CFA Level I Revision Class This files has expired at 30-Jun-13
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Financial Statement Analysis Corporate Finance Portfolio Management Equity investments Fixed income investments Alternative investments
Questions 1 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise otherwise noted. Which of the following is least likely to be classified as a financial statement element? A. Asset B. Revenue C. Net In Income
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Questions 1 – Answer • Net income is not an element of the financial statements, but the net result of revenues less expenses. The elements are: assets, liabilities, owners’ equity, revenue and expenses
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Questions 2 – Financial Statement Analysis • An analyst prepares common-size balance sheets for two companies operating in the same industry. The analyst notes that both companies had the same proportion of current liabilities, long-term liabilities, and shareholders’ equity and the following ratios: HUL
P&G
Current Ratio
2.0
2.0
Cash Ratio
0.5
0.5
Quick Ratio
0.8
1.2
The most reasonableThis conclusion is that, compared with P&G, had a: files has expired at HUL 30-Jun-13
A. higher percentage of assets associated with inventory. B. higher percentage of assets associated with accounts receivable. C. lower percentage of assets associated with marketable securities
Questions 2 – Answer • The current ratio includes inventory but the quick ratio does not. (Current ratio is higher than quick ratio and quick ratio is higher than cash ratio.) The quick ratio includes accounts receivable but the cash ratio does not. The denominator for all three ratios is current liabilities, which are the same proportion for both companies. The difference in ratios is therefore created by inventory and accounts receivable. HUL has the higher percentage of inventory because the difference between the current ratio and quick ratio is greater for that company. P&G had the higher percentage of accounts receivable because the difference between the quick ratio and the cash ratio is greater for P&G.
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Questions 3 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. At the end of the year, a company sold equipment for $25,000 cash. The company paid $100,000 for the equipment several years ago and had recorded accumulated depreciation of $60,000 at the time of its sale. All else equal, the equipment sale will result in the company’s cash flow from: A. Investing activities increasing by $25,000 B. Investing activities decreasing by $15,000 C. Operating activities being $10,000 less than net income
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Questions 3 – Answer • The book value of the equipment at the time of sale is $100,000 - $60,000 = $40,000. The proceeds are $25,000; therefore a loss of $15,000 is reported on the income statement. The loss reduces net income, but it is a non-cash amount, so is added back to net income in the calculation of the cash from operations. Therefore, cash from operations is higher than net income, not lower. The total amount of the proceeds, $25,000, is the cash inflow from the transaction and is shown as a cash inflow from investing activities.
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Questions 4 – Financial Statement Analysis • An analyst gathers the following annual information ($ millions) about a company that pays no dividends and has no debt: Net income
48.5
Depreciation
18.2
Loss on sale of equipment
1.6
Decrease in accounts receivable
4.2
Increase in inventories
3.4
Increase in accounts payable
2.5
Capital expenditures
7.3
Proceeds from sale of stock
8.5
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The company’s annual free cash flow to equity ($ millions) is closest to: A. 53.1 B. 58.4 C. 65.3
Questions 4 – Answer • Free cash flow to equity in a company without any debt is equal to cash flow from operations (CFO) less capital expenditures. CFO = net income + depreciation + loss on sale of equipment + decrease in accounts receivable – increase in inventories + increase in accounts payable. (The loss on sale of equipment is added back when calculating CFO. It would have been deducted in the calculation of net income but the loss is not the cash impact of the transaction (the proceeds received, if any, would be the cash effect) and cash flows related to equipment transactions are investing activities, not operating activities. CFO = 48.5 + 18.2 +1.6 + 4.2 – 3.4 +2.5 = $72.6 million $72.6 – $7.3 = $65.3 million free cash flow to equity. This files has expired at 30-Jun-13
Questions 5 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. The following information is available from the accounting records of a company as at 31 December 2008 (all figures in $ thousands): Account
$
Accounts payable
20
Accounts receivable
85
Bank loan, due on demand
44
Cash
12
Income taxes payable
8
Inventory
47
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Investments accounted for by the equity method
112
Loan payable, due 30 June 30 2010
50
Deposits from customers for deliveries in 2009
8
The working capital for the company (in $ thousands) is closest to: A. 64 B. 72 C. 176
Questions 5 – Answer Current Assets: • Cash • Accounts receivable • Inventory
12 85 47 144
Current Liabilities • Bank loan, due on demand 44 • Accounts payable 20 This files has expired8 at 30-Jun-13 • Income taxes payable • Deposits from customers for deliveries in 2009 8 80 64.0 • Working capital (CA – CL)
Questions 6 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company reports earnings before taxes of $900,000 for the year. The table below indicates selected items which were included in earnings before taxes and their associated tax status. Included in determining Net Income
Tax Status
Depreciation Expense
$80,000
$90,000 allowed for tax purposes
Dividend Income
$125,000
Dividends not taxable
Fine related to environmental damage
$90,000
Not deductible for tax purposes
R&D Expenditures
$50,000
$25,000 allowed for tax purposes
This files has expired at 30-Jun-13 The company’s tax rate is 35 percent. The company’s current income taxes payable (in $) is closest to: A. 206,500 B. 308,000 C. 360,500
Questions 6 – Answer • • • • • • • • •
Net income $900,000 Add back book depreciation 80,000 Deduct tax allowed depreciation (90,000) Deduct Dividend income (125,000) Add back Fine 90,000 Add back book R&D 50,000 Deduct tax allowed R&D (25,000) Earnings before taxes 880,000 This35% files has expired at 30-Jun-13 Current taxes payable x $880,000=308,000
Questions 7 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms: Annual lease payment due 31 December
$50,000
Lease term
5 years
Estimated useful life of the machine
6 years
Estimated salvage value of the machine Carrying value (cost) of leased asset Implied interest rate on lease
$0 $150,000 8%
This files has expired at 30-Jun-13 The firm is reasonably assured of the collection of the lease payments. Which of the following best describes the classification of the lease on the company’s financial statements for 2008? A. Operating lease B. Sales type lease C. Direct financing lease
Questions 7 – Answer • It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%) and the asset is on its books at less than the present value of the lease payments ($199,635) (PMT = $50,000, N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments.
