CFA L1 Practice Test 2 (61-120)

~~An analyst gathered the following data about a company: 1,000 common shares are outstanding (no change during the year). Net income is $5,000. The company paid $500 in preferred dividends. The company paid $600 in common dividends. The average market price of their common stock is $60 for the year. The company had 100 warrants (for one share each) outstanding for the entire year, exercisable at $50. The company's diluted earnings per share is closest to: A) $4.42. B) $4.55. C) $4.83.

A) $4.42. - The warrants are dilutive because their exercise price is less than the average market price. shares issued to warrant holders = 100 warrants generate cash of 100(50) = $5,000 repurchased shares=5,000 / 60 = 83 net new shares created = 100 − 83 = 17 Alternatively, 60−50 / 60 × 100 ≈ 17 diluted EPS = NI−preferred dividends / weighted average # shares + warrant adjust diluted EPS = 5,000 − 500 / 1,017 = $4.42

~Rodgers, Inc., has fixed operating expenses of $2 million and will break even with sales of $5 million. For sales of $7 million, an analyst would estimate the firm's operating income as: A) $800,000. B) $1,200,000. C) $2,000,000.

A) $800,000. Since at breakeven sales, fixed costs + variable costs = revenue, variable costs for Rodgers at sales of $5 million must be $5 million − $2 million = $3 million, or 60% of sales. With sales of $7 million, variable costs are 0.6 × 7 million = 4.2 million. Operating income is then 7 million − 4.2 million − 2 million = $800,000. By assuming some arbitrary price for the product such as $1,000, this problem can be solved in units as well. Variable costs would be $600 per unit and operating income would be 7,000 (1,000 − 600) − 2 million = $800,000.

During a period of falling costs of manufacturing, which of the following inventory cost methods would result in the greatest reported net income? A) LIFO. B) FIFO. C) Average cost.

A) LIFO. - With LIFO, more recent, lower costs would be used for COGS. A reduction in COGS will increase gross profits and net income, other things equal.

~Which of the following statements about probability concepts is most accurate? A) Subjective probability is a probability that is based on personal judgment. B) A conditional probability is the probability that two or more events happen concurrently. C) An empirical probability is one based on logical analysis rather than on observation or personal judgment.

A) Subjective probability is a probability that is based on personal judgment. - Subjective probability is based on personal judgment. A joint probability is a probability that two or more events happen concurrently. An a priori probability is one based on logical analysis rather than on observation or personal judgment. An empirical probability is calculated using historical data. A conditional probability is the probability of one event happening on the condition that another event is certain to occur.

~The two primary assumptions in preparing financial statements under IFRS are: A) accrual accounting and going concern. B) reasonable accuracy and accrual accounting. C) going concern and reasonable accuracy.

A) accrual accounting and going concern. - In the IFRS framework, the two assumptions that underlie the preparation of financial statements are accural accounting and the going concern assumption.

~Time-series analysis of a firm's common-size balance sheets reveals the following data: 20X3 20X4 20X5 Current assets 20% 22% 25% Inventory 8% 9% 11% Short-term debt 10% 11% 12% Long-term debt 24% 21% 18% Based only on the data provided, an analyst can conclude that the firm's: A) debt ratio is decreasing. B) quick ratio is decreasing. C) inventory/sales ratio is increasing.

A) debt ratio is decreasing. The debt ratio is total debt to total assets. Because common-size balance sheet data are stated as percentages of total assets, the debt ratio can be determined from the data given. 20X3: 10% + 24% = 34% 20X4: 11% + 21% = 32% 20X5: 12% + 18% = 30% The debt ratio is decreasing over the period shown. Neither the inventory/sales ratio nor the quick ratio can be determined from the data given because the data do not include sales or current liabilities.

A natural monopoly is most likely to exist when: A) economies of scale are great. B) average total cost increases as output increases. C) a single firm owns essentially all of a productive resource.

A) economies of scale are great. - A natural monopoly may exist when economies of scale are great. The large economies of scale mean that a single producer results in the lowest production costs.

~Which of the following statements about the normal distribution is least accurate? The normal distribution: A) has a mean of zero and a standard deviation of one. B) is completely described by its mean and standard deviation. C) is bell-shaped, with tails extending without limit to the left and to the right.

A) has a mean of zero and a standard deviation of one. - The standard normal distribution has a mean of 0 and a standard deviation of 1.

