CFA Institute CFA-LEVEL-1 Online Practice Questions and Exam Preparation

CFA Institute CFA-LEVEL-1 Online Questions & Answers

• Question 1961:

  After the initial feasibility studies, all software development costs can be capitalized under US GAAP. Ultrasoft and Littlesoft are rival firms which are similar in size and scope of operations. Ultrasoft has decided not to capitalize but expense software development costs in Year

  1. Littlesoft, on the other hand, has decided to capitalize a similar amount of development costs, to be amortized over 5 years. Which of the following is/are true over the next 5 years?

  I. Littlesoft will show higher equity than Ultrasoft

  II. The difference in Littlesoft's assets and Ultrasoft's assets will be lower in Year 3 than in Year 2.

  III.

  The total tax deductions due to the development costs are equal for the two firms.

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

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  Explanation

  When Littlesoft capitalizes the expenses, its assets increase, net of depreciation and tax expenses. Hence, it shows higher assets than Ultrasoft (but this difference reduces steadily to zero over the period over which the expense is amortized). This difference also translates into an equal difference between the retained earnings as well as equity (Recall assets = liabilities + equity). Thus, over the next 5 years, Littlesoft will show higher equity than Ultrasoft. The difference will reduce to zero by the end of the period over which the capitalized expense is amortized. Over 5 years, the total tax deductions taken by the two firms are equal to the initial expense. Hence, the taxes paid are equal; the difference is that Ultrasoft delays the payment of taxes by expensing. Lesson: Expensing delays tax payments, capitalizing hastens them.

• Question 1962:

  According to the Prudent Investor Rule, the trustee must: - adhere to loyalty, impartiality and prudence - maintain overall portfolio risk at a reasonable level - provide for reasonable ________ of trust investments - act with prudence in deciding whether and how to delegate authority to experts and in selecting and supervising agents - be cost conscious when investing

  A. supervision
  B. commitment
  C. diversification
  D. none of these answers
  C. diversification

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  Explanation

  Modern Portfolio Theory dictates that trustees consider a portfolio in its entirety and not just on an investment-by-investment basis. As a fiduciary, therefore, the trustee must: - adhere to fundamental fiduciary duties of loyalty, impartiality and prudence. - maintain overall portfolio risk at a reasonable level - the trade-off between risk and return is the fiduciary's central concern. - provide for reasonable diversification of trust investments. - act with prudence in deciding whether and how to delegate authority to experts and in selecting and supervising agents. - be cost conscious when investing.

• Question 1963:

  Intelligent Semiconductor is considering the development of a new data storage medium, which will allow tremendous increases in the efficiency of its customer's high-end server lines. The development of the new system will take place in Intelligent's existing facilities, and the storage costs for the additional equipment are expected to be residual in nature. The following information applies to this project: Rent expense for existing facilities ($10,500) Initial cash outlay ($50,000) t1: $15,000 t2: $11,000 t3: $11,000 t4: $15,000 t5 $25,000 Discount rate: 9% Assuming no taxes or related charges, that the initial cash outlay does not include any sunk costs, and a $0.00 salvage value at after the fifth year, which of the following choices best represents the payback period for this investment?

  A. 4 years
  B. 3. 75 years
  C. 3. 13 years
  D. 3. 87 years
  E. 4. 23 years
  D. 3. 87 years

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  Explanation

  Remember that the rental expense of the firm's existing facilities is a sunk cost, and should not be incorporated into the calculation. This is due to the fact that the rental expense is not incremental in nature, and is unaffected by the acceptance of the project in question. In this example, the payback period is approximately 3. 87 years. After the third year, $37,000 of the initial $50,000 investment has been recouped, leaving $13,000 to be recovered. The following period has a cash inflow of $15,000, exceeding the $13,000 amount required to completely "pay back" the initial investment. To calculate the period required, divide the $13,000 left to be recouped by the $15,000 cash inflow during period 4. This will yield an answer of 0.8667, which is added to the three-year period already passed, giving an answer of 3. 87 years. While somewhat appealing in a simplistic sense, the payback period is not an advisable method for valuation and analysis of capital projects, primarily due to the fact that this method completely ignores the time value of money principle which governs the field of finance.

• Question 1964:

  The best stock for investment purposes

  A. is the one that is the most undervalued.
  B. has the highest expected rate of return.
  C. is the one issued by the best company.
  D. has the least risk.
  A. is the one that is the most undervalued.

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  Explanation

  The best stock for investment purposes is not necessarily issued by the best company, because the best company's stock may be overvalued. The stock with the highest expected rate of return may have excessive risk, while the stock with the lowest risk may have an excessively low expected rate of return. Rather, the stock that is the most undervalued is the best investment.

• Question 1965:

  Assuming that the inflation rate and risk-free rate of interest are relatively high, which of the following correctly illustrates the calculation of the nominal risk-free rate?

