CFA Level 1 Practice Questions

Under Standard I(A) Knowledge of the Law, a member must not knowingly participate in or assist a violation of applicable laws, rules, or regulations. When the member becomes aware of a violation, the member should encourage the relevant firm or person to cease the conduct and should report the violation to the appropriate persons or authorities, unless doing so would breach confidentiality or conflict with other legal or ethical obligations. Ignoring the matter or immediately contacting regulators is not the prescribed first step.

The Code and Standards establish an ethical benchmark that promotes integrity, professionalism, and investor confidence in the integrity of capital markets. They supplement rather than replace applicable laws and regulations, and they apply to both CFA Institute members and candidates. They do not and cannot guarantee investment performance.

Standard III(C) Suitability requires a member to determine that an investment is suitable for the client before taking investment action. Discretionary authority permits the manager to execute trades without prior approval, but it does not remove the duty to assess suitability. Pursuing the highest expected return without regard to client circumstances is inconsistent with the standard.

Standard III(B) Fair Dealing requires members to deal fairly and equitably with all clients and prospective clients. Fair dealing does not mean identical treatment, but allocation policies must not favor higher-fee clients, family members, or the member's own accounts.

Standard II(A) Material Nonpublic Information prohibits members from acting or causing others to act on material nonpublic information and requires reasonable efforts to prevent its transmission and misuse. Trading for the client, sharing the information, or attempting to make it public through personal publication would violate the standard.

Standard III(B) Fair Dealing requires fair and equitable treatment of all clients. Allocating scarce investment opportunities based on fee revenue rather than an objective, documented policy unfairly disadvantages other clients and is a classic violation of the fair dealing standard.

Standard I(B) Independence and Objectivity requires members to maintain independence and objectivity and to avoid being influenced by pressure, conflicts of interest, or outside factors. Issuing a rating under pressure, even with a disclaimer, violates the standard.

Standard VI(C) Referral Fees requires members to disclose to the employer, client, or prospective client, in writing before services are provided, any compensation or benefit received for referring clients or investment services. This disclosure helps clients understand the member's incentives and potential conflicts.

The statement is false. Standard I(A) Knowledge of the Law prohibits knowingly participating in or assisting a violation of laws, rules, or regulations, and also prohibits inducing others to violate the law. A member can therefore violate the Standards by knowingly assisting someone else's prohibited conduct.

Disclosing referral fees, declining gifts that could impair objectivity, and preserving client confidentiality subject to legal requirements are consistent with Standards VI(C), I(B), and III(E), respectively. Trading on material nonpublic information violates Standard II(A), and directing a client trade error to the member's own account violates the duty to place client interests first.

NPV equals the present value of future cash flows minus the initial investment. Here, NPV = -100 + 120 / 1.10 = -100 + 109.09 = 9.09. Because NPV is positive, the investment earns more than the required rate of return.

The IRR is the discount rate that makes NPV equal to zero. For conventional cash flows, NPV decreases as the discount rate increases. If the required rate of return is below the IRR, the project's NPV is positive.

The present value is the future cash flow divided by (1 + r)^n: 1,000 / 1.05^3 = 1,000 / 1.157625 = 863.84.

The probability of an event and the probability of its complement must sum to 1. Therefore, the complement probability is 1 - 0.25 = 0.75.

Chebyshev's inequality states that at least 1 - 1/k^2 of the observations lie within k standard deviations of the mean for any distribution. With k = 2, the minimum proportion is 1 - 1/4 = 75%.

Correlation equals covariance divided by the product of the standard deviations: 0.0036 / (0.20 x 0.15) = 0.0036 / 0.03 = 0.12. Correlations must lie between -1 and 1, so 1.20 cannot be correct.

A Type I error is rejecting the null hypothesis when it is actually true. Its probability is the significance level of the test. Failing to reject a false null hypothesis describes a Type II error.

The statement is true. A one-tailed 5% test places all 5% in one tail, corresponding to a critical value of about 1.645. A two-tailed 5% test places 2.5% in each tail, corresponding to critical values of about plus and minus 1.96.

A higher discount rate reduces the present value of a future cash flow. The future value factor is (1 + r)^n. An annuity due pays at the beginning of each period, so its cash flows are discounted for one fewer period and it has a higher present value than an otherwise identical ordinary annuity. The IRR is the discount rate that sets NPV equal to zero. An ordinary annuity pays at the end of each period, so statement b is incorrect.

The present value of a perpetuity is C / r, the standard error of the sample mean is s / sqrt(n), the variance of a Bernoulli random variable is p(1 - p), and the probability that two independent events both occur is P(A) x P(B).

