benefit) of a good minus the price paid for it, summed over the quantity bought. Because no consumer will (willingly) pay a price greater than the marginal value or benefit, consumer surplus is always positive.

Answer = B

“Demand and Supply Analysis: Consumer Demand,” Richard V. Eastin and Gary L. Arbogast 2012 Modular Level I, Vol. 2, pp. 89–90
Study Session 4-14-b, e, f
Describe the use of indifference curves, opportunity sets, and budget constraints in decision making.

35.If the minimum efficient scale of a single producer is small relative to the demand for an undifferentiated good, the market structure of the producer is best described as being:

A.an oligopoly.

B is correct. Perfect competition involves the sale of a homogeneous product by many sellers; monopolistic competition may also involve many sellers, but its product involves differentiation.

36.In regard to the aggregate demand curve and an increase in one of its associated factors, which of the following relationships is least accurate?

37.Holding the working-age population constant, if the labor force participation ratio declines while the number of people employed remains unchanged, the unemployment rate will most likely:

A.increase.

“Understanding Business Cycles,” Michele Gambera, Milton Ezrati, and Bolong Cao 2012 Modular Level I, Vol. 2, pp. 322–324
Study Session 5-18-d
Explain the types of unemployment, and describe measures of unemployment.

B is correct. For a given working-age population, a decline in the labor force participation rate, often the result of an increase in discouraged workers, reduces the labor force. If the number of people employed remains the same while the labor force is smaller, the number of workers defined to be unemployed must be smaller and the unemployment rate lower.


	100	100

	80%	75%

38.Which of the following statements is most accurate? For a country to gain from trade it must have:

A.an absolute advantage.

B is correct. A comparative advantage arises if one entity can produce an item at a lower opportunity cost than another. An absolute advantagein producing a good (or service) arises if one entity can produce that good at a lower cost or use fewer resources in its production than its trading partner. Even if a country does not have an absolute advantage in producing any of its goods, it can still gain from trade by exporting the goods in which it has a comparative advantage. The country with the lower opportunity cost (with the comparative advantage) should specialize and produce its low opportunity cost item, and the other country should produce the high opportunity cost item, trading the goods between each other to make both better off.

B.8.

C.11.

A is correct. The profit-maximizing output will arise when MR = MC. MR = 150 – 10 × Q = MC = 3 × Q2 – 20 × Q + 73.

On reduction, this becomes: 3 × Q2 – 10 × Q – 77 = 0.

Units	Marginal revenue	Marginal cost	TR	TC	Net Profit
7	150 – 10 × 7 = 80	3 × 7 2 – 20 × 7 + 73 = 80	805	484	321
8	150 – 10 × 8 = 70	3 × 8 2 – 20 × 8 + 73 = 105	880	576	304
11	150 – 10 × 11 = 40	3 × 11 2 – 20 × 11 + 73 = 216	1045	1045	0

A.Price floors
B.Price ceilings
C.Imposing an additional per-unit tax of $1 on sellers

Answer = A

B.expand the economy through a lower policy interest rate. C.contract the economy through a lower policy interest rate.

Answer = A

42.Consider two countries, A and B. Country A is a closed country with a relative abundance of labor and holds a comparative advantage in the production of textiles. Country B has a relative abundance of capital. When the textile trade is opened between the two countries, Country A will most likely experience a favorable impact on:

A.labor.

“International Trade and Capital Flows,” Usha Nair-Reichert and Daniel Robert Witschi 2012 Modular Level I, Vol. 2, pp. 450–452
Study Session 6-20-b, c, d
Distinguish between comparative advantage and absolute advantage.

Explain the Ricardian and Heckscher–Ohlin models of trade and the source(s) of comparative advantage in each model.

B.begin to allow free movement of the factors of production.

C.establish common economic institutions and coordination of economic policies.

A.1.0296.
B.1.0425.
C.1.1154.

Answer = B

Questions 45 through 68 relate to Financial Statement Analysis

45.Which of the following is least likely to appear in a company’s proxy statement?

B is correct. Significant events, conditions, trends, and contingencies that may affect future operations are contained in the Management’s Discussion and Analysis. Compensation agreements for directors and management and their potential conflicts of interest are required in the proxy statement.

