MCQs i mess up once studying is finished Flashcards
Which of the following return calculating methods is best for evaluating the annualized returns of a buy-and-hold strategy of an investor who has made annual deposits to an account for each of the last five years?
A
Geometric mean return.
B
Arithmetic mean return.
C
Money-weighted return.
A
Geometric mean return.
The geometric mean return compounds the returns instead of the amount invested.
For a risky asset with volatile historical returns, which of the following measures of mean return will be most likely be highest?
A
Harmonic mean
B
Arithmetic mean
C
Geometric mean
B
Arithmetic mean
As long as the returns aren’t the same every year, the arithmetic mean always produces higher averages than the geometric mean. Analysts should be aware of this bias and identify whether returns are quoted on a geometric or arithmetic average.
The nominal risk-free rate is best described as the sum of the real risk-free rate and a premium for:
A
maturity.
B
liquidity.
C
expected inflation.
C
expected inflation.
Which of the following methods is the least likely recommended approach when dealing with outliers?
A
Do nothing and use the data without any adjustment.
B
Substitute the median for extreme values to stabilize the distribution.
C
Set a pair of boundaries and remove all observations that fall outside the boundaries.
B
Substitute the median for extreme values to stabilize the distribution.
There are three ways to deal with outliers:
No adjustments
Remove all outliers (trimmed mean)
Replace outliers with either an upper or lower limit (winsorized mean)
It is not appropriate to substitute the median for extreme values. This will create artificial stability that gives a misleading impression that the distribution is less volatile than it actually is.
The return metric that most accurately evaluates the performance of a portfolio manager who does not exercise control over the timing of new contributions and withdrawals is the:
A
time-weighted return.
B
internal rate of return.
C
money-weighted return.
A
time-weighted return.
Time-weighted return, which is unaffected by the timing and amount of cash flows, is most appropriate for measuring the performance of a manager who does not control new contributions and withdrawals.
he average return for Portfolio A over the past twelve months is 3%, with a standard deviation of 4%. The average return for Portfolio B over this same period is also 3%, but with a standard deviation of 6%. The geometric mean return of Portfolio A is 2.85%. The geometric mean return of Portfolio B is most likely:
A
less than 2.85%.
B
equal to 2.85%.
C
greater than 2.85%.
A
less than 2.85%.
Which of the following statements is most accurate? Compared to analytical methods, Monte Carlo simulation:
A
provides more precision when valuing options.
B
provides more insight into causal relationships.
C
can be used to value a wider variety of options than analytical methods.
C
can be used to value a wider variety of options than analytical methods.
The Black-Scholes-Merton option pricing model is most likely based on the assumption that the prices of underlying assets are:
A
t-distributed.
B
Chi-square distributed.
C
lognormally distributed.
C
lognormally distributed.
Analysts performing bootstrap:
A
seek to create statistical inferences of population parameters from a single sample.
B
repeatedly draw samples of the same size, with replacement, from the original population.
C
must specify probability distributions for key risk factors that drive the underlying random variables.
Bootstrapping through random sampling generates the observed variable from a random sampling with unknown population parameters. The analyst does not know the true population distribution, but through sampling can infer the population parameters from the randomly generated sample.
B is incorrect because, when performing bootstrap, the analyst repeatedly draws samples from the original sample and not population, where each individual resample has the same size as the original sample and each item drawn is replaced for the next draw.
An analyst takes a sample of an equity index’s monthly returns over a five-year period and determines that the the natural logarithm of this random variable follows a normal distribution. Based only on this information, it is most likely that:
A
the index’s monthly return data is normally distributed.
B
the index’s monthly return data is lognormally distributed.
C
there is not sufficient evidence to reach a conclusion about the distribution of the index’s monthly return data.
B
the index’s monthly return data is lognormally distributed.
If a random variable is lognormally distributed, it follows that its natural logarithm is normally distributed. It is also true that, if a random variable’s natural logarithm is normally distributed, the variable itself must be lognormally distributed.
Which of the following methods is most appropriate to use when only some members of a finite population can be identified?
A
Systematic sampling
B
Simple random sampling
C
Stratified random sampling
A
Systematic sampling
Systematic sampling can be used when not all members of a population can be coded or even identified to be placed in groups. It involves selecting every Kth member of a population until the desired size of the sample is reached.
Compared with bootstrap resampling, jackknife resampling:
A
is done with replacement.
B
usually requires that the number of repetitions is equal to the sample size.
C
produces dissimilar results for every run because resamples are randomly drawn.
B
usually requires that the number of repetitions is equal to the sample size.
For a sample of size n, jackknife resampling usually requires n repetitions. In contrast, with bootstrap resampling, we are left to determine how many repetitions are appropriate.
A researcher would like to gather a sample of fifty people. He divides the range of the people’s heights into ten intervals of equal length and randomly selects two people from each interval. This is most likely an example of:
A
cluster sampling.
A researcher would like to gather a sample of fifty people. He divides the range of the people’s heights into ten intervals of equal length and randomly selects two people from each interval. This is most likely an example of:
A
23%
cluster sampling.
B
70%
stratified sampling.
C
7%
systematic sampling.
C
systematic sampling.
B
stratified sampling.
The following table shows the significance level (a) and the p-value for two hypothesis tests.
Level of Significance p-Value
Test 1 0.02 0.05
Test 2 0.05 0.02
In which test should we most likely reject the null hypothesis?
A
Test 1 only
B
Test 2 only
C
Both Test 1 and Test 2
B
Test 2 only
The p-value is the smallest level of significance at which the null hypothesis can be rejected. If the p-value is less than the level of significance, the null is rejected.
In Test 1, the p-value exceeds the level of significance, whereas in Test 2, the p-value is less than the level of significance.
A sample is taken from a normally distributed population with known variance. The observations in this sample are sorted according to an ordinal scale. To test a hypothesis regarding the sample mean, an analyst would most likely use a:
A
t-test.
B
z-test.
C
nonparametric test.
C
nonparametric test.
When data is ranked, such as when it has been sorted according to an ordinal scale, the assumptions of parametric tests (e.g., z-test, t-test) do not hold and a nonparametric test should be used.
Parametric tests require a stronger measurement scale.
Which of the following statements is most likely an example of a null hypothesis for a one-sided test?
A
The equity risk premium is equal to 5.0%.
B
The equity risk premium is greater than 6.0%.
C
The equity risk premium is less than or equal to 7.0%.
C
The equity risk premium is less than or equal to 7.0%.
A hypothesis is a statement about a population parameter that can be tested with sample statistics. Hypothesis testing requires two mutually exclusive and collectively exhaustive statement — an alternative hypothesis that is the “hoped for” outcome and null hypothesis that must be accepted unless there is sufficient evidence to reject it.
If an analyst expects to observe that the equity risk premium is greater than 7.0%, this would be used as the alternative hypothesis and the corresponding null hypothesis would be that the equity risk premium is less than or equal 7.0%. Using a one-sided test, the test statistic will either be in the region of rejection region at the right tail or it will fall in the region to the left and it will be concluded that there is insufficient evidence to reject the null hypothesis.
A statement that the equity risk premium is greater than 6.0% is consistent with a one-sided test, but this would be the alternative hypothesis. A null hypothesis must include the point of equality. In this scenario, the null hypothesis would be that the equity risk premium is equal to or less than 6.0%.
The level of significance of a hypothesis test is best used to:
A
calculate the test statistic.
B
define the test’s rejection points.
C
specify the probability of a Type II error.
B
define the test’s rejection points.
The level of significance is used to establish the rejection points of the hypothesis test.
The power of a hypothesis test is most likely:
A
equivalent to the level of significance.
B
the probability of not making a Type II error.
C
unchanged by increasing a small sample size.
B
the probability of not making a Type II error.
The power of a hypothesis test is the probability of correctly rejecting the null when it is false. Failing to reject the null when it is false is a Type II error
The probability of correctly rejecting the null hypothesis is most likely the:
A
p-value.
B
power of a test.
C
level of significance.
B
power of a test.
A machine learning model that has been underfit will most likely:
A
treat noise in a training dataset as true parameters.
B
fail to recognize true relationships in a training dataset.
C
identify relationships in a training dataset that are not found in the validation dataset.
B
fail to recognize true relationships in a training dataset.
underfit models are overly simplistic and can fail to identify true relationships that are present in a training dataset.
By contrast, a model is described as overfit when it treats noise in the training dataset as true parameters, but it is unable to find the same relationships in the validation dataset.
HTML code is most accurately classified as:
A
structured data.
B
unstructured data.
C
semistructured data.
C
semistructured data.
The critical value for the chi-square test of independence is most likely determined by the:
A
number of observations in the sample.
B
number of rows and columns in the contingency table.
C
magnitude of the squared deviations between expected and observed frequencies.
B
number of rows and columns in the contingency table.
The critical chi-square value used in a test of independence is determined two factors. The first is the desired region of rejection on the right side of the chi-square distribution. The second factor is the test statistic’s degrees of freedom
Which of the following statements is most accurate? For a financial system to be described as having complete markets, it:
A
may not be either informationally efficient and operationally efficient.
B
must be informationally efficient, operationally efficient, and allocationally efficient.
C
must be both informationally efficient and operationally efficient, but may not be allocationally efficient.
A
may not be either informationally efficient and operationally efficient.
A financial system is considered to have complete markets if the following conditions are met:
Investors can earn an appropriate risk-adjusted return in exchange for agreeing to move money from the present to the future
Creditworthy borrowers can easily obtain funds from lenders
Investors can reduce, trade, or eliminate risk by hedging
Currencies and commodities can be easily traded
If all of this can be done at a low cost, the financial system is said to be operationally efficient. If asset prices reflect all relevant available information, the financial system is said to be informationally efficient.
However, it is not necessary for a financial system to be either operationally or informationally efficient in order to be said to have complete markets.
The Standard & Poor’s Depositary Receipts (SPDRs) is an investment that tracks the S&P 500 stock market index. Purchases and sales of SPDRs during an average trading day are best described as:
A
primary market transactions in a pooled investment.
B
secondary market transactions in a pooled investment.
C
secondary market transactions in an actively managed investment.
B
secondary market transactions in a pooled investment.
You have placed a sell market-on-open order—a market order that would automatically be submitted at the market’s open tomorrow and would fill at the market price. Your instruction, to sell the shares at the market open, is a(n):
A
execution instruction.
B
validity instruction.
C
clearing instruction.
B
validity instruction.
An instruction regarding when to fill an order is considered a validity instruction.
Tony Harris is planning to start trading in commodities. He has heard about the use of futures contracts on commodities and is learning more about them. Which of the following is Harris least likely to find associated with a futures contract?
A
Existence of counterparty risk.
B
Standardized contractual terms.
C
Payment of an initial margin to enter into a contract.
A
Existence of counterparty risk.
Harris is least likely to find counterparty risk associated with a futures contract. There is limited counterparty risk in a futures contract because the clearinghouse is on the other side of every contract.
Over the long-term, equity investors who do not believe that they possess superior information will most likely:
A
hold only cash until they acquire superior information.
B
have longer holding periods than information-motivated traders.
C
achieve returns that closely track the performance of a broad market index.
C
achieve returns that closely track the performance of a broad market index.
Equity investors who do not believe they have superior information will most likely passively hold a diversified portfolio such as one composed of stocks included in a broad market index (according to their representative weights). It is not necessary to eliminate all potential for earning an equity risk premium by holding cash until superior information can be acquired.
In an order-driven market, orders at the same price are most likely ranked according to the:
A
uniform pricing rule.
B
derivative pricing rule.
C
secondary preference rules.
C
secondary preference rules.
In order-driven markets, the highest priority is given to the most aggressively priced orders. For orders at the same price, order-driven market use secondary preference rules to establish trading priority. Precedence may be granted based on the time that the orders were received or whether the entire order size is displayed. While each market is free to use its own order-ranking criteria, the objective is to establish rules that increase liquidity.
The uniform pricing rule is used in call markets to determine a price at which all trades of a given security are executed in order to maximize trading volume.
Commercial banks are most likely different from non-financial corporations in their ability to issue which of the following types of money markets securities?