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Questions 8 – Financial Statement Analysis • A company uses the LIFO inventory method, but most of the other companies in the same industry use FIFO. Which of the following best describes one of the adjustments that would be made to the company’s financial statements to compare it with other companies in the industry? The amount reported for the company’s ending inventory should be: A. Increased by the ending balance in its LIFO reserve. B. Decreased by the ending balance in its LIFO reserve. C. Increased by the change in its LIFO reserve for that period.
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Questions 8 – Answer • LIFO Reserve = FIFO Inventory – LIFO Inventory Adding the ending balance in the LIFO reserve to the LIFO inventory would equal the ending balance for inventory on a FIFO basis.
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Questions 9 – Financial Statement Analysis • An analyst gathers the following information about a company: Average market price per share of common stock during the year
$50
Exercise price per share for options on 50,000 common shares
$60
Exercise price per share for warrants on 20,000 common shares
$40
Using the treasury stock method, the number of incremental shares used to compute diluted earnings per share is closest to: A. 4,000. B. 16,000. C. 20,000.
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Questions 9 – Answer • Diluted EPS is calculated using the treasury stock method that considers what would be the effect if the options or warrants had been exercised. Only options or warrants that are in-the-money are included, as out-of-the-money options would not be exercised. Therefore only the warrants are dilutive: their exercise price is below the average market price of the stock. Using the treasury stock method, the number of new shares issued on exercise is reduced by the number of shares that could be purchased with the cash received upon exercise of the warrants: 20,000($40) = $800,000 in proceeds. $800,000 / $50 = 16,000 shares treasury stock. Incremental shares using the treasury stock method = 20,000 – 16,000 = 4,000. This files has expired at 30-Jun-13
Questions 10 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. At the beginning of the year, a lessee company enters into a new lease agreement that is correctly classified as a finance lease, with the following terms: Annual lease payments due at the end of the year
Lease term Appropriate discount rate Depreciation method Estimated salvage value
$100,000
5 years 12% straight-line basis $0
With respect to the effect of the lease on the expired company’s financial statements in the first year of the This files has at 30-Jun-13 lease, which of the following is most accurate? The reduction in the company’s: A. Pretax income is $72,096. B. Cash flow from financing is $56,742. C. Cash flow from operations is $72,096.
Questions 10 – Answer • The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original PV is $43,257.31 and represents the interest component of the payment in the first year. The difference between the annual payment and the interest is the amortization of the lease obligation included in cash flow from financing. $100,000 – 43,257.31 = $56,742.69. Depreciation is $360,477.62 / 5 or $72,095.52 so the total reduction in pretax income would be interest plus depreciation or $115,352.83. Cash flow from operations would be reduced by the amount of the interest only because the depreciation would be added back to determine cash flow from operations.
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Questions 11 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company using the LIFO inventory method reports a LIFO reserve at year-end of $85,000, which is $20,000 lower than the prior year. If the company had used FIFO instead of LIFO in that year, the company’s financial statements would have reported: A. A lower cost of goods sold, but a higher inventory balance. B. A higher cost of goods sold, but a lower inventory balance. C. Both a higher cost of goods sold and a higher inventory balance.
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Questions 11 – Answer • The negative change in the LIFO reserve would increase the cost of goods sold under FIFO compared to LIFO. FIFO COGS = LIFO COGS – Change in LIFO reserve. The LIFO reserve has a positive balance so that FIFO inventory would be higher than LIFO inventory. FIFO inventory = LIFO inventory + LIFO reserve.
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Questions 12 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. An analyst gathers the following information about a company: Shares of common stock outstanding
1,000,000
Net income for the year
$1,500,000
Par value of convertible bonds with a 4 percent coupon rate
$10,000,000
Par value of cumulative preferred stock with a 7 percent dividend rate
$2,000,000
Tax rate
30%
The bonds were issued at par and can be converted into 300,000 common shares. All securities were outstanding for the entire year. Dilutedhas earnings per shareat is closest to: This files expired 30-Jun-13
A. $1.05. B. $1.26. C. $1.36.
Questions 12 – Answer • Dividends of $140,000 (0.07 x 2,000,000) should be deducted from net income to determine the amount available to common shareholders: $1,360,000 = (1,500,000 – 140,000). Basic EPS would be $1,360,000 / 1,000,000 or $1.36 per share. Diluted EPS would consider the convertible bonds if they were dilutive. Interest on the bonds is $400,000 and the after-tax amount add back to net income is $400,000 (1-.30) = $280,000. Diluted EPS, assuming conversion, is ($1,360,000 + 280,000) / (1,000,000 +300,000) = 1,640,000/1,300,000= $1.26 per share. The bonds are dilutive.
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Questions 13 – Financial Statement Analysis • When the financial statements materially depart from accounting standards and are not fairly presented, the audit opinion would be a(n): A. Adverse opinion. B. Qualified opinion. C. Disclaimer of opinion.
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Questions 13 – Answer • An adverse opinion occurs when the financial statements materially depart from accounting standards and are not fairly presented. A qualified opinion is one in which there is some limitation or exception to accounting standards.