The law of demand states that, holding all other factors constant, an increase in price causes a decrease in quantity demanded. This is a movement along the existing demand curve, not a shift of the curve. The demand curve shifts only when a non-price determinant, such as income or preferences, changes. Because the good is normal, the price increase reduces quantity demanded, while income effects would be relevant only if income changed.

In perfect competition, there are many buyers and sellers of a homogeneous product, and each firm is a price taker. A firm that tries to charge above the market price sells nothing, whereas it can sell any quantity at the market price. Monopolists, oligopolists, and monopolistically competitive firms face downward-sloping demand curves and possess at least some degree of pricing power.

The expenditure approach measures GDP as the sum of personal consumption expenditures, gross private domestic investment, government purchases of goods and services, and net exports (exports minus imports). Imports are subtracted because they represent spending on goods produced abroad; using total exports rather than net exports would overstate domestic production. Wages, interest, and rent belong to the income approach.

A change in income is a non-price determinant of demand, so it shifts the entire demand curve. If coffee is a normal good, higher incomes raise the quantity demanded at every price, shifting demand to the right. A change in the price of coffee causes a movement along the demand curve rather than a shift, and a decrease in the number of buyers would shift demand to the left.

Central banks pursue expansionary monetary policy by lowering policy rates, reducing reserve requirements, and/or buying government securities. These actions increase the money supply, lower borrowing costs, and stimulate aggregate demand. Raising policy rates, raising reserve requirements, and selling securities in open market operations are contractionary measures.

In a quote expressed as U.S. dollars per euro, the euro is the base currency and the U.S. dollar is the price currency. A rise from 1.10 to 1.15 means one euro now buys $1.15 instead of $1.10, so the euro has appreciated, or strengthened, against the dollar while the dollar has depreciated against the euro. The movement provides no information about the euro's value relative to other currencies.

Expansionary fiscal policy uses higher government spending and/or lower taxes to boost aggregate demand and close a recessionary gap. Decreasing spending and raising taxes are contractionary measures intended to slow an overheated economy. Fiscal policy is set by the government, whereas buying or selling government bonds is a tool of monetary policy.

A price elasticity of demand of -0.4 indicates inelastic demand: a 5% price increase causes quantity demanded to fall by roughly 2% (0.4 x 5%). Because the percentage decline in quantity is smaller than the percentage rise in price, total revenue (price x quantity) increases. Whether the good is a luxury or a necessity does not change the conclusion once the elasticity is known.

True. A perfectly competitive firm is a price taker: it can sell any quantity it chooses at the prevailing market price but cannot sell anything above it. The firm's demand curve is therefore horizontal, or perfectly elastic, at the market price. The market demand curve, in contrast, is downward sloping.

The AD curve shifts right when consumption, investment, government purchases, or net exports rise at a given price level. Higher consumer confidence raises consumption, higher government purchases add directly to aggregate demand, and higher net exports add to aggregate demand. A decrease in the aggregate price level causes a movement down along the AD curve rather than a shift. Higher raw-material costs shift the short-run aggregate supply curve to the left, not the AD curve to the right.

The balance sheet, also called the statement of financial position, presents assets, liabilities, and shareholders' equity at a point in time and is organized around the accounting equation: Assets = Liabilities + Shareholders' equity. The income statement and the statement of cash flows cover a period of time, while the statement of changes in equity explains changes in equity components during the period.

Accrual accounting recognizes revenue when it is earned, generally when a performance obligation is satisfied, rather than when cash changes hands. Cash receipts affect the statement of cash flows and accounts receivable, but under accrual accounting they do not by themselves determine when revenue is recognized. Signing a contract or reaching fiscal year-end is not the recognition event.

Under FIFO, the oldest, lower costs flow to cost of goods sold and the most recent, higher costs remain in ending inventory. Under LIFO, the newest, higher costs flow to cost of goods sold and the older, lower costs remain in inventory. With rising costs, FIFO therefore produces higher ending inventory and lower cost of goods sold than LIFO.

Straight-line depreciation expense equals (Cost - Salvage value) / Useful life. Here, ($120,000 - $20,000) / 5 = $20,000 per year. The depreciable base is $100,000; dividing the full $120,000 purchase price by 5 would incorrectly produce $24,000.

Under US GAAP, interest paid and interest received are classified as operating cash flows. Under IFRS, interest paid may be classified as operating or financing and interest received as operating or investing, provided the choice is applied consistently. Because the question specifies US GAAP, cash paid for interest is an operating cash outflow.