	$4,000

Repayment of long-term debt	$1,000
Proceeds from shares issued	$1,000

Answer = C

“Financial Reporting Mechanics,” Thomas R. Robinson, Jan Hendrik van Greuning, Karen O’Connor Rubsam, Elaine Henry, and Michael A. Broihahn
2012 Modular Level I, Vol. 3, pp. 46–51
Study Session: 7-23-b, e
Explain the accounting equation in its basic and expanded forms.

47.A retailer provides credit cards only to its most valued customers who pass a rigorous credit check. A credit card customer ordered an item from the retailer in May. The item was shipped and delivered in July. The item appeared on the customer’s July credit card statement and was paid in full by the due date in August. The most appropriate month in which the retailer should recognize the revenue is:

A.May.

B is correct. The appropriate time to recognize revenue would be in the month of July; the risks and rewards have been transferred to the buyer (shipped and delivered), the revenue can be reliably measured, and it is probable that the economic benefits will flow to the seller (the rigorous credit check was completed). Neither the actual payment date nor the credit card statement date is relevant here.

Assets

Cash & investments Accounts receivable Inventories
	212,800
	63,000

Liabilities

Accounts payable

A.took advantage of early payment discounts.

B.paid its accounts within the payment terms provided.

Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared with peer companies.

C is correct.

Answer = A

“Financial Analysis Techniques,” Elaine Henry, Thomas R. Robinson, and Jan Hendrik van Greuning
2012 Modular Level I, Vol. 3, pp. 374–379, 380–381, 383
“Cost of Capital,” Yves Courtois, Gene C. Lai, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, p. 57
Study Session 8-28-c, d, e, 11-37-h
Describe the relationships among ratios, and evaluate a company using ratio analysis.

The higher a company’s ROE and its ability to finance itself from internally generated funds (a higher retention ratio), the greater its sustainable growth rate.

In the five-factor ROE, any factor that increases ROE will increase sustainable growth:

1.	purchased a customer list for $100,000, which is expected to provide equal annual benefits for the next 4 years.

Based on those events, the amortization expense that the company should report in 2011 is closest to:

A.$25,000.
B.$45,000.
C.$85,000.

51.The following items are from a company’s cash flow statement.

Distinguish between the direct and indirect methods of presenting cash from operating activities, and describe the arguments in favor of each method.

A is correct. The direct method of cash flow statement presentation shows the specific cash inflows and outflows that result in reported cash flow from operating activities (cash from customers, cash to suppliers, etc.). Companies using IFRS can decide to report interest and dividend receipts as either an investing or operating activity, whereas under U.S. GAAP, they must report such income as an operating activity. The listed operating and investment activities indicate that the company reports under IFRS, using the direct method.

	$ million
	4.3
	4.1
	3.8

If the company is using International Financial Reporting Standards (IFRS), instead of U.S. GAAP, its cost of goods sold ($ millions) is most likely:

A.the same.
B.0.3 lower.
C.0.3 higher.

53.For which of the following assets is it most appropriate to test for impairment at least annually?

A.Land
B.A patent with a legal life of 20 years
C.A trademark with an expected indefinite life

54.On 1 January 2011 the market rate of interest on a company’s bonds is 5% and it issues a bond with the following characteristics:

If the company uses IFRS, its interest expense (in millions) in 2011 is closest to:

A.€1.846.
B.€2.307.
C.€2.386.

55.Given the following information about a company:

(€ millions)	2011	2010
	2,240	5,400
	2,000	1,200
	12,000	9,000
	23,250	21,175
EBIT	3,850	3,800
Interest payments	855	837
	800	800

Answer = A

C.use of operating leases versus financing leases.

Answer = A

57.The least likely reason thata security analyst needs to understand the accounting process is to:

A.prevent earnings manipulation by management.

58.What is the most likely effect on the accounting equation when a company purchases office equipment with cash?

A.Assets increase, and liabilities increase.

59.Which of the following statements best describes the role of the International Organization of Securities Commissions (IOSCO)? The IOSCO:

Robinson
2012 Modular Level I, Vol. 3, pp. 111–112
Study Session: 7-24-b
Describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions.