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Questions 14 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company acquires a manufacturing facility in which it will produce toxic chemicals. The cost of the facility (exclusive of the underlying land) is $25 million and it is expected to provide a 10-year useful life, after which time the company will demolish the building and restore the underlying land. The cost of this restoration and cleanup is estimated to be $3 million at that time. The facility will be amortized on a straight-line basis. The company’s discount rate associated with this obligation is 6.25 percent. The total expense that will be recorded in the first year associated with the asset retirement obligation on this property is closest to: A. $163,618. B. $224,945. C. $265,879.
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Questions 14 – Answer • The PV of the future cleanup costs = 1,636,183 (FV = 3,000,000; N = 10; I/Y = 6.25; PMT = 0; CPT PV). The firm will record asset retirement costs of $1,636,183 as part of the cost of the property and a corresponding ARO liability of $1,636,183. The asset retirement costs will be amortized at the same rate as the property (10 years, straight-line) and an accretion expense representing the change in the ARO liability will also arise. Depreciation Expense: 1/10 x 1,636,183 = 163,618 Accretion Expense
Total Expense
6.25% x 1,636,183=102,261
265,879
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Questions 15 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms: Annual lease payment due 31 December
$75,000
Lease term
6 years
Estimated useful life of the machine
7 years
Estimated salvage value of the machine Carrying value (cost) of leased asset Implied interest rate on lease
$0 $300,000 7%
This files has expired at 30-Jun-13 • The firm is reasonably assured of the collection of the lease payments.
The total affect on 2008 pre-tax income for the lessor from this lease is closest to: A. $32,143. B. $75,000. C. $82,519.
Questions 15 – Answer • This is a sales type lease: the lease period covers more than 75% of its useful life (6/7=85.7%) and the asset is on its books at less than the present value of the lease payments ($357,490) (PMT = $75,000, N=6, i=7%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments. The income in the first year will therefore consist of the gross profit on the sale (357,490300,000)=57,490 plus interest revenue from financing the lease = 25,024 Year 1
Start Balance Interest Payment End Balance 357,490 7%x357,490=25,024 75,000 357,490-(75,000-25,024)=307,514 This files has expired at 30-Jun-13
Total income = 57,490 + 25,024 = 82,514
Questions 16 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Compared to the completed contract method of revenue recognition, will the percentage of completion method most likely result in higher: Total assets Liabilities A. No B. No C. Yes
No Yes No
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Questions 16 – Answer • Compared to the completed contract method, the percentage of completion method will most likely result in higher total assets, reflecting the accrual of gross profit during the contract period and lower liabilities, as the higher level of construction in progress provides a larger offset to advance billings
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Questions 17 – Financial Statement Analysis • An analyst has calculate the following ratios for Marico Ltd. – Number of days of receivables 48 – Number of days of inventory 37 – Number of days of payables 28 The operating cycle and cash conversion cycle respectively for M arico are closet to:
operating cycle A. 57 days B. 57 days C. 85 days
cash conversion cycle 57 days 85 days 85 days This files has expired at 30-Jun-13
Questions 17 – Answer • The operating cycle = no of days of inventory + no of days of receivables =48+37= 85 • The cash conversion cycle = no of days of inventory + no of days of receivables – no of days of payables= 48 + 37 -28= 57
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Questions 18 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. An adjustment to operating income for the effects of a change in LIFO reserves will most likely be required if the change in LIFO reserve is the result of: A. Price declines B. A decrease in the number of units held in inventory C. An increase in the number of units held in inventory
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Questions 18 – Answer • The reason that a LIFO reserve might decline during a given period and evaluate the implications of such decline for financial analysis. A liquidation of LIFO inventory produces unsustainable profit margins.
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Questions 19 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise otherwise noted. During inflationary periods, a company’s reported net income i ncome is least likely to be overstated relative r elative to the economic income if the company depreciates fixes assets using: A. Accelerated depreciation and long average lives B. Accelerated Accelerated depreciatio depreciation n and and short short averag average e lives lives C. Straight Straight line line depreciat depreciation ion and and long long average average lives lives
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Questions 19 – Answer • During inflationary periods, the difference between historic costs and replacement value becomes greater; using accelerated depreciation and short average lives l ives will produce reported net income that is closer to economic income.
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Questions 20 – Financial Statement Analysis • An analyst made the appropriate adjustments to the financial statements of retail companies that are lessees using a substantial number of operating leases. l eases. Compared to ratios computed from the t he unadjusted statements, the ratios computed from the adjusted statements would most likely be higher for: A. A. the debt-equity ratio but not the the interest coverage ratio. B. The interes interestt coverage coverage ratio ratio but but not the debt-eq debt-equity uity ratio. ratio. C. Both the the debt-equ debt-equity ity ratio ratio and the interest interest coverage coverage ratio. ratio.
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Questions 20 – Answer • The adjustments for operating leases would increase the amount of total debt in the debt-equity ratio, thus increasing the ratio; the estimated lease interest expense would lower the interest coverage ratio
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Questions 21 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. An analyst gathered the following data for four profitable companies operating in the same industry: Company
Deferred tax assets
Deferred tax liability
A
$50,000
$200,000
B
$300,000
$400,000
C
$85,000
$50,000
D
$170,000
$115,000
If the applicable corporate income tax rate is decreased and nothing else changes, which company will most likely experience the largest decrease reported equity? This files has in expired at 30-Jun-13
A. Company A B. Company B C. Company C
Questions 21 – Answer • In the case of a tax rate decrease, the greatest reduction in reported equity would go to the firm with the largest net deferred tax asset. The net deferred tax asset for Company 4 is $55,000($170,000 $115,000), which is the largest of the group.