The quick ratio excludes inventory from current assets: (Current assets - Inventory) / Current liabilities = ($500,000 - $200,000) / $250,000 = $300,000 / $250,000 = 1.2. The current ratio, which includes inventory, would be $500,000 / $250,000 = 2.0.

Under the indirect method, net income is adjusted for non-cash items and changes in working capital. Depreciation is a non-cash expense that reduced net income, so it is added back. Increases in current operating assets such as accounts receivable and inventory consume cash and are subtracted, and a decrease in accounts payable also consumes cash and is subtracted.

False. LIFO is prohibited under IFRS; companies applying IFRS may use FIFO, the weighted-average cost method, or specific identification where appropriate. LIFO is permitted under US GAAP, which is a common reason inventory amounts must be reconciled when comparing companies reporting under the two frameworks.

Under US GAAP, operating activities include the cash effects of producing and delivering goods and services, such as payments to suppliers, interest paid, and income taxes paid. Cash dividends paid to shareholders are financing activities, and purchases of property, plant, and equipment are investing activities. The US GAAP qualifier is important because under IFRS, interest paid may instead be classified as a financing activity.

The quick ratio uses the most liquid current assets, cash, marketable securities, and accounts receivable, divided by current liabilities; it excludes inventory. Return on equity is net income divided by average total shareholders' equity. The current ratio is current assets divided by current liabilities, including inventory. The debt-to-equity ratio is total debt divided by total shareholders' equity.

The optimal capital structure minimizes the firm's WACC and, as a result, maximizes the value of the firm for a given level of operating cash flows. Minimizing only one financing cost, such as the cost of debt, can be suboptimal because it ignores the effect of leverage on the cost of equity and on financial risk. A structure that minimizes WACC does not necessarily maximize the current dividend per share.

WACC = 0.60(12%) + 0.40(5%) = 7.2% + 2.0% = 9.2%. The after-tax cost of debt of 5% already reflects the tax benefit of debt, so the marginal tax rate should not be applied a second time. The correct weights are the target market-value weights of equity and debt.

For mutually exclusive projects, NPV is the preferred decision criterion because it directly measures the expected increase in shareholder wealth and discounts cash flows at the opportunity cost of capital. IRR can rank projects incorrectly when project sizes or cash flow timing differ. The crossover rate helps explain a ranking conflict, but it does not by itself determine which project should be accepted; the project with the higher NPV should be chosen.

Operating leverage arises from fixed operating costs. The higher the proportion of fixed costs, the more operating income (EBIT) changes for a given percentage change in revenue. Financial leverage, in contrast, relates to the use of debt and fixed financing costs rather than to the company's operating cost structure.

Financial leverage magnifies the risk borne by shareholders because fixed interest obligations increase the volatility of earnings available to equity. The Hamada equation shows that the equity beta rises as the debt-to-equity ratio increases: levered beta = unlevered beta x [1 + (1 - tax rate)(debt/equity)]. The higher systematic risk raises the required return on equity, so the cost of equity increases rather than decreases.

The static trade-off theory balances the tax advantage of debt against the expected costs of financial distress, which include direct costs such as legal and administrative expenses and indirect costs such as lost customers and constrained investment. The optimal capital structure equates the marginal benefit of the debt tax shield with the marginal expected cost of financial distress; beyond that point, additional debt reduces firm value. A maximum debt rating is not the objective, and using zero debt forgoes valuable tax shields.

Independence is judged by the absence of a material relationship with the company, its affiliates, or its management. A current or former executive, a large shareholder with management ties, or a representative of a major lender may lack independence. Independent directors are expected to provide objective oversight of management, including monitoring executive compensation and related-party transactions.

Under a residual dividend policy, the firm first invests in all projects with positive NPV and then pays out any remaining, or residual, earnings as dividends. This policy maintains the target capital structure and avoids issuing new equity solely to fund dividends, but it can produce volatile dividend payments because earnings and investment needs change from year to year.

A positive NPV means the present value of expected cash inflows exceeds the present value of cash outflows when discounted at the opportunity cost of capital. Accepting such a project adds value to the firm and increases shareholder wealth; independent projects with negative NPV should be rejected.

Using the capital asset pricing model, required return on equity = risk-free rate + beta x market risk premium. A higher risk-free rate, a higher beta, or a higher expected market risk premium raises the required return on equity. The marginal tax rate affects the after-tax cost of debt rather than the cost of equity, and a lower expected dividend growth rate reduces the required return implied by the dividend discount model for a given stock price.