Forman, Inc., and Swoft, Inc., both operate within the same industry. Forman's stated strategy is to differentiate its premium products relative to its competitors, while Swoft is a low-cost producer. Given the companies' stated strategies, Forman most likely has: A) higher gross margins relative to Swoft. B) lower advertising expenses relative to Swoft. C) lower research and development expenses relative to Swoft.

A) higher gross margins relative to Swoft. - An analyst can use the historical trend in a firm's financial ratios as well as an industry relative comparison to assess the firm's business strategy. A firm producing premium products with a strategy of differentiation should have higher gross margins, higher advertising expenses, and higher research and development expenses relative to firms in its industry that pursue a low-cost-of-production strategy.

Investing in a project that will help achieve a particular social or environmental objective is most accurately described as an example of: A) impact investing. B) positive screening. C) responsible investing.

A) impact investing. Impact investing refers to promoting a specific social or environmental goal through investment actions, which may include investing in a particular project. Positive screening refers to identifying companies with best practices regarding environmental, social, or governance for consideration when investing. Responsible or sustainable investing refers to integrating social or environmental considerations in general into investment decisions.

~A company takes a $10 million impairment charge on a depreciable asset in 20X3. The most likely effect will be to: A) increase reported net income in 20X4. B) decrease net income and taxes payable in 20X3. C) increase return on equity and operating cash flow in 20X4.

A) increase reported net income in 20X4. - The impairment writedown in 20X3 will reduce depreciation expense in 20X4, which will increase 20X4 EBIT and net income. Operating cash flow and taxes payable are not affected because an impairment cannot be deducted from income for tax reporting purposes until the asset is sold or otherwise disposed of.

~The ratio of operating cash flow to net income is most likely to indicate low quality of earnings when it is: A) less than one. B) highly variable. C) increasing over time.

A) less than one. - Operating cash flow that is less than net income (ratio less than one) or declining over time may indicate low-quality earnings from aggressive accounting or accounting irregularities. A ratio of operating cash flow to net income that is highly variable, but consistently greater than one, is not necessarily indicative of low-quality earnings.

An advantage of the Herfindahl-Hirschman Index (HHI) over the N-firm concentration ratio as a summary measure of the market structure of an industry is that the HHI is more sensitive to: A) mergers. B) barriers to entry. C) elasticity of demand.

A) mergers. The HHI is more sensitive to the effects of mergers compared to the N-firm concentration ratio. Neither measure accounts for elasticity of demand or barriers to entry.

~Ron's Organic Markets has limited access to borrowed funds and must choose among ten independent projects with returns greater than their cost of capital. All the projects under consideration have the same required investment of $2 million, and Ron's has $10 million available for capital investments this year. Which of the following selection criteria is least likely to identify the five projects that will produce the greatest expected increase in the value of the firm? Choose the five projects with: A) the highest IRRs. B) the greatest total NPV. C) the largest sum of profitability indexes.

A) the highest IRRs. - Since the net present value of the five projects is the expected increase in firm value from undertaking the projects, maximizing the NPV of the projects chosen will result in the selection of the optimal group of five projects. Since the profitability index is the ratio of the present value of the expected after-tax cash flows to the initial outlay, choosing the five projects with the greatest profitability indexes will identify the five projects with the greatest total present values and the projects with the greatest total net present values.

The country of Colfax can produce 15 units of rice or 10 units of plastic per day of labor. The country of Birklund can produce 18 units of rice or 12 units of plastic per day of labor. With regard to potential benefits of trading rice and plastic between Colfax and Birklund: A) there are no potential gains from trade. B) Colfax should produce and trade rice for Birklund's plastic. C) Birklund should produce and trade rice for Colfax's plastic.

A) there are no potential gains from trade. - In this case, there are no clear potential benefits from trade because the countries' opportunity costs of production are equal. Colfax's opportunity cost of rice = 10 / 15 = 0.67 units of plastic, and Birklund's opportunity cost of rice = 12 / 18 = 0.67 units of plastic. Colfax's opportunity cost of plastic = 15 / 10 = 1.5 units of rice, and Birklund's opportunity cost of plastic = 18 / 12 = 1.5 units of rice.

~Given the following correlation matrix, a risk-averse investor would least prefer which of the following 2-stock portfolios (all else equal)? Stock W X Y Z W +1 X -0.2 +1 Y +0.6 -0.1 +1 Z +0.8 -0.3 +0.5 +1 A)W and Y. B)X and Y. C)X and Z.

