Question of the Day
While assessing an investor's risk tolerance, a financial adviser is least likely to ask which of the following questions?
"What rate of investment return do you expect?" While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance.
Darth Corporation's most recent income statement shows net sales of $6,000, and Darth's marginal tax rate is 40%. Cash expenses reported were $3,200. In addition, depreciation expense was reported at $800. A further examination of the most recent balance sheets reveals that accounts receivable during that period increased by $1,000. The cash flow from operating activities reported by Darth should be:
$1,000 Net income is ($6,000 - 3,200 - 800)(1 - 0.4) = $1,200. Adjustments to reconcile net income to cash flow from operating activities will require that depreciation ($800) be added back, and increase in accounts receivable ($1,000) be subtracted: $1,200 + 800 - 1,000 = $1,000.
What is the value of a stock that paid a $0.25 dividend last year, if dividends are expected to grow at a rate of 6% forever? Assume that the risk‐free rate is 5%, the expected return on the market is 10%, and the stock's beta is 0.5.
$17.67 The discount rate is ke = 0.05 + 0.5(0.10 - 0.05) = 0.075. Use the infinite period dividend discount model to value the stock. The stock value = D1 / (ke - g) = (0.25 × 1.06) / (0.075 - 0.06) = $17.67.
Assume that a perfectly competitive firm produces 10 units of a good and sells them each for a price (P) equal to $15. If the marginal cost (MC) of the 10th unit is $15 and the average total cost (ATC) is $13, economic profit for the firm is closest to:
$20 When MR = MC = P, economic profit equals TR - TC. In this case, TR = $150 = 10 × $15 and TC = $130 = 10 × ATC = 10 × $13. So, economic profit is $20 = $150 - $130.
At the beginning of 2004, Osami Corporation had 1.4 million shares of common stock outstanding and no preferred stock. At the end of August 2004, Osami issued 1.2 million new shares of common stock. If Osami reported net income equal to $7.2 million, what were its earnings per share (EPS) for 2004?
$4.00. The new shares were only outstanding 4 months of the year. Thus, the weighted average number of shares outstanding is [1.4 + (4/12)(1.2)] million = 1.8 million shares. So basic EPS = $7.2 million / 1.8 million = $4.00.
An annuity will pay eight annual payments of $100, with the first payment to be received one year from now. If the interest rate is 12% per year, what is the present value of this annuity?
$496.76. N = 8; I/Y = 12%; PMT = -$100; FV = 0; CPT → PV = $496.76.
Baker Computer earned $6.00 per share last year, has a retention ratio of 55%, and a return on equity (ROE) of 20%. Assuming their required rate of return is 15%, how much would an investor pay for Baker on the basis of the earnings multiplier model?
$74.93. g = Retention × ROE = (0.55) × (0.2) = 0.11 P0/E1 = 0.45 / (0.15 - 0.11) = 11.25 Next year's earnings E1 = E0 × (1 + g) = (6.00) × (1.11) = $6.66 P0 =11.25($6.66) = $74.93
Consider a call option with an exercise price of $32. If the stock price at expiration is $41, the value of the call option is:
$9 The call has a $9 ($41 − $32) value at expiration, because the holder of the call can exercise his right to buy the stock at $32 and then sell the stock on the open market for $41. The intrinsic value of a call at expiration is Max(0, S − X).
Adding a stock to a portfolio will reduce the risk of the portfolio if the correlation coefficient is less than which of the following?
1 Adding any stock that is not perfectly correlated with the portfolio (+1) will reduce the risk of the portfolio.
Robinson Company had 1 million shares outstanding at the beginning of the year. On April 1, Robinson issued an additional 300,000 shares. On July 1, Robinson issued 200,000 more shares. What is Robinson's weighted average number of shares outstanding for the calculation of earnings per share?
1,325,000 shares. Weighted average shares = 1,000,000 + (0.75) 300,000 + (0.5) 200,000 = 1,325,000 shares.
The spot exchange rate for United States dollars per United Kingdom pound (USD/GBP) is 1.5775. If 30‐day interest rates are 1.5% in the United States and 2.5% in the United Kingdom, and interest rate parity holds, the 30‐day forward USD/GBP exchange rate should be:
1.5762. Forward USD/GBP = spot USD/GBP × (1 + U.S. interest rate) / (1 + UK interest rate)= 1.5775 × [(1 + 0.015/12) / (1 + 0.025/12)]= 1.5762
A single independent project with a negative net present value has an initial cost of $2.5 million and would generate cash inflows of $1 million in each of the next three years. The discount rate the company used when evaluating this project is closest to:
10% Given that the NPV is negative, the discount rate used by the company evaluating the project must be greater than the IRR (the discount rate for which the NPV equals zero). On a financial calculator: CF0 = -2.5; CFj = 1; Nj = 3; CPT IRR = 9.7%. Since the discount rate used for this project is greater than 9.7%, it must be closer to 10% than to either of the other answer choices.