A
Commercial paper only
B
Certificates of deposit only
C
Both commercial paper and certificates of deposit
B
Certificates of deposit only
Both commercial banks and non-financial corporations issue commercial paper. However, only banks are able to issue certificates of deposit.
An investor who purchases both a corporate bond and a credit default swap based on that underlying asset has least likely used the financial system for which purpose?
A
Saving
B
Borrowing
C
Managing risk
B
Borrowing
By purchasing a corporate bond, the investor has saved. The investor used the financial system to move money from the present to the future.
In purchasing a credit default swap, the investor has mitigated risk. The swap is an insurance policy that pays out if the issuer of the underlying bond defaults on its obligations.
An investment bank leading a best efforts initial public offering most likely has:
A
no conflict of interest with the issuer.
B
a conflict of interest that creates an incentive to overvalue the issuer.
C
a conflict of interest that creates an incentive to undervalue the issuer.
A
no conflict of interest with the issuer.
Although this dynamic exists for underwritten offerings, it does not exist for best efforts offerings. In such cases, the investment bank acts only as a broker and is not obligated to purchase any unsold shares. This eliminates the potential for a conflict of interest.
Which of the following statements about exchange-traded funds is most correct?
A
Exchange-traded funds are not backed by any assets.
B
The investment companies that create exchange-traded funds are financial intermediaries.
C
The transaction costs of trading shares of exchange-traded funds are substantially greater than the combined costs of trading the underlying assets of the fund.
B
The investment companies that create exchange-traded funds are financial intermediaries.
The role of brokers is most accurately described as:
A
trading with clients in quote-driven markets.
B
finding buyers for infrequently-traded assets.
C
holding assets as inventory until a buyer can be found.
B
finding buyers for infrequently-traded assets.
Commodities that can be stored and delivered at low cost are most likely:
A
perishable with a high value-to-weight ratio.
B
nonperishable with a low value-to-weight ratio.
C
nonperishable with a high value-to-weight ratio.
C
nonperishable with a high value-to-weight ratio.
Commodities that can be stored and delivered at low cost are typically nonperishable items with high value-to-weight ratio. Examples include industrial diamonds, precious metals and high-value industrial metals.
Consider a mutual fund that invests primarily in fixed-income securities that have been determined to be appropriate given the fund’s investment goal. Which of the following is least likely to be a part of this fund?
A
Warrants.
B
Commercial paper.
C
Repurchase agreements.
A
Warrants.
Which of the following market structures most likely relies heavily on dealers as a source of liquidity?
A
Order-driven markets
B
Quote-driven markets
C
Continuous trading markets
B
Quote-driven markets
Dealers are the only source of liquidity in quote-driven markets
Minimum capital requirements can most effectively be imposed by:
A
insurers.
B
regulators.
C
counterparties.
B
regulators.
Minimum capital standards exist to minimize the potential for one company’s failure to have a significant widespread negative impact on financial markets. In theory, counterparties could require minimum capital requirements as conditions of contracts, but governments and their regulatory agencies have more power to enforce compliance.
You are the manager of an ETF based on a price-weighted index. Over the past quarter, one of your stocks, Sunrise, Inc., has appreciated by 10%, while other index components have remained relatively flat. There were no stock splits. In order to minimize tracking error, you will most likely:
A
sell some Sunrise, Inc. shares.
B
buy additional Sunrise, Inc. shares.
C
maintain the current portfolio weights.
C
maintain the current portfolio weights.
In the absence of stock-splits, price-weighted indices do not rebalance based on price changes, because the weights adjust in concert with pricesC
When creating a security market index, the target market:
A
determines the investment universe.
B
is usually a broadly defined asset class.
C
determines the number of securities to be included in the index.
A
determines the investment universe.
The target market determines the investment universe and the securities available for inclusion in the index.
Commodity index values are based on:
A
futures contract prices.
B
the market price of the specific commodity.
C
the average market price of a basket of similar commodities.
A
futures contract prices.
A float-adjusted market-capitalization-weighted index weights each of its constituent securities by its price and:
A
its trading volume.
B
the number of its shares outstanding.
C
the number of its shares available to the investing public.
C
the number of its shares available to the investing public.\
“Float” is the number of shares available for public trading.
Which of the following statements regarding sector indexes is most accurate? Sector indexes:
A
track different economic sectors and cannot be aggregated to represent the equivalent of a broad market index.
B
provide a means to determine whether an active investment manager is more successful at stock selection or sector allocation.
C
apply a universally agreed upon sector classification system to identify the constituent securities of specific economic sectors, such as consumer goods, energy, finance, health care.
B
provide a means to determine whether an active investment manager is more successful at stock selection or sector allocation.
A price-weighted index is most likely to be reconstituted after one of its component firms:
A
is acquired.
B
pays a dividend.
C
executes a stock split.
A
is acquired
Indexes are reconstituted in order to continue to reflect the performance of a target market. Events such as bankruptcies, mergers, acquisitions, and de-listings may prompt index providers to replace an acquired firm with another representative firm.
While a price-weighted index must be rebalanced in order to adjust for stock splits, this does not necessitate a reconstitution.
Which index method will most likely result in a value tilt?
A
Price weighting
B
Fundamental weighting
C
Market capitalization weighting
B
Fundamental weighting
The value tilt is a key feature of fundamental weighting. Indexes created with this method heavily invest in stocks with high book-to-market ratios.
A unique feature of hedge fund indexes is that they:
A
are frequently equal weighted.
B
are determined by the constituents of the index.
C
reflect the value of private rather than public investments.
B
are determined by the constituents of the index.
Hedge funds are not required to report their performance to any party other than their investors. Therefore, each hedge fund decides to which database(s) it will report its performance. Thus, for a hedge fund index, constituents determine the index rather than index providers determining the constituents.
After inception, the value of the total return version of a security market index will most likely:
A
lags the value of the price return version of the index.
B
match the value of the price return version of the index.
C
exceed the value of the price return version of the index.
C
exceed the value of the price return version of the index.
At inception, the total return and price return versions of a security market index are both set to the same value. As constituent companies pay dividends, the total return version of the index will grow faster than the price return version.
In comparison to equity indexes, the constituent securities of fixed-income indexes are:
A
more liquid.
B
easier to price.
C
drawn from a larger investment universe.
C
drawn from a larger investment universe.
the fixed-income market has more issuers and securities than the equity market.
Security market indexes are used as:
A
measures of investment returns.
B
proxies to measure unsystematic risk.
C
proxies for specific asset classes in asset allocation models.
C
proxies for specific asset classes in asset allocation models.
Security market indexes play a critical role as proxies for asset classes in asset allocation models.
Which of the following is not a real estate index category?
A
Appraisal index.
B
Initial sales index.
C
Repeat sales index.
B
Initial sales index.
The goal of a broad market equity index is most likely to represent the performance of:
A
an entire asset class.
B
a collection of markets.
C
an entire economic sector.
A
an entire asset class.
A broad market index attempts to broadly represent an asset class (i.e., equity).
Which of the following index weighting methods requires the most frequent rebalancing?
A
Price weighting.
B
Equal weighting.
C
Market-capitalization weighting.
B
Equal weighting.
Uses of market indexes do not include serving as a:
A
measure of systemic risk.
B
basis for new investment products.
C
benchmark for evaluating portfolio performance.
A
measure of systemic risk.
Security market indexes are used as proxies for measuring market or systematic risk, not as measures of systemic risk.
A security market index represents the:
A
risk of a security market.
B
security market as a whole.
C
security market, market segment, or asset class.
C
security market, market segment, or asset class.
A security market index represents the value of a given security market, market segment, or asset class.
Security market indexes are:
A
constructed and managed like a portfolio of securities.
B
simple interchangeable tools for measuring the returns of different asset classes.
C
valued on a regular basis using the actual market prices of the constituent securities.
A
constructed and managed like a portfolio of securities.
company has arranged to sell their accounts receivable to a lender at a steep discount. In this arrangement, the company would pass the credit granting and collection process to the lender.
The arrangement is best described as:
A
Revolvers
B
Factoring
C
Committed line of credits
B
Factoring
Which of the following statements is most accurate?
A
Commodity indexes all share similar weighting methods.
B
Commodity indexes containing the same underlying commodities offer similar returns.
C
The performance of commodity indexes can be quite different from that of the underlying commodities.
C
The performance of commodity indexes can be quite different from that of the underlying commodities.
In comparison to equity indexes, the constituent securities of fixed-income indexes are:
A
more liquid.
B
easier to price.
C
drawn from a larger investment universe.
C
drawn from a larger investment universe.
When creating a security market index, the target market:
A
determines the investment universe.
B
is usually a broadly defined asset class.
C
determines the number of securities to be included in the index.
A
determines the investment universe.
With respect to efficient markets, a company whose share price changes gradually after the public release of its annual report most likely indicates that the market where the company trades is:
A
semi-strong-form efficient.
B
subject to behavioral biases.
C
receiving additional information about the company.
C
receiving additional information about the company.
In a market that is perfectly efficient except for transaction costs of 0.10% per trade, securities prices would most likely:
A
equal to their intrinsic value.
B
be at least 0.10% different from their intrinsic value.
C
be no more than 0.10% different from their intrinsic value.
C
be no more than 0.10% different from their intrinsic value.
In an efficient market, investors buy any undervalued securities and sell any overvalued securities, with the result that the market value of a security quickly becomes the intrinsic value. With transaction costs, the investor is limited at the margins – buying a security undervalued by 0.10% does not present an arbitrage opportunity if transaction costs are twice that amount. There will be a band of efficiency, in which the value of the inefficiency is less than the transaction costs.
The existence of an earnings surprise anomaly is most appropriately interpreted as evidence that a market is:
A
weak-form efficient.
B
semi-strong-form efficient.
C
semi-strong-form inefficient.
C
semi-strong-form inefficient.
A market in which it is possible to consistently earn risk-adjusted profits (net of fees) based on earnings surprises cannot be considered semi-strong-form efficient.
According to the semi-strong form of the market efficiency hypothesis, prices reflect all historical market data and publicly-available information (for example, reported earnings compared to analysts’ prior estimates). The earnings surprise anomaly is observed when prices fail to quickly and fully reflect the portion of reported earnings that were not reflected in analysts’ estimates.
A security’s intrinsic value most likely:
A
does not fluctuate.
B
cannot be known with certainty.
C
is different for different investors.
B
cannot be known with certainty.
A security’s intrinsic value is how much investors would value it if they could produce an unbiased analysis of all relevant information. Because such an analysis is not possible, a security’s intrinsic value cannot be known with certainty.
The difference between a stock at the end of its first day trading on a secondary market after an initial public offering (IPO) and its issue price is most accurately described as:
A
an earnings surprise.
B
an information cascade.
C
the degree of underpricing.
C
the degree of underpricing.
In a relatively efficient secondary market, a stock will trade near its intrinsic value by the end of its first day of trading after an IPO. Due to the various pressures faced by the investment banks that underwrite IPOs, the issue price is often set at a level that is below its Day 1 closing price. The difference between these prices is known as the degree of underpricing.
Overconfidence bias is most likely attributable to:
A
a lack of information.
B
an inability to accurately process information.
C
a belief that markets are informationally efficient.
B
an inability to accurately process information.
Investors who exhibit overconfidence bias overestimate their ability to process information accurately. Overconfidence bias is not caused by a lack of information – even the most well-informed market participants may be overconfident.
Which of the following statements is most accurate? Arbitrage trading:
A
makes markets less efficient.
B
makes markets more efficient.
C
may increase or decrease market efficiency depending on the circumstances.
B
makes markets more efficient.
Markets are inefficient when assets with identical payoffs have different prices. Arbitrageur trading increases market efficiency by selling the overpriced assets and buying underpriced assets until it is no longer possible to earn risk-free profits. Any restriction on arbitrage trading makes markets less efficient.
With respect to rational and irrational investment decisions, the efficient market hypothesis requires:
A
only that the market is rational.
B
that all investors make rational decisions.
C
that some investors make irrational decisions.
A
only that the market is rational.