Variance and standard deviation capture the total variability of an asset's returns, including both systematic and unsystematic risk. Beta measures only systematic risk relative to the market, alpha measures risk-adjusted performance relative to a benchmark, and tracking error measures the deviation of a portfolio's returns from its benchmark.

As securities with less than perfect positive correlation are combined, unsystematic, or firm-specific, risk is diversified away. Systematic, or market, risk cannot be eliminated by diversification because it arises from economy-wide factors that affect all securities. The risk-free rate is a market-determined rate, not a risk that diversification can reduce.

CAPM: required return = risk-free rate + beta x (expected market return - risk-free rate) = 3% + 1.2(11% - 3%) = 3% + 9.6% = 12.6%. The market risk premium is the difference between the expected market return and the risk-free rate, not the expected market return itself.

The CML describes the risk-return combinations available from efficient portfolios formed by combining the risk-free asset with the market portfolio, and it uses total risk, measured by standard deviation, on the horizontal axis. The SML applies to all assets and uses beta, a measure of systematic risk. Along the SML, fairly priced securities plot exactly on the line.

The two-fund separation theorem states that all investors hold a combination of the risk-free asset and the same tangency portfolio of risky assets; risk preferences determine only the proportion allocated to each. Under CAPM assumptions, the tangency portfolio is the market portfolio. The global minimum-variance portfolio is not generally optimal for all investors because it does not reflect the risk-return trade-off.

The expected return of a portfolio is the weighted average of the expected returns of its components: 0.70(8%) + 0.30(14%) = 5.6% + 4.2% = 9.8%. Correlation affects portfolio risk but not the portfolio's expected return.

Under the weak form, current prices fully reflect all historical market data, including past prices and trading volume, so technical analysis based on those data should not consistently produce abnormal returns. Rapid adjustment to public news relates to semi-strong efficiency, and the average underperformance of active managers after fees is broadly consistent with market efficiency.

Semi-strong efficiency implies that prices adjust quickly and completely to all publicly available information, including financial statements, earnings announcements, and economic data. Because that information is already reflected in prices, an analyst relying only on public information cannot consistently earn abnormal risk-adjusted returns. Private, or insider, information is addressed by the strong form of market efficiency.

In the CAPM, beta measures systematic risk relative to the market, the SML shows expected return = risk-free rate + beta x market risk premium, and only systematic risk is priced because unsystematic risk can be diversified away. The market portfolio contains all risky assets weighted by market value. A zero-beta asset's expected return equals the risk-free rate, not the market risk premium.

Beta captures systematic risk: a beta of 1.0 moves with the market. Standard deviation captures total risk, including systematic and unsystematic components. The Sharpe ratio divides excess return by portfolio standard deviation, so it measures compensation per unit of total risk. Alpha is the actual or expected excess return not explained by beta under the CAPM; a positive alpha indicates outperformance relative to the security market line.

When the coupon rate equals the market discount rate used to discount the bond's cash flows, the present value of the coupon payments and the principal repayment equals the face value, so the bond trades at par. If the coupon rate were above the market discount rate, the bond would trade at a premium; if below, at a discount. No additional information about face value is needed to determine the relative price.

Bond prices and market discount rates move in opposite directions. The bond's future cash flows are fixed, so a higher discount rate lowers their present value and reduces the bond's price. This inverse relationship holds regardless of whether the bond is currently trading at a premium, par, or a discount.

A bond trades at a premium when its coupon rate is higher than its yield to maturity. Because the 5% coupon exceeds the 4% market yield, investors pay more than par to receive above-market coupon income. Over time, a premium bond's price declines toward par as it approaches maturity.

Macaulay duration is the weighted average time until a bond's cash flows are received, with weights equal to each cash flow's present value as a proportion of the bond's price. A zero-coupon bond has only one cash flow, at maturity, so its Macaulay duration equals its time to maturity of 10 years. The value 10 divided by 1.07 would be an approximation of modified duration, not Macaulay duration.

Modified duration equals Macaulay duration divided by one plus the yield per period: 7.50 / (1 + 0.06) = 7.08. Modified duration approximates the percentage change in a bond's price for a 1 percentage point change in its yield to maturity, assuming no change in expected cash flows.

Effective duration is calculated as (PV- - PV+) / (2 x PV0 x change in yield), where PV- is the price after a downward yield shift, PV+ is the price after an upward yield shift, and PV0 is the initial price. Substituting: (100.20 - 97.50) / (2 x 99.00 x 0.005) = 2.70 / 0.99 = 2.73. Effective duration is especially useful for bonds with embedded options because it uses actual price changes rather than assuming unchanged cash flows.