Fisher, Inc., is evaluating the benefits of investing in a new industrial printer. The printer will cost $28,000 and increase after‐tax cash flows by $7,000 during each of the next four years and $6,000 in each of the two years after that. The internal rate of return (IRR) of the printer project is closest to:
11.6%. IRR Keystrokes: CF0 = -$28,000; CF1 = $7,000; F1 = 4; CF2 = $6,000; F2 = 2; CPT → IRR = 11.6175%.
Mark Ritchie purchased, on margin, 200 shares of TMX Corp. stock at a price of $35 per share. The margin requirement was 50%. The stock price has increased to $42 per share. What is Ritchie's return on investment before commissions and interest if he decides to sell his TMX holdings now?
40% 200 shares × $35 = $7000 Initial Market Value$7000 × .50 = $3500 cash payment and $3500 borrowed. The new market value of the stock after price increase is (200 × $42) = $8400. If Ritchie sold his holdings he would have $4900 ($8400 - $3500) left after the loan was paid. So Ritchie's return on his original $3500 investment is:$4900/3500 - 1 = 1.4 - 1.0 = 0.40 = 40%.
Technical analysts who use cycles define a Kondratieff wave as a cycle of:
54 years. The Kondratieff wave is a 54-year cycle that some technical analysts believe exists for equity market prices.
The SSP Company had 5 million shares outstanding on January 1. On February 15 the board of directors approved a 3:2 stock split, effective April 1. What is the weighted average number of shares outstanding for the SSP Company for year‐end?
7,500,000 shares. Stock splits and stock dividends are applied to all shares that existed at the beginning of the period and shares that were issued or repurchased during the period, but prior to the split or dividend. For SSP, the 5 million beginning-of-year shares outstanding are adjusted to 7.5 million shares (5.0 × 3/2) as a result of the 3:2 split.
Which of the following is an example of an arbitrage opportunity?
A portfolio of two securities that will produce a certain return that is greater than the risk‐free rate of interest. An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless rate to purchase the position will produce a certain future amount greater than the amount required to repay the loan.
Which of the following statements about indexes is CORRECT?
A price‐weighted index assumes an equal number of shares (one of each stock) represented in the index. The descriptions of value weighted and unweighted indexes are switched. The denominator of a price-weighted index must be adjusted to reflect stock splits and changes in the sample over time. A market value-weighted series assumes you make a proportionate market value investment in each company in the index.
Which of the following items is least likely an example of an intangible asset with an indefinite life?
Acquired patents. Acquired patents are most likely purchased with the intent to use over a specific period of time and therefore would be an example of an intangible asset with a finite life. Goodwill, by definition, is an intangible asset with an indefinite life. Trademarks that can be renewed at minimal cost are also considered to be intangible assets with infinite lives.
An analyst has gathered the following data about a company: Average receivables collection period of 37 days. Average payables payment period of 30 days. Average inventory processing period of 46 days. What is their cash conversion cycle?
An analyst has gathered the following data about a company: Average receivables collection period of 37 days. Average payables payment period of 30 days. Average inventory processing period of 46 days. What is their cash conversion cycle? Cash conversion cycle = average receivables collection period + average inventory processing period - payables payment period = 37 + 46 - 30 = 53 days.
A quoted Libor interest rate is least likely to refer to a specific:
Bank Libor rates are averages calculated from a number of different banks' quotes on the interbank money market. Each Libor rate refers to a specific maturity (in a range from overnight to one year) and currency.
One of a firm's assets is 270‐day commercial paper that the firm intends to hold to maturity. One of its liabilities is a short position in a common stock, which the firm holds for trading purposes. How should this asset and this liability be classified on the firm's balance sheet?
Both should be classified as current. The commercial paper should be classified as current because it will be converted to cash in less than a year. A liability that is held primarily for trading purposes, such as this short position, should also be classified as current.
Which of the following represents a long position in an option?
Buying a put option. A long position is always the buying position. Remember that the buyer of an option is said to have gone long the position, while the writer (seller) of the option is said to have gone short the position.
