1998 sample exam · 9. don smith, a cfa candidate employed by hunter investment counselors, inc.,...

©Association for Investment Management and Research 1

Sample Examination 1 for 1998 Candidates CFA® Level I 120 Questions

3 Hours AIMR has constructed two sample examinations to help candidates practice taking multiple choice tests. Each 120-question sample examination represents a three-hour section (one-half the regular examination time). By combining the two sample examinations provided, candidates have the equivalent of one full six-hour test. To simulate realistic examination-day conditions, candidates may want to set aside a block of three hours in which to take each sample examination. Doing so will allow 1 ½ minutes, on average, for each question. The sample examinations are intended only to give candidates practice at answering questions that are similar in style to those that will appear on the 1998 CFA Level I examination. None of these sample questions will appear on that examination. Candidates should not rely on the sample examinations as their only means of preparing for the 1998 CFA Level I examination. Careful reading and study of the readings listed in the 1998 CFA Level I Study Guide are essential to being well prepared. AIMR strives to be accurate with the guideline answers to the sample examinations. If you detect any irregularities, please submit them by fax to: Coordinator, Level I Examination at (804)980-3670. Corrections will be printed in the Candidate Bulletin or will be sent by mail to all candidates. No individual replies will be given.

Sample Examination Structure

Question Topic Percent Number

1-18 Ethical and Professional Standards 15 18

19-36 Quantitative Analysis 15 18

37-50 Economics 12 14

51-80 Accounting and Corporate Finance 25 30

81-92 Global Markets and Instruments 12 12

93-106 Asset Valuation 12 14

107-120 Portfolio Management 12 14

Total 100%* 120

* The percentages do not add exactly to 100% because of rounding.

2 ©Association for Investment Management and Research

QUESTIONS 1 THROUGH 18 RELATE TO ETHICAL AND PROFESSIONAL STANDARDS AND ARE ALLOCATED 27 MINUTES (OR 1 ½ MINUTES EACH).

1. To fulfill their obligation regarding informing their employer of their obligation to comply with the Code and Standards, members: A. Can notify their employer of their obligation to comply with the Code and Standards via

e-mail. B. Must inform their immediate supervisor, in writing, of their obligation to comply with the

Code and Standards. C. Need not inform their employer of their obligation to comply with the Code and

Standards if the employer has publicly adopted AIMR's Code and Standards as part of its firm's policies.

D. All of the above.

2. Anderb, a portfolio manager for XYZ Investment Management Company—a registered investment organization that advises investment companies and private accounts—was promoted to that position three years ago. Bates, her supervisor, is responsible for reviewing Anderb’s portfolio account transactions, and her required monthly reports of personal stock transactions. Anderb has been using Jonelli, a broker, almost exclusively for portfolio account brokerage transactions. For securities in which Jonelli’s firm makes a market, Jonelli has been giving Anderb lower prices for personal purchases and higher prices for personal sales than Jonelli gives Anderb’s portfolio accounts and other investors. Anderb has been filing monthly reports with Bates only in those months in which she has no personal transactions, which is about every fourth month. Which of the following applies/apply?

I. Anderb violated the Code and Standards in that she failed to disclose to her employer her personal transactions.

II. Anderb violated the Code and Standards by breaching her fiduciary duty to her clients.

III. Bates violated the Code and Standards by failing to enforce reasonable procedures for supervising and monitoring Anderb in Anderb’s trading for her own account.

A. I only. B. I and II only. C. II and III only. D. I, II, and III.


3. Saunders, a mining analyst for Hokassen Investments, has completed his analysis of Okun Drilling & Mining for a wealthy client of Hokassen. He has concluded that, based on core samples and geological surveys of land owned or leased by Okun, the company has in excess of 1 million ounces of gold available to mine. Saunders drafts a research report stating the following: "Based on the fact that the company has 1 million ounces of gold to be mined, I recommend purchasing Okun stock for your portfolio." If Saunders presents his report to the wealthy client, he will have: A. Violated the AIMR Standards of Professional Conduct because he did not distinguish

between fact and opinion. B. Violated the AIMR Standards of Professional Conduct because he made conclusions

based only on his own research. C. Violated the AIMR Standards of Professional Conduct because he did not indicate the

basic characteristics of the investment. D. Complied with the AIMR Standards of Professional Conduct.

4. All of the following statements about the payment of brokerage commissions (soft dollars) are true EXCEPT: A. brokerage commissions should be directed in the best interests of the client. B. brokerage commissions may be directed to pay for the investment manager's operating

expenses. C. brokerage commissions may be directed to pay for securities research used in managing

the client's portfolio. D. brokerage commissions paid should be commensurate with the value of the brokerage

and research services received.

5. John Vickery, a trustee for the pension plan of Richardson Industries, has just received a commission schedule from XYZ Brokerage, a firm with which he is not now trading. The fee schedule is lower than the schedule of ABC Brokerage, which is the firm Vickery now uses for most transactions. ABC also provides research data and performance measurement for the pension plan, services that XYZ cannot handle. Vickery is concerned that he may be violating his fiduciary duty of loyalty by not using the lowest cost brokerage firm. Based on AIMR Standards of Professional Conduct, which of the following statements is true? A. Vickery will violate his fiduciary duty unless he immediately begins trading through

XYZ. B. Vickery will not violate his fiduciary duty unless he personally profits from his

relationship with ABC. C. Vickery can continue to trade through ABC if he determines, in good faith, that the value

of the services is commensurate with the cost. D. The "safe harbor" concept allows fiduciaries to pay higher commissions even though the

services are not fully commensurate with the cost.


6. Tony Clinton, a portfolio manager with Northwest Bank, has just been given investment authority for a newly-acquired pension account. Client objectives have not yet been established. On the day Clinton was given the account, $2 million of the account’s bond holdings, representing 4 percent of the portfolio, matured. Based on AIMR Standards of Professional Conduct, which of the following is Clinton's best course of action on that day? A. Make no decision until the client’s objectives are established. B. Invest the proceeds in line with the bank's current asset allocation strategy. C. Invest the proceeds in cash equivalents until Clinton can arrange a meeting with the client

to establish fund objectives. D. Contact the client's former investment advisor to find out the appropriate investment

action based on previously-used guidelines.

7. Jim Orlando, CFA, is a research analyst with a brokerage firm. He decided to change his recommendation on the common stock of Alpha Company from a "buy" to a "sell." He faxed this change in investment advice to all his current customers. The next day, a new customer called to buy 500 shares of Alpha Company. According to AIMR Standards of Professional Conduct, Orlando: A. should advise the customer of the change in recommendation before accepting the order. B. may accept the order because he has complied with the standard on fair dealing with

customers. C. may accept the order when the customer specifies in writing that he was notified of the

change in the recommendation. D. should delay executing the order until five days have elapsed after the communication of

the change in recommendation.

8. Which of the following statements is a recommendation of the Standards of Practice Handbook with regards to personal investing? A. Preclearance of all trades. B. Disclosure of all holdings in which the employee has a beneficial interest. C. Restrictions on participation in an IPO of equity or equity-related securities. D. All of the above.


9. Don Smith, a CFA candidate employed by Hunter Investment Counselors, Inc., provides investment advice to the board of trustees of a private university endowment fund. The trustees have given Smith the fund's financial information, including planned expenditures. Smith received a phone call on Friday afternoon from Mark Murdock, a prominent alumnus, requesting that Smith fax to him comprehensive financial information about the fund. According to Murdock, he has a potential contributor but needs the information today to close the deal and cannot contact any of the trustees. Based on AIMR Standards of Professional Conduct, Smith may: A. send Murdock the information because disclosure would benefit the client. B. send Murdock the information provided Smith promptly notifies the trustees. C. send Murdock the information because it is not material nonpublic information. D. not send Murdock the information because Smith must preserve confidentiality.

10. Jane Doe, a CFA candidate, is a junior research analyst with Howard & Sons, a brokerage and investment banking firm. Howard's mergers and acquisitions department, which handles mergers and acquisitions, has represented Britland Company in all its acquisitions for the past 20 years. Two of Howard's senior officers are directors of various Britland subsidiaries. Doe has been asked to write a research report on Britland. Based on AIMR Standards of Professional Conduct, what is Doe's best course of action? A. Doe may write the report provided the officers agree not to alter it. B. Doe may write the report if she discloses Howard & Sons’s special relationship with

Britland in the report. C. Doe may write the report but must refrain from expressing any opinions because of the

special relationships between the two companies. D. Doe should not write the report because the two Howard & Sons officers are

"constructive insiders."

11. Bob Ryan, CFA, is an analyst with a large insurance company. His personal portfolio includes a significant investment in the common stock of QRS Company, which his firm does not now follow. The director of the insurance company’s research department asks Ryan to analyze QRS and write a report about its investment potential. Based on AIMR Standards of Professional Conduct, Ryan should: A. place his shares of QRS in a trust. B. sell his shares of QRS before completing the report. C. disclose the ownership of the stock to his employer and in the report. D. decline to write the report without specific approval of his supervisor.


12. Stone, a financial analyst, follows the Amity Paving Company for his employer. Which of the following scenarios is Stone least likely to have to disclose to his employer: A. Stone's ownership of Amity securities. B. Stone's participation on Amity's board of directors. C. Stone's personal relationship with the CEO of Amity. D. The fact that Stone's son worked at Amity as a laborer during the summer while in

school.

13. Gaines, a financial analyst for Skinner Investment Counseling, is told by the investor relations representative for Firebird Avionics, a major aircraft manufacturer, that the firm is in the final stages of building a new fuel efficient jet engine. This information is divulged by Firebird at the most recent quarterly conference call for analysts. In a research report, Gaines uses this information along with other information he obtained from the company distributed to the public in a research report that includes a "buy" recommendation for Firebird stock. Which of the following statements is true: A. Gaines violated AIMR Standards of Professional Conduct because he used material

inside information. B. Gaines violated AIMR Standards of Professional Conduct because he failed to separate

opinion from fact. C. Gaines violated AIMR Standards of Professional Conduct because he has a material

misrepresentation in his report. D. Gaines' actions did not violate AIMR Standards of Professional Conduct.

14. The term "material" in the phrase “material nonpublic information” refers to information that is likely to affect significantly the market price of the issuing company's securities or that: A. is derived by the financial analyst from direct communication with an issuing company's

management. B. is likely to preclude the financial analyst or the analyst’s firm from rendering unbiased or

objective advice. C. is acquired by the financial analyst from a special or confidential relationship with the

issuing company. D. is likely to be considered important by reasonable investors in determining whether to

trade a particular security.


15. Which of the following statements regarding the AIMR Performance Presentation Standards is false? A. The AIMR-PPS standards are voluntary standards for the industry. B. The AIMR-PPS standards are explicitly incorporated in the AIMR Code of Ethics and

Standards of Professional Conduct. C. One of the stated goals of the Standards is to achieve greater uniformity and

comparability among performance presentations. D. Some aspects of the AIMR-PPS are mandatory (i.e., they must be followed to claim

compliance); other aspects are recommended (i.e., they should be followed).

16. All of the following are main topics of the AIMR Performance Presentation Standards EXCEPT: A. disclosures. B. selection of an index. C. calculations of returns. D. creation and maintenance of composites.

17. Which of the following is/are correct under the Code and Standards?

I. AIMR members are prohibited from undertaking independent practice in competition with their employer.

II. Written consent from the employer is necessary to permit independent practice that could result in compensation or other benefit in competition with a member’s employer.

III. Written consent from the outside perspective client is necessary to permit independent practice that could result in compensation or other benefit in competition with a member’s employer.

IV. Members are prohibited from making arrangements or preparations to go into a competitive business before terminating their relationship with their employer.

A. IV only. B. I and IV only. C. II and III only. D. II, III, and IV only.


18. Which of the following is/are (a) correct statement(s) of a member’s duty under the Code and Standards?

I. In the absence of specific applicable law or other regulatory requirements, the Code and Standards govern the member’s actions.

II. A member is required to comply only with applicable local laws, rules, regulations, or customs even though the AIMR Code and Standards may impose a higher degree of responsibility or a higher duty on the member.

III. A member who trades securities in a foreign securities market where no applicable local laws or stock exchange rules regulate the use of material nonpublic information may take investment action based on material nonpublic information.

A. I only. B. III only. C. I and II only. D. II and III only.


QUESTIONS 19 THROUGH 36 RELATE TO QUANTITATIVE ANALYSIS AND ARE ALLOCATED 27 MINUTES (OR 1 ½ MINUTES EACH).

19. What is the present value of the following stream of year-end payments discounted at 12 percent per year?

Year 1 Year 2 Year 3 Year 4 –$100 –$200 –$100 $450

A. –$53.37. B. –$44.65. C. –$33.92. D. –$13.06.

20. An individual deposits $1,500 today and $1,500 one year from today into an interest-earning account. The deposits earn 12 percent compounded annually. The total amount in the account two years from today is closest to: A. $3,180. B. $3,360. C. $3,382. D. $3,562.

21. An investment of $231 will increase in value to $268 in three years. The annual compound growth rate is closest to: A. 3.0%. B. 4.0%. C. 5.0%. D. 6.0%.

22. An individual is buying a $100,000 house with a 30-year mortgage requiring payments to be made at the end of each year. The interest rate is 10 percent and the first payment is due one year from today. The annual payment is closest to: A. $10,608. B. $10,672. C. $12,343. D. $13,303.


23. An individual is creating a charitable trust to provide six annual payments of $20,000 each, beginning today. How much money must the individual set aside now at 10 percent interest compounded annually to meet the required disbursements? A. $75,815. B. $78,815. C. $83,397. D. $95,816.

24. At an 8 percent rate of return, how much must an investor have in her investment account on her 65th birthday in order that she can withdraw $30,000 on that birthday and on each of the next 19 birthdays? A. $264,540. B. $288,120. C. $294,540. D. $318,108.

25. To lease some specialized equipment, Luck Enterprises has acquired a capital lease that is carried on its books at a present value of $50,000 (discounted at 16 percent) and an annual payment of $10,000. At the end of the lease, Luck Enterprises will take possession of the equipment, which will have a value of $7,000 at that time. What is the amount of interest expense from the lease in the first and second years? First Year Second Year A. $6,880 $6,381 B. $8,000 $6,720 C. $8,000 $7,680 D. $10,000 $10,000 Use the following expectations for Stocks X and Y for Questions 26 through 28. Round to the nearest percent.

Bear Market Normal Market Bull Market Probability 0.2 0.5 0.3 Stock X –20% 18% 50% Stock Y –15% 20% 10%


26. What is the expected return for Stocks X and Y? Stock X Stock Y A. 18% 5% B. 18% 12% C. 20% 11% D. 20% 10%

27. The standard deviation of returns on Stocks X and Y is closest to: Stock X Stock Y A. 15% 26% B. 20% 4% C. 24% 13% D. 28% 8%

28. An investor has a $10,000 portfolio consisting of $9,000 in Stock X and $1,000 in Stock Y. What is the investor’s expected return on the portfolio? A. 18%. B. 19%. C. 20%. D. 23%.

29. The standard deviation of Stock A is 0.20. The standard deviation of Stock B is 0.12. The covariance between Stock A and B is 0.0096. The correlation between Stock A and Stock B is: A. 0.20. B. 0.24. C. 0.36. D. 0.40.

30. If the correlation coefficient between Baker Fund and the S&P 500 Stock Index is 0.70, what percentage of Baker Fund's total risk is specific (i.e., unsystematic)? A. 35%. B. 49%. C. 51%. D. 70%.