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Questions 22 – Financial Statement Analysis • The Regional Bank of Australia receives interest income on the loans it has outstanding. Durango Manufacturing Inc. also receives interest income on some surplus funds they currently have invested in corporate bonds. For each company, respectively, the interest income they receive would be classified as which type of business activity for financial reporting purposes? Regional Bank of Australia A. Operating activity B. Operating activity C. Investing activity
Durango Operating activity Investing activity Operating activity
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Questions 22 – Answer • For a bank, lending money and earning interest on it is an operating activity; but for a manufacturing company, they are not in the business of lending or investing money and the interest they receive would be more correctly classified as an investing activity.
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Questions 23 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. During a period of declining prices, a company using the LIFO inventory method instead of FIFO would most likely report: A. Lower current assets and higher gross income. B. Higher current assets and lower gross income. C. Higher current assets and higher gross income.
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Questions 23 – Answer • If prices were declining, using LIFO would match the lower (most recent) costs with current sales. Costs of goods sold would be lower with LIFO and gross profit (income) would be higher compared to using FIFO. Lower cost of goods sold means inventory balances, consisting of older, higher-priced items, would be higher using LIFO, increasing current assets relative to FIFO.
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Questions 24 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Most of the differences among companies with respect to quality of earnings are addressed when companies are compared using: A. Price to cash flow ratios but not price to earnings ratios. B. Price to earnings ratios but not price to cash flow ratios. C. Either price to cash flow ratios or price to earnings ratios.
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Questions 24 – Answer • Most quality of earnings differences between companies (use of aggressive versus conservative accounting methods) are not likely to be a problem when using P/CF ratios, but are a problem when using P/E ratios
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Questions 25 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company's cash conversion cycle is most likely to decrease if that company experiences a(n): A. Increase in the payables turnover ratio. B. Decrease in the inventory turnover ratio. C. Increase in the receivables turnover ratio.
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Questions 25 – Answer • An increase in receivables turnover would indicate that receivables were outstanding for a shorter period of time, decreasing the cash conversion cycle.
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Questions 26 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. If a company has a current ratio of 2.0, that company's repayment of $150,000 in short-term borrowing obtained from a bank would most likely decrease: A. The company's cash flow from operations, but not the company's current ratio. B. Both the company's current ratio and the company's cash flow from operations. C. Neither the company's current ratio nor the company's cash flow from Operations.
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Questions 26 – Answer • The current ratio is above 1.0, so the payment of short-term borrowing would increase the current ratio; it would reduce both the numerator and denominator by the same amount. The repayment of shortterm debt would reduce cash flow from financing, not cash flow from operations.
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Questions 27 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. During late December 2009 Jayco Publishing Inc. acquired a small competitor, Max's Magazines. In the evaluation of the acquisition it was determined that the customer lists of Max's Magazines had a fair value of $50,000. Jayco Publishing had spent $15,000 during the year updating and maintaining its own customer lists. What is the correct amount and asset account that will be recorded by Popular Publishing for the year-ended December 31, 2009, related to customer lists? A. $50,000 identifiable intangible asset B. $65,000 identifiable intangible asset C. $50,000 unidentifiable intangible asset This files has expired at 30-Jun-13
Questions 27 – Answer • The purchased customer list is an identifiable intangible because it can be sold separately from the company and it would be recorded at its fair market value, the amount paid for it in the acquisition, $50,000. The amount spent by Popular on its own lists, $15,000, would have to be expensed because internally generated intangibles are not capitalized.
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Questions 28 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Which of the following factors is an analyst least likely to consider when determining if a company's deferred tax liabilities should be treated as a liability or equity? A. The expectation that temporary differences will reverse. B. The use of accelerated depreciation methods for tax purposes. C. The average discount rate of liabilities.
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Questions 28 – Answer • The classification of deferred taxes as liabilities or equity depends on the likelihood, or expectation, of reversal. For growing firms and those using accelerated methods of depreciation, the temporary differences tend not to reverse. If the analyst determined the deferred tax liabilities were likely to reverse, and hence should be classified as liabilities, then it would be appropriate to discount them at the company’s average discount rate. But the discount rate is not a factor in determining if reversal is likely.
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Questions 29 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. All else equal, the net profit margin for a company will be highest if, for new depreciable assets, that company uses: A. High salvage value estimates and long average lives. B. Low salvage value estimates and short average lives. C. High salvage value estimates and short average lives.
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Questions 29 – Answer • A high salvage value estimate reduces the depreciable base and thus depreciation expense; long average lives reduce the annual depreciation expense for any given depreciable base. The combination of the two would result in the lowest depreciation expense, which leads to the highest net income and profit margins.
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Questions 30 – Financial Statement Analysis • Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Bains Corporation uses the LIFO inventory method, but most of the other companies in Bains's industry use FIFO. Which of the following best describes one of the adjustments that would be made to Bains's financial statements to compare that company with other companies in the industry? To adjust Greene's ending inventory to the FIFO method, the amount reported for Greene's ending inventory should be: A. Increased by the ending balance in Greene's LIFO reserve. B. Decreased by the ending balance in Greene's LIFO reserve. C. Increased by the change in Greene's LIFO reserve for that period. This files has expired at 30-Jun-13
Questions 30 – Answer • Adding the ending balance in the LIFO reserve to the LIFO inventory would equal the ending balance for inventory on a FIFO basis.
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Questions 31 – Corporate Finance • A large corporation accepts a project which generates no revenue and has a negative net present value. The project most likely is classified in which of the following categories? A. Replacement project. B. New product or service. C. Regulatory or environmental project.
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Questions 31 – Answer • Regulatory, safety, and environmental projects are often mandated by governmental agencies. They may generate no revenue and might not be undertaken by a company maximizing its own private interests. For example, a corporation may be required to install equipment to meet a regulatory standard, and the cost of satisfying the standard is born by the corporation. In this case, the corporation selects the lowest cost alternative that meets the requirement, i.e., the alternative with the least negative net present value.