Sales and purchases of non‐produced, non‐financial assets are included in which of a country's trade accounts?
Capital account. The capital account consists of sales and purchases of non-produced, non-financial assets plus capital transfers.
With which of the following types of equity shares does the investor typically have the greatest voting power?
Common shares While common shares have voting rights, preference shares typically do not. With unsponsored depository receipts, the depository bank retains the right to vote the shares.
In which of the following industries are technological factors least likely a significant influence?
Confections. Technological influences are relatively important in the pharmaceuticals and oil services industries, but they are generally not a significant influence in the confections industry.
Who benefits least from tariffs?
Domestic consumers. A tax imposed on imports is called a tariff, which benefits domestic producers and domestic governments. Domestic consumers lose through higher prices, less choice of products, and lower quality products.
Which of the following statements about the importance of risk and return in the investment objective is least accurate?
Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible.
Which of the following best describes the underlying principles upon which the Global Investment Performance Standards (GIPS) are based?
Full disclosure and fair representation of performance results. The GIPS standards are a set of voluntary standards based on the fundamental principles of full disclosure and fair representation of performance results.
Felker Inc. owns a piece of specialized machinery. The original cost of the machinery was $500,000 and to date there is an accumulated depreciation balance of $140,000. Which of the following will Felker recognize on its income statement if it sells the machinery for $400,000?
Gain of $40,000. With a sale of an asset to a third party, the difference between the proceeds and carrying value is reported as a gain or loss on the income statement. The carrying value is $360,000, which equals the original cost ($500,000) less the accumulated depreciation ($140,000). Therefore, the gain is equal to $40,000 ($400,000 proceeds less $360,000 carrying value).
Which of the following statements regarding plain‐vanilla interest rate swaps is least accurate?
In a swap contract, the counterparties usually swap the notional principal. The notional principal is generally not swapped, as it is usually the same for both parties in the swap deal.
All else equal, an increase in a company's growth rate will most likely cause its P/E ratio to:
Increase Increase in g: As g increases, the spread between ke and g, or the P/E denominator, will decrease, and the P/E ratio will increase.
An analyst belongs to a nationally recognized charitable organization, which requires dues for membership. The analyst has worked out a deal where he provides money management advice in lieu of paying dues. Which of the following must the analyst do?
Must treat the charitable organization as his employer. An employee/employer relationship does not necessarily mean monetary compensation for services. If the analyst is performing services for the organization, then the analyst must treat the position as if he were an employee.
Vasco Ltd. purchased a unit of heavy equipment one year ago for £500,000 and capitalized it as a long‐lived asset. Because demand for equipment of this type has grown significantly, Vasco believes the fair value of its equipment has increased to £600,000. If Vasco revalues its equipment to £600,000, what will be the most likely effect on Vasco's financial results, compared to not revaluing the equipment?
Net income will be lower in the periods following the revaluation. Revaluing the asset to £600,000 will increase future depreciation expense, and therefore reduce net income in subsequent periods. Because Vasco has not previously recognized a loss on this asset, the revaluation is not recognized as income but is recorded as an adjustment to equity. An increase in equity (with unchanged debt) will decrease the debt-to- equity ratio.
Fifty mutual funds are ranked according to performance. The five best performing funds are assigned the number 1, while the five worst performing funds are assigned the number 10. This is an example of a(n):
Ordinal Scale The ordinal scale of measurement categorizes and orders data with respect to some characteristic. In this example, the ordinal scale tells us that a fund ranked "1" performed better than a fund ranked "10," but it does not tell us anything about the difference in performance.
Which of the following statements about American and European options is most accurate?
Prior to expiration, an American option may have a higher value than an equivalent European option. American and European options both give the holder the right to exercise the option at expiration. An American option also gives the holder the right of early exercise, so American options will be worth more than European options when the right to early exercise is valuable, and they will have equal value when it is not.
The financial manager at Johnson & Smith estimates that its required rate of return is 11%. Which of the following independent projects should Johnson & Smith accept?
Project Z requires an up‐front expenditure of $600,000 and generates an internal rate of return of 12.0%. When projects are independent, you can use either the NPV method or IRR method to make the accept or reject decision. Only Project Z has an IRR in excess of the required rate of return and therefore has a positive NPV.
For an investment with negatively skewed returns, the most appropriate of the following risk measures is:
Sortino ratio. The Sortino ratio uses downside deviation, and therefore will capture the effects of negative skewness better than measures that use standard deviation. Value at risk (VaR) is a downside risk measure that estimates the potential loss from outcomes in the left tail of the distribution of returns but uses standard deviation, as does shortfall risk.