31. The correlation between the Charlottesville International Fund and the EASE Index is 1.0. The expected return on the EASE Index is 11 percent; the expected return on the Charlottesville International Fund is 9 percent; and the risk-free return in EASE countries is 3 percent. Based on this information, the implied beta of the Charlottesville International Fund is: A. negative. B. 0.75. C. 0.82. D. 1.00. Use the following data to answer Questions 32 through 34. The annual rate of return for JSI's common stock has been:

1993 1994 1995 1996 Return 14% 19% –10% 14%

32. What is the arithmetic mean rate of return for JSI's common stock over the four years? A. 8.62%. B. 9.25%. C. 14.00%. D. 14.25%.

33. What is the geometric mean rate of return for JSI's common stock over the four years? A. 8.62%. B. 9.25%. C. 14.21%. D. It cannot be calculated because of the negative return in 1995.

34. What are the median and mode of the rate of return data for JSI's common stock? Median Mode A. 9.25% 14.50% B. 14.00% undefined C. 14.00% 14.00% D. 14.50% 14.00%


35. If Stock X’s expected return is 0.30 and its expected variance is 0.0025, Stock X’s expected coefficient of variation is: A. 0.167. B. 0.833. C. 1.200. D. 6.000.

36. When several independent variables in a multiple regression are highly correlated with each other, the problem is called: A. autocorrelation. B. multicollinearity. C. homoscedasticity. D. heteroscedasticity.


QUESTIONS 37 THROUGH 50 RELATE TO ECONOMIC ANALYSIS AND ARE ALLOCATED 21 MINUTES (OR 1 ½ MINUTES EACH).

37. In macroeconomics, the crowding-out effect refers to: A. the impact of government deficit spending on inflation. B. a situation in which the unemployment rate is below its natural rate. C. the impact of government borrowing on interest rates and private investment. D. increasing population pressures and associated movements toward zero population

growth.

38. The public in a country decides to decrease its holdings of currency and to increase its holdings of checking account funds by an equal amount. If the country’s central bank does not take any offsetting actions, how will the money supply be affected? A. The money supply will decrease. B. The money supply will not be affected because the increase in checking account holdings

will offset the decrease in currency holdings. C. The action does not directly affect the money supply, but the action will reduce the

excess reserves of banks and tend to reduce the money supply indirectly. D. The action does not directly affect the money supply, but the action will increase the

excess reserves of banks and tend to increase the money supply because banks may expand their loans.

39. Use the table below to answer the question.

Observed Period Rate of Inflation 1 2% 2 4 3 6 4 8

According to the adaptive expectations hypothesis, at the beginning of period 4, decision makers would expect the rate of inflation to be: A. 4%. B. 5%. C. 6%. D. 8%.


40. When the price elasticity of demand is inelastic: A. price and total revenue move in the same direction. B. price and total revenue move in the opposite direction. C. total revenue increases whether price goes up or down. D. total revenue remains constant whether price moves up or down.

41. A 10 percent increase in income caused a group of consumers to increase their purchases of television sets from 100 to 110. What would be the group's income elasticity of demand for television sets? A. 0.10. B. 0.83. C. 1.00. D. 2.00.

42. How would an unanticipated shift to a more expansionary monetary policy in the United States typically affect the demand for foreign currencies in the United States and the value of the U.S. dollar? Demand for Foreign Exchange Foreign Currencies Value of the Dollar A. Increase No change B. Increase Decrease C. No change Decrease D. Decrease Increase

43. If a profit-maximizing firm finds that its marginal revenue exceeds its marginal cost, the firm should: A. increase output no matter whether the firm is a price taker or a price searcher. B. decrease output no matter whether the firm is a price taker or a price searcher. C. increase output if the firm is a price taker but not necessarily if the firm is a price

searcher. D. increase output if the firm is a price searcher but not necessarily if the firm is a price

taker.


44. The law of comparative advantage suggests that:

I. specialization and exchange will permit trading partners to maximize their joint output.

II. a nation can gain from trade even when it has an absolute disadvantage in the production of all goods.

III. a nation cannot gain from trade when its trading partners are low-wage countries.

A. I only. B. II only. C. I and II only. D. II and III only.

45. The following chart illustrates the domestic prices of three items of similar quality in the United States and Britain.

United States Britain Items (dollars) (pounds) Shoes 20 80 Watches 40 180 Electric motors 80 600

If $1 exchanges for five British pounds and transportation costs are zero, Britain will import: A. all three goods from the United States. B. electric motors and the United States will import shoes and watches. C. shoes and watches and the United States will import electric motors. D. import shoes and the United States will import watches and electric motors.

46. If the exchange rate value of the British pound goes from US$1.80 to US$1.60, then: A. the pound has appreciated, and the British will find U.S. goods cheaper. B. the pound has depreciated, and the British will find U.S. goods cheaper. C. the pound has appreciated, and the British will find U.S. goods more expensive. D. the pound has depreciated, and the British will find U.S. goods more expensive.


47. Under a system of fixed exchange rates, a nation experiencing an excess of imports over exports can try to remedy this situation by: A. adopting tariffs and quotas. B. reducing its income from investments abroad. C. applying an expansionary macroeconomic policy to drive prices up and interest rates

down. D. building up its reserves of foreign currencies and reserve balances with the International

Monetary Fund.

48. Under a system of fixed exchange rates, a country can try to remedy its balance-of-payments deficit by: A. reducing its income from investments abroad. B. applying restrictive macroeconomic policy to keep prices down and interest rates up. C. applying expansionary macroeconomic policy to drive prices up and interest rates down. D. building up its reserves of foreign currencies and reserve balances with the International

Monetary Fund.

49. A Japanese automobile manufacturer builds an automobile plant in the United States. In the foreign exchange market, this action creates: A. a supply of both dollars and yen. B. a demand for both dollars and yen. C. a supply of dollars and a demand for yen. D. a demand for dollars and a supply of yen.

50. All of the following are expected impacts of a country’s unanticipated shift to a more expansionary monetary policy EXCEPT: A. real interest rates should rise. B. there will likely be a net capital outflow. C. value of the domestic currency should depreciate. D. the current account should shift toward a surplus.


QUESTIONS 51 THROUGH 80 RELATE TO FINANCIAL STATEMENT ANALYSIS AND ARE ALLOCATED 45 MINUTES (OR ½ MINUTES EACH). Note to Candidates: Assume U.S. GAAP (generally accepted accounting principles)

applies unless otherwise noted.

51. For a material item to be classified as an extraordinary item on the income statement, the item must be: A. estimated and probable. B. current and unusual in frequency. C. probable and infrequent in nature. D. unusual in nature and infrequent in occurrence.

52. When a company discontinues and disposes of an operation, the action is considered: A. an extraordinary item. B. a prior-period adjustment. C. a cumulative effect of a change in an accounting principle. D. separately and is shown net of taxes on the income statement.

53. A firm has a current ratio greater than 1.0. If the firm’s ending inventory is understated by $3,000 and beginning inventory is overstated by $5,000, the firm’s net income and the current ratio will be:

Net Income Current Ratio A. overstated by $2,000 lower B. understated by $2,000 lower C. understated by $8,000 lower D. understated by $8,000 higher

54. If net purchases are overstated by $1,000 and ending inventory is overstated by $4,000, then net income will be. A. overstated by $1,000. B. overstated by $3,000. C. overstated by $5,000. D. understated by $4,000.


55. Which of the following statements about inventories is true? A. U.S. generally accepted accounting principles require the use of the lower-of-cost-or-

market-valuation basis for inventories. B. Last-in, first-out (LIFO) inventory accounting is less likely to facilitate management of

income than first-in, first-out (FIFO) accounting. C. During inflation, LIFO inventory accounting tends to overstate the current ratio. D. FIFO inventory balances generally contain old and outdated costs that have little or no

relationship to current costs.

56. In periods of rising prices and stable or increasing inventory quantities, which of the following descriptions of the impact of LIFO and FIFO on the financial statements are true? LIFO FIFO

I. Cost of goods sold Higher Lower II. Net income Lower Higher

III. Cash flows Lower Higher IV. Working capital Higher Lower

A. I and II only. B. I and IV only. C. II and III only. D. III and IV only.

57. A switch from the FIFO method to the LIFO method of inventory accounting: A. applies to all inventory classifications. B. results in a lower current ratio during periods of rising prices. C. removes the opportunity to affect net income by varying purchasing policy. D. results in a more meaningful inventory valuation during periods of rising prices.

58. Which of the following is a change in an accounting principle? A. A change from FIFO to LIFO. B. Recording a prior-period adjustment. C. A change in the estimated service life of machinery. D. Recording depreciation expense for the first time on machinery purchased five years ago.


59. The two inventory accounting methods most commonly used by the major non-U.S. economies are: A. FIFO and LIFO. B. LIFO and the units-of-production method. C. FIFO and the weighted-average cost method. D. LIFO and the weighted-average cost method.

60. The capitalization of interest cost during construction: A. increases future net income. B. increases future depreciation expense. C. decreases future depreciation expense. D. decreases net income during the construction phase.

61. For companies in an expansion phase, capitalization of interest may result in a gain in earnings over an extended period because: A. the cost of financing project debt will exceed the cost of equity financing. B. the average projected expenditures for the period will exceed specific borrowings. C. earnings will be greater under capitalization than under the expense method over the life

of the qualifying asset. D. the amount of interest amortization will not catch up with the amount of interest

capitalized in the current period.

62. Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment? Depreciation Method Inventory Method A. Straight line FIFO B. Straight line LIFO C. Double declining balance FIFO D. Double declining balance LIFO

63. To account for the purchase of a machine, a company may use either straight-line (SL) depreciation or the sum-of-the-year’s-digits (SYD) depreciation. Return on investment for the machine will: A. remain constant under SL. B. decrease over time under SL. C. initially be higher under SL than under SYD. D. initially be higher under SYD than under SL.


64. Which of the following statements about straight-line depreciation is true? Straight-line depreciation: A. results in a decreasing return on equity over the asset's life. B. introduces a built-in increase in return on investment over the asset's life. C. recognizes the increasing rate of obsolescence of an asset with the passage of time. D. results in higher total tax payments over the life of an asset than accelerated depreciation.

65. Which of the following statements about accounting practices is true? A. Capitalization of interest results in higher earnings over the life of an asset. B. FIFO results in more conservative earnings figures, except during deflationary periods. C. Interest may be capitalized for some assets intended for use by the firm but not for assets

intended to be sold. D. In the absence of a decision to abandon or dispose of assets at a loss, the timing and

amount of any write-down are largely discretionary.

66. Which of the following statements about deferred taxes is true? Deferred taxes: A. will decrease only when a cash payment is made. B. are not found on the liability side of the balance sheet. C. result from permanent differences between taxable and reported earnings. D. that arise from depreciation of a particular asset will ultimately reduce to zero as the item

is depreciated.

67. White Company has a net temporary difference between tax and book income of $90 million, resulting in deferred taxes of $30.6 million. Under Statement of Financial Accounting Standards 96, an increase in the tax rate would have which of the following impacts on deferred taxes and net income? Deferred Taxes Net Income A. Increase No effect B. Increase Decrease C. No effect No effect D. No effect Decrease

68. Which of the following statements best explains what occurs when a deferred tax liability account "reverses"? A. A cash drain takes place. B. Cash outflow is lessened by the amount of the reversal. C. The actual tax bill is the same as in the expense statement. D. The actual tax bill is lower than the expense in the income statement.


69. All of the following statements about accounting practices are true EXCEPT:

A. Debt is considered to be extinguished if the firm places risk-free assets in an irrevocable

trust solely for extinguishing that debt. B. Commitments under unconditional purchase obligations that provide financing to

suppliers need not be recognized on the purchaser's balance sheet. C. Violation of a long-term debt covenant will cause the debt to be classified as short-term

debt if the condition is not reversed before the end of the accounting period. D. Short-term obligations may be classified as long-term obligations f the company intends

to refinance them on a long-term basis and can demonstrate the ability to do so.

70. Empire Corporation issues a zero-coupon bond with $100,000 face value, a 5-year maturity, and a market rate of 8 percent. Interest on corporate bonds is normally paid semi annually. In the liability section of Empire’s balance sheet, the proceeds from selling the zero-coupon bond immediately after issuance will be closest to: A. $60,000. B. $67,556. C. $68,058. D. $100,000.

71. If a firm capitalizes a lease instead of treating the lease as an operating lease, the effect on the current ratio and the debt to equity ratio will be: Current Ratio Debt/Equity Ratio A. Increase Increase B. Increase Decrease C. Decrease Increase D. Decrease Decrease

72. Firms report payments for capital leases in the cash flow statement: A. only as investing cash flows. B. only as financing cash flows. C. partly as operating cash flows and partly as investing cash flows. D. partly as operating cash flows and partly as financing cash flows.


73. Compared with firms with capital leases, firms with operating leases generally report: A. lower cash flow from operations. B. higher cash flow from operations. C. identical cash flow from operations. D. levels of cash flow from operations that may be higher or lower depending on market

interest rates.

74. Under Statement of Financial Accounting Standards 87, firms must disclose all of the following for defined-benefit pension plans EXCEPT: A. the fair value of plan assets. B. the projected benefit obligation. C. the cost of administering the plan. D. the accumulated benefit obligation.

75. Ten years ago, a firm issued $10 million in $1,000 par value bonds with an 8 percent coupon rate paid annually. The bonds mature 15 years from today and now sell at 97 percent of their par value. If the firm's marginal tax rate is 28 percent, what is its after-tax cost of debt? A. 5.76%. B. 5.94%. C. 6.02%. D. 8.36%.

76. Global Company has 150,000 bonds outstanding, each with a $1,000 par value and a current market price of $980. Global also has 3 million shares of common stock outstanding with a current market price of $36 per share and a book value of $45 per share. Global’s management does not expect to change the firm's capital structure in any material way in the future. What weights for debt and equity should the firm use to calculate its weighted-average cost of capital? Debt Equity A. 52.13% 47.87% B. 52.63% 47.37% C. 57.65% 42.35% D. 58.14% 41.86%


77. A firm must externally raise $25 million for a new project. The flotation costs for selling debt and equity are 4 percent and 12 percent, respectively. The firm has a target debt-to-equity ratio of 50 percent. If the firm considers flotation costs, how much capital must the firm raise for the new project? A. $27.17 million. B. $27.33 million. C. $27.57 million. D. $29.00 million.

78. Dillon Lighting Company practices a strict residual dividend policy and maintains a capital structure of 25 percent debt and 75 percent equity. The firm's after-tax earnings for the year are $6 million. What is Dillon Lighting’s maximum amount of capital spending possible without selling new equity? A. $4.5 million. B. $6.0 million. C. $7.5 million. D. $8.0 million.

79. According to the clientele effect of dividend policy, which of the following groups is/are attracted to low-payout common stocks?

I. Corporate investors. II. Tax-exempt Investors.

III. Wealthy individual investors. A. I only. B. II only. C. I and II only. D. I, II, and III.

80. With corporate taxes and bankruptcy costs, the value of the firm is maximized when which of the following is/are minimized?

I. The weighted average cost of capital. II. The probability of bankruptcy.

III. The cost of equity capital. IV. The cost of debt capital.

A. I only. B. I and II only. C. III and IV only. D. I, II, and IV only.


QUESTIONS 81 THROUGH 92 RELATE TO GLOBAL MARKETS AND INSTRUMENTS AND ARE ALLOCATED 18 MINUTES (OR 1 ½ MINUTES EACH).

81. Yields on nonconvertible preferred stock are usually lower than yields on bonds of the same company because of differences in: A. risk. B. taxation. C. marketability. D. call protection.

82. All else being equal, which of the following bonds most likely would sell for the highest price (or lowest yield)? A. Putable debenture. B. Callable debenture. C. Putable mortgage bond. D. Callable mortgage bond.