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Questions 32 – Corporate Finance • An analyst gathers the following information about the capital structure and before-tax component costs for a company. The company’s marginal tax rate is 40 percent. Capital Component
Book Value (,000)
Market Value (,000)
Component Cost
Debt
$100
$80
8%
Preferred stock
$20
$20
10%
Common stock
$100
$200
12%
The company’s weighted average cost of capital (WACC) is closest to: A. 8.55%. B. 9.95%. C. 10.80%
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Questions 32 – Answer • Because the target capital weights are not given, market value weights are used to compute the WACC. The market value weights for debt, preferred stock and equity are 0.2667, 0.0667, and 0.6667 respectively. WACC = wd × r d × (1 – t) + wp × r p + we × r e = 0.2667 × 8% × (1 – 0.4) + 0.0667 × 10% + 0.6667 × 12% = 9.95%
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Questions 33 – Corporate Finance • A company is considering issuing a 10-year, option-free, semiannual coupon bond with a 9 percent coupon rate. The bond is expected to sell at 95 percent of par value. If the company’s marginal tax rate is 30 percent, then the after-tax cost of debt is closest to: A. 6.30%. B. 6.86%. C. 9.80%.
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Questions 33 – Answer • Using a financial calculator: N = 20, PMT = 45, PV = –950, FV = 1000; solve for I/Y = 4.90%. The annual yield is twice the semiannual yield = 4.90% × 2 = 9.80%. The after-tax cost of debt = annual yield × (1 – t) = 9.80% × (1 – 0.30) = 6.86%
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Questions 34 – Corporate Finance • An analyst gathers the following information about a company and the market: Current market price per share of common stock
€32.00
Most recent dividend per share paid on common stock
€2.40
Expected dividend payout rate
40%
Expected return on equity (ROE)
15%
Beta for the common stock
1.5
Expected return on the market portfolio
12%
Risk-free rate of return
4%
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Using the dividend discount model approach, the cost of common equity for the company is closest to: A. 16.0%. B. 16.5%. C. 17.2%.
Questions 34 – Answer • According to the dividend discount model approach, the cost of common equity is equal to the dividend yield plus the growth rate. In this case, the growth rate is the earnings retention rate times the expected ROE or (1 – dividend payout rate) × expected ROE = 1 – 0.4) × 15% = 9%. The expected dividend = 2.40 × (1 + 0.09) = 2.616. The expected dividend yield = 2.616 / 32 = 8.175%. The cost of common equity = 8.175% + 9.0% ≈ 17.2%.
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Questions 35 – Corporate Finance • Which of the following is least likely classified as a takeover defense? A. Greenmail. B. Cumulative voting. C. Golden parachutes.
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Questions 35 – Answer • The ability to use cumulative voting enables shareowners to vote in a manner that enhances the likelihood that their interests are represented on the board. It is a valuable shareowner right.
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Questions 36 – Corporate Finance • An analyst gathers the following information about the cost and availability of raising various amounts of new debt and equity capital for a company: Amount of New debt (in mn)
Cost of debt (after tax)
Amount of new equity (in millions)
Cost of equity
≤ €4.0
4%
≤ €5.0
13%
> €4.0
5%
> €5.0
15%
The company’s target capital structure is 60 percent equity and 40 percent debt. If the company raises €9.5 million in new financing, the marginal cost of capital is closest to: A. 9.8%. B. 10.6%. C. 11.0%.
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Questions 36 – Answer • The break-points for debt and equity are €10 million ( €4.0 million / 0.40) and €8.33 million ( €5.0 million / 0.60), respectively. The cost of debt and equity if the firm raises €9.5 million in new financing will be 4% and 15%, respectively, because €9.5 million is below the debt breakpoint and above the equity breakpoint. The marginal cost of capital = 0.40 × 4% + 0.60 × 15% = 10.6%.
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Questions 37 – Corporate Finance • A company is offered trade credit terms of 2/10, net 45. The implicit cost of failing to take the discount and instead paying the account in 45 days is closest to: A. 21.28%. B. 23.10%. C. 23.45%.
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Questions 37 – Answer • The cost of trade credit if paid on day 45 = (1 + 2 / 98)365/35 – 1 = 23.45%.
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Questions 38 – Corporate Finance • Regarding corporate governance, which of the following most likely would be a reason for concern when evaluating an independent board member’s qualifications? The board member: A. Has served on the board for 14 years. B. Owns 1,000 shares of the corporation’s equity. C. Has formerly served on the boards of several successful companies
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Questions 38 – Answer • Such long-term participation may enhance the individual board member’s knowledge of the company, but it also may cause the board member to develop a cooperative relationship with management that could impair his/her willingness to act in the best interests of shareowners.
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Questions 39 – Corporate Finance • For two mutually exclusive capital projects with normal cash flows, the NPV and IRR methods will most likely produce conflicting rankings when the: A. Cost of capital is equal to the crossover rate. B. Cost of capital is less than the crossover rate. C. Cost of capital is greater than the crossover rate.
