Quiz 1 Answers Fusionné Compressé

Quiz 1 – Corporate Governance
1. Corporate governance is a system that provides a framework that defines the rights, roles, and
responsibilities of various groups. Which one is not one of these groups?
A. Directors
B. Shareholders
C. Employees
Answer:
Corporate governance is a system that provides a framework that defines the rights, roles and
responsibilities of Board members / Director, Shareholders / Shareowners and company /
management, not employees.
2. To protect their interest, shareholders should ensure that:

A. board members have no transactions or business relations with the management.
B. members only meet in the presence of the management.
C. the chairman of the board should also be CEO of the company.
Answer:
Members of the board should also meet outside of management's presence, and best practices
suggest that the chairman of the board should not be the CEO, to ensure one person does not have
too much executive power.
3. Which of the following relationships compromises the independence of members of the board?
A. A member who is also the supplier of an essential raw material.
B. A member with no previous relationship with management.
C. A member who is not a former employee of the firm.
Answer:
According to the best practices of corporate governance, a member of the board who is also a supplier
can compromise the independence of the board.
4. Which of the following potential board members is least likely to be chosen to be part of a firm's
board of directors?
A. Potential board member "A" has been part of 7 other board of directors in the past.
B. Potential board member "B" is regarded as having problem-solving skills, leadership skills and
an understanding of the latest management techniques.
C. Potential board member "C" is a Chartered Professional Accountant that is able to direct
financial and operational matters, and is currently responsible for the day-to-day operations
of the company.
Answer:
Directing financial and operational matters is beyond the scope of a director's role and responsibilities.
Potential board member "C" should keep the responsibilities he already has.
Potential board member "A" has a key qualification to serve on a board of directors, which is
experience. Most companies look for directors who have senior leadership experience or who have
served as a director of another company in the same or a similar industry. For example, companies
that are regulated by the government look for directors who have government relations experience.
Global companies specifically look for board members with international skills and experience.
Potential board member "B" has strategic skills, which is also a key qualification to serve on a board
of directors. Strategic thinking skills, problem-solving skills, leadership skills and an understanding of
the latest management techniques as critical skills for board members.
5. Simon Segal is an investor of Insert.net Ltd who is evaluating board members and the
remuneration committee. Which of the following is the least important element to analyze?
A. If the firm has provided loans to members.
B. If the terms of options granted are reasonable.
C. If the members are Chartered Professional Accountants.
Answer:
It is not a requirement for the members of the remuneration committee to be Chartered Professional
Accountants.
6. Identify the duties of the nomination committee.