83. Which of the are following characteristics of good financial markets for investors?

I. Availability of timely and accurate information. II. Liquidity.

III. Large bid-ask spreads. IV. Rapid price adjustment to new information.

A. I and IV only. B. II and III only. C. I, II, and IV only. D. I, II, III, and IV.

84. Which of the following best describes a securities exchange, such as the Paris Bourse, that uses a call auction system to determine prices for a security? A. Market makers or specialists are setting prices. B. A single market price is established for all executed orders. C. Prices are being determined for call options on the security. D. Prices are being determined for transactions off the floor of the exchange.


85. Based on empirical evidence, a U.S. equity money manager who wants to acquire the full benefits of international diversification would be best advised to:

I. Invest directly in foreign stocks. II. Invest in U.S. multinational firms.

III. Hedge his or her portfolio by short selling foreign stocks. A. I only. B. II only. C. II and III only. D. I, II, and III.

86. A put on Stock X with a strike price of $40 is priced at $2.00 per share; while a call with a strike price of $40 is priced at $3.50. What is the maximum per share loss to the writer of the uncovered put and the maximum per share gain to the writer of the uncovered call? Maximum Loss Maximum Gain to Put Writer to Call Writer A. $38.00 $3.50 B. $38.00 $36.50 C. $40.00 $3.50 D. $40.00 $40.00

87. If stock prices in general are expected to increase substantially after the transaction is completed, which of the following transactions in the stock index option market would be most risky for an investor to undertake? A. Buying a put option. B. Buying a call option. C. Writing an uncovered put option. D. Writing an uncovered call option.

88. Which of the following statements describing options is false? A. A put option’s profit increases when the value of the underlying asset increases. B. A call option will be exercised only if the market value of the underlying asset is more

than the exercise price. C. A put option will be exercised only if the market value of the underlying asset is less than

the exercise price. D. A put option gives its holder the right to sell an asset for a specified price on or before the

option’s expiration date.


89. Futures contracts differ from forward contracts in which of the following ways?

I. Futures contracts are standardized. II. Performance of each party in a futures transaction is guaranteed by a

clearinghouse. III. Futures contracts require that traders post margin in order to trade.

A. I and II only. B. I and III only. C. II and III only. D. I, II, and III.

90. Most futures contracts are closed through: A. delivery. B. arbitrage. C. reversing trade. D. exchange-for-physicals.

91. An investor purchases stock for $38/share and sells call options on that stock with an exercise price of $40 for a premium of $3/share. Ignoring dividends and transactions costs, what maximum profit can the investor earn if the position is held to expiration? A. $2. B. $3. C. $5. D. none of the above.

92. Which of the following statements about European and American options is/are true?

I. An American option permits the owner to exercise at any time before or at expiration. A European option permits the owner to exercise only at expiration.

II. In actual markets, most options are European options. III. American options are easier to analyze.

A. I only. B. I and II only. C. I and III only. D. none of the above.


QUESTIONS 93 THROUGH 106 RELATE TO ASSET VALUATION (EQUITY ANALYSIS AND FIXED-INCOME ANALYSIS) AND ARE ALLOCATED 21 MINUTES (OR 1 ½ MINUTES EACH).

93. In applying the constant-growth dividend discount model, lowering the required rate of return on the stock will cause the stock’s intrinsic value to: A. increase. B. decrease. C. remain unchanged. D. decrease or increase, depending on other factors.

94. If all other factors remain unchanged, which of the following events would most likely reduce a firm's price/earnings multiple? A. Investors become less risk averse. B. The dividend payout ratio increases. C. The yield on Treasury bills increases. D. The level of inflation is expected to decline.

95. A stock has a required return of 15 percent, a constant growth rate of 10 percent, and a dividend payout ratio of 45 percent. The stock’s price-earnings multiple is most likely to be: A. 3.0 times. B. 4.5 times. C. 9.0 times. D. 11.0 times.

96. If a firm’s return on equity is 15 percent and its retention ratio is 40 percent, the sustainable growth rate of the firm’s earnings and dividends should be: A. 6%. B. 9%. C. 15%. D. 40%.


97. Technical analysis is best characterized by which of the following sets of assumptions? A. Security prices adjust rapidly to new information, and liquidity is provided by securities

dealers. B. Security prices adjust gradually to new information, and liquidity is provided by

securities dealers. C. Security prices adjust rapidly to new information, and market prices are determined by

the interaction of supply and demand. D. Security prices adjust gradually to new information, and market prices are determined by

the interaction of supply and demand.

98. Which of the following would be a bullish signal to a technical analyst using contrary opinion rules? A. Mutual funds have a relatively small cash position. B. The ratio of odd-lot short sales to total odd-lot sales is relatively high. C. A large proportion of speculators expect the price of stock index futures to rise. D. The ratio of the Nasdaq Stock Market volume to New York Stock Exchange volume is

relatively high.

99. When technical analysts say a stock has “good relative strength,” they mean the: A. ratio of the price of the stock to a market index has trended upward. B. recent trading volume in the stock has exceeded the normal trading volume. C. total return on the stock has exceeded the total return on other stocks in the same

industry. D. stock has performed well compared with other stocks in the same risk category as

measured by beta.

100. All of the following characterize the maturity stage of the industry life cycle EXCEPT: A. slowly growing sales. B. a highly competitive environment. C. many new competitors enter the market. D. price tends to be a major competitive weapon.


101. An investment in a coupon bond will provide the investor with a return equal to the bond's yield to maturity at the time of purchase if:

I. the bond is called for redemption at a price that exceeds its par value. II. all sinking fund payments are made in a prompt and timely fashion during the

life of the issue. III. the reinvestment rate is the same as the bond's yield to maturity.

A. I only. B. III only. C. I and II only. D. II, and III only.

102. Bond price volatility normally is: A. lower for higher coupons. B. lower for longer duration. C. greater for shorter maturities. D. none of the above.

103. The yield to maturity on a bond is: A. the interest rate that makes the present value of the payments equal to the bond price. B. based on the assumption that all future payments received are reinvested at the coupon

rate. C. based on the assumption that all future payments received are reinvested at future market

rates. D. below the coupon rate when the bond sells at a discount and above the coupon rate when

the bond sells at a premium.

104. Convexity of bonds increases in importance when interest rates are: A. low. B. high. C. expected to change very little. D. less than the coupon rate on the bond.


105. Which of the following statements about the term structure of interest rates is true? A. The expectations hypothesis contends that the long-term rate is equal to the anticipated

short-term rate. B. The liquidity preference theory indicates that, all else being equal, longer maturities will

have lower yields. C. The segmented market theory contends that borrowers and lenders prefer particular

segments of the yield curve. D. The expectations hypothesis indicates a flat yield curve if anticipated future short-term

rates exceed current short-term rates.

106. Which of the following two sources of bond risk have offsetting effects? A. default risk and interest rate risk. B. reinvestment risk and default risk. C. interest rate risk and reinvestment risk. D. none of the above.


QUESTIONS 107 THROUGH 120 RELATE TO PORTFOLIO MANAGEMENT AND ARE ALLOCATED 21 MINUTES (OR 1 1/2 MINUTES EACH).

107. All of the following statements about various types of risk are true EXCEPT: A. Liquidity risk is the uncertainty introduced by the secondary market for an investment. B. Business risk is the uncertainty of income flows caused by the nature of a firm’s

business. C. Financial risk is the uncertainty introduced by the method by which the firm finances its

investments. D. Exchange rate risk is the uncertainty of returns caused by the possibility of a major

change in the political or economic environment of a country.

108. A company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, the most likely expectation is: A. an abnormal price change at the announcement. B. an abnormal price decrease after the announcement. C. an abnormal price increase before the announcement. D. no abnormal price change before or after the announcement.

109. The semi-strong form of the efficient market hypothesis asserts that stock prices: A. may be predictable. B. fully reflect all public information. C. fully reflect all historical security market information. D. fully reflect all relevant information from public and private sources.

110. Which of the following would provide evidence against the semi-strong form of the efficient market theory? A. Trend analysis is worthless in determining stock prices. B. About 50 percent of pension funds outperform the market in any year. C. All investors have learned to exploit signals about future performance. D. Low P/E stocks generally have positive abnormal returns over the long run. Use the following information for Questions 111 and 112. Bill Parsons manages an equity fund with an expected risk premium of 10 percent and an expected standard deviation of 14 percent. The rate on U.S. Treasury bills is 6 percent. Diane Webb, Parson’s client, chooses to invest $60,000 of her portfolio in the equity fund and $40,000 in a Treasury-bill money market fund.


111. The expected return on Webb’s portfolio will be:

A. 8.4%. B. 10.0%. C. 12.0%. D. 14.0%.

112. The expected standard deviation of return on Webb’s portfolio will be: A. 8.4%. B. 10.0%. C. 12.0%. D. 14.0%.

113. The concept of beta is most closely associated with: A. liquidity risk. B. correlation coefficients. C. mean-variance analysis. D. the capital asset pricing model.

114. Capital asset pricing theory asserts that portfolio returns are best explained by: A. specific risk. B. diversification. C. systematic risk. D. economic factors.

115. Which statement about portfolio diversification is true? A. Proper diversification can reduce or eliminate systematic risk. B. As more securities are added to a portfolio, total risk is likely to fall at a decreasing rate. C. Diversification reduces the portfolio's expected return because diversification reduces a

portfolio's total risk. D. The risk-reducing benefits of diversification do not occur meaningfully until at least 30

individual securities are included in the portfolio.


116. For a two-stock portfolio, the most preferred correlation coefficient between the two stocks would be: A. –1.00. B. 0. C. +0.50. D. +1.00.

117. An analyst gathers the following data:

Expected (estimated) rate return on the market = 15% Risk-free rate = 8% Expected (estimated) rate of return on Stock X = 17% Stock X’s beta = 1.25

Using these data and the capital asset pricing model, which of the following statements about X’s stock is true? Stock X is: A. properly valued. B. overvalued by 1.75 percentage points. C. undervalued by 1.40 percentage points. D. undervalued by 0.25 percentage points.

118. The security market line depicts: A. the market portfolio as the optimal portfolio of risky securities. B. a security's expected rate of return as a function of its systematic risk. C. the relationship between a security's return and the return on an index. D. the complete portfolio as a combination of the market portfolio and the risk-free asset.

119. The expected return of a zero-beta security is: A. a zero rate of return. B. a negative rate of return. C. the market rate of return. D. the risk-free rate of return.


120. Both Portfolio X and Portfolio Y are well-diversified. The risk-free rate is 8 percent, and the return for the market is 16 percent. That is:

Portfolio Expected Return Beta X 16% 1.00 Y 12% 0.25

In this situation, which of the following about Portfolio X and Portfolio Y is true? Portfolio X Portfolio Y A. Overvalued Properly valued B. Properly valued Undervalued C. Undervalued Properly valued D. Properly valued Overvalued


GUIDELINE ANSWERS FOR SAMPLE EXAM 1

1. D Reference: Standards of Practice Handbook, 7th ed., Standard II(B), Professional Misconduct, pp. 23–25, Standard III(E), Responsibilities of Supervisors, pp. 53–59 and Standard IV(B.1), Fiduciary Duties, pp. 83–93.

2. D Reference: Standards of Practice Handbook, 7th ed., Standard II(B), Professional Misconduct, pp. 23–25, Standard III(E), Responsibilities of Supervisors, pp. 53–59 and Standard IV(B.1), Fiduciary Duties, pp. 83–93.

3. A Reference: Standards of Practice Handbook, 7th ed., Standard IV(A.2), Research Reports, part (b) in particular, pp. 69–74.

4. B Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.1), Fiduciary Duties, pp. 83–93, and Fiduciary Duty Topical Study, pp. 155–168.

5. C Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.1), Fiduciary Duties, pp. 83–93, and Fiduciary Duty Topical Study, pp. 155–168.

6. C Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.2), Portfolio Investment Recommendations and Actions, pp. 95–102.

7. A Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.3), Fair Dealing, pp. 103–13.


8. D

Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.4), Priority of Transactions, pp.115–121, and Personal Investing Topical Study, pp. 183–189.

9. D Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.5), Preservation of Confidentiality, pp. 123–26.

10. B Reference: Standards of Practice Handbook, 7th ed., Standard IV(A.2), Research Reports, pp. 69–81, and Standard IV(B.7), Disclosure of Conflicts to Clients and Prospects, pp. 131–37.

11. C Reference: Standards of Practice Handbook, 7th ed., Standard III(C), Disclosure of Conflicts to Employer, pp. 47–50, and Standard IV(B.7), Disclosure of Conflicts to Clients and Prospects, pp. 131–37.

12. D Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.7), Disclosure of Conflicts to Employer, pp. 47–50.

13. D Reference: Standards of Practice Handbook, 7th ed., Standard V(A), Prohibition against Use of Material Nonpublic Information, pp. 141–46; and Insider Trading Topical Study, pp. 169–182.

14. D Reference: Standards of Practice Handbook, 7th ed., Standard V(A), Prohibition against Use of Material Nonpublic Information, pp. 141–46.

15. B Reference: "Performance Presentation Standards," in 1998 CFA Level I Candidate Readings, p. 1.


16. B

Reference: "Performance Presentation Standards," in 1998 CFA Level I Candidate Readings, pp. 12–19.

17. C Reference: Standards of Practice Handbook, 7th ed., Standard III (B), Duty to Employer, pp. 39–40.

18. A Reference: Standards of Practice Handbook, 7th ed., Standard I, Fundamental Responsibilities, pp. 11–15.

19. C Solution:

PV = 0.8929 (−$100) + 0.7972(−$200) + 0.7118(−$100) + 0.6355($450) = −$89.29 − $156.44 − $71.18 + 285.98 = −$33.93 Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 118–22.

20. D Solution:

FV = $1,500(1.12)2 + $1,500(1.12) = $1,881.60 + $1,680.00 = $3,561.60, or $3,562. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 112–18.


21. C Solution:

r = (FV/PV)1/t −1 = ($268/$231)1/3 − 1 = 1.05077 − 1 = 0.05077, or 5.1%. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 123–25.

22. A Solution:

Annual payment = $100,000/PVIFA30 yrs,10% = $100,000/9.4269 = $10,607.94, or $10,608 (rounded). Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 133–35.

23. D Solution:

PV = $20,000 + $20,000(PVIFA5 yrs,10%) = $20,000 + $20,000(3.7908) = $95,816. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 133–35.

24. D Solution:

Annuity present value factor = [1 − (1/(1 + r)n)]/r = [1 − 1/(1 + 0.08)19]/0.08 = [1 − 1/4.3157]/0.08 = 0.76829/0.08 = 9.6036. The present value of the 19 withdrawals of $30,000(9.6036) = $288,108 plus the $30,000 withdrawn in year 0 is $318,108. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 137–38.


25. C Solution:

First–year interest expense: $50,000 × 0.16 = $8,000 Repayment of principal: $50,000 − $8,000 = $2,000 Ending balance: $50,000 − $2,000 = $48,000 Second–year interest expense: $48,000 × 0.16 = $7,680 Second–year interest: $50,000 Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 112–13.

26. D Solution:

The formula for the expected return is: Stock X: E(R) = 0.2(−20%) + 0.5(18%) + 0.3(50%) = −4% + 9% + 15% = 20% Stock Y: E(R) = 0.2(−15%) + 0.5(20%) + 0.3(10%) = −3% + 10% + 3% = 10%. Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 33–34; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 11–14.


27. C Solution:

The formula for the standard deviation of returns is:

Stock X: σ = [(0.2)(-20% - 20%) + (0.5)(18% - 20%) + (0.3)(50% - 20%)2 2 2 = (320 + 2 + 270) = 592 = 24.33, or 24% (rounded). Stock Y: σ = [(0.2)(-15% - 10%) + (0.5)(20% - 10%) + (0.3)(10% - 10%) ]2 2 2 = (125 + 50 + 0) = 175 = 13.23, or 13% (rounded). Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 39–42; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting, pp. 12–15.