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Questions 39 – Answer • The NPV and IRR methods lead to conflicting decisions when the cost of capital is less than the crossover rate
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Questions 40 – Corporate Finance • A company that sells ice cream is evaluating an expansion of its production facilities to allow the company to also produce frozen yogurt. The expansion project is based on a marketing study that concluded producing frozen yogurt would increase the company's ice cream sales because of an increase in brand awareness. Should an analyst include the cash flows associated with the expected increase in ice cream sales in the calculation of the project's net present value (NPV)? A. No, because the projected increase in ice cream sales is an opportunity cost. B. Yes, because the project's NPV will be overstated if the cash flows associated with the projected increase in ice cream sales are not included. C. Yes, because the project's NPV will be understated if the cash flows associated with the projected increase in ice cream salesfiles are not included. This has expired at 30-Jun-13
Questions 40 – Answer • The increase in ice cream sales (externality) should be treated as an incremental cash flow and should be included in the analysis of the project's net present value
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Questions 41 – Corporate Finance • An investor currently has a portfolio valued at $700,000. the investor’s objectives is long term growth, but the investor will need $30,000 by the end of the year to pay his son’s college tuition and another $10,000 by year end for his annual vacation. The investor is considering four alternative portfolios: Portfolio
Expected return
Standard deviation of returns
1
8%
10%
2
10%
13%
3
14%
22%
4
18%
35%
Using Roy’s safety first criterion which has of the expired following alternative portfolios minimizes the probability This files at 30-Jun-13 that the investor’s portfolio will have a value lower than $700,000 at year end. A. Portfolio 1 B. Portfolio 2 C. Portfolio 3
Questions 41 – Answer • The investor requires minimum return of 40,000/700,000=5.71%. The highest safety first ratio is associated with portfolio 3. (14%-5,71%)/22%= 0.3768
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Questions 42 – Corporate Finance • Which of the following is least likely to concern an investor that is evaluating a corporation's shareowner rights provisions? A. Shareowners may nominate board members. B. Shareowners must attend the annual meeting to vote their shares. C. Shares held by the founding family have supernormal voting rights.
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Questions 42 – Answer • The ability to nominate one or more individuals to the board can prevent erosion of shareowner value. Shareowners may be able to force the board or management to take steps to address shareowner concerns.
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Questions 43 – Corporate Finance • Two mutually exclusive projects have conventional cash flows, but one pr oject has a larger NPV while the other project has a higher IRR. Which of the following is least likely responsible for this conflict? A. Timing of the projects' cash flows. B. Size of the projects' initial investments. C. Risk of the projects as reflected in the required rate of return.
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Questions 43 – Answer • Conflicting decision rules based on the NPV and IRR methods are related to the reinvestment rate assumption, the timing of the cash flows, or the scale of the projects. Differing required rates of return are not related to conflicting NPV and IRR decisions.
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Questions 44 – Portfolio Management • Over time, the major source of investment return and risk can most likely be attributed to: A. Stock selection. B. Asset allocation. C. Risk management.
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Questions 44 – Answer • The asset allocation decision explains about 90% of a fund’s returns over time. Across al funds, asset allocation explains an average of 40% of the variation in fund returns, and slightly more than 100% of the average fund’s level of return.
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Questions 45 – Portfolio Management • An analyst has gathered monthly returns for two stock indexes A and B: Month
Returns for Index A
Returns for Index B
1
-6.4%
-6.2%
2
6.6%
19.0%
3
12.9%
-7.7%
4
3.2%
4.0%
The covariance between Index A and Index B is closest to: A. 10.37. B. 13.82. C. 19.64.
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Questions 45 – Answer • Calculation of the covariance proceeds as follows: 1) Compute the average for each index: Index A = (-6.4 + 6.6 + 12.9+3.2)/4 = 4.08 Index B = (-6.2 + 19.0 - 7.7 + 4)/4 = 2.28 2) Compute the following sum: (-6.4-4.08) × (-6.2-2.28) + (6.6-4.08) × (19.0-2.28) + (12.9-4.08) × (-7.72.28) + (3.2-4.08) × (4.0-2.28) = 41.47 3) Divide the sum found in 2) by number of observation minus one = 41.47/(4-1) =13.82 This files has expired at 30-Jun-13
Questions 46 – Portfolio Management • Which of the following statements about portfolio risk and diversification is least accurate? A. Unsystematic risk can be substantially reduced by diversification B. Systematic risk can be eliminated by holding securities in a well diversified international portfolio C. Diversification results form combining securities that have less than perfect positive correlation between their returns to reduce portfolio risks
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Questions 46 – Answer • Systematic risk cannot be eliminated by diversification. Diversification benefits will occur any time security returns have less than perfect positive correlations.
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Questions 47 – Portfolio Management • Portfolios located to the right of the market portfolio on the capital market line are: A. Lending portfolios. B. Low-risk portfolios. C. Borrowing portfolios.
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Questions 47 – Answer • The only way an investor can achieve a portfolio to the right of the market portfolio is to borrow at the risk-free rate and invest the proceeds in the market portfolio; 100% of the investor's wealth plus the borrowed funds are invested in the market portfolio.
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Questions 48 – Portfolio Management • Regarding an individual's investment policy statement, which of the following is least appropriate as the investment objective? The portfolio seeks: A. 12% annual returns with above-average market risk. B. To match the performance and risk characteristics of the S&P 500 Index. C. Long-term capital appreciation with market risk comparable to the MSCI EAFE Index.
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Questions 48 – Answer • The investment objective must be expressed in terms of both risk and return and current income from dividends and interest represents only the investor’s return objective. It does not include any reference to risk tolerance or risk limits as provided in the other alternatives.
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Questions 49 – Portfolio Management • Which of the following statements about the relation between covariance and correlation is least accurate? If the covariance of returns between two assets is positive, the correlation coefficient for those two assets: A. Could be a negative number. B. Could indicate a strong positive relation if both return series were stable. C. Could indicate a weak positive relation if both return series were volatile.
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Questions 49 – Answer • If the covariance of returns between two assets is a positive number, the correlation coefficient for those two assets cannot be negative. The correlation coefficient is equal to the covariance standardized by the product of the individual standard deviations (which are always positive).