The efficient market hypothesis and asset-pricing models only require that the market is rational. Behavioral finance is used to explain some of the market anomalies as irrational decisions.
Which of the following statements is most accurate? Closed-end investment funds:
A
trade in the primary market.
B
may trade at a premium above net asset value per share.
C
trade at a discount to net asset value per share that is entirely attributable to illiquidity concerns.
B
may trade at a premium above net asset value per share.
While it is common for closed-end investment funds to trade at prices below their net asset value per share, they can (and, in some cases, do) trade at a premium.
Closed-end investment funds trade in secondary markets, not the primary market.
The practice of discovering a statistically significant relationship indicating the possibility of earning abnormal returns before establishing a hypothesis is most accurately described as:
A
data mining.
B
technical analysis.
C
identifying a time-series anomaly.
A
data mining
Data mining occurs when analysts repeatedly run tests of market data until a statistically significant relationship can be found and subsequently formulate a hypothesis for why this relationship might exist. This is the opposite order that these steps occur when following generally accepted research practices and can lead to the identification of apparent market anomalies with no compelling rationale for their existence.
If a market is semi-strong-form efficient, the risk-adjusted returns of a passively managed portfolio relative to an actively managed portfolio are most likely:
A
lower.
B
higher.
C
the same.
B
higher.
The level of a market’s efficiency is most likely inversely related to:
A
the number of participants.
B
restrictions on foreign investment.
C
the ability for investors to take short positions.
B
restrictions on foreign investment.
If a researcher conducting empirical tests of a trading strategy using time series of returns finds statistically significant abnormal returns, then the researcher has most likely found:
A
a market anomaly.
B
evidence of market inefficiency.
C
a strategy to produce future abnormal returns.
A
a market anomaly.
Return on equity (ROE) is most likely calculated based on the book value of equity rather than the market value of equity because:
A
the market value of equity is too volatile.
B
management has more control over the book value of equity.
C
the book value of equity better reflects the company’s intrinsic value.
B
management has more control over the book value of equity.
There are other formulas that relate earnings to a stock’s market value, but ROE is frequently used when analysts want to directly measure management’s performance.
Which of the following is incorrect about the risk of an equity security? The risk of an equity security is:
A
based on the uncertainty of its cash flows.
B
based on the uncertainty of its future price.
C
measured using the standard deviation of its dividends.
C
measured using the standard deviation of its dividends.
Some equity securities do not pay dividends, and therefore the standard deviation of dividends cannot be used to measure the risk of all equity securities.
Which of the following measures is the most difficult to estimate?
A
The cost of debt.
B
The cost of equity.
C
Investors’ required rate of return on debt.
B
The cost of equity.
The cost of equity is not easily determined. It is dependent on investors’ required rate of return on equity, which reflects the different risk levels of investors and their expectations about the company’s future cash flows.
Which of the following forms of equity is most likely to maximize an investor’s potential to profit from a company’s improved operating performance?
A
Putable common shares
B
Callable common shares
C
Cumulative preference shares
A
Putable common shares
Putable common shares can be sold back to their issuer at a pre-specified price. However, investors have no obligation to do so and there is no limit on the potential value of these shares.
Callable common shares provide only limited potential to profit from a company’s improved operating performance. If the value of these shares rises above a pre-specified exercise price, the issuer has the right to repurchase them at a discount to their market price.
Emerging markets have benefited from recent trends in international markets. Which of the following is less likely to have been a benefit of these trends?
A
Emerging market companies do not have to worry about a lack of liquidity in their home equity markets.
B
Emerging market companies have found it easier to raise capital in the markets of developed countries.
C
Emerging market companies have benefited from the stability of foreign exchange markets.
C
Emerging market companies have benefited from the stability of foreign exchange markets.
The trends in emerging markets have not led to the stability of foreign exchange markets.
Which of the following statements is most accurate? Unlike sponsored depository receipts, unsponsored depository receipts:
A
do not pay dividends.
B
are not issued by the underlying company.
C
are not guaranteed payment in the event of bankruptcy.
B
are not issued by the underlying company.
The difference between sponsored and unsponsored depository receipts comes down to issuance.
Unsponsored depository receipts are issued by a depository bank of a company’s stock in a foreign market.
By contrast, sponsored depository receipts (DRs) are issued directly by the underlying company in a foreign market.
Both types of depository receipts pay dividends. Similar to common stock, neither are guaranteed payment in the event of bankruptcy.
Which of the following statements is most accurate in describing a company’s book value?
A
Book value increases when a company retains its net income.
B
Book value is usually equal to the company’s market value.
C
The ultimate goal of management is to maximize book value.
A
Book value increases when a company retains its net income.
A company’s book value increases when a company retains its net income.
An equity’s risk is most accurately characterized as the uncertainty surrounding expected:
A
total return.
B
market price.
C
free cash flows.
A
total return.
Which of the following securities issued by a French retailer would most likely trade in the company’s domestic equity markets?
A
Global registered shares only
B
Global depository receipts only
C
Neither global registered shares nor global depository receipts
A
Global registered shares only
Global registered shares may trade simultaneously in multiple markets with prices quoted in local currencies. They provide the underlying securities for the issuers of global depository receipts.
An Australian mining firm has issued sponsored depository receipts. The responsibilities of the depository bank most likely include:
A
exercising voting rights.
B
processing dividend payments.
C
pricing the issue of new shares.
B
processing dividend payments.
A company is holding its annual shareholder meeting, at which candidates will be elected to serve on its seven-member board of directors. If the company uses the cumulative voting method, what is the maximum number of votes that an investor who holds 100 cumulative preference shares will most likely be able to cast for any single candidate?
A
0
B
100
C
700
A
0
Unless otherwise specified, preference shares do not provide investors with any voting rights.
When an investor purchases an American depository receipt, the underlying security they are buying is most likely a:
A
depository share.
B
unit of common stock.
C
sponsored depository receipt.
A
depository share.
Depository receipts are international claims on depository shares. These shares may act very similar to common stock, but they are a different type of security, designed specifically for foreign investment.
Which of the following is least likely to be cited as a justification for imposing restrictions on foreign investment?
A
Reducing the volatility of capital flows
B
Improving domestic equity market performance over the long-run
C
Providing opportunities for domestic investors to own shares of foreign companies
B
Improving domestic equity market performance over the long-run
Empirical evidence indicates that restrictions on foreign investment cause domestic equity markets to underperform over the long-term.
Global depository receipts (GDRs) are most likely:
A
issued in the United States.
B
denominated in US dollars.
C
unavailable to US investors.
B
denominated in US dollars.
Global depository receipts are not required to be denominated in US dollars, however, the majority are.
The type of equity voting right that grants one vote for each share of equity owned is referred to as:
A
proxy voting.
B
statutory voting.
C
cumulative voting.
B
statutory voting.
Which of the following is least likely to be a reason for a company to issue equity securities on the primary market?
A
To raise capital.
B
To increase liquidity.
C
To increase return on equity.
C
To increase return on equity.
Which of the following statements is least accurate in describing a company’s market value?
A
Management’s decisions do not influence the company’s market value.
B
Increases in book value may not be reflected in the company’s market value.
C
Market value reflects the collective and differing expectations of investors.
A
Management’s decisions do not influence the company’s market value.
A company’s market value is affected by management’s decisions. Management’s decisions can directly affect the company’s book value, which can then affect its market value.
he voting method that is most beneficial to shareholders with a small number of shares in a company is:
A
proxy voting.
B
statutory voting.
C
cumulative voting.
C
cumulative voting.
Cumulative voting is more beneficial to shareholders with a small number of shares. It allows these shareholders to apply all of their votes to elect one candidate on the board of directors, providing an opportunity for a higher level of representation than would be possible under statutory voting
The book value of the company is equal to
total assets minus total liabilities
With respect to Level III sponsored ADRs, which of the following is least likely to be accurate? They:
A
have low listing fees.
B
are traded on the NYSE, NASDAQ, and AMEX.
C
are used to raise equity capital in US markets.
A
have low listing fees.
The listing fees on Level III sponsored ADRs are high.
Which of the following equity securities are most likely traded on exchanges in the United States?
A=
American depository shares only
B
American depository receipts only
C
Both American depository shares and American depository receipts
B
American depository receipts only
American depository receipts (ADRs) are issued by company’s based outside of the United States, but are denominated in US dollars and trade on American exchanges.
A company’s cost of equity is often used as a proxy for investors’:
A
average required rate of return.
B
minimum required rate of return.
C
maximum required rate of return.
B
minimum required rate of return.
Companies try to raise funds at the lowest possible cost. Therefore, cost of equity is used as a proxy for the minimum required rate of return.
RJR Industries generates 80% of its revenues from manufacturing toys and 20% from publishing children’s books. The company has included labor and material costs, depreciation, certain salaries, and other expenses that are directly related to sales in the amount reported as cost of goods sold. The company has most likely grouped the accounts by:
A
nature.
B
function.
behavior with output.
B
function.
All else equal, a higher share of debt in a company’s capital structure will most likely affect its:
A
operating income.
B
degree of operating leverage.
C
ratio of net income to shareholders’ equity.
C
ratio of net income to shareholders’ equity.
Operating income is earnings before interest and tax, whereas net income is operating income less interest and taxes. Increasing the share of debt in a company’s capital structure will affect net income through higher interest costs, but operating income will be unaffected. Financial leverage has no effect on operating leverage.
When conducting company analysis, which of the following is least relevant to determining a company’s business model?
A
Company annual report describing the firm’s product lines
B
Comments by management about competing products and substitutes
C
Industry white papers regarding the company’s product pricing strategy
B
Comments by management about competing products and substitutes
Competing products and substitutes are analyzed in Porter’s Five Forces. This analysis is usually performed to better understand a company’s industry and its competitive positioning. Management comments are unlikely to guide the analyst to better understand the company’s business model.
Lower industry concentration is usually associated with a high degree of competitive intensity unless the industry is most likely:
A
global.
B
service-oriented.
C
one with low product differentiation.
B
service-oriented.
Lower industry concentration, defined as many small competitors in the market, is usually associated with a high degree of competitive intensity unless the industry is service-oriented, is local in nature, or has high product differentiation.
An analyst is assessing the pricing power of an organic food manufacturer. The company’s products, which have been sold exclusively in local specialty stores, will soon be carried by large retail chain stores. The analyst notes that the company’s industry is characterized by heterogeneous product offerings and low fixed costs.
Which of the following factors most likely limits the company’s pricing power?
A
Fixed costs
B
Product offerings
C
New distribution channels
c
New distribution channel
While selling its products through large retailers will likely increase its sales volume, the company’s its pricing power will be reduced below its current level as it sells to customers that have more bargaining power that the company’s current customer base (local specialty stores).
Which of the following is not a limitation of the cyclical/non-cyclical descriptive approach to classifying companies?
A
A cyclical company may have a growth component in it.
B
Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.
C
A global company can experience economic expansion in one part of the world while experiencing recession in another part.
B
Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.
Business-cycle sensitivity falls on a continuum and is not a discrete “either/or” phenomenon.
PESTLE analysis is a framework for identifying:
A
industry themes.
B
the level of industry concentration.
C
determinants of industry profitability.
A
industry themes.
PESTLE analysis is a framework for identifying “themes” or “narratives” that investors may take a perspective on and desire exposure to.
An alternative method of grouping companies by geography is least likely to be completed using:
A
location of head office.
B
geographic composition of revenue.
C
primary listing of its equity securities.
C
primary listing of its equity securities.
Classification by country is typically by the country where the issuer is incorporated, the country of the primary listing of its equity securities, the location of its headquarters, or market perception.
Which of the following is most likely a risk of executing a differentiation competitive strategy?
A
pricing premiums become too high
B
larger competitors outcompete on price
C
a desire for premium-ization among customers
A
pricing premiums become too high
The risks of a differentiation strategy include imitation by competitors, buyers becoming sophisticated and no longer demanding level of service, and pricing premiums becoming too high for customers to beat; such a strategy may also preclude high market share, as customers value exclusivity.