σ =n

n = P R - E R .i i iΣ

1[ ( ) ]2


28. B Solution:

The formula for the expected return of a portfolio is:

E( R ) =

n

W Rt =

port i i∑1

where Wi = the percent of the portfolio in asset I Ri = the expected rate of return for asset I So, WX = $9,000/$10,000 = 0.9; WY = $1,000/$10,000 = 0.1. E(Rport) = 0.9(20%) + 0.1(10%) = 18% + 1% = 19%. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 33–34; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 254–55.

29. D Solution:

r = Cov(RA,RB)/σAσB

= (0.0096)/(0.20 × 0.12) = 0.40. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 57–58; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 259–261.


30. C Solution:

The S&P 500 Stock Index is a market index, has a beta equal to 1.0, and consists only of systematic risk. If the correlation coefficient between the Baker Fund and the S&P Stock 500 Stock Index is 0.70, the coefficient of determination is 0.49, or 49 percent (i.e., 0.702). Because 49 percent of the Baker Fund’s total risk is systematic risk, the remaining 51 percent of the total risk is specific or unsystematic risk: Total risk = systematic risk and unsystematic risk; 100% = 49% − unsystematic risk; Unsystematic risk = 100% − 49% = 51%. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 59–62.

31. B Solution:

The capital asset pricing model is: E(Ri) = Rf. + bi (Rm − Rf ) So, 9% = 3% + bi (11% − 3%) solving for bi, bi = (9% − 3%)/(11% − 3%) = 6%/8% = 0.75. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models Management," pp. 287–91.

32. B Solution:

Arithmetic mean (AM) = SRi /n = (14% + 19% −10% + 14%)/4 = 37%/4 = 9.25%. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 8–10.


33. A Solution:

Geometric mean (GM) = p1/n − 1, where p = the product of the annual holding period returns GM = (1.14 × 1.19 × 0.90 × 1.14)1/4 −1 = (1.392)1/4 − 1 = 1.0862 − 1 = 0.0862, or 8.62%. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," p. 8–10.

34. C Solution:

The mode is the most frequent event. The most frequent value is 14%. The median is the middle value of −10%, 14%, 14%, 19%; or 14%. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, p. 39.

35. A Solution:

The coefficient of variation (CV) is the ratio of the standard deviation to the mean (expected value): standard deviation = σ 2

= 0.0025 = 0.05. CV= σ/E(R) = 0.05/0.30 = 0.167. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, p. 36; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," p. 15.


36. B

Reference: Schroeder, Sjoquist, and Stephan, Understanding Regression Analysis: An Introductory Guide, pp. 71–72.

37. C Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 11, "Modern Macroeconomics: Fiscal Policy," pp. 272–73.

38. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 12, "Money and the Banking System," pp. 305–06.

39. C Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 14, "Expectations, Inflation, and Unemployment," pp. 359–61.

40. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 17, "Demand and Consumer Choice," pp. 455.

41. C Solution:

Income elasticity of demand equals percentage change in quantity demanded divided by the percentage change in income: 10%/10% = 1.00. Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 17, "Demand and Consumer Choice," p. 455–57.

42. B Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 13, "Modern Macroeconomics: Monetary Policy," pp. 335–36, and Ch. 33, "International Finance and the Foreign Exchange Market," pp. 879–82.


43. B Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 19, "The Firm Under Pure Competition," pp. 506–08, and Ch. 21, "Price–Searcher Markets with High Barriers to Entry," pp. 554–57.

44. C Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 32, "Gaining from International Trade," pp. 846–48

45. B Solution:

Calculate the prices of U.S. items in pounds and of British items in dollars, under the assumption that $1 = 5 British pounds.

Items

United States (dollars)

Dollar price of British items

British (pounds)

Pound price of U.S. items

Shoes 20

16

80

100

Watches 40

36

180

200

Electric motors 80

120

600

400

The United States gains by importing shoes and watches, and Britain gains by importing electric motors. Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 32, "Gains from International Trade," pp. 854–56.

46. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 33, "International Finance and the Foreign Exchange Market," pp. 874–76.

47. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 33, "International Finance and the Foreign Exchange Market," pp. 882–84.


48. B Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 33, "International Finance and the Foreign Exchange Market," pp. 882–84.

49. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 33, "International Finance and the Foreign Exchange Market," p. 888.

50. A Reference: Gwartney & Stroup, Economics: Private and Public Choice, 8th ed., Ch. 33, "International Finance and the Foreign Exchange Market," p. 892.

51. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," p. 164.

52. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 167–70.

53. C Solution:

The basic relationship is: EI = BI + P − COGS or COGS = BI + P − EI, where EI = ending inventory BI = beginning inventory P = the purchase or manufacture of goods COGS = cost of goods sold Understatement of ending inventory by $3,000 and overstatement of beginning inventory by $5,000 causes COGS to be $8,000 higher, resulting in an understatement of net income of $8,000. Understating ending inventory results in lower reported current assets and a lower current ratio.


Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 332.

54. B Solution:

COGS = BI + P − EI Overstatement of ending inventory by $4,000 and overstatement of the purchase price of goods by $1,000 causes COGS to be understated by $3,000, which adds $3,000 to net income, thus overstates the correct amount by $3,000. Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," pp. 332–34.

55. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 336.

56. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 336.

57. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 352.

58. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," p. 170, and Ch. 5, "Analysis of Inventories," pp. 357–59.

59. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," pp. 379–80.


60. B

Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Financing Liabilities," pp. 409–11.

61. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 409–11.

62. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," pp. 349–52, and Ch. 6 "Analysis of Long–Lived Assets," pp. 424–27, 434–39.

63. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 425–32.

64. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 425, 426, and 434.

65. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 458–64.

66. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 7, "Analysis of Income Taxes," pp. 513–20.

67. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 7, "Analysis of Income Taxes," pp. 520–31.


68. A

Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 7, "Analysis of Income Taxes," pp. 536–41.

69. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," pp. 563–83.

70. B Solution: Because interest is normally paid semi–annually, the $100,000 is discounted to the present

using a market rate of 4 percent for 10 periods. Therefore, Empire Corporation will record the proceeds from the issue as a liability equal to: PV = $100,000(PV4%, 10 periods) = $100,000 (0.67556) = $67,556. Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," pp. 570–72.

71. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," pp. 594–602.

72. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," p. 137, and Ch. 8, "Analysis of Financing Liabilities," p. 601.

73. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," p. 602.


74. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 9, "Pension and Other Postemployment Benefits," p. 651.

75. C Solution:

Current bond price = 97% × $1,00 = $970. Coupon payment = $80 per year for 15 years. Maturity value = $1,000. The pretax cost of debt is equal to the yield to maturity of the bond. With a financial calculator, the yield to maturity is found to equal 8.36 percent. The after–tax cost of debt is equal to 8.36 percent × (1 − 0.28), where 0.28 is the firm’s marginal tax rate. The result is 6.02 percent (annual payments). Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 14, "Cost of Capital," pp. 450–53.

76. C Solution:

Market value of debt = 150,000 bonds × $980 per bond = $147,000,000. Market value of equity = 3,000,000 shares × $36 per share = $108,000,000. Combined market value = $147,000,000 + $108,000,000 = $255,000,000. Weight of debt = $147,000,000/$255,000,000 = 57.65%. Weight of equity = $108,000,000/$255,000,000 = 42.35%. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 14, "Cost of Capital," pp. 452–54.


77. C Solution:

Target debt/equity = 50%. Target debt/value = 0.333. Target equity/value = 0.667. Weighted–average flotation cost = 0.333(0.04) + 0.667(0.12) = 0.0933. The total amount of capital to be raised (true cost of the new project) = $25 million/(1 − 0.0933) = $27.57 million. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 14, "Cost of Capital," pp. 460–63.

78. D Solution:

After–tax earnings = $6 million. Minimum dividend = 0. Available internally generated equity = $6 million. Ratio of equity to value = 0.75. Maximum capital spending = $6/0.75 = $8 million. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 16, "Dividends and Dividend Policy," pp. 519–21.

79. C Reference: Ross, Westerfield and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 16, "Dividends and Dividend Policy," pp. 515–19.

80. A Reference: Ross, Westerfield and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 15, "Financial Leverage and Capital Structure Policy," pp. 491–95.


81. B

Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 3, "Selecting Investments in a Global Market," p. 81.

82. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 3, "Selecting Investments in a Global Market," pp. 79–81; and Fabozzi, "Introduction," in 1998 CFA Level I Candidate Readings, pp. 193–98.

83. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 4, "Organization and Functioning of Securities Markets," pp. 106–07.

84. B Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," p. 177; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 4, "Organization and Functioning of Securities Markets," p. 114.

85. A Reference: Solnik, International Investments, 3rd ed., Ch. 7, "Equity: Concepts and Techniques," pp. 228–29.

86. A Solution:

The put buyer could theoretically earn $40 − 0 − $2 = $38, so $38 is also the put seller’s maximum loss. The call writer could earn only the option premium of $3.50. Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 11, "Option Payoffs and Option Strategies," pp. 340–50.

87. D Reference: Reilly, Investment Analysis and Portfolio Management, 5th ed., Ch. 11, "An Introduction to Derivative Markets and Securities," in Special Excerpts for CFA Candidates, pp. 7–8.


88. A

Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 10, "The Options Market," pp. 313, 341–42, 347–48.

89. D Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 1, "Introduction, " p. 3, and Ch. 2, "Futures Markets," pp. 14–20.

90. C Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 2, "Futures Markets," pp. 20–22.

91. C Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 11, "Option Payoffs and Option Strategies," p. 372.

92. A Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 10, "The Options Market," p. 315.

93. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "An Introduction to Security Valuation," pp. 441–43.

94. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "An Introduction to Security Valuation," pp. 445–47.


95. C Solution:

P1 /E1 = (D1/E1)/(k − g) = (0.45)/(0.15 − 0.10) = 9.0 times. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "An Introduction to Security Valuation," pp. 345–47.

96. A Solution:

g = Retention Rate x Return on Equity g = 0.40 × 0.15 = 0.06 or 6%. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "An Introduction to Security Valuation," pp. 453–56.

97. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 21, "Technical Analysis," pp. 772–74.

98. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 21, "Technical Analysis," pp. 777–81.

99. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 21, "Technical Analysis," p. 792.

100. C Reference: Kolb, "Industry Analysis," in 1998 CFA Level I Candidate Readings, pp. 122–24.


101. B

Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 530–31.

102. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," p. 562.

103. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 530–34.

104. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 569–73.

105. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 556–60.

106. C Reference: Fabozzi, Ch. 1, "Introduction," in 1998 CFA Level I Candidate Readings, pp. 5–8.

107. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 20–22.

108. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 7, "Efficient Capital Markets," pp. 209–212.


109. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 7, "Efficient Capital Markets," pp. 211–212.

110. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 7, "Efficient Capital Markets," p. 223.

111. C Solution:

The risk premium is the required rate of return above the nominal risk–free rate. Because the risk premium is 10 percent and the risk–free rate is 6 percent, the rate of return for the equity fund is 16 percent (10 percent + 6 percent). The rate of return on Treasury bills is 6 percent. The portfolio weights are 60 percent ($60,000/$100,000) in the equity fund and 40 percent in the Treasury–bill money market fund. Therefore, the expected return on Webb’s portfolio is: E(Rport) = 0.60(16%) + 0.4(6%) = 9.6% + 2.4% = 12%. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 20–22, and Ch. 8, "An Introduction to Portfolio Management," p. 254.

112. A Solution:

The expected standard deviation of the equity fund is 14 percent and zero percent for the Treasury–bill money market fund because Treasury–bills are risk free. Because the standard deviation of the Treasury–bill money market fund is zero, the standard deviation of return on Webb’s two–asset portfolio is:

σport = [(0.6) (0.14) + (0.4) (0) + 2(0.6)(0.4)(0)]2 2 2 2 = 0.084, or 8.4% or σport = 0.6(14%) = 8.4%.

port 12

12

22

22

1 2 1,2 = + + 2σ σ σW W W W Cov


Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 261–69, and Ch. 9, "An Introduction to Asset Pricing Models," pp. 280–83.

113. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch 9, "An Introduction to Asset Pricing Models," pp. 283–87.

114. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 286–90.

115. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 284–85.

116. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 3, "Selecting Investments in a Global Market," pp. 71–73, Ch. 8, "An Introduction to Portfolio Management," pp. 259–61, and Ch. 9, "An Introduction to Asset Pricing Models," p. 284.

117. D Solution:

Required return for Stock X: E(Rx ) = 0.08 + 1.25(0.15 − 0.08) = 0.1675, or 16.75%. Estimated return for Stock X: 17.00%. Estimated return − required return = 17.00% − 16.75% = 0.25%. Stock X is undervalued by 0.25 percentage points because the stock is expected to provide a rate of return greater than required based on its systematic risk. That is, Stock X would plot above the security market line, which suggests that the stock is undervalued.


Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 287–91.

118. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 24–28, and Ch. 9, "An Introduction to Asset Pricing Models," pp. 288–89.

119. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 288–89.

120. B Solution:

If Portfolio X and Portfolio Y are well diversified, each portfolio should have a beta of about 1.00. According to the capital asset pricing model, the required rates of return on Portfolio X and Portfolio Y are: E(Rx ) = 0.08 + 1.00(0.16 − 0.08) = 0.16, or 16.00%. E(Ry) = 0.08 + 0.25(0.16 − 0.08) = 0.10, or 10.00%. Portfolio X is properly valued because its required and expected rates of return are the same. Portfolio Y is undervalued because its expected return minus its required return (12% − 10%) is positive. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 287–91.


Sample Examination 2 for 1998 Candidates CFA® Level I 120 Questions

3 Hours AIMR has constructed two sample examinations to help candidates practice taking multiple choice tests. Each 120-question sample examination represents a three-hour section (one-half the regular examination time). By combining the two sample examinations provided, candidates have the equivalent of one full six-hour test. To simulate realistic examination-day conditions, candidates may want to set aside a block of three hours in which to take each sample examination. Doing so will allow 1 ½ minutes, on average, for each question. The sample examinations are intended only to give candidates practice at answering questions that are similar in style to those that will appear on the 1998 CFA Level I examination. None of these sample questions will appear on that examination. Candidates should not rely on the sample examinations as their only means of preparing for the 1998 CFA Level I examination. Careful reading and study of the readings listed in the 1998 CFA Level I Study Guide are essential to being well prepared. AIMR strives to be accurate with the guideline answers to the sample examinations. If you detect any irregularities, please submit them by fax to: Coordinator, Level I Examination at (804)980-3670. Corrections will be printed in the Candidate Bulletin or will be sent by mail to all candidates. No individual replies will be given.

Sample Examination Structure

Question Topic Percent Number

1-18 Ethical and Professional Standards 15 18

19-36 Quantitative Analysis 15 18

37-50 Economics 12 14

51-80 Accounting and Corporate Finance 25 30

81-92 Global Markets and Instruments 12 12

93-106 Asset Valuation 12 14

107-120 Portfolio Management 12 14

Total 100%* 120

* The percentages do not add exactly to 100% because of rounding.


QUESTIONS 1 THROUGH 18 RELATE TO ETHICAL AND PROFESSIONAL STANDARDS AND ARE ALLOCATED 27 MINUTES (OR 1 ½ MINUTES EACH).

1. Zeller and Toffler have both passed Level II of the CFA Exam Program. Zeller circulates a resume stating that he is a candidate for the CFA designation and has passed Level II of the CFA Program. Toffler circulates a resume stating that he is a CFA II. Which of the following statements is true? A. Only Zeller has violated the Code and Standards. B. Only Toffler has violated the Code and Standards. C. Both Zeller and Toffler have violated the Code and Standards. D. Neither Zeller nor Toffler has violated the Code and Standards.