When considering convertible preferred stock which of the following components of the earnings per share (EPS) equation needs to be adjusted to calculate diluted earnings per share?
The numerator and denominator. The numerator will increase because earnings available to the common shareholder are increased by the reduction in preferred dividends. The denominator increases because the weighted average number of shares increases upon conversion of the preferred stock.
In analyzing disclosures related to the financing liabilities of a company, which of the following disclosures would be least helpful to the analyst?
The present value of the future bond payments discounted at the coupon rate of the bonds. When analyzing disclosures related to financing liabilities, analysts would review the balance sheet and find the present value of the promised future liability payments. These payments would then be discounted at the rate in effect at issuance (i.e., the yield to maturity), not the coupon rate of the bonds.
Which of the following statements about the efficient frontier is NOT correct?
The slope of the efficient frontier increases steadily as one moves up the curve. This statement should read, "The slope of the efficient frontier decreases steadily as one moves up the curve." The other statements are true.
During the contraction phase of the business cycle, how will an active portfolio manager using an industry rotation strategy treat stocks of companies in a cyclical industry?
Underweight the industry. A cyclical industry is one that is expected to outperform during an expansion and underperform in a contraction. The industry rotation strategy for a cyclical industry is to overweight during an expansion and underweight during a contraction.
An executive describes her company's "low latency, multiple terabyte" requirements for managing Big Data. To which characteristics of Big Data is the executive referring?
Volume and velocity. Big Data may be characterized by its volume (the amount of data available), velocity (the speed at which data are communicated), and variety (degrees of structure in which data exist). "Terabyte" is a measure of volume. "Latency" refers to velocity.
Which of the following statements is most accurate regarding commodity indexes?
Weighting methodology varies among index providers and leads to differences in index risk and returns. Weighting methodology is a major issue for commodity indexes. Several different methodologies are used, including equal weighting and global production values. Differences in weighting cause differing exposures for the indexes and lead to different risk and return profiles.Commodity indexes represent futures contracts on commodities, not the actual spot prices of commodities. Commodity index returns come from three sources: the risk-free rate of return, changes in futures prices, and the roll yield.
Which of the following statements about portfolio diversification is CORRECT?
When a risk‐averse investor is confronted with two investment opportunities having the same expected return, the investor will take the opportunity with the lower risk. The other statements are false. The lower the correlation coefficient; the greater the potential for diversification. Efficient portfolios lie on the efficient frontier.
Which of the following statements about portfolio theory is least accurate?
When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will not decrease the overall portfolio standard deviation. When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio standard deviation. Any time the correlation coefficient is less than one, there are benefits from diversification. The other choices are true.
Should a company accept a project that has an IRR of 14% and an NPV of $2.8 million if the cost of capital is 12%?
Yes, based on the NPV and the IRR. The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital.
Assuming the issuer does not default, can capital gains or losses be a component of the holding period return on a zero‐coupon bond that is sold prior to maturity?
Yes, because the bond's yield to maturity may have changed. Prior to maturity, a zero-coupon bond's price may be different than its constant-yield price trajectory and the bondholder may realize a capital gain or loss by selling the bond. For a zero-coupon bond that is held to maturity, the increase from the purchase price to face value at maturity is interest income.
To finance a proposed project, Youngham Corporation would need to issue £25 million in common equity. Youngham would receive £23 million in net proceeds from the equity issuance. When analyzing the project, analysts at Youngham should:
add the £2 million flotation cost to the project's initial cash outflow. The recommended method is to treat flotation costs as a cash outflow at project initiation rather than as a component of the cost of equity.
In the Heckscher‐Ohlin model, whether a country has a comparative advantage relative to another country is determined by:
amounts of labor and capital the countries possess. In the Heckscher-Ohlin model a country that has relatively more capital will export capital- intensive goods and import labor-intensive goods, while a country that has relatively more labor will export labor-intensive goods and import capital-intensive goods.
In the top‐down approach to asset allocation, industry analysis should be conducted before company analysis because:
an industry's prospects within the global business environment are a major determinant of how well individual firms in the industry perform. In general, an industry's prospects within the global business environment determine how well or poorly individual firms in the industry do. Thus, industry analysis should precede company analysis. The goal is to find the best companies in the most promising industries; even the best company in a weak industry is not likely to perform well.