A)W and Y. - A risk-averse investor prefers less risk to more risk. The lower the correlation, the greater the risk reduction. Thus, a risk-averse investor would most prefer the portfolio with the lowest correlation coefficient and least prefer the one with the highest. Of the choices given, W and Y's correlation coefficient of +0.6 is the highest.

~~An investor wants to receive $10,000 annually for ten years with the first payment five years from today. If the investor can earn a 14% annual return, the amount that she will have to invest today is closest to: A) $27,091. B) $30,884. C) $52,161.

B) $30,884. This problem involves determining the present value of an annuity followed by finding the present value of a lump sum. Enter PMT = 10,000, N = 10, and I = 14. Compute PV = 52,161.16. That is the present value of the 10-year annuity, four years from today. Next, we need to discount that back to present for four years to find the amount of the investment today. Enter FV = −52,161.16, N = 4, I = 14, PMT = 0. Compute PV = 30,883.59. 4 years not 5 years

Al Pike, CFA, is analyzing Red Company by projecting pro forma financial statements. Pike expects Red to generate sales of $3 billion and a return on equity of 15% in the next year. Pike forecasts that Red's total assets will be $5 billion and that the company will maintain its financial leverage ratio of 2.5. Based on these forecasts, Pike should project Red's net income to be: A) $100 million. B) $300 million. C) $500 million.

B) $300 million. Based on the data given, use the basic DuPont equation and solve for expected net income. ROE = (net income / revenues) × (revenues / total assets) × (total assets / total equity) 0.15 = (net income / $3 billion) × ($3 billion / $5 billion) × 2.5 net income / $3 billion = 0.1 net income = $300 million Alternatively, A/E = 2.5 and assets = $5 billion, so equity = $2 billion. net income / equity = 15%, so net income = 0.15($2 billion) = $300 million.

~~Rolly Parker, CFA, has managed the retirement account funds for Misto Inc. for the last two years. Contributions and withdrawals from the account are decided by Misto's CFO. The account history is as follows, with account values calculated before same-date deposits and withdrawals: Jan 1, 20X1 Beginning portfolio value $10 million Jul 1, 20X1 Account value $11.2 million Jul 1, 20X1 Deposit of cash $1.2 million Jan 1, 20X2 Account value $12.5 million Jan 1, 20X2 Withdrawal of cash $0.6 million Dec 31, 20X2 Account value $15 million The appropriate annual return to use in evaluating the manager's performance is closest to: A) 9%. B) 19%. C) 22%.

B) 19%. Since the portfolio manager is not directing the flow of cash into and out of the account, the time-weighted annual rate of return is the appropriate performance measure. Calculate the 2-year holding period return +1, then take the square root and subtract 1 to get the annual time-weighted rate of return: [(11.2 / 10) (12.5 / 12.4) (15 / 11.9)]^1/2 − 1 = 19.29%.

~~Consider two currencies, the WSC and the BDR. The spot WSC/BDR exchange rate is 2.875, the 180-day riskless WSC rate is 1.5%, and the 180-day riskless BDR rate is 3.0%. The 180-day forward exchange rate that will prevent arbitrage profits is closest to: A) 2.833 WSC/BDR. B) 2.854 WSC/BDR. C) 2.918 WSC/BDR.

B) 2.854 WSC/BDR. - Arbitrage-free forward = Spot Ex Rate x [(1 + WSC rate / 2) / (1 + BDR Rate / 2)] = 2.875 WSC/BDR × [(1 + 0.015 / 2) / (1 + 0.03 / 2)] = 2.8538 WSC/BDR.

~~An analyst identifies the following cash flows for an average-risk project: Year 0 −$5,000 Year 1-2 $1,900 Year 3 $2,500 Year 4 $2,000 If the company's cost of capital is 12%, the project's discounted payback period is closest to: A) 2.5 years. B) 3.0 years. C) 3.9 years.

B) 3.0 years Discounted cash flow CF0 = -5,000 C01 = 1900 F01 = 2 C02 = 2500 F01 = 1 I= 12 NPV = -$9.45 discounted payback period= 3 + 9.45 / 1,271.04 = 3.01 years

Janet Adams, CFA, is reviewing Rival Company's financial statements. Rival's long-term debt totals $35 million, while total shareholder equity equals $140 million. Rival's long-term debt has a YTM of 9%. Rival's tax rate is 40% and its beta is 0.9. Adams gathers the following additional facts: - Treasury bills earn 4.0%. - The equity risk premium is 4.5%. Based on the information provided, Rival's weighted average cost of capital is closest to: A) 4.6%. B) 7.5%. C) 8.2%.