2. According to the AIMR Standards of Professional Conduct, when presenting material to others, members will not "copy or use, in substantially the same form as the original, material prepared by another without acknowledging and identifying the name of the author, publisher, or source of such material." Members may use, without acknowledgment, information from other sources if the information: A. was originally communicated verbally. B. does not include a buy or sell recommendation. C. is being reported only to the member’s employer or associates. D. is factual information published in recognized financial and statistical reporting services

or similar sources.

3. Clifford Brown is a partner in a money management firm. Brown recently attended a seminar where he learned about a quantitative model presented by Art Dixon. Upon returning to his office, Brown began testing the model and making a few minor alterations to it. He showed his model to his partners, who were impressed and decided to promote the model as proof of the money management firm's continuing innovation and value added. In the next newsletter mailed by the firm, Brown included a discussion of the model, the results of tests of the model, and financial data on several stocks selected by the model. These factual corporate financial data were taken from a Standard & Poor's publication. According to the AIMR Standards of Professional Conduct, which of the following actions is Brown required to take? A. Brown must credit both Dixon for having developed the original model and Standard &

Poor's as the source of the data. B. Brown must credit Dixon for having developed the original model, but he need not credit

Standard & Poor's as the source of the data. C. Brown must credit Standard & Poor's as the source of the data, but he need not credit

Dixon for having developed the original model. D. Brown need not credit either Dixon for having developed the original model or Standard

& Poor's as the source of the data.


4. Juan Mendez, CFA, is an investment advisor who operates as a sole proprietor and has five

clients. According to the AIMR Standards of Professional Conduct, if Mendez seeks additional employment with a brokerage firm and is later hired he: A. must get written consent from his new employer to keep his old clients and must advise

his old clients in writing of his employment with the brokerage firm. B. must advise his old clients in writing of his employment with the brokerage firm but does

not need to get written consent from his new employer to keep his old clients. C. must get written consent from his new employer to keep his old clients but does not need

to advise his old clients in writing of his employment with the brokerage firm. D. does not need to advise his old clients in writing of his employment with the brokerage

firm or get written consent from his new employer to keep his old clients.

5. Diane Miller, CFA, heads the research department of a large brokerage firm. The firm has many analysts, some of whom are subject to the AIMR Code of Ethics and Standards of Professional Conduct. If Miller delegates some supervisory duties, which of the following statements best describes her responsibilities under the Code and Standards? A. The Code and Standards prevent Miller from delegating supervisory duties to

subordinates. B. Miller retains supervisory responsibility for all subordinates despite her delegation of

some duties. C. Miller no longer has supervisory responsibility for those duties delegated to her

subordinates. D. Miller's supervisory responsibilities do not apply to those subordinates who are not

subject to the Code and Standards.

6. William Green, CFA, is the research analyst responsible for following Brown Company. All the information he has accumulated and documented suggests the stock should be rated a weak "hold" because the outlook for the firm's new products is poor. During a recent luncheon, Green overheard a financial analyst from another firm offer opinions that conflict with his own forecasts and expectations. Upon returning to his office, Green released a strong "buy" recommendation to the public based on this new information. Green: A. was in full compliance with AIMR Standards of Professional Conduct. B. violated AIMR Standards of Professional Conduct by failing to distinguish between facts

and opinions in his recommendation. C. violated AIMR Standards of Professional Conduct because he did not have a reasonable

and adequate basis for his recommendation. D. violated AIMR Standards of Professional Conduct because he did not seek approval of

the change from his firm's compliance department.


7. The corporate finance department of Howard Brothers, an investment banking firm, has decided to compete for the business of ETV Corporation. Knowing that the firm's brokerage unit now has a "sell" recommendation on ETV, the head of investment banking has asked the head of the brokerage unit to change the recommendation from "sell" to "buy.” According to the AIMR Standards of Professional Conduct, the brokerage unit should: A. assign a new analyst to decide if the stock deserves a higher rating. B. reassign responsibility for rating the stock to the head of the investment banking unit. C. increase the rating by no more than one increment (in this case, to a "hold"

recommendation). D. remove the company from the research universe, put it on a restricted list, and give only

factual information about the firm.

8. Bill Elliott, CFA, manages the discretionary account of the Jones Corporation employees profit-sharing plan. Diane Jones, the company president, recently asked Elliott to vote the shares in the firm's profit-sharing plan in favor of the company-nominated slate of directors and against the directors sponsored by a dissident stockholder group. Elliott does not want to lose Jones as a client, because he directs all the client's trades to a brokerage firm that provides Elliott with useful information about tax-free investments. Although this information is not of value in managing the Jones Corporation account, such information is helpful in managing several other accounts. The brokerage firm providing this information also offers the lowest prices for trades. Elliott investigates the proxy-fight issue, concludes that management's slate of directors is better for the long-run performance of the firm than those recommended by the dissident group, and votes accordingly. According to the AIMR Standards of Professional Conduct, Elliott: A. violated the Standards by directing trades to the brokerage firm but not by voting the

shares as requested by Jones. B. violated the Standards by voting the shares in the manner requested by Jones and by

directing trades to the brokerage firm. C. violated the Standards by voting the shares in the manner requested by Jones but not by

directing trades to the brokerage firm. D. did not violate the Standards by voting the shares in the manner requested by Jones or by

directing trades to the brokerage firm.


9. Susan Wright, CFA, works for an investment counseling firm. James Johnson, a new client of the firm, is meeting with Wright for the first time. Johnson had used another counseling firm for financial advice for years, but he switched his account to Wright's firm. At the beginning of their meeting, Wright explains to Johnson that she has discovered a highly undervalued stock that offers large potential gains. Wright recommends that Johnson buy the stock for his account. Wright’s actions violated the AIMR Standards of Professional Conduct. Which of the following statements best describes the action Wright should have taken? Wright should have: A. explained her qualifications, including her education, training, experience, and the

meaning of the CFA designation. B. determined Johnson’s needs, objectives, and tolerance for risk before making a

recommendation for any type of security. C. explained the characteristics of the company to Johnson, including the characteristics of

the industry in which the company operates. D. asked Johnson why he changed counseling firms. If the discovery process indicated that

he had been treated unfairly at the other firm, Wright would have a responsibility to notify AIMR of any violation.

10. Which of the following requirements will NOT help to ensure the fair treatment of brokerage firm clients when a new investment recommendation is made? A. Monitor the trading activities of firm personnel. B. Minimize elapsed time between the decision and the dissemination of a recommendation. C. Limit the number of people in the firm who are aware in advance that a recommendation

is to be disseminated. D. Establish procedures to ensure that institutional clients are informed of the new

recommendation prior to smaller individual accounts.

11. Which of the following statements clearly conflicts with the recommended procedures for compliance presented in AIMR’s Standards of Practice Handbook? A. Prior approval must be obtained for the personal investment transactions of all

employees. B. Investment recommendations may be changed by an analyst without prior approval of a

supervisory analyst. C. For confidentiality reasons, personal transactions should not be compared to those of

clients or the employer unless requested by regulatory organizations. D. Personal transactions include transactions in securities owned by the employee and

members of his or her immediate family and transactions involving securities in which the employee has a beneficial interest.


12. Waters is an investment analyst who has accumulated and analyzed several pieces of nonpublic information through her contacts with drug firms. Although none of the information is "material," Waters correctly concluded that the earnings of one of the drug firms would be unexpectedly high in the coming year. According to the AIMR Standards of Professional Conduct, Waters: A. Can use the information to make investment recommendations and decisions. B. Cannot legally invest or make investment recommendations based on this information. C. Should urge the drug firm to make public dissemination of the information immediately. D. May use the information, but only after approval from a compliance officer or

supervisory analyst.

13. Which of the following concepts does the AIMR Code of Ethics include?

I. Integrity and dignity. II. Independent judgment.

III. Competence. IV. Contractual provisions.

A. I only. B. II and IV only. C. I, II, and III only. D. I, II, III, and IV.

14. Simpson is a financial analyst with Flanders Brokerage Company. She is preparing a purchase recommendation on Burns Corporation. Which of the following situations would represent a conflict of interest for Simpson and, therefore, would have to be disclosed?

I. Simpson is on retainer as a consultant to Burns Corporation. II. Flanders holds for its own account a substantial common stock interest in Burns

Corporation. III. Simpson has material beneficial ownership of Burns Corporation through a

family trust. IV. Simpson’s brother-in-law is a supplier to Burns Corporation.

A. I and IV only. B. II and III only. C. I, II, and III only. D. I, II, and IV only.


15. Janzen tells a prospective client, “I may not have a long-term track record yet, but I’m sure that you’ll be very pleased with my recommendations and service. In the three years that I’ve been in the business, my equity-oriented clients have averaged a total return of more than 26 percent per year.” The statement is true, but Janzen only has a few clients, and one of his clients took a large position in a penny stock (against Janzen’s advice) and realized a huge gain. This large gain caused the average of all of Janzen’s clients to exceed 26 percent a year. Without this one investment, the average gain would have been 8 percent a year. Has Janzen violated the Standards? A. Yes, because the statement misrepresents Janzen’s track record. B. Yes, because the statement about return ignores the risk preferences of his clients. C. No, because the statement is a true and accurate description of Janzen’s track record. D. No, because Janzen is not promising that he can earn a 26 percent return in the future.

16. Kite has been hired by Watson Industries, Inc. to manage its pension fund. Kite’s fiduciary duty is owed to: A. The shareholders of Watson. B. The management of Watson. C. The participants and beneficiaries of Watson’s pension plan. D. Each of the above equally.

17. An investment banking department of a brokerage firm often receives material nonpublic information that could have considerable value if used in advising the firm’s brokerage clients. In order to conform to the Code and Standards, which of the following is the best policy for the brokerage firm? A. Monitor the exchange of information between the investment banking department and the

brokerage operation. B. Permanently prohibit both purchase and sell recommendations of the stocks of clients of

the investment banking department. C. Establish physical and informational barriers within the firm to prevent the exchange of

information between the investment banking and brokerage operations. D. Prohibit purchase recommendations when the investment banking department has access

to material nonpublic information but, in view of the fiduciary obligations to clients, allow sale of current holdings.


18. Maggert is scheduled to visit the corporate headquarters of Hoch Industries. Maggert expects to use the information obtained to complete his research report on Hoch stock. Maggert learns that Hoch plans to pay all of Maggert’s expenses for the trip, including the costs of meals, hotel room, and air transportation. Which of the following actions would be the best course for Maggert to take under the Code and Standards? A. Write the report without taking the trip. B. Accept the expense-paid trip and write an objective report. C. Pay for all travel expenses, including costs of meals and incidental items. D. Accept the expense-paid trip but disclose the value of the services accepted in the report.


QUESTIONS 19 THROUGH 36 RELATE TO QUANTITATIVE ANALYSIS AND ARE ALLOCATED 27 MINUTES (OR 1 ½ MINUTES EACH).

19. An investment has the following stream of annual year-end cash flows:

Year-End Cash Flows 1 2 3 4

$15 $25 $10 –$5 If the discount rate is 12 percent, the present value of this stream of cash flows is closest to: A. $28.60. B. $37.26. C. $43.62. D. $45.00.

20. An investor wants to have $140,000 available at the end of 12 years. This investor plans to make 12 equal year-end payments into an investment that is expected to earn an 8 percent annual rate of return. The required amount of each year-end payment is closest to: A. $4,633. B. $6,831. C. $7,377. D. $10,802.

21. An investor wants to buy an annuity that will pay $25,000 at the end of each of the next 15 years. If the investor can earn 8 percent interest per year on the annuity, the purchase price of the annuity is closest to: A. $125,470. B. $213,987. C. $347,222. D. $375,000.

22. A portfolio realized a 10 percent return in Year 1 and a –10 percent return in Year 2. The geometric mean return for the two-year period is: A. –0.500%. B. 0%. C. 0.990%. D. 0.995%.


23. An analyst estimates that a stock has the following probabilities of return in the three states of the economy:

State of Economy Probability Rate of Return Good 0.1 15%

Normal 0.6 13 Poor 0.3 7

The expected return of the stock is: A. 7.8%. B. 11.4%. C. 11.7%. D. 13.0%.

24. An analyst developed the following list of the potential rates of return for Stock A under four scenarios and later revised the expected rate of return for each scenario:

Scenario Original Expected Rate of

Return

Revised Expected Rate of Return

1 15.0% 15.9% 2 20.0 21.2 3 25.0 26.5 4 30.0 31.8

If Stock A's original expected rate of return is 23 percent, Stock A's revised expected rate of return will be: A. 21.7%. B. 23.0%. C. 23.9%. D. 24.4%.


25. An analyst developed the following probability distribution of potential rates of return for

Stock Z under three scenarios and later revised the expected rate of return for each scenario:

Scenario Probability Original Expected Rate of

Return

Revised Expected Rate of Return

1 0.20 0.20 0.210 2 0.50 0.30 0.310 3 0.30 0.50 0.525

If the original variance of the expected rate of return was .0124, Stock Z's revised standard deviation of expected return will be: A. .1050. B. .1114. C. .1141. D. .1169.

26. An analyst estimates the following return distribution for a stock:

Probability Rate of Return 0.3 0.05 0.5 0.10 0.2 0.20

The variance of the expected return is closest to: A. 0.0027. B. 0.0522. C. 0.1050. D. 0.1167.

27. Given a data series that is normally distributed with a mean of 100 and a standard deviation of 10, about 95 percent of the numbers in the series will fall within: A. 60 to 140. B. 70 to 130. C. 80 to 120. D. 90 to 110.


28. An analyst makes the following calculations about the returns for Stock X and Stock Y: Cov(RX, RY) = 0.005 σX = 0.20 σy = 0.06 The correlation coefficient between the returns for Stock X and Stock Y is between: A. 0.00 and 0.25. B. 0.25 and 0.50. C. 0.51 and 0.75. D. 0.76 and 1.00.

29. An analyst makes the following estimates:

Rate of Return Scenario Probability Stock I Stock J

1 0.5 0.30 0.20 2 0.5 0.10 –0.10

Based on these data, the covariance between the rates of return on Stock I and Stock J is: A. –0.0163. B. +0.0500. C. +0.0150. D. +0.2000.

30. An analyst developed the following data on Stock X and the market: Return on the market = 0.1200 Covariance between the return on Stock X and the return on the market = 0.0288 Correlation coefficient of the return on Stock X and the return on the market = 0.8000 Standard deviation of the return on Stock X = 0.1800 Standard deviation of the return on the market = 0.2000 Based on these data, the beta of Stock X is: A. 0.144. B. 0.720. C. 0.800. D. 0.889.


31. An analyst regresses the excess returns of Stock J against the returns on a market index, M. Using the following regression equation,

Rj = aj + bj RM + ej, which of the following statements is/are true?

I. The intercept, aj, is the amount of Stock J’s price movement explained by the market.

II. The term bj is the slope of the regression line and is assumed to be constant. III. The disturbance term, ej, is assumed to be uncorrelated with the explanatory

variable, RM, and of zero expectation. A. I only. B. II only. C. II and III only. D. I, II, and III.

32. When a multiple regression results in a high F-value and high t-values for each independent variable coefficient, the most likely interpretation is that: A. the regression equation and the independent variables are significant. B. the regression equation and the independent variables are not significant. C. the regression equation is significant but the independent variables are not significant. D. the regression equation is not significant but the independent variables are significant.

33. In hypothesis testing, which of the following statements about Type I and Type II errors is/are true?

I. A Type I error refers to accepting the null hypothesis when it is false. II. A Type II error refers to rejecting the null hypothesis when it is true.

III. Minimizing the probability of a Type II error maximizes the power of the test. A. I only. B. II only. C. III only. D. I, II, and III.


34. An analyst conducts a two-tailed t-test to determine whether a sample mean involving 100 observations differs from a theoretical mean of zero. The computed t-statistic is 2.90. Using a 5 percent significance level, which of the following conclusions is the most appropriate to reach? A. Refrain from drawing a conclusion because the number of observations is insufficient. B. Accept the null hypothesis that the sample mean is not significantly different from zero. C. Reject the alternative hypothesis that the sample mean is significantly different from

zero. D. Reject the null hypothesis and accept the alternative hypothesis that the sample mean is

significantly different from zero.