C is correct. The IOSCO is not a regulator of financial markets. To ensure consistent application of international financial standards, it is important to have uniform regulation and enforcement across national boundaries. IOSCO assists in attaining this goal of uniform regulation as well as cross-border cooperation in combating violations of securities and derivatives laws.


	(%)
Cash & Short-Term Investments	43.2
Accounts Receivable	9.4
	0.6
	53.2
	3.9
	40.0
Other Long-Term Assets	2.9
Total Assets	100.0


	1.6
	17.8
	19.4
Long-Term Debt	20.1
Other Long-Term Liabilities	6.5
	46.0
	54.0
	100.0

Answer = B

“Understanding Balance Sheets,” Elaine Henry and Thomas R. Robinson
2012 Modular Level I, Vol. 3, pp. 252–259
Study Session: 8-26-h
Convert balance sheets to common-size balance sheets, and interpret the common-size balance sheets.

B.details on the specific sources of operating receipts and payments. C.insight on differences between net income and operating cash flows.

Answer = C

Cash Flow Item	(€)
Net income
Non-cash charges

		210
Working capital expenditures

		40%

The free cash flow to the firm is closest to:

63.An analyst gathers the following information about a company’s common stock:

•	1 January 2011
•
•		2 for 1 stock split
•	31 December 2011	500,000 shares outstanding

2012 Modular Level I, Vol. 3, pp. 189–190
Study Session 8-25-g
Describe how earnings per share is calculated, and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures.

C is correct. The weighted average number of shares is determined by the length of time each quantity of shares was outstanding. A stock split is treated as if it occurred at the beginning of the year.

A.the cash ratio.

B.the current ratio.

Describe the relationships among ratios, and evaluate a company using ratio analysis.

C is correct. A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and provides insight into what portion of a company’s assets is liquid. In contrast, cash and current ratios measure liquidity relative to current liabilities, not relative to total assets.

“Inventories,” Michael A. Broihahn
2012 Modular Level I, Vol. 3, pp. 411–413
Study Session: 9-29-c
Calculate cost of sales and ending inventory using different inventory valuation methods, and explain the impact of the inventory valuation method choice on gross profit.

A is correct.

	Units
	1,000	$22.50	$22,500
Purchase #2	800	$25.00	$20,000
Purchase #3	400	$25.50	$10,200
	2,200		$52,700

Ending inventory	2,200 – 1,700 = 500 units		$ 11,975

“Income Taxes,” Elbie Antonites and Michael A. Broihahn 2012 Modular Level I, Vol. 3, pp. 493–495
Study Session: 9-31-c, d
Determine the tax base of a company’s assets and liabilities.

Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate.

After three years:	50,000 × 0.8 × 0.8 × 0.8 =	25,600
Difference between accounting and tax values		9,400
		2,820

$ millions

In the analyst’s opinion, which of the following conclusions is most appropriate? Compared with Company A, Company B:

“Financial Reporting Quality: Red Flags and Accounting Warning Signs,”Thomas R. Robinson and Paul Munter
2012 Modular Level I, Vol. 3, p. 595
“Financial Statement Analysis: Applications,” Thomas R. Robinson, Jan Hendrik van Greuning, Elaine Henry, and Michael A. Broihahn
2012 Modular Level I, Vol. 3, pp. 645–650
Study Session: 10-33-b, 10-35-e
Describe activities that will result in a low quality of earnings.

Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.

	Company A	Company B
	1.35	1.50

Estimated average remaining useful life

	10 years	15 years

68.An analyst has made three observations in his worksheets about a company that he is reviewing. Which of the observations most likely reduces the quality of earnings of the company? The company:

A.reported for the first time an asset titled “Deferred customer acquisition costs.”
B.has reduced its estimate of the expected useful life of computer equipment from 8 years to 5 years.

A is correct. An asset such as “deferred acquisition costs” could indicate the company is deferring current period expenses to future periods, which is a warning sign and an indication of lower quality earnings.