B) 7.5%. Weight of debt = 35 / (35 + 140) = 0.2 Weight of equity = 140 / (35 + 140) = 0.8 After-tax cost of debt = 9%(1 − 0.4) = 5.4% Cost of equity = 4% + 0.9(4.5%) = 8.05% WACC = 0.2(5.4%) + 0.8(8.05%) = 7.52%

When computing weighted average cost of capital (WACC), what is the correct treatment of flotation costs, related to raising additional equity capital? A) Increase the discount rate to account for flotation costs. B) Adjust the initial project costs by the amount of the flotation costs. C) Flotation costs are not substantial enough to be considered in adjusting the cost of equity.

B) Adjust the initial project costs by the amount of the flotation costs. - The correct method to account for flotation costs is to make the adjustment in the initial project cost. Adjusting the WACC is incorrect because flotation costs are a cash outflow at the initiation of the project, rather than an ongoing expense. Flotation costs can be substantial, typically 2% to 7% of the amount raised.

~Which of the following statements about the analysis of cash flows is least accurate? A) Interest payments on debt are not a financing cash flow under U.S. GAAP. B) Both the direct and indirect methods involve adding back noncash items such as depreciation and amortization. C) When using the indirect method, an analyst should add any losses on the sales of fixed assets to net income.

B) Both the direct and indirect methods involve adding back noncash items such as depreciation and amortization. When using the direct method of calculating operating cash flows, depreciation and amortization are not "added back" (to net income) because we don't begin with net income under the direct method. Depreciation and amortization are noncash changes and are not used under the direct method. The other statements are true. Interest payments on debt affect cash flow from operations. When using the indirect method, an analyst should add any losses on sales of fixed assets to net income since they are not operating cash flows.

~Which of the following is least likely a problem associated with the internal rate of return (IRR) method of choosing investment projects? A) Using IRR to rank mutually exclusive projects assumes reinvestment of cash flows at the IRR. B) For independent projects, the IRR and NPV can lead to different investment decisions. C) If the project has an unconventional cash flow pattern, the result can be multiple IRRs.

B) For independent projects, the IRR and NPV can lead to different investment decisions. - IRR and NPV lead to the same decision when choosing independent projects but may lead to different decisions when choosing between projects.

With regard to environmental, social, and governance (ESG) considerations, which of the following statements is most accurate? A) Fiduciary duty requires managers to integrate their clients' ESG-related considerations into investment decisions. B) Integrating ESG factors into the analysis of a company's risk and return characteristics is not considered a violation of fiduciary duty. C) A "values-based" objective involves investing in companies that have ESG-related opportunities that are not fully reflected in their share prices.

B) Integrating ESG factors into the analysis of a company's risk and return characteristics is not considered a violation of fiduciary duty. - Using ESG factors in estimating the risk and returns of a company is not considered a violation of a manager's fiduciary duty to clients and beneficiaries. ESG considerations may conflict with fiduciary duty if they result in the manager accepting lower returns or higher risk than they otherwise would. A "values-based" investment objective is to express the investor's ethical beliefs through investment decisions. A "value-based" approach to ESG investing refers to considering ESG-related risks and opportunities alongside traditional investment considerations.

Which of the following statements about the security market line (SML) and capital market line (CML) is most accurate? A) The SML involves the concept of a risk-free asset, but the CML does not. B) The SML uses beta, but the CML uses standard deviation as the risk measure. C) Both the SML and CML can be used to explain a stock's expected return.

B) The SML uses beta, but the CML uses standard deviation as the risk measure. - The SML and CML both intersect the vertical axis at the risk-free rate. The SML describes the risk/return tradeoff for individual securities or portfolios, whereas the CML describes the risk/return tradeoff of various combinations of the market portfolio and a riskless asset.

A manager forecasts a bond portfolio return of 10% and estimates a standard deviation of annual returns of 4%. Assuming a normal returns distribution and that the manager is correct, there is: A) a 90% probability that the portfolio return will be between 3.2% and 17.2%. B) a 95% probability that the portfolio return will be between 2.16% and 17.84%. C) a 32% probability that the portfolio return will be between 6% and 14%.

B) a 95% probability that the portfolio return will be between 2.16% and 17.84%. - The 95% confidence interval is 10% ± 1.96(4%) or from 2.16% to 17.84%. The 90% confidence interval is 10% ± 1.65(4%) or from 3.4% to 16.6%. The probability of a return ± 1 standard deviation from the mean, between 6% and 14%, is approximately 68%.