A. Recording the expenses of board members
B. Recruiting qualified board members
C. Setting the remuneration of board members
Answer:
Setting the remuneration is the responsibility of the compensation committee and recording expenses
of board members is beyond the scope of duties of the nomination committee.
7. Which of the following provisions should be added in a strong corporate governance Code of
Ethics?
A. Members and management should be discouraged to use the company's assets.
B. Family members of board members should be allowed to have related party agreements.
C. A firm's Code of Ethics should not be audited after its implementation.
Answer:
A firm's Code of Ethics should be audited on a regular basis and family members of the board should
be discouraged to have related party agreements.
8. From the shareowners perspective, which of the following activity will impair the voting rights of
shareholders?
A. Allowing proxy voting rights
B. Requiring attendance to cast votes
C. Not grouping the meeting dates with the meeting dates of other companies in the same
region
Answer:
Not allowing to vote without attending the meeting in person impairs the shareholders' right to vote.
9. Which of the following corporate structural issues does not require the shareholders' approval?
A. The sale of 10% of the firm to a third party
B. The approval of an anti-takeover measure
C. Moving a factory from one continent to another
Answer:
Changes in the geographical market for the firm's products and services does not require
shareholders' voting or approval.
10. Identify which of the following firms can face adversity in raising equity capital for fixed
investments.
A. Firms that separate voting rights across different classes
B. Firms that do not separate voting rights across different classes
C. Firms that regularly pay dividends and regularly hold meetings with shareholders
Answer:
It has been proven that firms that separate voting rights from economic rights face more trouble
raising equity capital than firms that do not.
11. While evaluating a firm's ownership structure, which of the following issues regarding equity is
considered negative?
A. The safeguard of inferior voting rights of shareowners in bylaws and articles of association
B. In a recently privatized firm, all voting rights are held by previous owners
C. Shareholders have the power to nominate board members
Answer:
In a recently privatized firm, if the voting rights are still held by previous owners, it may prevent
shareholders from receiving the full value of their shares.
12. Takeover defenses are provisions that are used to make a firm less attractive. Which party is
effectively deterred by such a move?
A. Shareholders
B. Regulators
C. Hostile bidders
Answer:
Takeover defenses are provisions that are used to make a firm less attractive to hostile bidders.
13. Which one of these statements is the least likely accurate regarding corporate governance?
A. Best practices suggest that 75% of the board members should be independent.
B. Board members should only meet in the presence of the management.
C. The chair of the board (COB) can also be the chief executive officer (CEO).
Answer:
Board members should meet regularly, with or without the presence of the management.
With few exceptions, in many U.S. companies, the chief executive officer (CEO), who holds the top
management position in the company, also serves as chairman of the board. It is suggested that at
least 75% of the board members should be independent.
14. Which one of these statements is most accurate regarding corporate governance?
A. If all members of management are CFA charterholders, a company's code of ethics is not
required.
B. The nomination committee is responsible for recruiting senior management.
C. Each board member should take action in the best interest of shareholders.
Answer:
A code of ethics should be required to ensure that management and employees work in the best
interest of shareholders, even if all members are CFA charterholders. Also, the nomination committee
is responsible for recruiting board members, not senior management.
15. Which one of the following statements is least accurate regarding shareholder rights?
A. Shareholders cannot vote without attending meetings.
B. Cumulative voting gives small shareholders more rights.
C. Shareholders do not like takeover defences
Answer:
Shareholders can vote without attending meetings. Shareholders may vote at a meeting by attending
in person but, in fact, most shareholders vote by "proxy" without being present in person.
Options B is correct. Cumulative voting is a type of voting system that helps strengthen the ability of
minority shareholders to elect a director. This method allows shareholders to cast all of their votes for
a single nominee for the board of directors when the company has multiple openings on its board.
Option C is correct. Takeovers benefit investors but threaten incumbent, inefficient management. As
such, takeover defenses are not well perceived by shareholders.
Question Bank – Corporate Governance
1. Haseeb Ahmed is constructing a portfolio based on the Investment Policy Statement of one of his
clients, who has mentioned a unique constraint in his IPS of investing in the equity of only
manufacturing companies that use renewable energy. This constraint is most likely related to
which of the following ESG factors?
A. Environmental
B. Social
C. Governance
Answer:
Environmental, social and governance (ESG) refers to the three central factors in measuring the
sustainability and ethical impact of an investment in a company or business. The environmental factor
includes the consideration of pollution prevention, energy efficiency, reduced emissions, and
adherence to environmental safety.
2. The investment manager at Sustain Capital, a firm famous for implementing ESG factors in its
investment strategies, is evaluating a large number of stocks of companies to include in his
portfolio. The firm's strategy involves screening a number of companies and excluding certain
companies from investment considerations due to the nature of their underlying business
activities or other environmental or social concerns. Which of the following appropriately
describes the investment manager's strategy?
A. Impact screening
B. Negative screening
C. Thematic screening
Answer:
Negative screening or exclusionary screening describes the practice of excluding certain sectors or
companies from investment considerations due to the nature of their underlying business activities or
other environmental or social concerns.
3. You have been hired to help streamline the corporate governance structure at Exim Bank. In the
process, you have established several facts about executive remuneration at the bank. The
remuneration plan you would be most concerned about is:
A. one that's wholly cash-based with no offer for equity or stock options
B. one that's consistent with the bank's competitors
C. one that varies from year to year
Answer:
It is not considered a good corporate governance practice to have a cash-only remuneration plan for
executives as this could result in a misalignment of incentives between management and other
stakeholders, including investors. It is important that part of the remuneration be equity-based or
linked to performance in some other practical way.
Option B is incorrect. Analysts would be concerned if the pay structure is significantly different from
industry-wide levels, particularly if wages are excessive.
Option C is incorrect. A plan that varies over time would typically be of less concern to an analyst
compared with one that did not change.
4. Which of the following is most likely in the best interest of shareholders?