  A. Nominal RFR = (1+ RFR)(1 + inflation premium) - 1
  B. Nominal RFR = (1 + RFR)(1 + inflation premium)
  C. Nominal RFR = RFR + E(I)
  D. None of these answers is correct.
  E. Nominal RFR = Real RFR * (1 + k)
  F. Nominal RFR = Real RFR * E(I)
  A. Nominal RFR = (1+ RFR)(1 + inflation premium) - 1

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  Explanation

  When either the real "inflation-free" interest rate or the expected inflation rate are significantly large, the calculation of the nominal risk-free rate differs from the equation used when these factors are significantly small. Specifically, the calculation of the nominal risk-free rate of interest when the inflation-free rate of interest and/or the inflation premium are significantly high is as follows:

  Nominal RFR = (1 + Real RFR)(1 + E(I)) - 1

  Where: Real RFR = the real inflation-free rate of interest and E(I) = the anticipated inflation rate.

  When the inflation-free rate of interest and/or the inflation premium are low, then the equation above can be approximated by the following: Nominal RFR = Real RFR + Inflation premium.

• Question 1966:

  Assume that all the assumptions of Modigliani and Miller hold. In particular, there are no taxes and transaction costs. A firm has a policy of paying out 8% of the stock price as dividends. However, an investor would like to receive only a 4% dividend. For this, he should:

  A. none of these answers.
  B. liquidate 8% of his stock holding after receiving the dividend.
  C. liquidate 4% of his stock holding after receiving the dividend.
  D. use half of the dividend amount to buy stock after receiving the dividend.
  D. use half of the dividend amount to buy stock after receiving the dividend.

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  Explanation

  Suppose the investor is holding stocks worth $100. The company then pays $8 as dividends. To reduce his dividend income to $4, the investor must buy stocks worth $4.

• Question 1967:

  Which of the following are substantive purposes for conducting post-audit procedures in capital budgeting situations? Choose the best answer.

  I. Improving forecasts

  II. Shifts in the Security Market Line

  III. Improving operations

  IV.

  Controlling management

  V.

  Adhering to Bond Covenants

  VII.

  Ensuring adherence to governmental guidelines for performance presentation

  A. I, III, IV
  B. I, II, III, IV, VII, VIII
  C. I, III, IV, VIII
  D. I, III
  E. II, IV, VIII
  F. I, V, VII, VIII
  D. I, III

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  Explanation

  An important aspect of the capital budgeting process is the post-audit, which involves comparing actual results with those forecasted and determining why any discrepancies exist. The post-audit process has two main purposes. First, the post-audit process is used to improve the forecasting capacity of the firm. Second, this process is used to improve the operations of the firm. "Shifts in the Security Market Line" has little to do with the post-audit process. Additionally, remember that aside from AIMR PPS and other suggested performance presentation guidelines, there are no real "guidelines for research and performance presentation." There are certainly no "governmental guidelines" for performance presentation; therefore, answer VII is incorrect.

• Question 1968:

  Which of the following best describes a type II error?

  A. The probability of incorrectly failing to reject the null hypothesis.
  B. (1 - the significance level).
  C. The probability of incorrectly rejecting the null hypothesis.
  D. The power of a test.
  E. More than one of these answers is correct.
  A. The probability of incorrectly failing to reject the null hypothesis.

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  Explanation

  A type II error occurs when one incorrectly fails to reject the null hypothesis. In most cases, the probability of a type II error is not expressly stated because the determination of this probability is inherently difficult. A type II error is contrasted by a type I error, which is defined as the act of incorrectly rejecting the null hypothesis.

• Question 1969:

  If you have $4,000 in an account today and withdraw $2,000 in 3 years, how much can you withdraw from the account in 5 years, if the account earns interest at 8% per year, compounded annually?

  A. $3,544. 51
  B. $3,407. 98
  C. $3,000.00
  D. $2,000.00
  E. $7,714. 93
  A. $3,544. 51

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  Explanation

  The way to approach this problem is to find the PV today of the $2,000 amount, determine the difference between this amount and the original $4,000 amount, and then move this remaining amount to the 5 year point. On the BAII Plus, press 3 N, 8 I/Y, 2000 FV, 0 PMT, CPT PV, which yields $1,587. 66. Then press + 4000 =. Then press PV, 5 N, CPT FV to see the answer. On the HP12C, press 3 n, 8 i, 2000 FV, 0 PMT, CPT PV. Then press 4000 +. Then press PV, 5 n, CPT FV to see the answer. Make sure the BAII Plus has the P/Y value set to 1.

• Question 1970:

  In the aggregate demand/aggregate supply model, an increase in a country's sustainable potential output is represented by an increase in

  A. actual unemployment.
  B. prices.
  C. aggregate demand.
  D. long-run aggregate supply.
  D. long-run aggregate supply.

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  Explanation

  Changes in long run aggregate supply affect the economy's long run potential output. Changes in short run aggregate supply do not affect the long run potential of the economy.