~A bank estimates the expected value of a one-month loss that exceeds ¥100 million to be ¥300 million. The ¥300 million estimate is best described as: A) a value at risk. B) a conditional VaR. C) a scenario-based VaR.

B) a conditional VaR. - Conditional VaR is the expected value of a loss, given that the loss exceeds a minimum amount. Value at risk is the minimum loss that will occur over a period with a specified probability.

Reasons why the unemployment rate is a lagging indicator of the business cycle least likely include: A) discouraged workers who begin seeking work. B) action lag in the implementation of unemployment insurance. C) high costs to employers of frequently hiring or firing employees.

B) action lag in the implementation of unemployment insurance. Unemployment insurance is an example of an automatic stabilizer that is not subject to the action lag of discretionary fiscal policy tools. One reason why the unemployment rate is a lagging indicator is the fact that employers are slow to lay off employees early in recessions and slow to add employees early in expansions, because frequent hiring and firing has high costs. Another reason is that early in expansions, more discouraged workers (who are not counted as unemployed because they are out of the labor force) may begin seeking work (thereby re-entering the labor force) than the number of new jobs that are available, which increases the unemployment rate.

~In a case where a client's ability to bear risk is significantly less than the client's expressed willingness to bear risk, the most appropriate action for a financial advisor is to: A) counsel the client and attempt to change his attitude towards risk. B) base the assessment of risk tolerance in the IPS on client's ability to bear risk. C) attempt to educate the client about investment risk and correct any misconceptions.

B) base the assessment of risk tolerance in the IPS on client's ability to bear risk. - In a situation where the client's expressed willingness to bear investment risk is significantly greater than the client's ability to bear investment risk, the advisor's assessment of the client's risk tolerance in the IPS should reflect the client's ability to bear investment risk.

~Paul Dufray, CFA, is estimating the asset beta for a new project based on a firm that primarily makes and sells a similar product. In addition to the beta of that firm, Dufray will need to estimate the firm's: A) sales risk and financial risk. B) debt-to-equity ratio and tax rate. C) operating leverage and financial leverage.

B) debt-to-equity ratio and tax rate. - To calculate the asset beta, the analyst will need to estimate the firm's beta, its debt-to-equity ratio, and its tax rate.

~An accounts receivable aging schedule is best used to: A) determine how the receivables turnover ratio has changed over time. B) identify trends in how well the firm is doing at collecting receivables and converting them to cash. C) compare a company's receivables management to those of the average for its industry or for a group of peer companies.

B) identify trends in how well the firm is doing at collecting receivables and converting them to cash. - Information is typically not available to compare the aging of receivables between companies, among groups of companies, or within an industry. Receivables turnover can be calculated from the balance sheet. An aging schedule shows either the absolute or percentage amount of accounts receivable that are current and that are past due by various lengths of time.

Xanos Corporation faced a 50% marginal tax rate last year and showed the following financial and tax reporting information: Deferred tax asset of $1,000. Deferred tax liability of $5,000. Based only on this information and the news that the tax rate will decline to 40%, Xanos Corporation's deferred tax: A) asset will be reduced by $400 and deferred tax liability will be reduced by $2,000. B) liability will be reduced by $1,000 and income tax expense will be reduced by $800. C) asset will be reduced by $200 and income tax expense will be reduced by $1,000.

B) liability will be reduced by $1,000 and income tax expense will be reduced by $800. - There is a 20% reduction in the tax rate [(40% − 50%) / 50% = -0.2]. Hence, the deferred tax asset will be $800 = $1,000(1 − 0.2), the deferred tax liability will be $4,000 = $5,000(1 − 0.2), and the income tax expense will fall by the net amount of the decline in the asset and liability balances ($1,000 - $200 = $800).

~A portfolio manager who is comparing portfolios based on their total risk should most appropriately use: A) Jenson's alpha. B) the Sharpe ratio. C) the Treynor measure.

B) the Sharpe ratio. - The Sharpe ratio measures excess return per unit of total risk. The Treynor measure and Jenson's alpha are calculated with beta, not standard deviation, and are appropriate for analyzing portfolios based on systematic risk.

~Weights to be used in calculating a company's weighted average cost of capital are least appropriately based on: A) information from the company about its target capital structure. B) the average capital structure weights for companies of a similar size. C) the average capital structure weights for companies in the same industry.

B) the average capital structure weights for companies of a similar size. - The weights used to calculate WACC should be based on the firm's target capital structure. If the company does not provide information about its target capital structure, an analyst can use the company's current capital structure or the average capital structure weights for the industry. Similar size is not enough for the average weights for other companies to be relevant if those companies are not in the same industry.