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Questions 50 – Portfolio Management • An analyst gathered the following information about two common stocks: Variance of returns for the Libby Company = 15.5 Variance of returns for the Metromedia Company = 22.3 Covariance between returns of Libby Company and Metromedia Company = 8.65 The correlation coefficient between returns for the two common stocks is closest to: A. 0.558 B. 0.388 C. 0.465
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Questions 51 – Equity • The four firms in the Internet search engine industry have the following market shares. Company Market Share Gigloo 50% Ohooho 25% MySearch 15% Foxnet 10% The Herfindahl Index and the "Equivalent Number" of firms in this industry, respectively, are closest to: The Herfindahl Index "Equivalent Number" of firms A. 0.345 This files4 has expired at 30-Jun-13 B. 0.345 2.9 C. 0.478 2.09
Questions 51 – Answer • Herfindahl Index = 0.52 + 0.252 + 0.152 + 0.12 = 0.25 + 0.0625 + 0.0225 + 0.01 = 0.345 • “Equivalent Number” of firms = 1 / 0.345 = 2.8986 ≈ 2.90
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Questions 52 – Equity • Chu Wang, CFA, gathered the following data to estimate the implied growth rate of dividends for Shenghai Toys Co. to use as an input for valuing the company's common stock. Return on Assets 10% Profit Margin 5% Total Assists CNY 50 million Debt Ration 40% Payout Ration 25% Wang's estimate of Shenghai Toys' implied growth rate would be closest to: A. 6.25%. B. 12.50%. C. 18.75%.
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Questions 52 – Answer • g = RR x ROE RR = (1 – Payout Ratio) = 1 – 0.25 = 0.75 Financial Leverage = TA / Equity Debt = TA x Debt Ratio = CNY 50 m x 0.4 = CNY 20 m Equity = CNY 50 m – CNY 20 m = CNY 30 m ROE = ROA x Financial Leverage; ROE = 10% x (50/30) = 16.67% g = 0.75 x 16.67 = 12.50% This files has expired at 30-Jun-13
Questions 53 – Equity • Strongsville Fabricators Inc. uses the FIFO method of inventory valuation. Assuming a rising costs environment and other factors held constant, Strongsville's price-to earnings and price-to-book multiples relative to those for another company that uses the LIFO method of inventory valuation would be: P/E multiple P/B multiple A. Overstated B. Understated C. Understated
Understated Overstated Understated
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Questions 53 – Answer • In a rising costs environment, FIFO would result in higher earnings, higher ending inventory, as well as higher book value of equity. Thus, both P/E and P/BV tend to be understated relative to a comparable firm that uses LIFO method.
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Questions 54 – Equity • Metiu Metev, an analyst with Sofia Equity Researchers, has gathered the following information about Balkan Steel Mills. Current year’s operating free cash flow BGN 5 million Cost of equity capital 15% Weighted average cost of capital 12.40% Estimated long-term growth rate 6% Given this information, Metev's best estimate of BSM's intrinsic value (in BGN millions) would be closest to: A. 58.89 million. B. 78.13 million. C. 82.81 million.
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Questions 54 – Answer • return and expected growth rate of dividends V = OFCF1 / (WACC - g) = 5 (1.06) / (0.124 - 0.06) = 82.81
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Questions 55 – Equity • An equity investment in a producer firm would be more attractive at what levels of the bargaining power of buyers and suppliers, respectively? Bargaining power of buyers Bargaining power of suppliers A. Low B. Low C. High
Low High Low
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Questions 55 – Answer • At high levels of the bargaining power of both buyers and suppliers, the producer would potentially experience a squeeze on profits and profit margins. Therefore, equity investments in producer firms with low levels of bargaining power of both buyers and sellers tend to be more attractive.
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Questions 56 – Equity • Geo Telecommunications Inc. is a fast growing company with a double-digit growth rate that is expected to continue for three more years. In his pursuit of valuing the company's stock, Dimiter Nenkov, a freelance equity analyst, has compiled the following data about the company: Current year’s free cash flow to equity €20 million Growth rate in free cash flow during the next three years 30% in years 1 and 2, 20% in year 3 Growth rate in free cash flow for year 4 and beyond 8% Weighted average cost of capital 12% Cost of equity capital 15% Number of outstanding shares 50 million This files has expired at 30-Jun-13 Based on the above information, Nenkov's best estimate of the value per share for Geo Telecommunications would be closest to: A. € 9.72. B. € 10.13. C. € 17.17.
Questions 56 – Answer Time period
FCFE
PVIF@15%
Present Value
1
20 x 1.30 = 26.0
0.8696
€ 22.61
2
20 x 1.302 = 33.8
0.7561
€ 25.56
3
20 x 1.302 x 1.20 = 40.56
0.6575
€ 26.67
4 & beyond
V3 = (40.56 x 1.08) / (0.15 – 0.08) = 625.78
0.6575
€411.46
Valuehas of Equity This files expired at 30-Jun-13 Value per share = Value of Equity / # of outstanding shares
€486.30 € 9.72
Questions 57 – Fixed income • The party making the fixed-rate payment under a swap contract could also have to make the variable payment on that contract if the payments are related to a(n): A. Equity swap. B. Currency swap. C. Interest rate swap.
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Questions 57 – Answer • If the value of the index on which the swap is based declines, the resulting negative return would have to be paid by the party making the fixed-rate payment. This characteristic is one of the distinguishing features of equity swaps.
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Questions 58 – Fixed income • An investor goes long an FRA that expires in 30 days for which the underlying is 90-day LIBOR for a notional of $10 million. A dealer quotes this instrument at 4.5%. At expiration, 60-day LIBOR is 3.5% and 90-day LIBOR is 4%. The payment made at expiration is closest to: A. $12,376 from the investor to the dealer. B. $12,376 from the dealer to the investor. C. $16,570 from the investor to the dealer.