Questions 69 through 78 relate to Corporate Finance

“Cost of Capital,” Yves Courtois, Gene C. Lai, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, pp. 41–42
Study Session 11-37-a, b
Calculate and interpret the weighted average cost of capital (WACC) of a company.

Describe how taxes affect the cost of capital from different capital sources.

“Cost of Capital,” Yves Courtois, Gene C. Lai, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, pp. 48–49
Study Session 11-37-f
Calculate and interpret the cost of fixed rate debt capital using the yield-to-maturity approach and the debt-rating approach.

A is correct. The debt-rating approach is an example of matrix pricing. The yield-to-maturity approach is not an example of matrix pricing.

“Capital Budgeting,” John D. Stowe and Jacques R. Gagne
2012 Modular Level I, Vol. 4, pp. 10–13, 17–19
Study Session 11-36-d, e
Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI).

		K = 15%	K = 18%	K = 21%	Calculation
0	–606,061	–606,061.0			–606,061.0
1			1,823,317.8	1,778,111.6
2	–2,542,424		–1,825,929.3	–1,736,509.8
3		657,516.2	608,630.9	564,473.9	+1,000,000 ÷ (1 + K)3

	NPV	–$100.0	–$41.7	+$14.7

Answer = A

“Working Capital Management,” Edgar A. Norton, Jr., Kenneth L. Parkinson, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, pp. 198–200
Study Session 11-40-g
Evaluate the choices of short-term funding available to a company, and recommend a financing method.

		Dealer commission	$3,000/12 = 250
		Backup costs	$4,000/12 = 333


		CP cost	(10,416 × 12) ÷ 1,990,167

A.1.5.
B.1.7.
C.2.6.

Answer = A

Answer = A

Answer = A

“Capital Budgeting,” John D. Stowe and Jacques R. Gagne
2012 Modular Level I, Vol. 4, p. 27
Study Session 11-36-f, g
Describe and account for the relative popularity of the various capital budgeting methods, and explain the relation between NPV and company value and stock price.

	10%
Cost of equity	16%
Debt-to-equity ratio (D/E)	50%
	30%

“Cost of Capital,” Yves Courtois, Gene C. Lai, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, pp. 40–43
Study Session 11-37-a, b
Calculate and interpret the weighted average cost of capital (WACC) of a company.

𝑤𝑒 = 1 − 𝑤𝑑 = 66.7%

𝑊𝐴𝐶𝐶 = 𝑤𝑑𝑟𝑑(1 − 𝑡) + 𝑤𝑝𝑟𝑝 + 𝑤𝑒𝑟𝑒

“Working Capital Management,” Edgar Norton, Jr., Kenneth L. Parkinson, and Pamela Peterson Drake
2012 Modular Level I, Vol. 4, p. 174
Study Session 11-40-e
Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines.

C is correct. Note that the face value is greater than the purchase price because the T-bill sells at a discount:

78.In a sales-driven pro forma analysis, net income grows from $1.2 million to $1.26 million. Assuming a dividend payout ratio of 40%, the increase in retained earnings is closest to (in $ millions):

A.0.720.
B.0.756.
C.1.260.

𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = $1.26 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − $0.504 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 0.756 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Or:

B.fundamental weighting.

C.float-adjusted market-capitalization weighting.

80.According to the industry life-cycle model, an industry in the shakeout stage is best characterized as experiencing:

A.slowing growth and intense competition.

A is correct. The shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability. During the shakeout stage, demand approaches market saturation levels because few new customers are left to enter the market. Competition is intense as growth becomes increasingly dependent on market share gains.

81.An investor uses the data below and Gordon’s constant growth dividend discount model to evaluate a company’s common stock. To estimate growth, she uses the average value of the:

If her required return is 15%, the stock’s intrinsic value is closest to:

A.$23.71.
B.$25.31.
C.$30.14.

Sustainable growth rate for the year 2011:

b = Earnings retention rate = (1 – Dividend payout ratio) = [1 –

82.According to behavioral finance, observed overreaction in securities markets most likely occurs due to:

A is correct. According to loss aversion related arguments in behavioral theories, investors dislike losses more than they like comparable gains. Thus, such a behavioral bias can explain observed overreaction in markets.