~A perfectly elastic aggregate supply curve represents: A) the productive capacity of an economy at full employment. B) the production decisions of firms only in the very short run. C) the short-run relationship between output and the price level.

B) the production decisions of firms only in the very short run. - The very short run aggregate supply curve is perfectly elastic because firms can adjust output by increasing or decreasing labor hours and capacity use without affecting input prices. The short-run aggregate supply curve is upward sloping. The long-run aggregate supply curve is perfectly inelastic and represents potential GDP, the full-employment output level of an economy.

Bear Company produces gravel-hauling equipment. The company recently began producing the Mauler, a new line of equipment. Prior to beginning production of the Mauler, the company spent $10 million in research and development costs. Bear expects the Mauler line to generate positive cash flows beginning in the fourth year. However, Bear is forecasting a one-time expense in year 5 to comply with new government emission standards. The company will use an empty building it already owns to produce the Mauler. When analyzing the project cash flows for the Mauler, Bear should least appropriately include: A) the use of the empty building. B) the research and development cost. C) the compliance cost for emissions standards.

B) the research and development cost. - The R&D expenditure is a sunk cost that should not be considered in the project's cash flows. The opportunity cost of the empty building in its next-best use should be considered in the project analysis.

~The median of a distribution is least likely equal to: A) the second quartile. B) the third quintile. C) the fifth decile.

B) the third quintile. - The median is the midpoint of a distribution, such that 50% of the observations are greater than the median and 50% are less than the median. This is equivalent to the second quartile (4 groups) and the fifth decile (10 groups). If a distribution is divided into quintiles (5 groups), 60% of the observations are less than the third quintile.

~The most appropriate method to estimate a company's cost of debt capital is to use: A) a weighted average of the coupon rates on all the company's outstanding debt. B) the yield to maturity on bonds of other companies with the same credit rating as the company's bonds. C) the average rate market rate on outstanding company bonds for a company that issues only floating-rate bonds.

B) the yield to maturity on bonds of other companies with the same credit rating as the company's bonds. - A company may use the YTM on the bonds of other companies with the same credit rating and maturity as the company's debt when it is not publicly traded, an example of matrix pricing. Market yields to maturity should be used rather than the coupon rates. For companies that issue floating-rate debt, analysts should use the yield for a longer term that is estimated from the yield curve, rather than using current short-term rates that will likely change over the life of the bonds.

~Which of the following portfolios will have the lowest diversification ratio? A portfolio of: A) 30 equally-weighted stocks with companies from the same industry. B) 20 equally-weighted stocks with companies from different industries. C) 30 equally-weighted stocks with companies from different industries.

C) 30 equally-weighted stocks with companies from different industries. - The diversification ratio of a portfolio equals its standard deviation of returns divided by the average standard deviation of the individual securities in the portfolio. Therefore, a more diversified portfolio will have a lower diversification ratio than a less diversified portfolio. A portfolio containing the highest number of securities from different industries will be the most diversified and will have the lowest diversification ratio. A portfolio of stocks from the same industry is likely to have a higher diversification ratio (reflecting less diversification) than a portfolio of stocks from different industries.

Alex White, CFA, is examining a portfolio that contains 100 stocks that are either value or growth stocks. Of these 100 stocks, 40% are value stocks. The previous portfolio manager had selected 70% of the value stocks and 80% of the growth stocks. What is the probability of selecting a stock at random that is either a value stock or was selected by the previous portfolio manager? A) 28%. B) 76%. C) 88%.

C) 88%. Previous Mngr Current Mngr Total Value stocks 28 (28%) 12 (12%) 40 Growth stocks 48 (48%) 12 (12%) 60 Total 76 24 100 This problem involves the addition rule for probabilities, P(A or B) = P(A) + P(B) − P(AB). P(A) is the probability that a randomly selected stock is a value stock, which is given as 40%. P(B) is the probability that a stock was picked by the previous manager. That probability is (0.7)(0.4) + (0.8)(1 − 0.4) = 0.76. The previous manager selected 76% of the stocks in the portfolio. P(AB) is the probability that a randomly selected stock is a value stock picked by the previous manager. Since the previous manager picked 70% of the 40% of the stocks that are value stocks, the probability that a randomly selected stock is a value stock picked by the previous manager is 40% × 70% = 28%. From this, we have P(A or B) = 40% + 76% − 28% = 88%.