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Questions 58 – Answer • The underlying of an FRA is an interest payment. The investor is long the rate and will benefit if rates increase. Since rates decreased, the investor must pay the dealer:
(0.04 0.045) (90 / 360) $12,376 1 0 . 04 ( 90 / 360 )
$10,000,000
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Questions 59 – Fixed income • If interest rates are expected to decline, an investor can earn a higher coupon interest rate by purchasing a(n): A. Callable bond. B. Inverse floater. C. Floater with a cap.
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Questions 59 – Answer • Inverse floaters have a coupon formula such that the coupon rate increases when the reference rate decreases and decreases when reference rate increases. The coupon rate moves in the opposite direction from the change in the reference rate.
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Questions 60 – Fixed income • All else equal, an increase in expected yield volatility is most likely to result in an increase in the price of a(n): A. Putable bond. B. Callable bond. C. Option-free bond selling at a discount to par.
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Questions 60 – Answer • An increase in expected yield volatility increases the price of the embedded put option. The price of a putable bond will increase because the price of the putable bond is equal to an option-free bond plus the put option.
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Questions 61 – Fixed income • An analyst determined that if interest rates increase 120 basis points the price of a bond would be $89.70, but if interest rates decrease 120 basis points the price of that bond would be $99.30. If the initial price of the bond is $95.40, the approximate percentage price change for a 100 basis point change in yield is closest to: A. 2.5%. B. 4.2%. C. 8.4%.
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Questions 61 – Answer • The formula for calculating the duration of a bond (estimated percentage price change for a 100 basis point change in yield) is: = Price if yields decline - price if yields increase / 2(initial price)(change price)(change in yield in decimal) = 99.3 - 89.7 / 2 (95.4)0.01 (95.4)0.0120 20 = 4.19287. 4.19287.
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Questions 62 – Fixed income • A portfolio manager is considering investing a portion of her fixed income portfolio in a security whose cash flows are dependent on an underlying pool of mortgages. The portfolio consists of Treasury bonds, corporate bonds and Ginnie Mae pass-through's. The security being considered is Tranche B of a collateralized mortgage obligation (CMO). The underlying collateral is a Ginnie Mae pass-through security. The rules of the CMO state that Tranche A is the first to receive monthly principal. By investing in Tranche B of the CMO, the portfolio manager will most likely reduce portfolio: A. Credit risk B. Sov Soverei ereign gn ris risk. k. C. Prep Prepay ayme ment nt risk risk..
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Questions 62 – Answer • Adding Tranche B of the CMO to the portfolio will most likely reduce prepayment. A passthrough security, such as a Ginnie Mae, can be prepaid as the underlying loans pay off principal, i.e., they are exposed to prepayment risk. On the other hand, the tranches in a CMO will be paid off sequentially, i.e., Tranche A then Tranche B. Tranche B has less prepayment risk than the underlying passthrough securities.
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Questions 63 – Fixed income • An analyst determines that an 10% option free bond maturing in 205 would experience a 2% change in price if market interest rates rise by 50 basis points. If market rates instead fall by 50 basis points then the price of the bond would increase by? A. Exactly 2% B. Less than 2% C. More than 2%
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Questions 63 – Answer • The bond is option free and will therefore exhibit positive convexity. an equal cange in rates will produce greater percentage gain when rates decrease then the percentage loss produced when rates increases.
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Questions 64 – Fixed income • According to the market segmentation theory an upward sloping yield curve is most likely due to: A. Investor expectations that short term interest rates will rise in the future B. Different levels of supply and demand for short term & long term funds’ C. An increasing yield premium required by investors for bearing interest rate risks
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Questions 64 – Answer • The market segmentation theory asserts that the supply and demand for funds determine the interest rates for each maturity sector
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Questions 65 – Fixed income • A fixed income portfolio manager owns a $5mn par value noncallable bond. The bond’s duration is 5.6 and currnet market value is $5,125,000. the dollar duration of the bond is closet to: A. $280,000 B. $287,000 C. $700,000
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Questions 65 – Answer • Dollar duration= 5.6*0.01*5,125,000 = $287,000
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Questions 66 – Alternative investments • A real estate investment has the following characteristics: Annual rental income $1,800,000 Annual operating expenses $1,200,000 Available mortgage rate 6% Financing percentage 90% Required rate of return 15% Estimated holding period 5 years Investor’s tax rate 25% This files 30-Jun-13 Based on the income approach, the valuehas of theexpired investment at is closest to: A. $4,000,000. B. $5,455,000. C. $6,133,000.
Questions 66 – Answer • Using the income approach: ($1,800,000 - $1,200,000) / 0.15 = $4,000,000
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Questions 67 – Alternative investments • An investor would most likely expect commodities to have correlations with traditional stock or bond investments and inflation that are: Correlation with traditional Correlation with inflation stock or bond investments A. Positive B. Negative C. Negative
Negative Positive Negative
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Questions 67 – Answer • A primary motivation for an investment in commodities, commodity derivatives, commodity-linked bonds, and commodity-linked equity are the diversification benefits provided due to the negative return correlation with other assets and the positive correlation with inflation.
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Questions 68 – Alternative investments • Which of the following statements is least accurate with respect to the advantages of open end exchange traded fund (ETF)? A. Provide for more immediate reinvestment of dividends than do index mutual funds B. Provide a more cost effective way for large institutions to invest in emerging marjets C. Provide lower exposure to capital gains distribution taxes than do traditional mutual funds
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Questions 68 – Answer • Some sectors and international ETFs have large bid ask spreads and substantial expense ratios compared to managed portfolios, which may provide a more cost efficient alternative to ETF
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Questions 69 – Alternative investments • Hedge funds that contain infrequently traded assets would most likely exhibit a downward bias with respect to: A. Measured risk but not correlations with conventional equity investments B. Correlations with conventional equity investments but not measured risk C. Both measured risk and correlations with conventional equity investments
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