When household incomes go down and the quantity of a product demanded goes up, the product is:
an inferior good. When household incomes go down and the quantity demanded of a product goes up, the product is an inferior good. Inferior goods include things like bus travel and margarine.
A portfolio manager who adds hedge funds to a portfolio of traditional securities is most likely seeking to:
both increase expected returns and decrease portfolio variance. For a portfolio of traditional securities, adding alternative investments such as hedge funds can potentially increase the portfolio's expected returns, because these investments often have higher expected returns than traditional investments, and decrease portfolio variance, because returns on these investments are less than perfectly correlated with returns on traditional investments.
A forward rate agreement (FRA):
can be used to hedge the interest rate exposure of a floating‐rate loan. An FRA settles in cash and carries both default risk and interest rate risk, even when based on an essentially risk-free rate. It can be used to hedge the risk/uncertainty about a future payment on a floating rate loan.
Aggressive accounting choices by management are most likely to:
comply with generally accepted accounting principles. Management may follow generally accepted accounting principles and still make biased (i.e., aggressive or conservative) accounting choices. Biased accounting choices diminish the decision-usefulness of financial reporting. Aggressive accounting choices are those that increase earnings, revenues, or operating cash flows in the current period (and likely reduce them in later periods).
Thematic investing is most accurately described as:
considering a single environmental or social factor when selecting investments. Thematic investing refers to selecting investments with a view to a specific environmental, social, or governance factor. Identifying the best companies in each sector with respect to environmental and social factors is referred to as best-in-class investing. Excluding companies or sectors from consideration for investment based on environmental and social factors is referred to as negative screening.
An analyst, who is a CFA charterholder, is working in a foreign country. Which of the following statements is CORRECT? The analyst is:
covered by the strictest of the following laws and rules: his own country's, the foreign country's or CFA Institute's Code and Standards. The analyst is covered by the strictest of the following laws and rules: his own country's, the foreign country's or CFA Institute's Code and Standards.
If the required margin on a floating rate note is greater than the quoted margin, it is most likely that the:
credit quality of the FRN has decreased. If the required margin is greater than the quoted margin, the credit quality of the bond must have decreased and the bond will be priced below par at the reset date.
Dividends or interest paid by the asset underlying a call option:
decrease the value of the option. Dividends or interest paid by the underlying asset decrease the value of call options.
Changes in population size and average age that affect industry growth and profitability are best described as:
demographic influences. Among the external influences that affect industries, "demographic factors" refers to those that are related to the size and composition of the population.
The primary difference between basic EPS and diluted EPS is that:
diluted EPS includes the potential effects of convertible securities while basic EPS does not. The primary difference between basic EPS and diluted EPS is that diluted EPS includes the potential effects of convertible securities while basic EPS does not.
Other things equal, a real exchange rate (stated as units of domestic currency per unit of foreign currency) will decrease as a result of an increase in the:
domestic price level. An increase in the domestic price level, other things equal, will decrease a real exchange rate. Increases in the nominal exchange rate or the foreign price level, other things equal, will increase a real exchange rate.
In a set of portfolios, the portfolio with the highest rate of return, but the same variance of the rate of return as the others, would be considered a(n):
efficient portfolio. The efficient frontier, which represents the set of portfolios that provides the highest return at each level of risk, is comprised of efficient portfolios. The optimal portfolio for each investor is the point on the highest indifference curve that is tangent to the efficient frontier.
Some forward contracts are termed cash settlement contracts. This means:
either the long or the short in the forward contract will make a cash payment at contract expiration and the asset is not delivered. In a cash settlement forward contract there is a cash payment at settlement by either the long or the short depending on whether the market price of the asset is below or above the contract price at expiration. The underlying asset is not purchased or sold at settlement.
Paul Clark, CFA, has just learned from a financial analyst at Corvac Industries that orders for their core products are running ahead of last year's orders by 15%, information that has not been publicly disclosed by the company. Clark currently has a hold rating on Corvac based on his expectation of a 5% increase in revenues for the current year. Based on Standard II(A) Material Non‐public Information, Clark's most appropriate course of action is to:
encourage Corvac to publicly release the order information and not act on that information until it is publicly disclosed. The Standard recommends that an analyst who possesses material non-public information encourage the company to release the information publicly. The Standards prohibit Clark from acting on the information until it is publicly disclosed. Since the information is only known by Clark, putting it on a restricted list is not necessary. Public disclosure of material non-public information by an analyst would likely be considered a violation of the Standard.
Proceeds from issuing a bond are recorded on the statement of cash flows as an inflow from:
financing (CFF). Cash from financing (CFF) is increased by the amount of the proceeds.