An analyst is studying the tax exposures and capital structures of Alpha Corporation and Beta Corporation. Both companies have equivalent weights of debt and equity in their capital structures. Pretax component costs of capital are the same for both companies. Alpha has total capital of $850 million while Beta has total capital of $370 million. The marginal tax rates for Alpha and Beta are 35% and 40%, respectively. Which of the following statements regarding Alpha and Beta is least accurate? A) Beta Corporation has a lower WACC than Alpha Corporation. B) An increase in Alpha Corporation's tax rate would decrease its WACC. C) A tax rate change will affect Alpha Corporation's cost of equity more than Beta Corporation.

C) A tax rate change will affect Alpha Corporation's cost of equity more than Beta Corporation. - Changes in the tax rate would not affect the cost of equity for either company. If two companies have the same capital structure (i.e., equal weights of debt and equity) and have the same pretax component costs of capital (i.e., equal costs of debt and equity) they will have the same weighted average cost of capital (WACC) only if the companies have the same marginal tax rate. If one company has a higher tax rate, the after-tax cost of debt, kd(1 − t), will be lower and the WACC, weke + wdkd(1 − t), will be lower as well. Beta Corporation has a lower current WACC since it has a higher tax rate. If Alpha's tax rate increases, its after-tax cost of debt will decrease and its WACC will decrease.

Which of the following sources of information should an analyst consider the least reliable? A) Form 10-Q. B) Proxy statement. C) Corporate press release.

C) Corporate press release. - Corporate press releases are written by management and are often viewed as public relations or sales materials because of the great possibility of inherent management bias in such documents. Often, little or none of the material is independently reviewed by outside auditors. Such documents are not mandated by the securities regulators. Form 10-Q (quarterly financial statements) and proxy statements are mandatory SEC filings in the United States, which inherently increases their reliability given the penalties that can be imposed by the SEC if any serious irregularities are subsequently found.

~Which of the following working capital management outcomes is least desirable? A) Low operating cycle. B) High inventory turnover. C) High cash conversion cycle.

C) High cash conversion cycle. The cash conversion cycle measures the amount of time it takes for the firm to turn the firm's cash investments in inventory back into cash. A high cash conversion cycle implies that the company has too much invested in working capital.

~For which of the following investments in securities is a firm most likely to report unrealized gains or losses on its income statement? A) Preferred stock, which the firm classifies as available-for-sale. B) Five-year bonds, which the firm purchased in a private placement. C) Listed call options, which the firm intends to exercise at expiration.

C) Listed call options, which the firm intends to exercise at expiration. - Options are derivatives, which are reported at fair value on the balance sheet with unrealized gains and losses recognized on the income statement. Available-for-sale securities are marked to market on the balance sheet, but unrealized gains and losses are reported in owners' equity as other comprehensive income. Bonds purchased in a private placement cannot be resold to the public and therefore are likely to be classified as held-to-maturity, in which case the firm does not recognize unrealized gains or losses.

~Which of the following statements about sampling and estimation is least accurate? A) Sampling error is the difference between the observed value of a statistic and the value it is intended to estimate. B) A simple random sample is a sample obtained in such a way that each element of the population has an equal probability of being selected. C) The central limit theorem states that the sample mean for a large sample size will have a distribution that is the same as the distribution of the underlying population.

C) The central limit theorem states that the sample mean for a large sample size will have a distribution that is the same as the distribution of the underlying population. - According to the central limit theorem, the sample mean for large sample sizes will be distributed normally regardless of the distribution of the underlying population.

Which of the following statements about risk is most accurate? A) The capital market line plots expected return against market risk. B) The efficient frontier plots expected return against unsystematic risk. C) The security market line plots expected return against systematic risk.

C) The security market line plots expected return against systematic risk. - The capital market line plots expected return against standard deviation of returns for efficient portfolios. The efficient frontier plots expected return against the standard deviation of return, a measure of total risk.

~From a liquidity management perspective, an increase in the number of days of payables is best described as: A) liquidity neutral. B) a pull on liquidity. C) a source of liquidity.

C) a source of liquidity. - An increase in the number of days of payables suggests a company is taking longer to pay its vendors. This reduces the cash conversion cycle and represents effective working capital management, a source of liquidity for a company. A decrease in days of payables would be a pull on liquidity because the company is paying its vendors more quickly, which uses cash.

Unlike members of free trade areas, customs union members: A) adopt a single currency. B) remove barriers to trade with all members. C) adopt uniform trade restrictions with non-members.