A. Members are allowed to receive compensations beyond their services.
B. Members of the board are encouraged to receive consultation fees.
C. None of the above.
Answer:
Members should be discouraged to receive compensation beyond their services and should be
discouraged from receiving consultation fees.
5. Which of the following statements is least likely accurate regarding the audit committee?
A. The external auditor is free from the influence of the management.
B. Committee members are not necessarily financial experts.
C. Proper accounting and auditing procedures should always be followed.
Answer:
Audit committee members should be finance or accounting experts.
6. Jude Akin is an analyst who is evaluating shareholders' voting rights. Which of the following
consideration will most likely lead to unbiased voting?
A. The firm uses a third party to tabulate votes.
B. The management tabulates the votes.
C. Tabulation is not subject to any audit.
Answer:
The following activities will lead to unbiased voting:
1) The firm uses a third party to tabulate votes and preserves the past tabulation record.
2) Tabulation is made subject to audit.
3) Shareholders are not required to be present to vote.
7. Which of the following documents can least likely provide information regarding the
shareowners' sponsored board nomination?
A. Quarterly financial reports
B. Articles of organization
C. Corporate bylaws
Answer:
Information regarding shareowners' sponsored board nomination can be found in articles of
organization, proxy statement, and corporate bylaws.
The quarterly annual reports contain information regarding the performance of the firm for the
quarter.
8. Which of the following should you analyze to evaluate if the legal rights of shareholders are
protected under the corporate governance code and legal statutes of jurisdiction in which the
firm is headquartered?
A. Analyze if shareholders are allowed to sponsor the audit committee
B. Analyze if members of the board possess the necessary experience
C. Analyze if the legal statute allows shareholders to take legal actions to enforce ownership
rights
Answer:
To evaluate if the legal rights of shareholders are protected under the corporate governance code
and under legal statutes of jurisdiction in which the firm is headquartered, investors should analyze
whether the legal statute allows shareholders to take legal actions to enforce ownership rights.
9. Which of the following is least likely a provision of takeover defense?

A. Golden parachutes
B. Poison pills
C. Options to board members
Answer:
Takeover defenses are used to decrease the value of the firm's shares to make a firm less attractive
to hostile bidders. To serve this purpose, a golden parachute, a poison pill, and/or greenmail defenses
can be used.
Options to board members would not serve the purpose of making a firm less attractive to hostile
bidders.
10. Gree is the market leader in the sporting goods manufacturing sector of China. However, the
company was recently accused of not providing minimum basic working conditions to its
employees. Due to these serious accusations, a number of pension funds reduced their
exposures to Gree's equity. Which of the following ESG factors the pension funds have most
likely considered?
A. Enviornmental
B. Social
C. Governance
Answer:
Environmental, social and governance (ESG) refers to the three central factors in measuring the
sustainability and ethical impact of an investment in a company or business. The social factor includes
the consideration for human rights issues and welfare concerns in the workplace as well as the impact
of product development on the community.
11. Which one of these statements is the least likely accurate regarding the audit
committee?
A. Some members of the audit committee should be considered financial experts.
B. The committee has the authority to approve or reject non-audit engagements with audit
firms.
C. All members of the committee should be independent.
Answer:
ALL members of the audit committee should be considered financial experts.
12. KKQ Chemicals Limited, a manufacturer of sodium bicarbonate, has its operations in Western
Europe. The company has been on an acquisition spree and has acquired ten small chemical
companies in the last two years. An equity analyst, while analyzing the company's filings, observes
that the company's board has ten members which include three independent members. The
analyst is concerned about the acquisition carried out by the company. However, the proposal to
acquire the companies were always discussed by the board and were subject to shareholder vote
at general meetings.
Which of the following statements is most appropriate?
A. The presence of independent directors on the board ensures discussion on proposals

without any undue influence from the company's management.
B. The company's board composition is not in accordance with corporate governance best
practices.
C. The company's board composition is in accordance with corporate governance best
practices.
Answer:
To be in accordance with corporate governance best practices, independent board members must
constitute at least a majority of the board.
Quiz 2 – Uses of Capital
1. Which of the following steps is least likely to be an administrative step in the capital
budgeting process?
A. Forecasting cash flows and analyzing project profitability.
B. Arranging financing for capital projects.
C. Conducting a post-audit to identify errors in the forecasting process.
Answer: The four administrative steps in the capital budgeting process are:
1. Idea generation
2. Analyzing project proposals
3. Creating the firm-wide capital budget
4. Monitoring decisions and conducting a post-audit
2. Mason Webb makes the following statements to his boss, Laine DeWalt about the
principles of capital budgeting.
Statement 1: Opportunity costs are not true cash outflows and should not be considered
in a capital budgeting analysis.
Statement 2: Cash flows should be analyzed on an after-tax basis.
Should DeWalt agree or disagree with Webb's statements?