The North American Free Trade Agreement (NAFTA) is most accurately described as a:
free trade area NAFTA is a free trade area, in which the member nations remove barriers to imports and exports among themselves. In a customs union, all members adopt common trade policies with non-members. A common market goes further, removing all barriers to movement of labor and capital among members.
A researcher is testing whether the average age of employees in a large firm is statistically different from 35 years (either above or below). A sample is drawn of 250 employees and the researcher determines that the appropriate critical value for the test statistic is 1.96. The value of the computed test statistic is 4.35. Given this information, which of the following statements is least accurate? The test:
has a significance level of 95%. This test has a significance level of 5%. The relationship between confidence and significance is: significance level = 1 - confidence level. We know that the significance level is 5% because the sample size is large and the critical value of the test statistic is 1.96 (2.5% of probability is in both the upper and lower tails).
Concentration measures are most likely to be used to:
identify the market structure of an industry. Concentration measures are used to identify the market structure of an industry (perfect competition, monopolistic competition, oligopoly, or monopoly). Concentration measures do not directly indicate an industry's barriers to entry or elasticity of demand.
Lee Hurst, CFA, is an equity research analyst who has recently left a large firm to start independent practice. He is able to re‐create several of his previous recommendation reports, based on his clear recollection of supporting documentation he compiled at his previous employer. He publishes the reports and obtains several new clients. Hurst is most likely:
in violation of Standard V(A) Diligence and Reasonable Basis. Hurst is most likely in violation of Standard V© Record Retention because the supporting documentation is unavailable. He needs to recreate the supporting records based on information gathered through public sources or the covered company. He may have a reasonable basis for his recommendations and have been diligent in his analysis, but must reconstruct the records of this analysis before issuing the reports.
A negative net cost of carry will:
increase the no‐arbitrage forward price. With a negative cost of carry (costs of holding the underlying are greater than benefits from holding the underlying), the no-arbitrage forward price is higher than it would be in the absence of costs or benefits of holding the underlying.
During its life the value of a long position in a forward or futures contract:
is opposite to the value of the short position. The long and short positions in a forward or futures contract have opposite values. A gain for one is an equal-sized loss for the other.
A large, creditworthy manufacturing firm would most likely get short‐term financing by:
issuing commercial paper. Large, creditworthy firms can get the lowest cost of financing by issuing commercial paper. Selling receivables to a factor is a higher cost source of funds used by firms with poor credit quality. A committed line of credit requires payment of a fee and represents bank borrowing, which would be attractive to a firm that did not have the size or creditworthiness to issue commercial paper.
One advantage of using price‐to‐book value (PBV) multiples for stock valuation is that:
it is a stable and simple benchmark for comparison to the market price. Book value provides a relatively stable measure of value that can be compared to the market price. For investors who mistrust the discounted cash flow estimates of value, it provides a much simpler benchmark for comparison. Book value may or may not be closer to the market value. A firm may have negative book value if it shows accounting losses consistently.
An additional risk of direct investment in real estate, which is not typically a significant risk in a portfolio of traditional investments, is:
liquidity risk. Direct investment in real estate involves liquidity risk because large sums may be invested for long periods before a sale of the property can take place. Market risk exists for both traditional portfolio and real estate investments. Counterparty risk applies mainly to derivative contracts that require a payment from a counterparty, such as swaps and forwards.
Investor overreaction that has been documented in securities markets is most likely attributable to investors exhibiting:
loss aversion. Loss aversion refers to the tendency for investors to dislike downside risks more than upside risks creating asymmetrical risk preferences. This dislike of losses may be a cause of investor overreaction. The standard economic notion of risk aversion assumes symmetric risk preferences. Conservatism is the behavioral bias whereby investors react slowly to new information and is unlikely to cause overreaction.
Insider trading can be defined as information that is:
material and nonpublic Information is material if it would be important to the investor in their investment making decision. Information is nonpublic if it is not yet available to the public.
Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT:
narrow the amount of trading opportunities to a more manageable range. Financial derivatives increase the opportunities to either speculate or hedge on the value of underlying assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders.
Restrictions on asset sales and borrowings most accurately describe:
negative covenants. Negative covenants are restrictions on a borrower's actions. Affirmative covenants are actions a borrower is required to take. There is no category known as neutral covenants.