C) adopt uniform trade restrictions with non-members. - Customs unions adopt uniform trade restrictions with non-members. Customs union members do not adopt a single currency. Both free trade areas and customs unions remove trade barriers among their members.

Stakeholder theory is most accurately described as the belief that corporate governance should focus on managing: A) the activities of a company in the best interests of its owners. B) employee activities in compliance with ethical standards and applicable laws. C) conflicts among different groups that have an interest in a company's activities.

C) conflicts among different groups that have an interest in a company's activities. - According to stakeholder theory, the focus of corporate governance is managing conflicts among the interests of different groups that have an interest in a company's activities. Shareholder theory holds that the focus of corporate governance should be to manage the activities of a company in the best interests of its owners.

~In choosing asset classes for establishing strategic portfolio allocation across assets, the manager would most prefer that: A) asset classes are only those with tradable liquid assets. B) the asset classes span the broadest universe of investable assets. C) correlations of asset returns within an asset class are significantly greater than correlations of asset class returns.

C) correlations of asset returns within an asset class are significantly greater than correlations of asset class returns. - The important points in the determination of asset classes are that assets included in a class have similar performance characteristics and a relatively high correlation of returns between assets, and that returns of asset classes have relatively low correlations to realize the benefits of diversification across asset classes. Some asset classes, such as real estate and hedge funds, may be illiquid. The asset classes in the strategic allocation should be mutually exclusive and cover the universe of investable assets available to the fund manager(s) based on the client's objectives and constraints, not the broadest possible universe of asset classes.

The public sector is most likely to increase as a proportion of economic output if fiscal policy: A) and monetary policy are both expansionary. B) is contractionary and monetary policy is expansionary. C) is expansionary and monetary policy is contractionary.

C) is expansionary and monetary policy is contractionary. Reducing taxes is likely to keep the public sector size unchanged, but an increase in government spending will increase the size of the public sector. Contractionary monetary policy is likely to decrease the output of the private sector as interest rates rise.

An analyst obtains the following annual returns for a group of stocks: 10%, 8%, 7%, 9%, 10%, 12%, 11%, 10%, 30%, and 13%. This distribution: A) has a median greater than its mode. B) is skewed to the right, and the mean is less than the median. C) is skewed to the right, and the mean is greater than the mode.

C) is skewed to the right, and the mean is greater than the mode. - Mean = 120 / 10 = 12, median = 10, and mode = 10. The distribution is skewed to the right, so the mean is greater than the median and mode. Generally, for positively skewed distributions, the mode is less than the median, which is less than the mean. In this case, the mode and median are equal because the number of observations is small.

~For a test with sample size n of whether two variables are correlated, the critical values are based on: A) n degrees of freedom. B) n - 1 degrees of freedom. C) n - 2 degrees of freedom.

C) n - 2 degrees of freedom. The test statistic for the hypothesis that correlation = 0 follows a t-distribution with n - 2 degrees of freedom.

Consider a manufacturing company and a financial services company. Interest expense is most likely classified as a non-operating component of net income for: A) both of these companies. B) neither of these companies. C) only one of these companies.

C) only one of these companies. - Interest expense is shown as a non-operating component of net income for a manufacturing company but would typically be classified as an operating expense for a financial services company.

The type of technical analysis chart most likely to be useful for intermarket analysis is a: A) candlestick chart. B) point-and-figure chart. C) relative strength chart.

C) relative strength chart. - Relative strength charts display the price of an asset relative to the price of another asset or benchmark over time. This type of chart is useful for demonstrating whether one asset class or market has outperformed or underperformed another. Candlestick charts and point-and-figure charts are generally used to display price patterns for a single asset or market over time.

Break points in a firm's marginal cost of capital schedule are best interpreted as representing: A) the maximum amounts of debt, preferred stock, and common stock the firm can issue. B) the amounts of new securities a firm would need to issue to take advantage of flotation cost discounts. C) the amounts of capital expenditure at which the company's weighted average cost of capital increases.

C) the amounts of capital expenditure at which the company's weighted average cost of capital increases. - Break points in the marginal cost of capital structure occur at the levels where the cost of one of the components of the company's capital structure increases, increasing its weighted average cost of capital.

~A security's beta is best estimated by the slope of: A) the capital market line. B) the security market line. C) the security's characteristic line.

C) the security's characteristic line. - Beta, a measure of systematic risk, can be estimated as the slope coefficient from a regression based on the market model, Ri = α + βi (Rmkt - Rf). This regression line is the security's characteristic line.