While modeling a manufacturing firm’s income statement, an analyst makes the following comment about the factors that are expected to have the biggest impact on expenses: “COGS will increase, in part, due to higher prices for ingredients and packaging, as well as the higher cost of maintaining the company’s production facilities. The primary driver of decreases in SG&A is a reduction in benefits paid to sales staff.”
Is this comment most likely correct?
A
Yes
B
No, because benefits for sales staff are not included in SG&A
C
No, because factory maintenance costs are not included in COGS
A
Yes
his comment is correct.
COGS include the cost of raw materials used in products and the direct labor costs incurred to produce (e.g., salaries of production staff). Additionally, COGS include overhead costs attributable to production, such as the cost of maintaining facilities.
The SG&A expense includes any costs incurred to sell or deliver a company’s products, such as salaries and benefits paid to sales staff.
An analyst is forecasting operating costs for a company with relatively high fixed costs, sensitivity to economic conditions, and commodity inputs with volatile pricing. The company does not follow a hedging strategy for commodity purchases but tries to buy when prices are low. Which of the following is most appropriate to use in forecasting operating costs? The analyst uses:
A
analyst discretion to forecast all operating costs.
B
management guidance to forecast all operating costs.
C
management guidance to forecast fixed operating costs and analyst discretion to forecast variable operating costs.
C
management guidance to forecast fixed operating costs and analyst discretion to forecast variable operating costs.
Management has an advantage in forecasting for objects that are subject to its actions (such as capital expenditures and inventories, which affect fixed costs). The analyst is likely to have an informational advantage when it comes to forecasting economic conditions and commodity prices, which affect revenues and variable costs.
A clothing company, which initially produced designer clothing, has increasingly entered into the mass market. Which of the following approaches to forecasting revenues is least appropriate?
A
Historical results
B
Analyst’s discretionary forecast
C
Historical base rates and convergence
A
Historical results
ABC Limited (ABCL) is currently profitable and is expected to remain so over the next five years. The company plans to retain all earnings over the next five years, forgoing any dividend payments and share repurchases. In the notes to the company’s financial statements, ABCL’s management has stated its goal to maintain a 30% debt-to-capital ratio. Based on this information, it is most likely that, over the next five years, the company will:
A
take on additional debt.
B
maintain a constant level of debt.
C
use a portion of its profits to pay down debt.
A
take on additional debt.
ABCL is expected to be profitable over the next five years and all earnings will be retained rather than paid out as dividends. This will increase the amount of equity in the company’s capital structure. In order to maintain a 30% debt-to-capital ratio, it will be necessary for the company to take on additional debt.
An analyst notes that a company’s capital expenditures do not follow a discernible pattern; the company seems to have periods of very low capital expenditures and periods of high capital expenditures. Management does not provide any guidance on capital expenditures. The analyst should develop a forecast of capital expenditures based on:
A
the company’s usage of PP&E capacity.
B
the industry’s average capital expenditures.
C
the company’s average capital expenditures.
A
the company’s usage of PP&E capacity.
Based on the company’s spending pattern, it most likely makes capital expenditures based on capacity needs as it grows. If it is approaching full usage of existing capacity, it will expand.
The asset-based value of the equity of a company is the
fair value (market value) of the assets minus the fair value of liabilities.
The market value of equity for a company can be calculated as enterprise value:
A
minus market value of debt, preferred stock, and short-term investments.
B
plus market value of debt and preferred stock minus short-term investments.
C
minus market value of debt and preferred stock plus short-term investments.
C
minus market value of debt and preferred stock plus short-term investments.
Enterprise value is calculated as the market value of equity plus the market value of debt and preferred stock minus short-term investments.
Which of the following is most likely used in a present value model?
A
Enterprise value.
B
Price to free cash flow.
C
Free cash flow to equity.
C
Free cash flow to equity.
A three-stage dividend discount model is the most appropriate for which of the following companies?
A
A company that is in the maturity phase
B
A young company entering the growth phase
C
An older company that has moved from a growth phase to a transition phase
B
A young company entering the growth phase
A three-stage dividend discount model is the most appropriate for a company that is fairly young and entering the growth phase.
A two-stage dividend discount model is suitable for an older company that has moved from the growth phase to the transition phase
a constant growth model is appropriate for a company that is in the mature phase of growth.
An analyst makes the following statement: “Use of P/E and other multiples for analysis is not effective because the multiples are based on historical data and because not all companies have positive accounting earnings.” The analyst’s statement is most likely:
A
inaccurate with respect to both historical data and earnings.
B
accurate with respect to historical data and inaccurate with respect to earnings.
C
inaccurate with respect to historical data and accurate with respect to earnings.
A
inaccurate with respect to both historical data and earnings.
The statement is inaccurate in both respects. Although multiples can be calculated from historical data, forecasted values can be used as well. For companies without accounting earnings, several other multiples can be used. These multiples are often specific to a company’s industry or sector and include price-to-sales and price-to-cash flow.
A price earnings ratio that is derived from the Gordon growth model is inversely related to the:
A
growth rate.
B
dividend payout ratio.
C
required rate of return.
C
required rate of return.
A disadvantage of the EV method for valuing equity is that the following information may be difficult to obtain:
A
Operating income.
B
Market value of debt.
C
Market value of equity.
B
Market value of debt.
According to the reading, analysts may have not have access to market quotations for company debt.
In the free cash flow to equity (FCFE) model, the intrinsic value of a share of stock is calculated as:
A
the present value of future expected FCFE.
B
the present value of future expected FCFE plus net borrowing.
C
the present value of future expected FCFE minus fixed capital investment.
A
the present value of future expected FCFE.
In the FCFE model, the intrinsic value of stock is calculated by discounting expected future FCFE to present value. No further adjustments are required.
The financial statement analysis framework includes the following steps:
Step 1: Articulate the purpose and context of the analysis
Step 2: Collect input data
Step 3: Process data
Step 4: Analyze/interpret processed data
Step 5: Develop and communicate conclusions/recommendations
Step 6: Follow-up
During which of these steps would an analyst most likely engage in discussions with a company’s competitors?
A
Step 2
B
Step 4
C
Step 5
A
Step 2
During the process of collecting input data (Step 2), analysts gather information from a variety of sources such as a company’s management, supplier, customers and competitors.
Subzero Corporation is currently involved in a legal dispute with one of its customers. The company’s legal counsel has advised that a potential loss from the dispute is probable but the amount of loss cannot be reasonably estimated. Subzero failed to adequately disclose the lawsuit in its financial statement notes. Subzero’s independent auditor will most likely issue:
A
a disclaimer of opinion.
B
a qualified audit opinion.
C
an unqualified audit opinion.
B
a qualified audit opinion.
US generally accepted accounting principles are currently developed by which entity?
A
The Securities and Exchange Commission.
B
The Financial Accounting Standards Board.
C
The Public Company Accounting Oversight Board.
B
The Financial Accounting Standards Board.
The FASB is responsible for the Accounting Standards Codification™, the single source of nongovernmental authoritative US generally accepted accounting principles.
Which of the following is least likely to result in changes to financial reporting standards?
A
New products
B
New companies
C
New types of transactions
B
New companies
Proxy statements are most likely:
A
required to be filed with regulators at least annually.
B
reported in a supplemental schedule to a company’s audited financial statements.
C
distributed to provide shareholders with information about matters to be voted on at a company’s annual meeting.
C
distributed to provide shareholders with information about matters to be voted on at a company’s annual meeting.
The purpose of the International Organization of Securities Commissions (IOSCO) is most likely to:
A
regulate securities and capital markets.
B
issue international financial reporting standards.
C
provide guidance on regulating securities and capital markets.
C
provide guidance on regulating securities and capital markets.
A qualified audit opinion is most likely required:
A
for a company with related-party transactions.
B
when the scope of the auditing process has not been limited.
C
in financial statements for the quarter after a major accounting policy change is implemented.
C
in financial statements for the quarter after a major accounting policy change is implemented.
Which of the following best describes the role of financial statement analysis?
A
To provide information about a company’s performance
B
To provide information about a company’s changes in financial position
C
To form expectations about a company’s future performance and financial position
C
To form expectations about a company’s future performance and financial position
The financial statement analysis framework includes the following steps:
Step 1: Articulate the purpose and context of the analysis
Step 2: Collect input data
Step 3: Process data
Step 4: Analyze/interpret processed data
Step 5: Develop and communicate conclusions/recommendations
Step 6: Follow-up
During which of these steps would an analyst most likely produce a report with a company valuation and estimated earnings per share?
A
Step 3
B
Step 4
C
Step 5
C
Step 5
The role of financial statement analysis is best described as:
A
providing information useful for making investment decisions.
B
evaluating a company for the purpose of making economic decisions.
C
using financial reports prepared by analysts to make economic decisions.
B
evaluating a company for the purpose of making economic decisions.
The primary role of financial statement analysis is to use financial reports prepared by companies to evaluate their past, current, and potential performance and financial position for the purpose of making investment, credit, and other economic decisions.
A core objective of the International Organization of Securities Commissions is to:
A
eliminate systemic risk.
B
protect users of financial statements.
C
ensure that markets are fair, efficient, and transparent.
C
ensure that markets are fair, efficient, and transparent.
In cases when the auditor believes that a company’s financial statements are not fairly presented in accordance with applicable accounting standards, the financial statements will most likely contain:
A
a qualified audit opinion.
B
an adverse audit opinion.
C
an unmodified audit opinion.
B
an adverse audit opinion.
A qualified audit opinion is most likely required:
A
for a company with related-party transactions.
B
when the scope of the auditing process has not been limited.
C
in financial statements for the quarter after a major accounting policy change is implemented.
C
in financial statements for the quarter after a major accounting policy change is implemented.
ubzero Corporation is currently involved in a legal dispute with one of its customers. The company’s legal counsel has advised that a potential loss from the dispute is probable but the amount of loss cannot be reasonably estimated. Subzero failed to adequately disclose the lawsuit in its financial statement notes. Subzero’s independent auditor will most likely issue:
A
a disclaimer of opinion.
B
a qualified audit opinion.
C
an unqualified audit opinion.
B
a qualified audit opinion.
The purpose of the International Organization of Securities Commissions (IOSCO) is most likely to:
A
regulate securities and capital markets.
B
issue international financial reporting standards.
C
provide guidance on regulating securities and capital markets.
C
provide guidance on regulating securities and capital markets.
Which statement is most accurate? A common size income statement:
A
restates each line item of the income statement as a percentage of net income.
B
allows an analyst to conduct cross-sectional analysis by removing the effect of company size.
C
standardizes each line item of the income statement but fails to help an analyst identify differences in companies’ strategies.
B
allows an analyst to conduct cross-sectional analysis by removing the effect of company size.
a company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for:
A
all prior periods.
B
current and future periods.
C
prior periods shown in a report.
C
prior periods shown in a report.
All else equal, capitalizing expenses rather than expensing them will most likely:
A
increase total asset turnover.
B
reduce net cash flow from operating activities.
C
increase cash outflows from investing activities.
C
increase cash outflows from investing activities.
If costs were expensed, they would be recognized as an operating cash outflow. By capitalizing these costs, net cash flows from operating activities and cash outflows from investing activities are both increased.
Under IFRS, gains attributable to the sale of a business unit should most likely be:
A
included in other comprehensive income.
B
disclosed in a separate line on the income statement.
C
treated as an extraordinary item and reported on a net of tax basis.
C
treated as an extraordinary item and reported on a net of tax basis.
When calculating diluted EPS, which of the following securities in the capital structure increases the weighted average number of common shares outstanding without affecting net income available to common shareholders?
A
Stock options
B
Convertible debt that is dilutive
C
Convertible preferred stock that is dilutive
A
Stock options
When a company has stock options outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from the exercise to repurchase as many shares possible at the weighted average market price of common stock during the period. As a result, the conversion of stock options increases the number of common shares outstanding but has no effect on net income available to common shareholders
Under IFRS, a loss from the destruction of property in a fire would most likely be classified as:
A
continuing operations.
B
discontinued operations.
C
other comprehensive income.
A
continuing operations.