35. Based on monthly data for 10 years, regression statistics describing the relationship between two securities and the Standard & Poor's 500 Index are as follows:

Security Estimated Alpha

Standard Error of Alpha

Estimated Beta

Standard Error of Beta

Coefficient of Determination

X 0.69 0.64 1.28 0.17 16.1 Y –0.59 0.29 1.08 0.08 39.7

If the level of significance value is 1.96, for which of the securities does a high confidence (about 95 percent) exist that the true systematic risk differs from that of the index? A. Security X only. B. Security Y only. C. Both Security X and Security Y. D. Neither Security X nor Security Y.

36. If returns are independent from one year to the next, all of the following statements regarding time diversification are valid EXCEPT: A. standard deviation of annualized returns diminishes with time. B. the dispersion of terminal wealth converges to the expected terminal wealth as the

investment horizon expands C. the notion that above-average returns tend to offset below-average returns over long time

horizons is called time diversification. D. critics of time diversification contend that if an investor elects a riskless alternative when

faced with a three-month horizon, that same investor should also select the riskless investment when the time horizon exceeds ten years.


QUESTIONS 37 THROUGH 50 RELATE TO ECONOMIC ANALYSIS AND ARE ALLOCATED 21 MINUTES (OR 1 ½ MINUTES EACH).

37. When an economy dips into recession, automatic stabilizers will tend to alter government spending and taxation so as to: A. ensure that the budget will remain in balance. B. enlarge the budget deficit (or reduce the surplus). C. reduce the budget deficit (or increase the surplus). D. reduce interest rates, thus stimulating aggregate demand.

38. Which of the following is/are (a) legitimate reason(s) why high tax rates are likely to retard the growth of output?

I. High marginal tax rates discourage work effort and reduce the productive efficiency of labor,

II. High tax rates adversely affect the rate of capital formation and the efficiency of its use.

III. High marginal tax rates encourage individuals to substitute less desired tax-deductible goods for more desired, nondeductible goods.

A. I only. B. III only. C. I and II only. D. I, II, and III.

39. When considering potential supply-side effects on economic activity, the key relationship is between: A. tax rates and output. B. tax rates and tax revenues. C. output and the business cycle. D. tax revenues and the business cycle.

40. The U.S. Federal Reserve System buys $10 million of government securities from the public. The reserve requirement is 20 percent. All banks have zero excess reserves. A few weeks later, if no excess reserves still exist, the total impact of this action on the money supply will be a: A. $2 million decease. B. $2 million increase. C. $10 million decrease. D. $50 million increase.


41. The major function of the U.S. Federal Reserve System is to:

A. implement fiscal policy. B. carry out monetary policy. C. serve as the country’s lender of last resort. D. maintain the safety and soundness of banks and other savings institutions.

42. According to the quantity theory of money, if the GDP is $6 trillion and the M1 money supply is $800 billion, the velocity of the M1 money supply is: A. 0.133. B. 0.153. C. 6.500. D. 7.500.

43. If the central bank attempts to “peg” the nominal interest rate at 4 percent by buying domestic government bonds, then every time the nominal interest rate exceeds 4 percent, the most likely effect of the central bank’s policy will be: A. low nominal interest rates and a reduction in the inflation rate. B. a decline in bank reserves, slow growth rate of the money supply, and deflation. C. rapid expansion of bank reserves, rapid growth in the money supply, and inflation. D. low nominal interest rates, a high rate of private investment, and rapid growth

accompanied by price stability.

44. Initially, the nominal interest rate is 8 percent and the expected inflation rate is 6 percent. One year later, the nominal interest rate is 12 percent and the expected inflation rate is 10 percent. Based on this information, the real interest rate: A. has risen. B. has fallen. C. has remained the same. D. cannot be determined because of insufficient information.

45. For an economy operating at full employment, the major long-term impact of increasing the money supply will be: A. higher prices. B. higher output. C. lower employment. D. lower interest rates.


46. Of the following, the most important in forecasting next year’s inflation rate using the adaptive expectations hypothesis is: A. last year’s inflation rate. B. announced changes in fiscal policy. C. announced changes in monetary policy. D. the forecasted federal government deficit.

47. The price elasticity of demand for a commodity is determined primarily by the: A. incomes of consumers. B. size of the consumer surplus. C. availability of complementary goods. D. availability of substitutes for the goods.

48. Which of the following statements about economic and accounting profits are true?

I. Economic profit is the difference between the firm’s total revenues and total costs.

II. Zero economic profit implies that the firm is about to go out of business. III. The accounting profit of a firm is generally smaller than the firm’s economic

profit. IV. A low rate of accounting profit implies economic losses.

A. I and III only. B. I and IV only. C. II and III only. D. II and IV only.

49. All of the following conditions exist in a market of pure competition EXCEPT: A. Each buyer and seller is small relative to the total market. B. A large number of independent firms produce the product. C. All firms in the market are producing a homogeneous product. D. High barriers exist to the entry of other firms into the market for the product.

50. Which of the following factors would NOT cause the demand curve for a given product to shift? A. Changes in price. B. Changes in income. C. Changes in the distribution of income. D. Changes in the price of a related good.


QUESTIONS 51 THROUGH 80 RELATE TO FINANCIAL STATEMENT ANALYSIS AND ARE ALLOCATED 45 MINUTES (OR 1 ½ MINUTES EACH). Note to Candidates: Assume U.S. GAAP (generally accepted accounting

principles) applies unless otherwise noted.

51. Under the accrual basis of accounting, which of the following statements is/are true?

I. Reported income provides a measure of the firm’s current operating performance.

II. Revenue is recognized when cash is received, and expenses are recognized when payment is made.

III. Cash flows may be allocated to time periods other than those in which they occur.

A. I only. B. II only. C. I and III only. D. I, II, and III.

52. A firm has net sales of $3,000, cash expenses (including taxes) of $1,400, and depreciation of $500. If accounts receivable increase in the period by $400, cash flows from operations equal: A. $1,200. B. $1,600. C. $1,700. D. $2,100. Questions 53 through 55 should be answered according to the provisions of Statement of Financial Accounting Standard 95 (Statement of Cash Flows) and using the following data: Cash payments for interest –$12 Retirement of common stock –32 Cash payments to merchandise suppliers –85 Purchase of land –8 Sale of equipment 30 Payment of dividends –37 Cash payment for salaries –35 Cash collection from customers 260 Purchase of equipment –40


53. Cash flows from operating activities are: A. $91. B. $128. C. $140. D. $175.

54. Cash flows from investing activities are: A. –$67. B. –$48. C. –$18. D. –$10.

55. Cash flows from financing activities are: A. –$81. B. –$69. C. –$49. D. –$37.

56. All of the following are general categories of nonrecurring items EXCEPT: A. accounting changes. B. capitalization of leases. C. discontinued operations. D. unusual or infrequent items.

57. Which of the following are examples of unusual or infrequent items?

I. Gains or losses from disposal of a portion of a business segment. II. Losses resulting from foreign government expropriation of assets.

III. A change from last-in, first-out to another inventory method. IV. Impairments, write-offs, write-downs, and restructuring costs.

A. I and IV. B. II and III only. C. III and IV only. D. I, II, III, and IV.


58. A firm discovered that it had used an incorrect accounting principle in 1996. On the firm’s 1997 financial statements, this firm should report the impact of this error as: A. a nonrecurring item. B. an extraordinary item. C. a prior-period adjustment. D. part of cost of goods sold.

59. Which inventory valuation method does U.S. generally accepted accounting principles (GAAP) require? A. Weighted-average method. B. First-in, first-out (FIFO) method. C. Last-in, first-out (LIFO) method. D. Lower-of-cost-or-market method.

60. In periods of rising prices and stable or increasing inventory quantities, which of the following statements about the impact of LIFO and FIFO accounting on the financial statements are true? LIFO FIFO

I. Income before taxes Higher Lower II. Income taxes Higher Lower

III. Cash flows Higher Lower IV. Inventory balance Lower Higher

A. I and II only. B. III and IV only. C. I, II, and IV only. D. I, II, III, and IV.

61. The year-end financial statements for a firm using LIFO accounting show an inventory level of $5,000, cost of goods sold (COGS) of $16,000, and inventory purchases of $14,500. If the LIFO reserve is $4,000 at year end and was $1,500 at the beginning of the year, the firm’s COGS using FIFO accounting would have been: A. $11,000. B. $12,000. C. $13,500. D. $18,500.


62. LIFO liquidation occurs when: A. the LIFO reserve declines in value. B. the firm is about to revalue inventory values upward. C. the firm changes from LIFO to another inventory method. D. the quantity of goods sold is greater than the quantity produced.

63. All else remaining equal, when LIFO liquidations occur during a period of rising prices, which of the following statements about effects on a firm’s financial statements is/are generally true?

I. Cost of goods sold increases. II. Gross profit margin increases.

III. Taxes decrease. IV. Net income increases.

A. I only. B. II only. C. I and III only. D. II and IV only.

64. Two growing firms are identical except that one firm capitalizes whereas the other firm expenses costs for long-lived resources over time. For these two firms, which of the following financial statement effects is/are generally true?

I. The capitalizing firm will show a less volatile pattern of reported income than the expensing firm.

II. The capitalizing firm will show a more volatile pattern of return on assets than the expensing firm.

III. The capitalizing firm will show higher cash flows from operations than the expensing firm.

A. I only. B. II only. C. I and III only. D. II and III only.


65. Which of the following statements about accelerated depreciation methods are true?

I. The matching principle supports the use of accelerated depreciation methods rather than the straight-line method.

II. Two common accelerated depreciation methods are the unit-of-production and service hours methods.

III. Accelerated depreciation methods tend to depress both net income and stockholders’ equity when compared with the straight-line method.

IV. A major reason that firms use accelerated depreciation methods in the United States is the methods’ beneficial effect on the firm’s tax burden.

A. I and II only. B. III and IV only. C. I, III, and IV only. D. I, II, III, and IV.

66. A firm using straight-line depreciation reports gross investment in fixed assets of $80 million, accumulated depreciation of $45 million, and annual depreciation expense of $5 million. The approximate average age of the fixed assets is: A. 7 years. B. 9 years. C. 15 years. D. 16 years.

67. A firm has variable-rate long-term debt outstanding. All else being equal, what effect will a rise in interest rates have on the firm’s debt-to-equity ratio and net income? Debt-to-Equity Ratio Net Income A. Decrease Decrease B. No change Increase C. Decrease Increase D. Increase Decrease

68. An analyst should treat preferred stock on a firm's balance sheet as debt when calculating leverage ratios if the preferred stock is: A. callable by the issuer. B. convertible into common stock. C. issued at a variable dividend rate. D. redeemable by the preferred shareholders.


69. Under U.S. GAAP, when firms retire bonds before maturity, the difference between the book value of the bonds and the amount paid to repurchase the bonds is treated as: A. an operating gain or loss on the income statement. B. an extraordinary gain or loss on the income statement. C. an adjustment to retained earnings on the balance sheet. D. a credit or charge to be amortized over the remaining life of the bond.

70. A company has issued bonds, with a face (book) value of $400,000, that can be called for $408,000. Without the call provision, the present value of cash flows associated with the bonds would be $415,500. If the bonds are called, the income statement will show a: A. loss of $8,000. B. gain of $8,000. C. loss of $15,500. D. gain of $15,500.

71. For a lessee, capitalizing a lease rather than treating the lease as an operating lease generally leads to: A. a higher current ratio. B. lower cash flow from operations. C. lower expenses at first but higher expenses later. D. higher operating income, even though net income is initially lower.

72. For its year-end 1996 statements, Brown Company increased the "pension discount rate" from 9 percent to 10 percent and the "assumed rate of compensation” from 8 percent to 8.5 percent. The effect of these changes is to: A. increase the return on assets assumption for 1996. B. increase the service cost element of pension costs in 1996. C. decrease the deferred experience gains or increase the deferred experience losses. D. increase the difference between the accumulated benefit obligation and the projected

benefit obligation.


73. Firms that sell their accounts receivable and use the proceeds to reduce their debt distort the pattern of cash flow from: A. financing, so analysts should switch the amount of receivables sold from current

liabilities to long-term debt when calculating the firm’s financial ratios. B. financing, but this distortion is offset by a similar distortion in cash flow from financing,

so no adjustment is necessary when calculating the firm’s financial ratios. C. operations, but this distortion is offset by a similar distortion in cash flow from financing,

so no adjustment is necessary when calculating the firm’s financial ratios. D. operations, so analysts should reverse the sale by increasing the firm’s receivables and

treating the proceeds of the sale as debt in computing the firm’s financial ratios.

74. Which of the following are relevant in determining project cash flow for a capital investment?

I. Sunk costs. II. Opportunity costs.

III. Side effects such as lost sales. IV. Changes in net working capital. V. Financing costs

A. I and II only. B. III and V only. C. II, III, and IV only. D. II, III, IV, and V only

75. A analyst makes the following estimates for a capital investment project:

Price = $100 per unit Variable costs = $50 per unit Cash fixed costs = $10,000 Depreciation = $2,000

The accounting breakeven is: A. 80 units. B. 100 units. C. 200 units. D. 240 units.


76. Which of the following statements about operating leverage is/are true?

I. A firm with low operating leverage will have low fixed costs compared with a firm with high operating leverage.

II. Fixed costs act like a lever, in the sense that a small percentage change in operating revenue can be magnified into a large percentage change in operating cash flow.

III. The higher the degree of operating leverage, the greater the potential danger from forecasting risk.

A. I only. B. II only. C. I and III only. D. I, II, and III.

77. Which of the following conditions should a firm meet to use its weighted-average cost of capital for decision-making purposes?

I. All projects should be funded solely by internal sources of financing. II. The firm should not materially change its financing policies as a result of the

investments it undertakes. III. The risk of the project under consideration should be essentially the same as

existing operations. A. I only. B. I and III only. C. II and III only. D. I, II, and III.

78. Winthrop Stores has a capital structure consisting of $150 million in 8 percent debt and $300 million in stock outstanding. The firm’s cost of equity is 20 percent. Winthrop decides to sell $50 million in stock and use the proceeds to buy back $50 million in debt. According to the Modigliani and Miller model of capital structure without taxes or bankruptcy costs, what effect should this restructuring have on the firm’s cost of equity and weighted-average cost of capital? Weighted-Average Cost of Equity Cost of Capital A. Decreases Decreases B. Increases Increases C. Decreases Remains constant D. Increases Remains constant


79. Dart Industries has earnings before interest and taxes of $800,000 and a corporate tax rate of 40 percent. The firm’s before-tax cost of debt is 10 percent, and its cost of equity in the absence of borrowing is 15 percent. According to the Modigliani and Miller approach to capital structure with corporate taxes, what is the total market value of Dart Industries with no leverage? A. $2,133,333. B. $3,200,000. C. $4,800,000. D. $5,333,000.

80. Which of the following statements regarding accounting for deferred taxes under FASB 109 is/are true?

I. Deferred taxes will be recognized for deductible temporary differences and tax credit carryforwards.

II. The requirements of FASB 109 are based on a deferred-income statement approach.

III. A unique provision of FASB 109 is the consideration of future economic events in assessing the likelihood of a deferred tax asset will be realized.

A. I only. B. III only. C. I and III only. D. I, II, and III.


QUESTIONS 81 THROUGH 92 RELATE TO GLOBAL MARKETS AND INSTRUMENTS AND ARE ALLOCATED 18 MINUTES (OR 1 ½ MINUTES EACH).