Don Roberts, a CFA Institute member, resides in Country L, where the securities laws and regulations are less strict than the CFA Institute Code and Standards. Roberts also does business in Country N, which has no securities laws or regulations. Thus, Country N has no laws prohibiting the use of material nonpublic information. Roberts has clients in both Country L and N. Country L's law states that the law of the locality where business is conducted governs. According to CFA Institute Standards of Professional Conduct about the use of material nonpublic information, Roberts may:
not take investment action on the basis of this information. Because applicable law states that the law of the locality where the business is conducted governs and local law is less strict than the Code and Standards, the member must adhere to the Code and Standards. Standard II(A) prohibits the use of material nonpublic information.
The period of time within which a hedge fund must fulfill a redemption request is the:
notice period. A notice period, typically 30 to 90 days, is the amount of time a fund has after receiving notice of a redemption request to fulfill the redemption request. A lockup period is a minimum length of time before an investor may redeem shares or make withdrawals.
When using net present value (NPV) profiles:
one should accept all independent projects with positive NPVs. Where the NPV intersects the vertical y-axis you have the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero). Where the NPV intersects the horizontal x-axis you have the project's internal rate of return. At this cost of financing, the cash inflows and cash outflows offset each other. The NPV profile is a tool that graphically plots the project's NPV as calculated using different discount rates. Assuming an appropriate discount rate, one should accept all projects with positive net present values, if the projects are independent. If projects are mutually exclusive select the one with the higher NPV at any given level of the cost of capital.
Isabella Travelli, CFA, is a research analyst for Worldwide Investments in Rome, Italy. Travelli was contacted by Seaside Partners of Milan, Italy, a regional brokerage firm, about doing research on companies in the beverage industry on a contract basis. Travelli may do the contract work without violating the Standards:
only after receiving consent from both Worldwide and Seaside. Standards IV(A) and IV(B) require members to obtain written consent from both their employer and the contracting party before undertaking independent practice in competition with their employer. Travelli needs to seek such consent from both entities because it does not appear that she can argue successfully that there is no competition between Worldwide and Seaside. Worldwide may have plans to offer coverage of the beverage industry of for geographical expansion. The best way to determine if her firm considers Seaside a competitor is to ask her supervisor and seek explicit permission to perform the work.
For the task of arranging a given number of items without any sub‐groups, this would require:
only the factorial function. The factorial function, denoted n!, tells how many different ways n items can be arranged where all the items are included.
A pooled investment fund buys all the shares of a publicly traded company. The fund reorganizes the company and replaces its management team. Three years later, the fund exits the investment through an initial public offering of the company's shares. This pooled investment fund is best described as a(n):
private equity fund. A private equity fund or buyout fund is one that acquires entire public companies, takes them private, and reorganizes the companies to increase their value. An event-driven fund is a hedge fund that invests in response to corporate events such as mergers or acquisitions. Venture capital funds invest in start-up companies.
The condition that occurs when a company disburses cash too quickly, stretching the company's cash reserves, is best described as a:
pull on liquidity. When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidity occurs when cash inflows lag.
Bill Fence, CFA, supervises a group of research analysts, none of whom have earned the CFA designation (nor are they CFA candidates). On several occasions he has attempted to get his firm to adopt a compliance system to ensure that applicable laws and regulations are followed. However, the firm's principals have never adopted his recommendations. Fence should most appropriately:
refuse supervisory responsibility. According to Standard IV©, Responsibilities of Supervisors, if the member cannot discharge supervisory responsibilities because of a poor or nonexistent compliance system, the member should decline in writing to accept supervisory responsibility until the firm adopts an adequate system.
Which of the following is least likely a characteristic of futures contracts? Futures contracts:
require weekly settlement of gains and losses. Futures contracts require daily settlement of gains and losses. The other statements are accurate.
Which of the following is an assumption of capital market theory? All investors:
see the same risk/return distribution for a given stock. All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-period time horizon, and have the same risk/return expectations.
The formative stage of venture capital investing when capital is furnished for market research and product development is best characterized as the:
seed stage. In the seed stage of venture capital investing, capital is furnished for product development, marketing, and market research. The angel investing stage is when investment funds are used for business plans and assessing market potential. The early stage refers to investments made to fund initial commercial production and sales.
The experience curve, which illustrates the cost per unit relative to output:
slopes downward. The experience curve, which shows the cost per unit relative to output, slopes downward because of increases in productivity and economies of scale, especially in industries with high fixed costs.