A fire may be infrequent, but it would still be part of continuing operations and reported in the profit and loss statement. Discontinued operations relate to a decision to dispose of an operating division.
Which of the following least accurately describes adjustments to a company’s earnings per share to be made if it has outstanding convertible debt?
A
Add back after-tax interest paid on that convertible debt
B
Add the potential new shares to the total number of shares outstanding
C
Multiply the outstanding convertible debt by the percentage likely to convert
C
Multiply the outstanding convertible debt by the percentage likely to convert
In June of 20X6, a US company announced that it would immediately begin the process of splitting off its profitable European division. In November of 20X6, the company issued an update on this process, which it expected to be formally completed in the fourth quarter of 20X7. Net income attributable to the European division should most likely be:
A
excluded from the company’s 20X6 income statement.
B
recorded as a separate line item in the company’s 20X6 income statement.
C
included in net income from the company’s continuing operations in its 20X6 income statement with details of the pending split-off disclosed in the notes.
B
recorded as a separate line item in the company’s 20X6 income statement.
Under both IFRS and US GAAP, revenues from a business unit that will not impact a company’s balance sheet in the future should be reported as income from discontinued operations in a separate line in the income statement.
Considered in isolation, which of the following events is least likely to produce a difference between a company’s basic and diluted earnings per share?
A
A stock split
B
The issuance of convertible debt
C
The issuance of convertible preferred stock
A
A stock split
Which of the following least accurately describes adjustments to a company’s earnings per share to be made if it has outstanding convertible debt?
A
Add back after-tax interest paid on that convertible debt
B
Add the potential new shares to the total number of shares outstanding
C
Multiply the outstanding convertible debt by the percentage likely to convert
C
Multiply the outstanding convertible debt by the percentage likely to convert
The initial measurement of goodwill is most likely affected by:
A
an acquisition’s purchase price.
B
the acquired company’s book value.
C
the fair value of the acquirer’s assets and liabilities.
A
an acquisition’s purchase price.
For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
C
They are a component of accumulated other comprehensive income.
For financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a component of Shareholders’ equity
Which of the following would an analyst most likely be able to determine from a common-size analysis of a company’s balance sheet over several periods?
A
An increase or decrease in sales.
B
An increase or decrease in financial leverage.
C
A more efficient or less efficient use of assets.
B
An increase or decrease in financial leverage.
Common-size analysis (as presented in the reading) provides information about composition of the balance sheet and changes over time. As a result, it can provide information about an increase or decrease in a company’s financial leverage.
For financial assets classified as held to maturity, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
A
They are not recognized.
Financial assets classified as held to maturity are measured at amortised cost. Gains and losses are recognized only when realized.
At the beginning of the year, a company paid $1.2 million to purchase debt securities and classified these as available-for-sale. At the end of the year, the securities had a market value of $1.5 million. All else equal, if these financial assets had been classified as trading securities, the company’s net income for the year would most likely have been:
A
lower.
B
the same.
C
higher.
C
higher.
Unrealized gains and losses on trading securities are included in the income statement.
By contrast, unrealized gains and losses on available-for-sale securities bypass the income statement and are instead included directly in shareholders’ equity.
For financial assets classified as trading securities, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through income into retained earnings.
C
They are a component of accumulated other comprehensive income.
B
They flow through income into retained earnings.
For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
A
They are not recognized.
B
They flow through retained earnings.
C
They are a component of accumulated other comprehensive income.
C
They are a component of accumulated other comprehensive income.
Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more:
A
liquid.
B
efficient.
C
profitable.
B
efficient.
LIFO will result in lower inventory and higher cost of sales. Gross margin (a profitability ratio) will be lower, the current ratio (a liquidity ratio) will be lower, and inventory turnover (an efficiency ratio) will be higher.
Carrying inventory at a value above its historical cost would most likely be permitted if:
A
the inventory was held by a producer of agricultural products.
B
financial statements were prepared using US GAAP.
C
the change resulted from a reversal of a previous write-down.
A
the inventory was held by a producer of agricultural products.
Valmore Mills manufactures forest products that are used in the construction of residential homes. The company’s inventory currently has a net realizable value in excess of its historical cost. Valmore Mills would most likely be required to carry its inventories at cost under:
A
US GAAP only.
B
both IFRS and US GAAP.
C
neither IFRS nor US GAAP.
C
neither IFRS nor US GAAP.
For most companies that adhere to IFRS, inventories must be carried at the lower of cost or net realizable value. Producers of commodities such as agricultural goods, forest products, and minerals are exempt from this requirement and may measure their inventories at net realizable value even if this exceeds historical cost. US GAAP make similar allowances for these types of companies.
Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by:
A
Zimt is too low.
B
Nutmeg is too low.
C
Nutmeg is too high.
A
Zimt is too low.
Zimt uses the FIFO method, so its cost of sales represents units purchased at a (no longer available) lower price. Nutmeg uses the LIFO method, so its cost of sales is approximately equal to the current replacement cost of inventory.
Since it was founded 50 years ago, XYZ Corp. has not had to write down its inventories, nor has the company ever pledged its inventories as security for any of its liabilities. In its financial statements for the most recent year, the company disclosed its cost of goods sold (COGS), the total carrying amount of its inventories at fair value less cost to sell, as well as its chosen inventory valuation method. XYZ Corp. has most likely:
A
met the disclosure requirements under IFRS.
B
disclosed more information than required by IFRS.
C
failed to meet the disclosure requirements under IFRS.
C
failed to meet the disclosure requirements under IFRS.
nternational Financial Reporting Standards require companies to disclose the following information:
Which inventory valuation method has been used
Amount of inventories recognized as an expense (COGS)
Carrying amount of inventory at carried fair value less selling costs
Total carrying amount of inventories as well as the carrying amount in classifications (e.g., raw materials, work in progress)
Additional disclosures are required regarding write-downs and any inventories that have been pledged as security for liabilities
In this example, XYZ Corp. has not met the requirement to report separate amounts for different categories of inventory.
Company A adheres to US GAAP and Company B adheres to IFRS. Which of the following is most likely to be disclosed on the financial statements of both companies?
A
Any material income resulting from the liquidation of LIFO inventory
B
The amount of inventories recognized as an expense during the period
C
The circumstances that led to the reversal of a write down of inventories
B
The amount of inventories recognized as an expense during the period.
Both US GAAP and IFRS require disclosure of the amount of inventories recognized as an expense during the period. Only US GAAP allows the LIFO method and requires disclosure of any material amount of income resulting from the liquidation of LIFO inventory. US GAAP does not permit the reversal of prior-year inventory write downs.
In a period of declining inventory unit costs and constant or increasing inventory quantities, which inventory method is most likely to result in a higher debt-to-equity ratio?
A
LIFO
B
FIFO
C
Weighted average cost
B
FIFO
Zimt AG wrote down the value of its inventory in 2017 and reversed the write-down in 2018. Compared to the results the company would have reported if the write-down had never occurred, Zimt’s reported 2018:
A
profit was overstated.
B
cash flow from operations was overstated.
C
year-end inventory balance was overstated.
A
profit was overstated.
The reversal of the write-down shifted cost of sales from 2018 to 2017. The 2017 cost of sales was higher because of the write-down, and the 2018 cost of sales was lower because of the reversal of the write-down. As a result, the reported 2018 profits were overstated. Inventory balance in 2018 is the same because the write-down and reversal cancel each other out. Cash flow from operations is not affected by the non-cash write-down, but the higher profits in 2018 likely resulted in higher taxes and thus lower cash flow from operations.
Corex, a producer of rare minerals used in various industrial processes, prepares its financial reports in accordance with IFRS. The company is most likely:
A
required to carry its inventory at the lower of cost or net realizable value.
B
permitted to carry its inventory at net realizable value even if this exceeds cost and there is not an active market for the minerals.
C
permitted to carry its inventory at net realizable value even if this exceeds cost, but only if the minerals trade in an active market.
B
permitted to carry its inventory at net realizable value even if this exceeds cost and there is not an active market for the minerals.
FRS allow mineral producers to report their inventories at their net realizable value even when this is greater than cost. (Most companies that adhere to IFRS must report inventories at the lower of cost or net realizable value, but producers of certain commodities are exempt from this requirement.)
If the products trade in an active market, a quoted market price may be used to determine fair value. Even if an active market does not exist, fair value can be established based on market determined prices, such as the price at which the most recent transaction was executed.
Beschlund Industries, which adheres to IFRS, is currently carrying inventory at its historical cost of €50,000. If the company determines that inventory’s net realizable value is €45,000, the €5,000 loss in value:
A
must be included as part of the cost of goods sold.
B
must be reported separately from cost of goods sold.
C
may be included as part of cost of goods sold or reported separately.
C
may be included as part of cost of goods sold or reported separately.
A write down of the value of inventory to its net realizable value will have a positive effect on the:
A
balance sheet.
B
income statement.
C
inventory turnover ratio.
C
inventory turnover ratio.
Activity ratios (for example, inventory turnover and total asset turnover) will be positively affected by a write down to net realizable value because the asset base (denominator) is reduced. On the balance sheet, the inventory carrying amount is written down to its net realizable value and the loss in value (expense) is generally reflected on the income statement in cost of goods sold, thus reducing gross profit, operating profit, and net income.
Which of the following is a required financial statement disclosure for long-lived intangible assets under US GAAP?
A
The useful lives of assets
B
The reversal of impairment losses
C
Estimated amortization expense for the next five fiscal years
C
Estimated amortization expense for the next five fiscal years
Under US GAAP, companies are required to disclose the estimated amortization expense for the next five fiscal years. Under US GAAP, there is no reversal of impairment losses. Disclosure of the useful lives—finite or indefinite and additional related details—is required under IFRS.
An analyst is valuing equities issued by two companies in the retail sector. Company A is based in the United States and reports in accordance with US GAAP. Company B is based in France and reports in accordance with IFRS. Which of the following statements is most accurate?
A
Company A must report carrying amounts based on the cost model
B
Company A may report carrying amounts based on the revaluation model
C
Company B must report carrying amounts based on the revaluation model
A
Company A must report carrying amounts based on the cost model
The cost model requires companies to report carrying amounts that represent the difference between historical cost and accumulated depreciation or amortization.
Reported carrying amounts based on the revaluation model represent the fair value of an asset at the time of its revaluation less any depreciation or amortization that has accumulated since that date. While US GAAP requires the use of the cost method and does not allow the use of the revaluation method, IFRS permits companies to choose either of these methods.
Which of the following assets is most likely to be amortized?
A
Goodwill
B
Machinery with a 5-year expected useful life
C
A purchased patent, set to expire in 10 years
C
A purchased patent, set to expire in 10 years
To be amortized, assets must have the following attributes:
Long-term
Intangible
Finite life
Goodwill is an intangible asset with an infinite lifetime. Rather than being amortized, it is tested annually for impairment.
Tangible assets, such as machinery, are depreciated rather than amortized. Conceptually, depreciation and amortization are essentially the same. The main distinction is that depreciation applies to tangible assets and amoriztation is used to expense the cost of intangible assets.
Which of the following statements is most accurate? Under US GAAP, an impairment loss:
A
may only be reversed for assets held for sale.
B
may not be reversed under any circumstances.
C
may be reversed for both assets held for sale and assets held for use.
A
may only be reversed for assets held for sale.
Under US GAAP, impairment losses attributable to assets held for use cannot be reversed. However, reversals of impairment losses attributable to assets held for sale are permitted.
According to IFRS, all of the following pieces of information about property, plant, and equipment must be disclosed in a company’s financial statements and footnotes except for:
A
useful lives.
B
acquisition dates.
C
amount of disposals.
B
acquisition dates.
IFRS do not require acquisition dates to be disclosed.
Berkley Manufacturing collected $2.3 million in cash from a tenant renting one of its unused facilities. The company recognizes this as deferred revenue for accounting purposes and pays taxes based on the cash payment. This will most likely result in Berkley recording:
A
a deferred tax asset.
B
a deferred tax liability.
C
neither a deferred tax asset nor a deferred tax liability.
A
a deferred tax asset.
Because the rent received in advance is taxed on a cash basis, Berkley must include this in taxable income for the financial year received.
