CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 1841:

  Free cash flow is not

  A. cash flow that includes discretionary uses such as debt reduction.

  B. the measure of cash available to the firm for discretionary uses after making all required cash outlays.

  C. better to have a large sum of.

  D. defined as cash flow from operations minus all capital expenditures.

  E. a cash flow with one definition because of its several discretionary uses.

  Correct Answer: E

  The definition of free cash flow varies widely, depending on how one defines required and discretionary uses.

• Question 1842:

  The following data have been obtained from a firm's financial statements:

  operating profit margin 34% interest expenses 465 depreciation expenses 123 debt-to-equity ratio 0.60 total assets 2,375 total sales 4,109 tax rate 37%

  The firm's ROE equals ________.

  A. 19.17%

  B. 22.88%

  C. 56.32%

  D. 34.44%

  Correct Answer: D

  The answer to this requires you to know the extended duPont system. However, you should NOT rely on your memory for complex formulas. Rather, start from the primary quantity needed (ROE here) and use some basic definitions and common sense. This approach will ensure that you are not caught by surprise during the exam. You need to calculate net income and total equity to obtain ROE, since ROE = net income/total equity. Operating profits equal earnings before depreciation, interest and taxes (EBDIT). The operating profit margin expresses EBDIT as a fraction of total sales and indicates the level of profitability of the firm. In this case, EBDIT = 4109*34% = 1,397. Since interest expenses are taxdeductible, EBT = 1,397 - interest expense - depreciation = 1,397 - 465 - 123 = 809. Therefore, net income after taxes = 809*(1 37%) = 510. Also, debt + equity = total assets and debt = 0.6*equity (given). So total assets = 2,375 = 1.6*equity, giving equity = 2,375/1.6 = 1,484. Finally, ROE = 510/1484 = 34.34%.

• Question 1843:

  Firms A and B are identical. In one year, Firm A's statements have the beginning inventory understated and the ending inventory overstated. Then,

  I. A's tax payment is higher.

  II. B's tax payment is higher.

  III. B shows a higher income.

  IV.

  A shows a higher income.

  A.

  I and IV

  B.

  II and III

  C.

  I and III

  D.

  II and IV

  Correct Answer: A

  COGS = Beginning inventory - Ending inventory + Purchases. Hence, if BI is understated and EI overstated, COGS is understated, implying income is overstated. Hence, Firm A will show higher income and pay higher taxes. It should be remembered that implicit in the use of the above inventory equation is the assumption that there have been no write-downs or write-ups in the inventory.

• Question 1844:

  The main use of the balance sheet for creditors would be

  A. to forecast future cash flow needs.

  B. to review the short-term liquidity of the firm.

  C. to forecast cash collections.

  D. to forecast changes in fixed assets thereby assisting in the firm's profitability.

  E. to provide information about the nature of assets that the firm uses as debt collateral.

  Correct Answer: E

  The balance sheet provides information about a firm's resources and obligations, including liquidity and solvency.

• Question 1845:

  A firm has a high debt-to-equity ratio. In order to improve this ratio in earlier years, it will prefer:

  A. LIFO accounting and accelerated depreciation.

  B. LIFO accounting and straight-line depreciation.

  C. FIFO accounting and straight-line depreciation.

  D. FIFO accounting and accelerated depreciation.

  Correct Answer: C

  The company will use FIFO (assuming prices are increasing) and straight line depreciation to increase income and hence, retained earnings. This improves the debt-to-equity ratio.

• Question 1846:

  Bungling, Inc., is currently facing a lawsuit as a defendant. Its honest lawyers estimate that there is a 60-40 chance that Bungling will lose the lawsuit. The jury could award the plaintiff punitive damages ranging from $10,000 to $50,000. Bungling should

  A. not recognize any liability but disclose the details in footnotes.

  B. not do anything since the lawsuit is still not decided and considerable uncertainty exists.

  C. recognize a liability of $50,000 on its balance sheet as a conservative estimate.

  D. recognize a liability of $10,000 on its balance sheet.

  Correct Answer: A

  If considerable uncertainty exists in measurement of an asset or a liability arising from events like a lawsuit, disclosure must occur in footnotes. The disclosure includes the nature of the contingency and an estimate or a range of estimates about the possible losses.

• Question 1847:

  A transaction that is unusual in nature and infrequent in occurrence should be reported separately as a component of income

  A. after cumulative effect of accounting changes and after discontinued operations of a segment of a business.

  B. before cumulative effect of accounting changes and before discontinued operations of a segment of a business.

  C. after cumulative effect of accounting changes and before discontinued operations of a segment of a business.

  D. before income from continuing operations.

  E. before cumulative effect of accounting changes and after discontinued operations of a segment of a business.

  Correct Answer: E

  A transaction that is unusual and infrequent is classified as an extraordinary item. The following is the order of items to be reported separately in the income statement: income from continuing operations, discontinued operations, extraordinary items, cumulative effect of changes in accounting principle, and net income.

• Question 1848:

  Which of the following is not subject to depreciation?

  A. automobiles

  B. land

  C. machinery

  D. land improvements

  Correct Answer: B

  Land has unlimited useful life and is not consumed when it is used, and therefore not subject to depreciation.

• Question 1849:

  Which of the following statements are correct?

  I. A company's choice of accounting principles for financial reporting purposes does not affect net cash flow for the accounting period.

  II. A company's choice of accounting principles for financial reporting purposes does not affect operating cash flow.

  III. If a company sells its receivables this will increase operating cash flow.

  IV.

  If a company sells its receivables this will increase financing cash flow.

  A.

  I and III

  B.

  I, II and III

  C.

  II and IV

  D.

  I and IV

  Correct Answer: A

  The choice of accounting principles affects only the classification and not the net cash flow, and reducing receivables in considered an increase in operating cash flow.

• Question 1850:

  A firm pays out half its earnings as dividends. If its net income is $50, then

  I. Its assets increase by $25

  II. Its equity increases by $25

  III. Its equity increases by $50

  IV.

  The book value of the firm increases by $50

  A.

  III and IV

  B.

  I and II

  C.

  I and IV

  D.

  II and IV

  Correct Answer: B

  Since half of $50 is paid out as dividends and the other half retained, the book value and equity increase by $25 and so do assets. Remember the basic equation, Assets = Liabilities + Equity.