Historical data on returns of real estate are most likely to exhibit:
smoothing. Appraisal methods used to value real estate tend to produce smoothed return patterns that understate standard deviations of returns. This causes Sharpe ratios to be biased upward. Methods used to construct real estate indexes tend to understate the correlation of real estate returns with other asset classes (and thus overstate its diversification benefits).
Securitized bonds are most likely to be issued by:
special purpose entities. The issuer of a securitized bond is typically a special purpose entity (SPE), also known as a special purpose vehicle (SPV) or special purpose company (SPC). An SPE is formed specifically to purchase and administer assets that will provide the cash flows to pay interest and principal on bonds the entity issues. These bonds are called securitized bonds.
Which of the following is a component of the Code of Ethics? CFA Institute members shall:
strive to maintain and improve their competence and the competence of others in the profession. Striving to maintain and improve their competence and the competence of others in the profession is one of the components of the Code of Ethics, whereas the other statements are part of the Standards of Professional Conduct.
Which of the following would least likely be considered a minimum requirement of an IPS? A(n):
target return figure. An IPS does not necessarily, or even typically, require a target return because future market movements are either difficult or impossible to predict with any degree of accuracy. At a minimum the IPS should contain a clear statement of client circumstances and constraints, and investment strategy consistent with these, and a benchmark portfolio or instrument against which to evaluate portfolio returns.
Compared to European put options on an asset, otherwise identical American put options on the asset are most likely to be more valuable if:
the asset value is significantly lower than the exercise price. Early exercise of an in-the-money American put option is valuable when the asset value is significantly below the exercise price (i.e. they are deep in-the money). The payment of interest or dividends from the underlying asset increases put values, so it does not make early exercise valuable as it does with call options.
The primary factors that influence the price elasticity of demand for a product are:
the availability of substitute goods, the time that has elapsed since the price of the good changed, and the proportions of consumers' budgets spent on the product. The three primary factors influencing the price elasticity of demand for a good are the availability of substitute goods, the proportions of consumers' budgets spent on the good, and the time since the price change. If there are good substitutes, when the price of the good goes up, some customers will switch to substitute goods. For goods that represent a relatively small proportion of consumers' budgets, a change in price will have little effect on the quantity demanded. For most goods, the price elasticity of demand is greater in the long run than in the short run.
Sometimes a CFA Institute member simply feels a law has been violated by his firm, and sometimes the member knows a law has been violated. Which of the following pairs of guidelines is CORRECT with respect to the first step a member should take in each case? The member should first contact:
the firm's counsel if he feels a law has been violated and contact his supervisor if he knows a law has been violated. Standard I(A) says that when a member feels a law has been broken, the member should seek advice from the firm's counsel. If the member feels the advice is unbiased and competent, the member should follow it. If the member knows a law has been violated, the member should contact a supervisor.
Cynthia Abbott, a CFA charterholder, is preparing a research report on Boswell Company for her employer, Capital Asset Management. Bob Carter, president of Boswell, invites Abbott and several other analysts to visit his company and offers to pay her transportation and lodging. Abbott pays for her own transportation and lodging, but while visiting the company, accepts an item of small value from Carter. Abbott does not disclose this gift to her supervisor at Capital when she returns. In the course of the company visit, Abbott overhears a conversation between Carter and his chief financial officer that the company's earnings per share (EPS) are expected to be $1.10 for the next quarter. Abbott was surprised that this EPS is substantially above her initial earnings estimate of $0.70 per share. Without further investigation, Abbott decides to include the $1.10 EPS in her research report on Boswell. Using the high EPS positively affects her recommendation of Boswell. Which of the following statements about whether Abbott violated Standard V(A), Diligence and Reasonable Basis and Standard I(B), Independence and Objectivity is CORRECT? Abbott:
violated Standard V(A) but she did not violate Standard I(B). Abbott violated Standard V(A), Diligence and Reasonable Basis, because she did not have a reasonable and adequate basis to support the $1.10 EPS without further investigation. By including the $1.10 EPS in her report, she did not exercise diligence and thoroughness to ensure that any research report finding is accurate. If Abbott suspects that any information in a source is not accurate, she should refrain from relying on that information. Abbott did not violate Standard I(B), Independence and Objectivity, because the gift from Carter would not reasonably be expected to compromise her independent judgment.
Yield spreads tend to widen when equity market performance is:
weak Conditions that cause equity markets to weaken, such as poor economic growth, also tend to widen yield spreads in the bond market. Likewise, strong equity market performance tends to coincide with narrowing yield spreads. Yield spreads tend to narrow when equity markets are stable because investors "reaching for yield" increase their demand for bonds.