When both the timing and amount of tax payments are uncertain, analysts should treat deferred tax liabilities as:
A
equity.
B
liabilities.
C
neither liabilities nor equity.
C
neither liabilities nor equity.
The deferred tax liability should be excluded from both debt and equity when both the amounts and timing of tax payments resulting from the reversals of temporary differences are uncertain.
A company will most likely record a deferred tax liability when:
A
the carrying amount of an asset exceeds its tax base.
B
certain losses are deducted for accounting purposes but not for tax purposes.
C
certain revenues are recognized for tax purposes but not for accounting purposes.
A
the carrying amount of an asset exceeds its tax base.
When an asset’s carrying value is greater than its tax base, a deferred tax liability is created. For example, depreciating an asset more rapidly for tax purposes than for accounting purposes will cause taxable income to be lower and the amount of tax paid will be less than what is implied by accounting net income.
Until the temporary difference is offset with higher tax payments in later periods, the company will carry a deferred tax liability on its balance sheet.
Which of the following is added to income tax payable to determine the company’s income tax expense as reported on the income statement?
A
Deferred tax assets
B
Deferred tax liabilities
C
Changes in deferred tax assets and liabilities
C
Changes in deferred tax assets and liabilities
The changes in deferred tax assets and liabilities are added to income tax payable to determine the company’s income tax expense (or credit) as it is reported on the income statement.
A and B are incorrect because it is the changes in deferred tax assets and liabilities that are added to income tax payable.
A company that has reported deferred tax assets in previous years records an increase to its valuation allowance in its latest financial statements. The most likely explanation for the use of this increase is that the company expects future taxable income to:
A
be higher than previously forecast.
B
offset the previously reported amount of its deferred tax asset.
C
be insufficient to utilize the previously reported amount of its deferred tax asset.
C
be insufficient to utilize the previously reported amount of its deferred tax asset.
A company reports a large amount of valuation allowance in its financial statements. The most likely implication of this valuation allowance in relation to future earnings prospects of the company is that the company does not expect to generate enough taxable profits to utilize the deferred tax assets.
Analysts should treat deferred tax liabilities that are expected to reverse as:
A
equity.
B
liabilities.
C
neither liabilities nor equity.
B
liabilities.
If the liability is expected to reverse (and thus require a cash tax payment) the deferred tax represents a future liability.
Which of the following will most likely result in the creation of a deferred tax liability?
A
Taxable temporary differences only
B
Deductible temporary differences only
C
Both taxable temporary differences and deductible temporary differences
A
Taxable temporary differences only
When accounting standards require an asset to be expensed immediately but tax rules require the item to be capitalized and amortized, the company will most likely record:
A
a deferred tax asset.
B
a deferred tax liability.
C
no deferred tax asset or liability.
A
a deferred tax asset.
Deferred tax liabilities should be treated as equity when:
A
they are not expected to reverse.
B
the timing of tax payments is uncertain.
C
the amount of tax payments is uncertain.
A
they are not expected to reverse.
In the current year, Michaels Company has a carrying amount of USD3,500,000 and tax base of USD5,000,000 for accounts receivable. Michaels will most likely recognize:
A
a deferred tax asset.
B
a deferred tax liability.
C
no deferred tax asset or liability.
A
a deferred tax asset.
because the carrying amount is less than the tax base for this asset, this difference is a temporary difference that will result in a deferred tax asset.
Which of the following statements about tax rates is correct?
A
The effective tax rate is typically used for forecasting cash flows.
B
The cash tax rate is relevant for projecting earnings on the income statement.
C
A company’s income tax expense equals the sum of current taxes plus the change in deferred tax assets and liabilities.
A company enters into a finance lease agreement to acquire the use of an asset for three years with lease payments of €19,000,000 starting next year. The leased asset has a fair market value of €49,000,000 and the present value of the lease payments is €47,250,188. Based on this information, the value of the lease liability reported on the company’s balance sheet at lease inception is closest to:
A
€47,250,188.
B
€49,000,000.
C
€57,000,000.
A is correct. Under the revised reporting standards under IFRS and US GAAP, a lessee must recognize an asset and a lease liability at inception of each of its leases (with an exception for short-term leases). The lessee reports a “right-of-use” (ROU) asset and a lease liability, calculated essentially as the present value of fixed lease payments, on its balance sheet. Thus, at lease inception, the company will record a lease liability on the balance sheet of €47,250,188.
A
€47,250,188.
Under US GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
A
a sales-type lease.
B
an operating lease.
C
a direct financing lease.
A
a sales-type lease.
A sales-type lease treats the lease as a sale of the asset, and revenue is recorded at the time of sale equal to the value of the leased asset.
an automobile manufacturer provides a defined-benefit pension plan to all of its employees. The company will most likely include pension costs attributable to its assembly line workers in which of the following categories on its income statement?
A
Cost of goods sold
B
Salaries and wages
C
Administrative expenses
A
Cost of goods sold
A manufacturing firm will count pension expenses attributable to production workers (as well as their salaries and other forms of compensation) toward inventory. This amount appears on the income statement as part of cost of goods sold as sales are recognized. Expenses incurred as compensation for employees who are not directly involved in the production process will be included with salaries or other administrative expenses.
Penben Corporation has a defined benefit pension plan. At 31 December, its pension obligation is €10 million and pension assets are €9 million. Under either IFRS or US GAAP, the reporting on the balance sheet would be closest to which of the following?
A
€10 million is shown as a liability, and €9 million appears as an asset.
B
€1 million is shown as a net pension obligation.
C
Pension assets and obligations are not required to be shown on the balance sheet but only disclosed in footnotes.
B
€1 million is shown as a net pension obligation.
The company will report a net pension obligation of €1 million equal to the pension obligation (€10 million) less the plan assets (€9 million).
Which of the following statements about a defined-benefit pension plan is least accurate?
A
The sponsor promises to make periodic payments to participants after retirement
B
If the plan is underfunded, a net pension liability will be recorded on the sponsor’s balance sheet
C
The value of benefits received by participants depends on the performance of the plan’s assets
C
The value of benefits received by participants depends on the performance of the plan’s assets
In a defined contribution plan, the pension ultimately paid by the plan depends on the performance of the plan’s assets. However, in a defined benefit plan, the pension ultimately paid by the plan is defined according to a benefit formula.
Which of the following is a difference between a stock grant and a stock option grant?
A
Whereas the fair value of stock grants is usually based on the market value at the date of the grant, the fair value of option grants must be estimated.
B
Companies account for stock grants by allocating compensation expense over the employee service period, whereas compensation expense for stock options is expensed immediately.
C
Compensation expense is determined based on the market value of a share of stock on the grant date, whereas the measurement date for the value of an option is when the employee exercises the option.
A
Whereas the fair value of stock grants is usually based on the market value at the date of the grant, the fair value of option grants must be estimated.
Which of the following is typically an objective of a share-based compensation plan?
A
Attracting new employees
B
Maximizing executive compensation
C
Alignment of employees’ interest with those of management
A
Attracting new employees
Which of the following conditions best explains why a company’s manager would obtain legal, accounting, and board level approval prior to issuing low-quality financial reports?
A
Motivation
B
Opportunity
C
Rationalization
C
Rationalization
Typically, conditions of opportunity, motivation, and rationalization exist when individuals issue low-quality financial reports. Rationalization occurs when an individual is concerned about a choice and needs to be able to justify it to herself or himself. If the manager is concerned about a choice in a financial report, she or he may ask for other opinions to convince herself or himself that it is okay.
Which technique most likely increases the cash flow provided by operations?
A
Stretching the accounts payable credit period
B
Applying all non-cash discount amortization against interest capitalized
C
Shifting classification of interest paid from financing to operating cash flows
A
Stretching the accounts payable credit period
Which of the following best describes an opportunity for management to issue low-quality financial reports?
A
Ineffective board of directors
B
Pressure to achieve some performance level
C
Corporate concerns about financing in the future
A
Ineffective board of directors
Opportunities to issue low-quality financial reports include internal conditions, such as an ineffective board of directors, and external conditions, such as accounting standards that provide scope for divergent choices
When earnings are increased by deferring research and development (R&D) investments until the next reporting period, this choice is considered:
A
non-compliant accounting.
B
earnings management as a result of a real action.
C
earnings management as a result of an accounting choice.
B
earnings management as a result of a real action.
Deferring research and development (R&D) investments into the next reporting period is an example of earnings management by taking a real action.
Financial reports of the lowest level of quality reflect:
A
fictitious events.
B
biased accounting choices.
C
accounting that is non-compliant with GAAP.
A
fictitious events.
Financial reports span a quality continuum from high to low based on decision-usefulness and earnings quality. The lowest-quality reports portray fictitious events, which may misrepresent the company’s performance and/or obscure fraudulent misappropriation of the company’s assets.
Earnings that result from non-recurring activities most likely indicate:
A
lower-quality earnings.
B
biased accounting choices.
C
lower-quality financial reporting.
A
lower-quality earnings.
An analyst is reviewing a company to look for warning signs of information manipulation. Which of the following would most likely qualify as a warning sign that the analyst should investigate further?
A
Inventory turnover is increasing
B
Net income is consistently below cash provided by operations
C
The company’s revenue growth is significantly higher than its competitors
C
The company’s revenue growth is significantly higher than its competitors
Bias in revenue recognition would least likely be suspected if:
A
the firm engages in barter transactions.
B
reported revenue is higher than the previous quarter.
C
revenue is recognized before goods are shipped to customers.
B
reported revenue is higher than the previous quarter.
Bias in revenue recognition can lead to manipulation of information presented in financial reports. Addressing the question as to whether revenue is higher or lower than the previous period is not sufficient to determine if there is bias in revenue recognition.
A trend analysis of a company’s financial statements with values stated in absolute currency terms is most likely to be effective:
A
at providing insights about a mature company.
B
at identifying structural changes that a company has experienced.
C
during periods of structural change in the macroeconomic environment.
A
at providing insights about a mature company.
Trend analysis is most valuable for analyzing mature companies and during periods of relative stability in macroeconomic conditions and the competitive landscape.
Which of the following is the least likely to be listed among the limitations of ratio analysis?
A
Companies may use different accounting methods
B
Companies may report results in different currencies
C
Companies may have operations in different industries
B
Companies may report results in different currencies
In order to assess a company’s ability to meet its short-term obligations, which of the following ratios would an analyst most likely examine?
A
Payables turnover
B
Defensive interval ratio
C
Working capital turnover
B
Defensive interval ratio
Liquidity ratios measure the company’s ability to meet short-term obligations. Liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.
A trend analysis of a company’s financial statements with values stated in absolute currency terms is most likely to be effective:
A
at providing insights about a mature company.
B
at identifying structural changes that a company has experienced.
C
during periods of structural change in the macroeconomic environment.
A
at providing insights about a mature company.
The return on invested capital (ROIC) metric most likely incorporates:
A
the degree of financial leverage.
B
operating liabilities relative to operating assets.
C
the firm’s competitiveness relative to companies in other tax regimes.
B
operating liabilities relative to operating assets.
Which of the following is most likely to be among the recommendations for an analyst using the discounted cash flow approach to estimate a company’s terminal value?
A
The forecast horizon should be based on the timing of the next inflection point
B
The terminal growth rate assumption should be based on the company’s historical growth rate
C
The terminal year free cash flow projection should be adjusted based on the timing of the business cycle
C
The terminal year free cash flow projection should be adjusted based on the timing of the business cycle
When using the DCF method to estimate a company’s terminal value, analysts should adjust their estimates of terminal year free cash flows to account for the timing of the business cycle. Using an estimate for a terminal year that coincides with the peak or trough of a cycle can lead to excessively high or low valuations. Cash flow estimates should be normalized before being incorporated into long-term projections.
The length of a forecast horizon should not be determined by the timing of inflection points, which are extremely difficult to predict.
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
French notes that for the year just ended (2019), Archway’s COGS was 30 percent of sales. To forecast Archway’s income statement for 2020, French assumes that all companies in the industry will experience an inflation rate of 8 percent on the COGS. After putting together income statement projections for Archway, French forecasts Archway’s balance sheet items. He uses Archway’s historical efficiency ratios to forecast the company’s working capital accounts.