83.Companies pursuing cost leadership will most likely:

“Introduction to Industry and Company Analysis,” Patrick W. Dorsey, Anthony M. Fiore, and Ian Rossa O’Reilly

	$50/share
Sale price	$55/share
Shares purchased	500
	45%
	6%

Transaction commission on purchase	$0.05/share

Answer = C

“Market Organization and Structure,” Larry E. Harris
2012 Modular Level I, Vol. 5, pp. 44–45
Study Session 13-47-f
Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

See Example 19 pp. 44–45.

Answer = A

“Market Organization and Structure,” Larry E. Harris
2012 Modular Level I, Vol. 5, pp. 58–61
Study Session 13-47-j
Describe how securities, contracts, and currencies are traded in quote-driven markets, order-driven markets, and brokered markets.

“Market Organization and Structure,” Larry E. Harris
2012 Modular Level I, Vol. 5, pp. 62–63
Study Session 13-47-k
Describe the characteristics of a well-functioning financial system.

C is correct. Accounting standards and reporting requirements that allow meaningful and timely financial disclosures reduce the costs of obtaining fundamental information and thereby allow analysts to form more accurate estimates of fundamental values. Liquid markets allow well-informed traders to fill their orders at low costs. Well-informed traders make prices
informationally efficient.

Answer = B

“Market Efficiency,” W. Sean Cleary, Howard J. Atkinson, and Pamela Peterson Drake 2012 Modular Level I, Vol. 5, pp. 130–134
Study Session 13-49-a, c
Explain market efficiency and related concepts, including their importance to investment practitioners.

Company	Return on equity (%)	Payout ratio (%)	Justified forward P/E
M	12.0	30	7.5
N	14.0	40	10.0

A.both companies would increase.

B.both companies would decrease.

A is correct. Dividend growth rate = (1 – Payout ratio) × ROE; Justified forward P/E: P0/E1 = p/(r – g).

Using the new payout ratios, the justified forward P/Es, calculated below, of both firms would increase.

Which of the following is the most appropriate decision for the fund manager?

A is correct. The company’s cost of equity is often used as a proxy for the investors’ minimum required rate of return because it is the minimum expected rate of return that a company must offer its investors to purchase its shares in the primary market and to maintain its share price in the secondary market. Using the CAPM, the company’s cost of equity = 3.50% + 1.80(5.25%) = 12.95%, compared with the fund manager’s required rate of return of 13.60%. Therefore, the fund manager should not invest in the stock.

Describe identified market pricing anomalies, and explain possible inconsistencies with market efficiency.

B is correct. The observation that stocks with high above-average price-to-earnings ratios have consistently underperformed those with below-average price-to-earnings ratios is a cross-sectional anomaly. It is a contradiction to the semi-strong form of market efficiency and weak-form market efficiency because all the information used to categorize stocks by their price-to-earnings ratios is publicly available.

C.amount needed to finance the purchase of the underlying asset.

Answer = B

B.an investment bank making cash settlement on a short euro futures position.

C.a multinational firm making cash settlement on a short U.S. dollar forward contract.

93.Which of the following statements most closely relates to the concept of moneyness?

A.The sum of money the option buyer pays the seller is called the premium.

94.The intrinsic value of an option is always zero:

A.at expiration.

95.Euribor would most likely be the interest rate quoted on a large:

“Forward Markets and Contracts,” Don M. Chance
2011 Modular Level I, Vol. 6, pp. 40–41
Study Session 17-61-e
Describe the characteristics of the euro dollar time deposit market, and define LIBOR and Euribor.

A is correct because Euribor is the interest rate on large euro currency time deposits traded in most major world cities.

“Swap Markets and Contracts,” Don M. Chance
2011 Modular Level I, Vol. 6, pp. 133–134
Study Session 17-64-a
Describe the characteristics of swap contracts, and explain how swaps are terminated.

C is correct because swaps are not listed on an exchange.

“Features of Debt Securities,” Frank J. Fabozzi
2012 Modular Level I, Vol. 5, p. 337
Study Session 15-53-e

B.highest coupon rate.

C.coupon rate closest to its market yield.