Statement 1 Statement 2
A. Disagree Disagree
B. Agree Agree
C. Disagree Agree
Answer: DeWalt should disagree with Webb's first statement. Cash flows are based on
opportunity costs. Any cash flows that the firm gives up because a project is undertaken
should be charged to the project. DeWalt should agree with Webb's second statement. The
impact of taxes must be considered when analyzing capital budgeting projects.
3. If two projects are mutually exclusive, a company:

A. must accept both projects or reject both projects.
B. can accept either project, but not both projects.
C. can accept one of the projects, both projects, or neither project.
Answer: Mutually exclusive means that out of the set of possible projects, only one project
can be selected. Given two mutually exclusive projects, the company can accept one of the
projects or reject both projects, but cannot accept both projects.
4. A single independent project with a negative net present value has an initial cost of $2.5
million and would generate cash inflows of $1 million in each of the next three years. The
discount rate the company used when evaluating this project is closest to:
1. 10%.
2. 8%.
3. 9%.
Answer: Given that the NPV is negative, the discount rate used by the company evaluating
the project must be greater than the IRR (the discount rate for which the NPV equals zero).
On a financial calculator: CF0 = -2.5; CFj = 1; Nj = 3; CPT IRR = 9.7%. Since the discount rate
used for this project is greater than 9.7%, it must be closer to 10% than to either of the other
answer choices.
5. Tapley Acquisition, Inc., is considering the purchase of Tangent Company. The acquisition
would require an initial investment of $190,000, but Tapley's after-tax net cash flows
would increase by $30,000 per year and remain at this new level forever. Assume a cost
of capital of 15%. Should Tapley buy Tangent?
A. Yes, because the NPV = $30,000.
B. Yes, because the NPV = $10,000.
C. No, because k > IRR.
Answer: This is a perpetuity.
PV = PMT / I = 30,000 / 0.15 = 200,000
200,000 − 190,000 = 10,000
6. Lane Industries has a project with the following cash flows:

Year Cash Flow
0 −$200,000
1 60,000
2 80,000
3 70,000
4 60,000
5 50,000
The project's cost of capital is 12%. The discounted payback period is closest to:
A. 3.4 years.
B. 2.9 years.
C. 3.9 years.
Answer: The discounted payback period method discounts the estimated cash flows by the
project's cost of capital and then calculates the time needed to recover the investment.
Year Cash Flow Discounted Cumulative
Cash Flow Discounted
Cash Flow
0 −$200,000 −$200,000.00 −$200,000.00
1 60,000 53,571.43 −146,428.57
2 80,000 63,775.51 −82,653.06
3 70,000 49,824.62 −32,828.44
4 60,000 38,131.08 5,302.64
5 50,000 28,371.30 33,673.98
7. For a project with cash outflows during its life, the least preferred capital budgeting tool
would be:
A. net present value.
B. profitability index.
C. internal rate of return.
Answer: The IRR encounters difficulties when cash outflows occur throughout the life of the
project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor the PI
suffer from these limitations.
8. Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net
present value of $10 million. Investors did not anticipate the sale because government
approval to sell to Cuba had never before been granted. The share price of Polington
should:
A. increase by the project NPV divided by the number of common shares outstanding.
B. increase by the NPV × (1 - corporate tax rate) divided by the number of common
shares outstanding.
C. not necessarily change because new contract announcements are made all the time.
Answer: Since the sale was not anticipated by the market, the share price should rise by the
NPV of the project per common share. NPV is already calculated using after-tax cash flows.
9. Which of the following least likely defines the Internal Rate of Return (IRR)?
A. The discount rate that makes the Net Present Value (NPV) of a project equal to zero.
B. An opportunity cost that is used to find the present value of cash flows.
C. A rate that is used to equate the investment costs of the project to the investment benefits of
the project.
Answer: The Internal Rate of Return (IRR) is the discount rate that makes the Net Present Value
(NPV) of a project equal to zero, and the discount rate or opportunity cost is the rate that is used to
find the present value of cash flows.
10. Which of the following statements is most likely accurate?