French’s approach to forecasting Archway’s working capital accounts would be most likely classified as a:
A
hybrid approach.
B
top-down approach.
C
bottom-up approach.
C
bottom-up approach.
French is using a bottom-up approach to forecast Archway’s working capital accounts by using the company’s historical efficiency ratios to project future performance.
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
Which profitability metric should French use to assess Archway’s five-year historic performance relative to its competitors?
A
Current ratio
B
Operating margin
C
Return on invested capital
B
Operating margin
Operating (EBIT) margin is a pre-tax profitability measure that can be useful in the peer comparison of companies in countries with different tax structures.
Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright. French is asked to evaluate Archway’s profitability over the past five years relative to its two main competitors, which are located in different countries with significantly different tax structures.
Based on his financial forecast for Archway, French estimates a terminal value using a valuation multiple based on the company’s average price-to-earnings multiple (P/E) over the past five years. Wright discusses with French how the terminal value estimate is sensitive to key assumptions about the company’s future prospects. Wright asks French:
“What change in the calculation of the terminal value would you make if a technological development that would adversely affect Archway was forecast to occur sometime beyond your financial forecast horizon?”
The most appropriate response to Wright’s question about the technological development is to:
A
increase the required return.
B
decrease the perpetual growth rate.
C
decrease the price-to-earnings multiple.
C
decrease the price-to-earnings multiple.
If the future growth or profitability of a company is likely to be lower than the historical average (in this case, because of a potential technological development), then the target multiple should reflect a discount to the historical multiple to reflect this difference in growth and/or profitability.
If a multiple is used to derive the terminal value of a company, the choice of the multiple should be consistent with the long-run expectations for growth and required retur
Which of the following statements is most accurate? Special purpose acquisition companies:
A
are pass-through entities.
B
raise equity capital through private placements.
C
place the proceeds of their equity issuance in trust.
C
place the proceeds of their equity issuance in trust.
A special purpose acquisition company (SPAC) is created as a vehicle to take a private company public. After raising equity capital in an initial public offering, the SPAC places the proceeds in a trust until a target company can be identified and acquired. SPACs are not pass-through entities.
Which of the following is most likely a disadvantage of using a private limited company structure rather than a public limited company structure as an organizational form for a business?
A
Taxation of retained earnings
B
Requirement to pay dividends
C
Restrictions on the number of shareholders
C
Restrictions on the number of shareholders
Many jurisdictions restrict the number of shareholders that private limited companies are allowed to have, which limits growth potential. By contrast, public limited companies (or corporations) face no such restrictions.
Dee’s Arbor Group Inc. (DAG Inc.) is a large international investor in timber and forest assets located on the North and South American continents. DAG Inc. is the general partner of DAG LP, a limited partnership that is the 100% owner of the timber and forest assets. DAG LP is controlled by DAG Inc. and its limited partners; the limited partners own a 20% stake in the partnership, while DAG Inc. holds the remaining majority stake.
DAG Inc.’s shares are listed on stock exchanges in the United States and Canada. DAG Inc. is organized as a special corporate form available in its jurisdiction in which it does not pay corporate income taxes so long as it distributes all of its net income as dividends to its shareholders and complies with other conditions. In the current and past fiscal years, DAG Inc. has complied with all of these conditions.
DAG Inc.’s shares are owned by various members of the Dee family, who hold several key senior management positions at DAG Inc. and DAG LP, and collectively they own 30% of the shares of DAG Inc. The remainder of DAG Inc.’s shares are owned by a variety of individual and institutional investors, none of whom own more than 5%.
Which of the following best describes the taxation of DAG Inc. and DAG LP?
A
DAG LP pays tax based on its pre-tax income.
B
Shareholders of DAG Inc. pay tax based on dividend income.
C
DAG Inc. pays tax based on its pre-tax income.
B
Shareholders of DAG Inc. pay tax based on dividend income.
DAG Inc. is organized as a special corporate form available in its jurisdiction in which it does not pay corporate income taxes. DAG LP, as a limited partnership, is a pass-through entity. DAG Inc. shareholders pay tax on dividend income.
The owners of Granville Precision Instruments are considering changing the company’s structure from a general partnership to a corporation in order to raise new equity. From the perspective of the owners, which of the following is most likely a disadvantage of this potential change?
A
Their control over the company’s operations will be reduced
B
The company’s retained earnings will be subject to double taxation
C
They will be required to enter into contracts on behalf of the company
A
Their control over the company’s operations will be reduced
From the corporate issuer’s perspective, the risk level of bonds compared to stocks is:
A
lower.
B
higher.
C
the same.
B
higher.
From the issuer’s perspective, bonds are riskier than stocks for the same reason bonds are safer than stocks for investors. Bonds increase risk to the corporation by increasing leverage. If the company is struggling and cannot meet its promised obligations to bondholders, bondholders have the legal standing to force certain actions upon the corporation, such as bankruptcy and liquidation.
Which of the following stakeholders are least likely to be positively affected by increasing the proportion of debt in the capital structure?
A
Senior management
B
Non-management employees
C
Shareholdera
B
Non-management employees
While leverage increases risk for all stakeholders, shareholders generally benefit through higher potential returns. Senior management typically benefits through equity-based compensation. For non-management employees, equity-based compensation is likely to be small to non-existent.
Which of the following board structures is most consistent with the stakeholder theory of corporate governance?
A
One-tiered board
B
Two-tiered board
C
Staggered board
B
Two-tiered board
Stakeholder theory is based on the idea that corporate governance should consider all stakeholders, not just shareholders. A two-tiered board structure includes a supervisory board, which is composed for non-executive directors representing a broader range of stakeholders, including employees, labor unions, and the general public.
Private lenders and bondholders most likely differ with respect to:
A
their payoff profiles.
B
their holding periods.
C
the priority of their claims.
B
their holding periods.
Private lenders (e.g., banks) initial loans with the intention of holding them until maturity. By contrast, bondholders generally have much shorter holding periods.
The existence of “stranded assets” is a specific concern among investors of:
A
energy companies.
B
health care companies.
C
property companies.
A
energy companies.
A specific concern among investors of energy companies is the existence of “stranded assets,” which are carbon-intensive assets at risk of no longer being economically viable because of changes in regulation or investor sentiment.
Which of the following represents a principal-agent conflict between shareholders and management?
A
Risk tolerance
B
Multiple share classes
C
Accounting and reporting practices
A
Risk tolerance
Shareholder and manager interests can diverge with respect to risk tolerance. In some cases, shareholders with diversified investment portfolios can have a fairly high risk tolerances because specific company risk can be diversified away
Which of the following is least likely to be included among the core objectives of corporate governance?
A
Managing incentives
B
Arranging checks and balances
C
Minimizing conflict between shareholders and directors
C
Minimizing conflict between shareholders and directors
The core of corporate governance is managing incentives and arranging a system of checks and balances for the purpose of minimizing and managing conflicts and potential conflicts between insiders and shareholders.
A credit committee formed in the aftermath of a bankruptcy most likely represents the interests of:
A
borrowers.
B
customers.
C
unsecured creditors.
C
unsecured creditors.
In certain jurisdictions, credit committees are formed to represent the interests of lenders, particularly unsecured creditors, during the bankruptcy process.
he CEO of a publicly-listed company makes the following statement: “By using proper governance mechanisms and control systems, it is possible to completely eliminate information asymmetry between principals and agents. However, it may be in the best interests of shareholders to maintain some level of information asymmetry relative to their agents.”
This statement is most likely:
A
correct.
B
incorrect because any information asymmetry is detrimental to shareholders.
C
incorrect because it is not possible to completely eliminate information asymmetry between principals and agents.
C
incorrect because it is not possible to completely eliminate information asymmetry between principals and agents.
The CEO is incorrect in claiming that it is possible to completely eliminate information asymmetry. Governance mechanisms and control systems can reduce, but not eliminate, information asymmetry between shareholders and managers.
A control system that is weak with respect to the quantity and quality of corporate information is most likely to serve the interests of:
A
directors.
B
managers.
C
shareholders.
B
managers.
Control systems that limit the quantity and quality of information prevent directors from conducting proper scrutiny of a company’s operations. In such an environment, managers have more opportunities to make decisions that benefit their own interests at the expense of shareholders.
A say on pay provision is least likely to limit the discretion of:
A
directors.
B
managers.
C
shareholders.
C
shareholders.
Say on pay provisions allow shareholders the opportunity to express their views about executive compensation packages. The purpose of these provisions is to limit the discretion that managers and directors have to award themselves excessive compensation and benefits.
Which of the following represents a responsibility of a company’s board of directors?
A
Implementation of strategy
B
Enterprise risk management
C
Considering the interests of shareholders only
B
Enterprise risk management
The board typically ensures that the company has an appropriate enterprise risk management system in place.
Greg Young is the CEO of Dataport, a firm that provides analytical services to companies in the transportation sector. Young also serves at the Chair of Dataport’s Board of Directors. Today, Young is meeting with Linda Marchman, Dataport’s CFO and a fellow Board member, to discuss the company’s corporate governance. During the course of their meeting, Young makes the following statement: “In my role as CEO, I act as an agent, not as a principal.”
Young’s claim is most likely:
A
correct.
B
incorrect because he does not act as an agent.
C
incorrect because he acts as both a principal and an agent.
C
incorrect because he acts as both a principal and an agent.
An agency relationship is defined by one party (the principal) engages another party (the agent) with the ability to control certain resources. The principal must trust the agent to make decisions related to those resources that are in the principal’s best interest. In this example, Young is correct in claiming that, as Dataport’s CEO, he is the agent of principals in the form of the company’s shareholders. However, he is also a principal in this role. Specifically, as a CEO, he cannot operate the company single-handedly and has delegated decision-making authority to agents in the form of executives and managers.
Which of the following examples would be best described as a drag on liquidity?
A
Reduced line of credit
B
Early payment to creditors
C
Delinquent account receivable
C
Delinquent account receivable
Two analysts are discussing the costs of external financing sources. The first states that the company’s bonds have a known interest rate but that the interest rate on accounts payable and the interest rate on equity financing are not specified. They are implicitly zero. Upon hearing this, the second analyst advocates financing the firm with greater amounts of accounts payable and common shareholders equity. Is the second analyst correct in his analysis?
A
He is correct in his analysis of accounts payable only.
B
He is correct in his analysis of common equity financing only.
C
He is not correct in his analysis of either accounts payable or equity financing.
C
He is not correct in his analysis of either accounts payable or equity financing.
Although accounts payable do not charge an explicit interest rate, the cost of accounts payable is reflected in the costs of the services or products purchased and in the costs of any discounts not taken. Accounts payable can have a very high implicit cost. Similarly, equity financing is not free. A required return is expected on shareholder financing just as on any other form of financing.
Which of the following projects is most likely to be undertaken without a capital budgeting/allocation analysis?
A
New product safety requirements
B
Installation of pollution control systems
C
A new aircraft to be used by senior managers
C
A new aircraft to be used by senior managers
While projects that are undertaken to comply with regulations related to product safety and environmental standards are typically required by external agencies rather than internally driven, companies use capital allocation analysis to determine, for example, whether these changes impact the financial viability of their operations or if there are advantages to early adoption.
By contrast, pet projects such as a new corporate aircraft may be approved without the scrutiny of a typical capital allocation analysis.
Larissa Soroka, an analyst at ABC company, has been asked to prepare cash flow forecasts for two mutually exclusive investment projects related to new products. ABC’s management asks Soroka to include the cost of market research that was recently completed as well as the potential loss of revenue from existing products that could occur if either project is undertaken.
When preparing the cash-flow forecasts for both projects, Soroka should include:
A
only the cost of the market research.
B
only the loss of revenue from existing products.
C
both the market research cost and the loss of revenue from existing products.
B
only the loss of revenue from existing products.