A.increases.

B.decreases.

100.An investor whose marginal tax rate is 33.5% is analyzing a tax-exempt bond offering a yield of 5.20%. The taxable-equivalent yield of the bond is closest to:

A.3.90%.

“Understanding Yield Spreads,” Frank J. Fabozzi
2012 Modular Level I, Vol. 5, pp. 464–465
Study Session 15-56-i
Calculate the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security.

C is correct because the Tax-equivalent yield = Tax-exempt yield/(1 – Marginal tax rate) = 5.20%/(1 – 0.335) = 7.82%.

C is correct because the Relative yield spread = (Bond yield – Reference yield)/Reference yield = (7.39% – 4.26%)/4.26% = 73.50%.

102.Consider a $100 par value bond, with an 8% coupon paid annually, maturing in 20 years. If the bond currently sells for $96.47, the yield to maturity is closest to:

Answer = B

“Understanding Yield Spreads,” Frank J. Fabozzi
2012 Modular Level I, Vol. 5, pp. 461–462
Study Session 15-56-g
Describe how embedded options affect yield spreads.

Period	Years	Spot Rate
1	0.5	1.60%
2	1.0	2.20%
3	1.5	2.70%
4	2.0	3.10%

“Introduction to the Valuation of Debt Securities,” Frank J. Fabozzi
2012 Modular Level I, Vol. 5, pp. 504–506
Study Session 16-57-f
Explain and demonstrate the use of the arbitrage-free valuation approach, and describe how a dealer can generate an arbitrage profit if a bond is mispriced.

B.a discount.
C.a premium.

Answer = C

Period	Years
1	0.5	1.20%
2	1.0	1.80%
3	1.5	2.30%
4	2.0	2.70%
5	2.5	3.00%

A.$101.52.
B.$104.87.
C.$106.83.

Answer = C

C.option-free.

Answer = A

Bond	Maturity	Price	Par Amount	Duration
1	17-year	$109.2461	$16 million	8.56
2	20-year	$100.4732	$4 million	9.19
3	25-year	$84.6427	$8 million	11.48

Based on this information, the duration of the portfolio is closest to:

A.9.35.
B.9.48.
C.9.74.

B.access to funds that are closed to new investors.

C.access to managers with expertise in finding reliable and good-quality hedge funds.

A.Lower bid–ask spreads
B.Managing the timing of capital gains
C.Ability to sell short and buy on margin

Answer = A

A.Leveraged equity rights
B.Real estate investment trusts (REITs)
C.Real estate limited partnerships (RELPs)

Answer = A

B.bond returns.
C.stock returns.

Answer = A

Answer = A

B.collateral yield, convenience yield, and roll yield.

C.convenience yield, dividend yield, and spot price return.

115.The execution step of the portfolio management process includes:

A.finalizing the asset allocation.

A is correct. Asset allocation occurs in the execution step.

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Security	A	B	C
A	1.0
B	0.5	1.0
C	0.0	–0.5	1.0

“Portfolio Risk and Return Part I,” Vijay Singal
2012 Modular Level I, Vol. 4, pp. 364–365
Study Session 12-44-f
Describe the effect on a portfolio’s risk of investing in assets that are less than perfectly correlated.

C is correct. The negative correlation of –0.5 between investment instruments B and C is lowest and therefore is most effective for portfolio diversification.

Answer = B

“Portfolio Risk and Return Part II,” Vijay Singal
2012 Modular Level I, Vol. 4, pp. 422–423
Study Session 12-45-f
Explain the capital asset pricing model (CAPM), including the required assumptions, and the security market line (SML).

Answer = B

“Portfolio Risk and Return Part II,” Vijay Singal
2012 Modular Level I, Vol. 4, pp. 429–432
Study Session 12-45-h
Describe and demonstrate applications of the CAPM and the SML.

A.Heisen Inc.

B.Booraem Inc.
C.Gutmann Inc.

120.In a strategic asset allocation, assets within a specific asset class are least likely to have:

A.low paired correlations.

A is correct. In a strategic asset allocation, assets within a specific asset class will have high paired correlations and low correlations with assets in other asset classes.