81. Which of the following statements about the costs of international investment is/are generally true?

I. Calculating average transaction costs in international trades is difficult because of the many ways a commission is charged.

II. Custody costs tend to be higher for international investments because of the necessity of a multicurrency system of accounting, reporting, and cash flow collection.

III. Fees charged by international money managers tend to be higher than those charged by domestic managers because of data collection, research, and communication costs.

A. I only. B. III only. C. II and III only. D. I, II, and III.

82. All of the following explain why U.S. stock market capitalization is larger relative to U.S. gross domestic product than is the case in most European countries EXCEPT: A. Privately held companies are a tradition in Europe. B. A greater proportion of firms in Europe are nationalized. C. Many European companies rely heavily on bank financing. D. European banks cannot own shares of stock of their client firms.

83. Which of the following statements best characterizes forward stock markets like the London and Paris markets? A. Settlement of transactions takes place infrequently, typically on one day each month. B. Share price is not determined, even after a transaction occurs, until a specified date in the

future. C. Investors buy and sell contracts for future delivery of shares, but the shares themselves

do not change ownership. D. Stock ownership changes occur on the day of the transaction, but money is not exchanged

until five business days later.


84. Which of the following statements about the operation of national stock markets is/are true?

I. In most national markets, stocks are traded on a cash basis and transactions must be settled within a couple of days.

II. Margin trading is costly, compared with trading on an organized futures market because private contracts must be arranged for each deal.

III. Most national markets are dealer markets in which active market makers ensure market liquidity.


85. Which of the following statements about price-driven and order-driven systems are true?

I. In a price-driven market, all traders publicly post their orders, and the transaction price is the result of the equilibrium of supply and demand.

II. In an order-driven market, market makers adjust their quotes continuously to reflect supply and demand for a security and their inventory.

III. The London SEAQ (Stock Exchange Automated Quotation) and the U.S. Nasdaq are price-driven systems.

IV. The Paris Bourse and Tokyo Stock Exchange are order-driven systems. A. I and II only. B. I and III only. C. II and IV only. D. III and IV only.

86. Which of the following statements best characterizes the taxation of returns on international investments in an investor's country and/or the country where the investment is made? A. The investor's country normally withholds taxes on dividend payments. B. Capital gains normally are taxed only by the country where the investment is made. C. Tax-exempt investors normally must pay taxes to the country where the investment is

made on dividend income earned. D. Investors in non-U.S. common stock normally avoid double taxation on dividend income

by receiving a tax credit for taxes paid to the country where the investment is made.


87. Which of the following statements about Anglo-American accounting rules and those used in continental Europe and Japan are true?

I. In the Anglo-American model, accounting rules are set in standards prepared by a well-established, influential accounting profession.

II. In continental Europe and Japan, accounting rules are set in a codified law system in which governmental bodies write the law.

III. Anglo-American countries typically report financial statements and earnings that conform to the method used to determine taxable income.

IV. Continental European countries and Japan typically report financial statements intended to give a true and fair view of the firm’s financial position.

A. I and II only. B. III and IV only. C. I, II, and III only. D. I, II, III, and IV.

88. Which of the following statements about national accounting principles are true?

I. In most countries, corporations publish financial statements that consolidate, to some extent, the accounts of their subsidiaries and affiliates.

II. In most countries, fixed assets are depreciated using accelerated depreciation methods.

III. Revaluation of assets is not permitted in the United States and Germany but is normally practiced in the United Kingdom.

IV. Few differences exist in the accounting for pensions and retirement liabilities among countries.

A. I and III only. B. II and III only. C. II and IV only. D. I, II, and IV only.

89. Empirical evidence suggests that which of the following aspects of international investing offers the greatest potential source of excess returns to international investors? A. Country selection. B. Industry selection. C. Indexed portfolios. D. Exchange rate fluctuations.


90. All of the following are factors commonly used in practice to develop international asset-pricing models EXCEPT: A. Tax factors. B. Statistical factors. C. Macroeconomic factors. D. Attribute factors of a firm.

91. All of the following statements about primary and secondary markets are true EXCEPT: A. A primary market is a market in which new securities are sold. B. The primary market benefits from the liquidity provided by the secondary market. C. A secondary market is a market in which existing securities are traded among investors. D. The proceeds from a sale in the secondary market go to the issuing unit, not the current

owner of the security.

92. A call is “in-the-money” when: A. the stock price is above the exercise price. B. the stock price is below the exercise price. C. the stock price and the exercise price are equal. D. not enough information to tell.


QUESTIONS 93 THROUGH 106 RELATE TO ASSET VALUATION (EQUITY ANALYSIS AND FIXED-INCOME ANALYSIS) AND ARE ALLOCATED 21 MINUTES (OR 1 ½ MINUTES EACH).

93. All of the following are operating performance ratios EXCEPT: A. return on equity. B. the current ratio. C. net profit margin. D. total asset turnover.

94. Which of the following ratios are components of a firm’s return on equity within the traditional DuPont system?

I. Net income to net sales. II. Net annual sales to average receivables.

III. Sales to total assets. IV. Total assets to common equity.

A. I and III only. B. II and IV only. C. III and IV only. D. I, III, and IV only.

95. An investor plans to buy a common stock and hold it for one year. The investor expects to receive both $1.50 in dividends and $26.00 from the sale of the stock at the end of the year. If the investor wants to earn a 15 percent return, the maximum price the investor should pay for the stock today is closest to: A. $22.61. B. $23.91. C. $24.50. D. $27.50.

96. The constant-growth dividend discount model will not produce a finite value for a stock if the dividend growth rate is: A. above its historical average. B. below its historical average. C. above the required rate of return on the stock. D. below the required rate of return on the stock.


97. In the dividend discount model, all of the following factors influence an investor’s required rate of return EXCEPT: A. the return on assets. B. the real risk-free rate. C. the risk premium for stocks. D. the expected rate of inflation.

98. Which of the following are underlying assumptions of technical analysis?

I. Past performance has no influence on future performance or market values. II. Security prices adjust rapidly to stock market information.

III. Security prices move in trends, which persist for appreciable lengths of time. IV. The market value of any good or service is determined solely by the interaction

of supply and demand for the good or service. A. I and II only. B. I and IV only. C. II and III only. D. III and IV only.

99. Given the following information on a stock market series:

Expected dividend payout ration = 40% Required rate of return = 12 % Expected growth rate of dividends = 7%

The expected price-to-earnings ratio (P/E) of the stock market series is closest to: A. 3.33. B. 5.71. C. 8.00. D. 12.00.

100. Which of the following statements about yield measures is/are true?

I. Nominal yield measures the current income rate. II. Current yield measures the coupon rate.

III. Realized (horizon) yield measures the expected rate of return for a bond likely to be sold before maturity.



101. The yield to maturity and current yield on a bond are equal: A. when market interest rates begin to level off. B. if the bond sells at a price in excess of its par value. C. when the expected holding period is greater than one year. D. if the bond’s coupon rate is equal to market interest rates for similar risk.

102. Which of the following bonds has the longest duration? A. 8-year maturity, 6% coupon. B. 8-year maturity, 11% coupon. C. 15-year maturity, 6% coupon. D. 15-year maturity, 11% coupon.

103. Which of the following statements about the Macaulay duration of a zero-coupon bond is true? The Macaulay duration of a zero-coupon bond: A. is equal to the bond's maturity in years. B. is equal to one-half the bond's maturity in years. C. is equal to the bond's maturity in years divided by its yield to maturity. D. cannot be calculated because of the lack of coupons.

104. Which of the following statements about duration characteristics are true?

I. The duration of a coupon bond will always be less than its term to maturity. II. There is generally an inverse relationship between term to maturity and

duration. III. There is a positive relationship between coupon and duration. IV. There is an inverse relationship between yield to maturity and duration.

A. I and II only. B. I and IV only. C. II and III only. D. III and IV only.


105. A bond with annual coupon payments has the following characteristics:

Coupon Rate Yield-to-Maturity Macaulay Duration 8% 10% 9

The bond's modified duration (in years) is: A. 8.18. B. 8.33. C. 9.78. D. 10.00.

106. A nine-year bond has a yield to maturity of 10 percent and a modified duration of 6.54 years. If the market yield changes by 50 basis points, the bond's expected price change is: A. 3.27%. B. 3.66%. C. 5.00%. D. 6.54%.


QUESTIONS 107 THROUGH 120 RELATE TO PORTFOLIO MANAGEMENT AND ARE ALLOCATED 21 MINUTES (OR 1 ½ MINUTES EACH).

107. An investor has a portfolio with a market value of $50,000 at the end of May. The market value of the portfolio is $48,700 at the end of June. The holding-period yield on the investor’s portfolio for June is closest to: A. –2.67%. B. –2.63%. C. –2.60%. D. –1.30%.

108. Stocks A, B, and C each have the same expected return and standard deviation. The following table shows the correlations between the returns on these stocks.

Correlation of Stock Returns Stock A Stock B Stock C

Stock A +1.0 Stock B +0.9 +1.0 Stock C +0.1 –0.4 +1.0

Given these correlations, the portfolio constructed from these stocks having the lowest risk is a portfolio: A. equally invested in stocks A and B. B. equally invested in stocks A and C. C. equally invested in stocks B and C. D. totally invested in stock C.

109. The correlation coefficient of Portfolio X's returns and the market's returns is 0.95, and the correlation coefficient of Portfolio Y's returns and the market's returns is 0.60. Which of the following statements best describes the levels of portfolio diversification? A. Both Portfolio X and Portfolio Y are well diversified. B. Both Portfolio X and Portfolio Y are poorly diversified. C. Portfolio X is well diversified and Portfolio Y is poorly diversified. D. Portfolio X is poorly diversified and Portfolio Y is well diversified.


110. The return on an asset added to a portfolio is less than perfectly positively correlated with the returns of the other assets in the portfolio but has the same standard deviation. What effect will adding the new asset have on the standard deviation of the portfolio's return? The standard deviation: A. will increase. B. will decrease. C. may increase or decrease, depending on the asset allocation model. D. may increase or decrease, depending on the individual securities mix in the portfolio.

111. A risk-averse investor owning stock in White Corporation decides to add the stock of either Black Corporation or Green Corporation to her portfolio. All three stocks offer the same expected return and total risk. The covariance of returns between White stock and Black stock is –0.05 and White stock and Green stock is +0.05. Portfolio risk is expected to: A. decline more by buying Black Corporation. B. decline more by buying Green Corporation. C. increase by buying either Black or Green Corporation. D. decline or increase, depending on other factors.

112. Beta and standard deviation differ as risk measures in that beta measures: A. only systematic risk, whereas standard deviation measures total risk. B. only unsystematic risk, whereas standard deviation measures total risk. C. total risk, whereas standard deviation measures only systematic risk. D. total risk, whereas standard deviation measures only unsystematic risk.

113. According to the capital asset pricing model, the rate of return of a portfolio with a beta of 1.2 and a risk premium of 6.5 percent while the risk-free rate of 5 percent is: A. 7.0%. B. 11.5%. C. 12.5%. D. 12.8%.

114. In contrast to the capital asset pricing model, arbitrage pricing theory: A. has fewer restrictive assumptions. B. uses risk premiums based on micro variables. C. requires normally distributed security returns. D. specifies the number and identities of specific factors that determine expected returns.


115. Key steps in the dynamic process of portfolio management are:

I. Identify and evaluate the investor’s objectives, preferences, and constraints. II. Monitor market conditions, relative asset values, and the investor’s

circumstances. III. Formulate appropriate investment strategies and their implementation through

selection of optimal combinations of financial and real assets in the marketplace.

IV. Adjust the portfolio as is appropriate to reflect significant change in any of the relevant variables.

The order of these steps in the portfolio management process is generally: A. I, III, II, IV. B. II, I, III, IV. C. III, I, IV, II. D. IV, III, II, I.

116. Which of the following is the most valid justification for including real estate as part of an investment portfolio? A. High liquidity. B. Low project-specific risk. C. Low management and information costs. D. Low correlation of real estate with stocks and bonds.

117. The net operating income figure used in valuing an income property is calculated by subtracting which of the following from the property’s gross potential rental income?

I. Interest on debt financing. II. Income taxes.

III. Property taxes. A. I only. B. II only. C. III only. D. I, II, and III.

118. A disadvantage of relying solely on the comparative sales approach to valuing real estate is that the approach: A. relies on selling prices, not asking prices. B. requires estimating a market capitalization rate. C. works well only for new or relatively new buildings. D. does not reflect the fact that all properties are unique in some respect.


119. All of the following statements about real estate investment trusts (REITs) are generally true EXCEPT: A. the shares of REITs are traded only on the New York Stock Exchange. B. REITs must keep at least 75 percent of their assets in real estate investments. C. REITs are required by law to pay out 95 percent of their income as dividends. D. REITs yield a return at least 1–2 percentage points above money market funds and about

the same return as high-grade corporate bonds.

120. The portfolio management process consists of the following four steps:

I. Monitoring of market conditions, relative asset values, and the investor’s circumstances.

II. Formulation of appropriate investment strategies and their implementation through selection of optimal combinations of financial and real assets in the marketplace.

III. Identification and evaluation of the investor’s objectives, preferences and constraints as a basis for developing an investment policy specific to that investor.

IV. Adjustment of the portfolio as is appropriate to reflect significant change in any of the relevant variables.

The proper ordering of these steps (from first to last) is: A. I, II, III, IV. B. II, I, III, IV. C. III, II, I, IV. D. IV, I, II, III.


GUIDELINE ANSWERS FOR SAMPLE EXAM 2

1. B Reference: Standards of Practice Handbook, 7th ed., Standard II(A), Use of Professional Designation, pp. 19–22.

2. D Reference: Standards of Practice Handbook, 7th ed., Standard II(C), Prohibition against Plagiarism, pp. 27–32.

3. B Reference: Standards of Practice Handbook, 7th ed., Standard II(C), Prohibition against Plagiarism, pp. 27–32.

4. A Reference: Standards of Practice Handbook, 7th ed., Standard III(B), Duty to Employer, pp. 39–45.

5. B Reference: Standards of Practice Handbook, 7th ed., Standard III(E), Responsibilities of Supervisors, pp. 53–56.

6. C Reference: Standards of Practice Handbook, 7th ed., Standard IV(A.1), Reasonable Basis and Representations, pp. 61–67.

7. D Reference: Standards of Practice Handbook, 7th ed., Standard IV(A.3), Independence and Objectivity, p. 80.

8. D Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.1), Fiduciary Duties, pp. 83–93, and Fiduciary Duty Topical Study, pp. 155–168.


9. B Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.2), Portfolio Investment Recommendations and Actions, pp. 95–102.

10. D Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.3), Fair Dealing, pp. 103–13.

11. A Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.4), Priority of Transactions, pp. 115–21.

12. A Reference: Standards of Practice Handbook, 7th ed., Standard V(A), Prohibition against Use of Material Nonpublic Information, pp. 141–49, and Insider Trading Topical Study, pp. 169–182.

13. C Reference: Standards of Practice Handbook, 7th ed., The Code of Ethics, p. 5.

14. C Reference: Standards of Practice Handbook, 7th ed., Standards IV(B.7), Disclosure of Conflicts to Clients and Prospects, and Standard III(C), Disclosure of Conflicts to Employer, pp. 131–33, and 47–8.

15. A Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.6), Prohibition against Misrepresentation, p.27.

16. C Reference: Standards of Practice Handbook, 7th ed., Standard IV(B.1), Fiduciary Duties, p. 83–8.


17. C Reference: Standards of Practice Handbook, 7th ed., Standard V(A), Prohibition against the Use of Material Nonpublic Information, pp. 141–3.