Capital allocation analysis should include only incremental cash flows associated with a new investment. The loss of revenue from existing products is an incremental negative effect that should be included in the analysis. The market research costs in this case are a sunk cost because the research has already been completed and therefore does not affect cash-flow estimates, no matter whether ABC undertakes either of these projects or neither of them.
Which of the following is true of the growth stage in a company’s development?
A
Cash flow may be negative or positive.
B
Cash flow is positive and growing quickly.
C
Cash flow is negative, by definition, with investment outlays exceeding cash flow from operations.
A
Cash flow may be negative or positive.
An analyst made the following statement:
“All else equal, if Modigliani and Miller’s assumptions hold, adding more debt to TWP’s capital structure will result in a higher asset beta.”
Is the analyst’s claim in the statement most likely correct?
A
Yes
B
No, because adding debt will result in a lower asset beta
C
No, because adding debt will have no effect on the asset beta
C
No, because adding debt will have no effect on the asset beta
The asset beta is a measure of business risk, or the systematic risk that cannot be diversified away. Assuming no change in a company’s business risk, changes to its capital structure will have no effect on its asset beta. Rather, the higher risk associated with an increase in a company’s financial leverage would be captured by an increase in its equity beta. As a result of this change, shareholders are exposed to greater risk and will demand a higher return on equity, but (all else equal) the asset beta will remain constant.
Which of the following is least likely to be true with respect to agency costs and senior management compensation?
A
A well-designed compensation scheme should eliminate agency costs.
B
Equity-based incentive compensation is the primary method to address the problem of agency costs.
C
High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency.
A
A well-designed compensation scheme should eliminate agency costs.
A well-designed management compensation scheme can reduce, but not eliminate, agency costs.
Which of the following mature companies is most likely to use a high proportion of debt in its capital structure?
A
An electric utility
B
A mining company with a large, fixed asset base
C
A software company with very stable and predictable revenues and an asset-light business model
A
An electric utility
An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity
Which of the following is the closest example of a one-sided network?
A
An online employment website
B
A social network for model train collectors
C
A website for home improvement contractors
B
A social network for model train collectors
A social network for model train collectors involves a single group of users and thus is closest to a one-side network. The others involve two user groups: employers and job-seekers in A, and homeowners and contractors in C.
Which of the following statements is most accurate? A company that markets and sells goods produced by other firms:
A
is a value added reseller.
B
receives licensing royalties.
C
has a contract manufacturing arrangement.
C
has a contract manufacturing arrangement.
Contract manufacturers produce that are marketed and sold by other firms that specialize in functions such as design and R&D.
A value added reseller distributes its own products while also providing complex services, such as customization, installation, and after-sales support.
Under a licensing arrangement, a company receives royalties for allowing other firms to manufacture and sell products that use its intellectual property.
A bundling pricing strategy is best suited to complementary products that have:
A
low profit margins and low marketing costs.
B
high profit margins and low marketing costs.
C
high profit margins and high marketing costs.
C
high profit margins and high marketing costs.
A bundling pricing strategy is particularly effective for selling complementary products with high incremental profit margins and high marketing costs relative to the cost of the product. For example, phone, internet, and cable television services.
hich of the following businesses is least likely to have network effects?
A
A telephone company
B
A price comparison website for travel airfares
C
A resume preparation service for online job seekers
C
A resume preparation service for online job seekers
The resume preparation service benefits from the network effects on various online job sites, but the service is not the source of those network effects.
The other businesses (A and B) become more valuable to their customers as they attract users. The telephone network is very useful because most people are on it. An airfare price comparison website is valuable to airlines because it has many shoppers and valuable to shoppers because it features prices for multiple airlines and routes.
Network effects are least likely to be an explicit consideration for a company that uses which of the following pricing strategies?
A
Dynamic pricing
B
Freemium pricing
C
Penetration pricing
A
Dynamic pricing
A dynamic pricing strategy is executed by charging different prices based on fluctuating demand, such as peak and off-peak rates. This strategy can be employed by many different types of companies and does not give explicit consideration to network effects. By contrast, both the freemium penetration pricing strategies are based on sacrificing revenues during an initial period in order to gain users and develop network effects.
A firm will most likely rely on estimates of opportunity cost if it uses:
A
cost-based pricing.
B
penetration pricing.
C
value-based pricing.
C
value-based pricing.
A value-based approach sets prices according to the value that a customer receives. Often, this involves estimating the opportunity cost of not making the purchase. For example, customers will be willing to pay a high price for a product or service that helps them avoid potentially catastrophic losses.
Over the long run, in an industry with perfect competition, the firm should most likely determine its optimal output quantity based on:
A
minimum efficient scale.
B
short-run average total cost.
C
marginal cost and marginal revenue.
A
minimum efficient scale.
To maximize long-run profit under perfect competition, a firm should operate at the minimum efficient scale point. On the other hand, the short-run (instead of long-run) profit is determined where marginal cost equals marginal revenue.
Deep River Manufacturing is one of many companies in an industry that make a food product. Deep River units are identical up to the point they are labeled. Deep River produces its labeled brand, which sells for $2.20 per unit, and “house brands” for seven different grocery chains which sell for $2.00 per unit. Each grocery chain sells both the Deep River brand and its house brand. The best characterization of Deep River’s market is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
C
monopolistic competition.
There are many competitors in the market, but some product differentiation exists, as the price differential between Deep River’s brand and the house brands indicates.
Which of the following statements is most accurate? Firms operating in monopolistically competitive markets:
A
face low barriers to entry and high barriers to exit.
B
are able to exercise a limited amount of pricing power.
C
sell highly differentiated products that are not close substitutes for products offered by their competitors.
B
are able to exercise a limited amount of pricing power.
Monopolistically competitive markets are characterized by low barriers to both entry and exit. Firms that operating in these markets offer products that are close substitutes for each other.
Two firms, Alpha and Beta, operate in a duopoly market. Alpha, the industry’s dominant firm, sets its output level. After observing Alpha’s decision, Beta chooses its optimal output level. This dynamic gives Alpha a first-mover advantage. These actions are most likely consistent with the:
A
Nash model.
B
Cournot model.
C
Stackelberg model.
C
Stackelberg model.
The Stackelberg model assumes that firms make decisions sequentially. The leader firm makes its decision first. Then the follower firm makes its decision after observing the leader firm’s decision.
A firm in a perfectly competitive market is operating at a point where marginal revenue is less than marginal cost. The firm should most likely:
A
increase production to return to profitability.
B
decrease production to return to profitability.
C
minimize losses in the short run by maintaining current production levels until prices allow for a return to profitability over the long run.
B
decrease production to return to profitability.
Companies most likely have a well-defined supply function when the market structure is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
B
perfect competition.
A company in a perfectly competitive market must accept whatever price the market dictates. The marginal cost schedule of a company in a perfectly competitive market determines its supply function.
What most likely happens in a monopolistically competitive industry as the market moves toward a long-run equilibrium?
A
New entrants come in and take away customers, reducing economic profits for incumbents
B
The number of incumbents will be reduced as larger companies acquire smaller competitors
C
The long-run level of output will approach the quantity produced by a perfectly competitive market
A
New entrants come in and take away customers, reducing economic profits for incumbents
Under conditions of perfect competition, a company will break even when market price is equal to the minimum point of the:
A
average total cost curve.
B
average variable cost curve.
C
short-run marginal cost curve.
A
average total cost curve.
One disadvantage of the Herfindahl–Hirschmann Index is that the index:
A
is difficult to compute.
B
fails to reflect low barriers to entry.
C
fails to reflect the effect of mergers in the industry.
B
fails to reflect low barriers to entry.
A company doing business in a monopolistically competitive market will most likely maximize profits when its output quantity is set such that:
A
average cost is minimized.
B
marginal revenue equals average cost.
C
marginal revenue equals marginal cost.
C
marginal revenue equals marginal cost.
A firm that increases its quantity produced without any change in per-unit cost is experiencing:
A
economies of scale.
B
diseconomies of scale.
C
constant returns to scale.
C
constant returns to scale.
Output increases in the same proportion as input increases occur at constant returns to scale.
In an industry comprised of three companies, which are small-scale manufacturers of an easily replicable product unprotected by brand recognition or patents, the most representative model of company behavior is:
A
oligopoly.
B
perfect competition.
C
monopolistic competition.
B
perfect competition.
The credible threat of entry holds down prices and multiple incumbents are offering undifferentiated products.
According to the Cournot model, a company operating in an oligopoly market most likely sets its output level assuming that which of the following will not change?
A
Its competitors’ prices
B
Its competitors’ output
C
Aggregate industry-level demand
B
Its competitors’ output
in an oligopoly, the industry is concentrated among relatively few firms. Unlike a pure monopoly where there are no competitors and pure competition where firms are price takers, the key challenge in an oligopoly is understanding the interactions with other producers. The Cournot model provides a framework for managing interactions between firms in this type of setting.
Over the long run, in an industry with perfect competition, the firm should most likely determine its optimal output quantity based on:
A
minimum efficient scale.
B
short-run average total cost.
C
marginal cost and marginal revenue.
A
minimum efficient scale.
To maximize long-run profit under perfect competition, a firm should operate at the minimum efficient scale point. On the other hand, the short-run (instead of long-run) profit is determined where marginal cost equals marginal revenue.
The minimum efficient scale point is the lowest point on the long-run average total cost (LRAC). It is not determined by the short-run average total cost (SATC).
A firm operating in a perfectly competitive market will most likely shut down production in the short run if marginal revenue is less than:
A
average total cost.
B
average fixed cost.
C
average variable cost.
C
average variable cost.
Two firms, Alpha and Beta, operate in a duopoly market. Alpha, the industry’s dominant firm, sets its output level. After observing Alpha’s decision, Beta chooses its optimal output level. This dynamic gives Alpha a first-mover advantage. These actions are most likely consistent with the:
A
Nash model.
B
Cournot model.
C
Stackelberg model.
C
Stackelberg model.
Which of the following statements is most accurate? Firms operating in monopolistically competitive markets:
A
face low barriers to entry and high barriers to exit.
B
are able to exercise a limited amount of pricing power.
C
sell highly differentiated products that are not close substitutes for products offered by their competitors.
B
are able to exercise a limited amount of pricing power.
Which of the following statements is most accurate? Compared to its concurrent business cycle, a typical credit cycle:
A
peaks later.
B
has a shorter duration.
C
has a steeper trajectory.
C
has a steeper trajectory.
Which of the following most likely to be interpreted as an indicator of a future economic expansion?
A
Higher trade sales
B
Higher weekly manufacturing hours
C
Lower average unemployment duration
B
Higher weekly manufacturing hours
Current economic statistics indicating little change in services inflation, rising residential building permits, and increasing average duration of unemployment are best interpreted as:
A
conflicting evidence about the direction of the economy.
B
evidence that a cyclical upturn is expected to occur in the future.
C
evidence that a cyclical downturn is expected to occur in the future.
B
evidence that a cyclical upturn is expected to occur in the future.
Rising building permits—a leading indicator—indicate that an upturn is expected to occur or continue.
Increasing average duration of unemployment—a lagging indicator—indicates that a downturn has occurred,
the lack of any change in services inflation—also a lagging indicator—is neither negative nor positive for the direction of the economy.
Taken together, these statistics indicate that a cyclical upturn may be expected to occur.
An increase in new capital goods orders and a decrease in the weekly number of initial unemployment insurance claims are most accurately characterized as:
A
leading indicators of an economic expansion.
B
coincident indicators of an economic expansion.
C
a leading and a lagging indictor, respectively, of an economic expansion.
A
leading indicators of an economic expansion.
Increases in new orders for capital goods and decreases in unemployment insurance claims are both leading indicators of an economic expansion.
The inventory–sales ratio is most likely to be rising:
A
as a contraction unfolds.
B
partially into a recovery.
C
near the top of an economic cycle.
C
near the top of an economic cycle.
Near the top of a cycle, sales begin to slow before production is cut, leading to an increase in inventories relative to sales.
The characteristic business cycle patterns of trough, expansion, peak, and contraction are most likely:
A
periodic.
B
recurrent.
C
of similar duration.
B
recurrent.
The stages of the business cycle occur repeatedly over time.