A credit spread is the difference between the yield on a risky bond and the yield on a comparable risk-free bond. A wider spread means investors require more compensation for the issuer's credit risk. With the risk-free yield unchanged, the risky bond's yield rises, its price falls, and the market's perception of creditworthiness or the compensation required for credit risk has deteriorated.

Interest rate risk, as measured by duration, increases with time to maturity and decreases with coupon rate. A zero-coupon bond has no interim cash flows, so its Macaulay duration equals its maturity of 20 years, the highest duration among the choices. For a given yield change, the bond with the highest duration exhibits the largest percentage price change.

The statement is true. A bond trades at a premium when its coupon rate exceeds its yield to maturity because the present value of its cash flows is greater than par. A bond trades at a discount when its coupon rate is below its yield to maturity, and at par when the two rates are equal.

Duration increases with time to maturity because cash flows are received further in the future, and it decreases with the coupon rate because larger interim cash flows return more capital earlier. For a given bond, a lower yield to maturity lengthens duration because distant cash flows receive relatively greater present value weight. A higher coupon rate and a higher yield to maturity both reduce duration.

The Gordon growth model values a stock as D1 / (r - g), where D1 is the expected dividend next period. D1 = $2.00 x 1.05 = $2.10, so V0 = $2.10 / (0.11 - 0.05) = $2.10 / 0.06 = $35.00. The just-paid dividend must be grown one period before it is used in the denominator.

The P/E ratio is market price per share divided by earnings per share. A trailing P/E uses the most recent reported EPS, while a leading or forward P/E uses forecasted next-year EPS. Price divided by book value is the price-to-book ratio, and dividends per share divided by EPS is the dividend payout ratio.

A price return index reflects only capital appreciation or depreciation from changes in constituent prices. A total return index also includes dividend income, typically assuming dividends are reinvested in the index. When constituents pay positive dividends, the total return is greater than the price return over the period.

Porter's five forces are the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitute products, and the intensity of rivalry among existing competitors. Government regulation can affect an industry's structure, barriers to entry, and profitability, but it is not one of the five forces itself.

First compute the expected dividends: D1 = $1.50 x 1.12 = $1.68 and D2 = $1.68 x 1.12 = $1.8816. The dividend at the start of the constant-growth phase is D3 = $1.8816 x 1.06 = $1.994496, so the terminal value at the end of year 2 is $1.994496 / (0.10 - 0.06) = $49.8624. Discounting the cash flows gives V0 = $1.68 / 1.10 + ($1.8816 + $49.8624) / 1.10^2 = $1.5273 + $42.7636 = $44.29.

The retention ratio is 1 - 0.40 = 0.60, so the sustainable growth rate is g = ROE x retention ratio = 0.15 x 0.60 = 0.09. Under the Gordon growth model, the justified leading P/E is the payout ratio divided by (r - g): 0.40 / (0.11 - 0.09) = 0.40 / 0.02 = 20.0. This relationship assumes constant dividend growth and a required return above the growth rate.

A price-weighted index is computed as the sum of constituent stock prices divided by a divisor. Because weights depend on share price, higher-priced stocks have greater influence. A stock split would mechanically reduce the summed prices even though the constituent's economic value is unchanged, so the divisor is adjusted to keep the index continuous. Equal percentage weights describe equal-weighted indices, and shares outstanding multiplied by price describes market-capitalization weighting.

The statement is true. The Gordon growth model values a stock as D1 / (r - g), which requires a constant dividend growth rate in perpetuity. It also requires the required rate of return r to exceed the growth rate g; if g were equal to or greater than r, the denominator would be zero or negative and the model would not produce a meaningful finite value.

A P/E ratio is undefined or not meaningful for companies with negative EPS, and volatile earnings can distort the ratio even when the stock price is unchanged. The ratio does not automatically adjust for accounting policy differences; in fact, differing accounting choices can reduce comparability across companies. P/E can be computed with trailing or forecasted earnings and does not depend on dividend payments.

Row r1 describes a price-weighted index, where the sum of constituent prices is divided by an adjusted divisor and high-priced stocks dominate. Row r2 describes an equal-weighted index, which assigns the same percentage weight to every constituent. Row r3 describes a market-capitalization-weighted index, with weights equal to price multiplied by shares outstanding. Row r4 describes a float-adjusted market-capitalization-weighted index, which uses only shares available for public trading and excludes closely held or restricted shares.