18. C Reference: Standards of Practice Handbook, 7th ed., Standard IV(A.3), Independence and Objectivity, pp. 75–6.

19. B Solution:

PV = $15/(1.12) + $25/(1.12)2 + $10/(1.12)3 – $5/(1.12)4 = $13.393 + $19.930 + $7.118 – $3.178 = $37.263, or $37.26. or PV = $15(0.8929) + $25(0.7972) + $10(0.7118) – $5(0.6355) = $13.394 +$19.930 + $7.118 – $3.178 = $37.264, or $37.26. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 118–122.

20. C Solution:

Annuity FV factor = [(1 + r)t – 1]/r = [(1.08)12 –1]/0.08 = 1.5182/0.08 = 18.977. Annuity = $140,000/FVIFA8%,12 YRS = $140,000/18.977 = $7,377. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," p.118.


21. B Solution:

Annuity present value = C × [(1 – Present value factor)/r], where C = the annuity r = the required rate of return (discount rate) . Annuity present value factor = [1 – 1/(1 + r)t]/r = [1 – (1/1.08)15)]/0.08 = 8.5595. Annuity present value = $25,000(8.5595) = $213.987.50. By calculator = $213,986.97 Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 5, "First Principles of Valuation: The Time Value of Money," pp. 133–134.

22. A Solution:

Geometric mean (GM) = π1/n – 1 = [(1.10) × (0.90)]½ –1 = (0.99)½ – 1 = 0.995 – 1 = –0.005, or 0.500%, where π = the product of the annual holding–period returns. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 8–10.


23. B Solution:

The formula for the expected value is:

E( R ) = P Ri i ii

n

( )( )=∑

1

Therefore, E(R )= 0.1(15%) + 0.6(13%) + 0.3(7%) = 1.5%+ 7.8% + 2.1% = 11.4%. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 33–34, and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed. Ch. 1, "The Investment Setting," pp. 11–14.

24. D Solution:

Multiplying a random variable by a constant changes its expectation by the same proportion. The new returns for each of the four scenarios are 1.06 times the previous returns (for Scenario 1, the new return/old return = 15.9/15 = 1.06). Therefore, Stock A's expected return will also be 1.06 times the previous expected return. Therefore, the new portfolio return is 1.06 (23 %) = 24.4 %. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, p. 34.


25. D Solution:

Multiplying a random variable by a constant will multiply the standard deviation by the (absolute value of this) constant. The new returns on each of the three stocks are actually 1.05 times the previous returns (for Scenario 1, the new return/old return = 0.21/0.20 = 1.05). Therefore, σ(kr) = Abs(k) × σ(r) = 1.05(.111355) = .1169; or σ(kr) = [0.2(0.21 0.357) + 0.5(0.315 0.357) + 0.3(0.525 0.357)2 2 2− − − = (0.004322 + 0.000882 + 0.008467) = 0.013671 = 0.1169, where kr = random variable Abs(k) = absolute value of a constant σ = standard deviation Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 34–35.

26. A Solution:

The expected return, E(R),is: E(R) = 0.3(0.05) + 0.5(0.10) + 0.2(0.20) = 0.015 + 0.05 + 0.04 = 0.105, or 10.5%. The formula for the variance of the expected return is:

Therefore, σ2 = 0.3(0.05 – 0.105)2 + 0.5(0.10 – 0.105)2 + 0.2(0.20 – 0.105)2 = 0.0009075 + .0000125 + 0.0018050 = 0.002725.

Variance, , = [ - ( ) ]i=1

n2 2σ P R E Ri i∑


Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 14, 33–34; and Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 34–35.

27. C Solution:

With a normal distribution, 95 percent of the values occur within plus or minus two standard deviations of the mean. Confidence interval = 100 ± 2(10) = 80 to 120. Reference: Bodie, Kane, and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 39–47; and Schroeder, Sjoquist and Stephan, Understanding Regression Analysis: An Introductory Guide, "Hypothesis Testing," pp. 49–51.

28. B Solution:

rx y = Cov(RxRY)/sXsy = 0.005/(0.20)(0.06) = 0.005/0.012 = 0.417 Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 57–58; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 259–61.

29. C Solution:

The formula for the covariance is: Covi j = E{[Ri – E(Ri)][Rj – E(Rj)]}. For Security I: E(R) = 0.5(0.30) + 0.5(0.10) = 0.20. For Security J: E(R) = 0.5(0.20) + 0.5(–0.10) = 0.05.


When applying the formula to the two scenario rates of return for Security I and Security J, the covariance formula becomes:

Therefore, Covij

= [(0.30 – 0.20)(0.20 – 0.05) + (0.10 – 0.20)(–0.10 – 0.05)]/2 = [0.0150 + 0.0150]/2 = 0.030/2 = 0.0150. Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 54–56; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch 8, "An Introduction to Portfolio Management," pp. 255–61.

30. B Solution:

βx = Cov(Rx , RM )/σM2

= 0.0288/0.2002

= 0.0216/0.040 = 0.720. Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, p. 59–62; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 288–89.

31. C Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 59–62; and Schroeder, Sjoquist and Stephan, Understanding Regression Analysis: An Introductory Guide, Ch. 1, "Linear Regression," pp. 11–29.

12 1

2

[ - ( )][ - ( )]

. = i i j j

iR E R R E R∑


32. A

Reference: Schroeder, Sjoquist, and Stephan, Understanding Regression Analysis: An Introductory Guide, pp. 46–53.

33. C Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 63–66.

34. D Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 63–68; and Schroeder, Sjoquist, and Stephan, Understanding Regression Analysis: An Introductory Guide, pp. 46–49.

35. D Solution:

H0: β = 1 H1: β¹ ≠1 Confidence interval: b – 1.96sb ≤ β ≤ b + 1.96sb Security X:1.28 – 1.96(0.17) ≤ 1 ≤ 1.28 + 1.96(0.17) = 0.85 ≤ 1 ≤ 1.61 Security Y:1.08 – 1.96(0.08) ≤ 1 ≤ 1.08 + 1.96(0.08) = 0.92 ≤ 1 ≤ 1.24 The null hypothesis cannot be rejected for Security X or Security Y because the null hypothesized value (β = 1) lies in the confidence interval for each security. Reference: Bodie, Kane and Marcus, Investments, 3rd ed., Appendix A, "Quantitative Review," in 1998 CFA Level I Candidate Readings, pp. 63–68; and Schroeder, Sjoquist, and Stephan, Understanding Regression Analysis: An Introductory Guide, pp. 46–51.

36. B Reference: Kritzman, "What Practitioners Need to Know...About Time Diversification," in 1998 CFA Level I Candidate Readings, pp. 71–2.


37. B

Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 11, "Modern Macroeconomics: Fiscal Policy," pp. 278–80.

38. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 11, "Modern Macroeconomics: Fiscal Policy," pp. 283–84.

39. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 11, "Modern Macroeconomics: Fiscal Policy," pp. 281–84.

40. D Solution:

Deposit expansion multiplier = 1/Required reserve ratio Required reserve ratio = 0.2 Deposit expansion multiplier = 1/0.2 = 5. Federal Reserve purchase of $10 million of government securities will increase reserves by $10 million. Expansion of money supply = Change in reserves × Deposit expansion multiplier =$10 million × 5 = $50 million increase. Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 12, "Money and the Banking System," pp. 302–08.

41. B Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 12, "Money and the Banking System," pp. 380–11.


42. D Solution:

GDP = MV where M = existing money stock V = velocity of money V =GDP/M = $6 trillion/$800 million = 7.5. Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 13, "Modern Macroeconomics: Monetary Policy," pp. 330–31.

43. C Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 13, "Modern Macroeconomics: Monetary Policy," pp. 339–42.

44. C Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 13, "Modern Macroeconomics: Monetary Policy," pp. 339–42.

45. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 13, "Modern Macroeconomics: Monetary Policy," pp. 339–42.

46. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 14, "Expectations, Inflation, and Unemployment," pp. 359–62.

47. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 17, "Demand and Consumer Choice," pp. 452–54.


48. B Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 18, "Costs and the Supply of Goods," p. 482.

49. D Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 19, "Price Takers and the Competitive Process," p. 505.

50. A Reference: Gwartney and Stroup, Economics: Private and Public Choice, 8th ed., Ch. 17, "Demand and Consumer Choice," pp. 443–46.

51. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 116–19.

52. A Solution:

Net sales $3,000 – Cash expenses (1,400) – Increase in accounts receivable (400) Cash flows from operations $1,200 Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 131–57.

53. B Solution:

Cash collections from customers $260 – Salaries paid (35) – Cash payments to suppliers (85) – Cash payments for interest (12) Cash flows from operating activities $128 Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 133–46.


54. C Solution:

Sale of equipment $30 – Purchase of land (8) – Purchase of equipment (40) Cash flows from investing activities ($18) Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 133–46.

55. B Solution:

− Payments to retire stock ($32) − Payment of dividends (37) Cash flows from financing activities ($69) Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis." pp. 133–46.

56. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," p. 159.

57. A Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," p. 160.

58. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 2, "Financial Statements: The Raw Data of Analysis," pp. 170–71.

59. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 336.


60. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," p. 340.

61. C Solution:

COGSF = COGSL – (LIFO reserveE – LIFO reserveB) = $16,000 – ($4,000 – $1,500) = $13,500, where the subscripts E and B refer to ending inventory and beginning inventory, respectively, and the subscripts F and L refer to FIFO and LIFO, respectively. Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 5, "Analysis of Inventories," pp. 344–46.



64. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 398–403.

65. C Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 426–27, 434.


66. B Solution:

Average age = Accumulated depreciation/Annual depreciation = $45 million/$5 million = 9 years. Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 6, "Analysis of Long–Lived Assets," pp. 452–53.

67. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," p. 572.


69. B Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," p. 582.

70. A Solution:

$400,000 – $408,000 = ($8,000). Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 8, "Analysis of Financing Liabilities," pp. 583–84.


72. D Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 9, "Pension and Other Postemployment Benefits," p. 653.


73. D

Reference: White, Sondhi, and Fried, The Analysis and Use of Financial Statements, Ch. 10, "The Analysis of Off-Balance-Sheet Activities and Hedging Transactions," pp. 716–17.

74. C Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 8, "Making Capital Investment Decisions," pp. 230–32.

75. D Solution: The formula for the accounting breakeven is:

Q = (FC + D)/(P – v), where Q = total units sold FC = fixed costs D = depreciation P = selling price per unit v= variable cost per unit. Therefore, Q = ($10,000 + $2,000)/($100 – $50) = $12,000/$50 = 240 units. Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 9, "Project Analysis and Evaluation," pp. 276–78.

76. D Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 9, "Project Analysis and Evaluation," pp. 283–84.

77. C Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 14 "Cost of Capital," pp. 452–55.


78. C

Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 15 "Financial Leverage and Capital Structure Policy," pp. 479–83.

79. B Solution:

Earnings before interest and taxes = $800,000 Interest = 0 (no leverage) Corporate taxes = 0.4 × $800,000 = $320,000 Firm value = ($800,000 – $320,000)/0.15 = $3,200,000 (no debt). Reference: Ross, Westerfield, and Jordan, Fundamentals of Corporate Finance, 3rd ed., Ch. 15 "Financial Leverage and Capital Structure Policy," pp. 483–86.

80. C Reference: Reed and Bartsch, "Accounting for Deferred Taxes Under FASB 109," in 1998 CFA Level I Candidate Readings, pp. 96–97.

81. D Reference: Solnik, International Investments, 3rd ed., Ch. 4, Appendix, "Costs of International Investment," pp. 127–28.

82. A Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," pp. 127–28.

83. A Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," pp. 176–77.

84. C Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," pp. 176–77.


85. D Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," pp. 177–78, 184–85.

86. D Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," pp. 191–93.

87. A Reference: Solnik, International Investments, 3rd ed., Ch. 6, "Equity: Markets and Instruments," p. 215.




91. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 4, "Organization and Functioning of Securities Markets," pp. 108–12.

92. A Reference: Kolb, Futures, Options and Swaps, 2nd ed., Ch. 10, "The Options Market," pp. 314–15.


93. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 12, "Analysis of Financial Statements," pp. 388–93.

94. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 12, "Analysis of Financial Statements," pp. 393–94.

95. B Solution:

P = $1.50/(1.15) + $26.00/(1.15) = $1.304 + $22.609 = $23.913, or $23.91. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "Introduction to Security Valuation," pp. 439–40.

96. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "Introduction to Security Valuation," p. 443.

97. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 13, "Introduction to Security Valuation," pp. 447–48.

98. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 21, "Technical Analysis," pp. 772–73.

99. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 18, "Stock Market Analysis," pp. 655–69.


100. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," p. 529.

101. D Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 530–33.

102. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 565–69.

103. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 566–68.

104. B Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," pp. 565–69.

105. A Solution:

Modified duration equals Macaulay duration, divided by 1, plus the current yield to maturity, divided by the number of payments in a year. Dmod =9/(1 + 0.10) = 9/1.1 = 8.18 years. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," p. 568.


106. A Solution:

The estimated percentage change in the price of the bond is: %∆P = –Dmod × ∆i, where –Dmod = the modified duration of the bond ∆I = yield change in basis points divided by 100. Therefore, %∆P = –6.54 × 50/100 = –6.54 × 0.50 = –3.27 . Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 16, "The Analysis and Valuation of Bonds," p. 568–69.

107. C Solution:

The holding period yield (HPY) is: HPY = (Ending value/Beginning value) – 1 = ($48,700/$50,000) – 1 = 0.974 – 1 = –0.025, or –2.6%. Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 1, "The Investment Setting," pp. 6–7.

108. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 255–68.

109. C Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 259–61, and Ch. 9, "An Introduction to Asset Pricing Models," pp. 283–84.


110. B

Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 262–69.

111. A Solution:

Assuming a two–asset portfolio, the standard deviation of this portfolio is:

The portfolio risk, as measured by the standard deviation, will decline more by buying Black Corporation stock. This is because the covariance of returns between White stock and Black stock (Cov1,2 = –0.05) is lower than between White stock and Green stock (Cov1,2 = +0.05). Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 8, "An Introduction to Portfolio Management," pp. 262–69.

112. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 283–87.

113. D Solution: A formula for the capital asset pricing model is:

E(Rport) = RFR + βport(Rm – RFR), where E(Rport) = the expected return on the portfolio RFR = the risk free rate Rm = the return on the market portfolio βport = the portfolio beta E(Rport)= 5% + 1.2(6.5%) = 12.8%.

port W W W Wσ σ σ = + + 212

12

22

22

1 2 1,2Cov


Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 288–89.

114. A Reference: Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 9, "An Introduction to Asset Pricing Models," pp. 297–300.

115. A Reference: Peavy and Sherrerd, Cases in Portfolio Management, "Portfolio Management: The Portfolio Construction Process," in 1998 CFA Level I Candidate Readings, pp. 126–27.

116. D Reference: Gitman and Joehnk, Fundamentals of Investing, 6th ed., Ch. 12, "Real Estate and Other Tangible Investments," in 1998 CFA Level I Candidate Readings, pp. 152–53; and Reilly, Brown, Investment Analysis and Portfolio Management, 5th ed., Ch. 3, "Selecting Investments in a Global Market," p. 93.

117. C Reference: Gitman and Joehnk, Fundamentals of Investing, 6th ed., Ch. 12, "Real Estate and Other Tangible Investments," in 1998 CFA Level I Candidate Readings, p. 161.

118. D Reference: Gitman and Joehnk, Fundamentals of Investing, 6th ed., Ch. 12, "Real Estate and Other Tangible Investments," in 1998 CFA Level I Candidate Readings, pp. 160–61.

119. A Reference: Gitman and Joehnk, Fundamentals of Investing, 6th ed., Ch. 12, "Real Estate and Other Tangible Investments," in 1998 CFA Level I Candidate Readings, p. 174–76.

120. C Reference: Peavy and Sherrerd, "Portfolio Management: The Portfolio Construction Process," in 1998 CFA Level I Candidate Readings, p. 126.

1998 sample exam · 9. don smith, a cfa candidate employed by hunter investment counselors, inc.,...

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