A. If two projects are mutually exclusive, the project with the highest IRR will be accepted according
to the IRR rule.
B. If two projects are independent, only the project with IRR greater than the opportunity cost
will be accepted as per the IRR rule.
C. If two mutually exclusive projects generate negative NPVs, the project with the smaller negative
NPV will be selected as per the NPV rule.
Answer: According to the IRR rule, out of two independent projects, only the projects with an IRR
greater than the opportunity cost shall be selected.
Option A is incorrect. If two projects are mutually exclusive, then only the project with the highest
IRR will be selected. However, if the highest IRR is smaller than the opportunity cost, then none of
the projects will be accepted according to the IRR rule.
Option C) is also incorrect. If two mutually exclusive projects generate negative NPVs, then none of
the projects will be selected as per the NPV rule.
11. Net present value, profitability index, payback and discounted payback are methods to:
A. evaluate cash flows.
B. evaluate projects.
C. evaluate capital budgeting.
Answer: They are all methods to evaluate the profitability of a project.
12. Identify the process of identifying and analyzing projects which will generate cash flows for a firm
over a period of time longer than one year.
A. Capital sequencing
B. Capital rationing
C. Capital budgeting
Answer: Capital budgeting is the process of identifying and analyzing projects which will generate cash
flows for a firm over a period of time longer than one year.
13. Which of the following is least likely a principle of capital budgeting?

A. Decisions are based on net income
B. Decisions are based on incremental cash flows
C. Cash flows are based on opportunity costs
Answer:Decisions are not based on net income. Decisions are based on incremental cash flows.
14. Determine the appropriate term for an effect that affects other firms' cash flows with the
acceptance of the project.
A. Sunk costs
B. Externalities
C. Cannibalization
Answer: An externality is a cost or benefit that affects a party who did not choose to incur that cost or
benefit.
15. Which of the following is the appropriate principle of the capital budgeting process?
A. Cash flows are analyzed on a before-tax basis.
B. Financing costs of projects are deducted separately.
C. Cash flows are based on opportunity costs.
Answer: Cash flows are based on opportunity costs.
A) and B) are incorrect because cash flows are analyzed on an after-tax basis and financing costs are
reflected in the required rate of return.
Question Bank – Uses of Capital
1. An associate at Brooklyn Holdings is given the task to determine the Present Value (PV) of the
forecasted cash flows that the firm is expected to receive from its most recent investment of $15
million in a housing project. Using the data given in the following table, the present value is closest
to:
A. $4,563,964.
B. $19,563,964.
C. $15,549,620.
Answer:
The question is only asking for the Present Value (PV) of cash Flows instead of the Net Present
Value (NPV) of cash flows.
PV = $4,200,000*1.1-1 + $4,600,000*1.1-2 + $5,100,000*1.1-3 + $6,000,000*1.1-4 =
$15,549,620
Options A) and B) are incorrect because we always take after-tax cash flows for capital
budgeting analyses.
2. An associate at Brooklyn Holdings is given a task to determine the present value (PV) of the
forecasted cash flows that the firm is expected to receive from its most recent investment of $15
million in a housing project. Using the details provided in the following table, the discounted
payback period of the housing project is closest to:
A. 3.86 years.
B. 3 years.
C. 3.6 years.
Answer:
The discounted payback period of the housing project with $15 million of investment = 3 years + Year
3 Cumul DCF / Year 4 DCF = 3 + 3,548,460/4,098,081 = 3.86 Years (as given in the following table)
Year 0 2017 2018 2019 2020
Cash Flow -$15,000,000.00 $4,200,000.00 $4,600,000.00 $5,100,000.00 $6,000,000.00
Discounted Cash Flow -$15,000,000.00 $3,818,181.82 $3,801,652.89 $3,831,705.48 $4,098,080.73
Cumulative DCF -$15,000,000.00 -$11,181,818.1 -$7,380,165.29 -$3,548,459.80 $549,620.93
3. Using the following information, the cross over rate which makes the NPV of Project Delta equal
to the NPV of Project Hype is closest to:
A. 19%.
B. 30%.
C. 38%.
Answer:
The crossover rate is that discount rate that makes the NPV of two projects equal to each other. We can
calculate the crossover rate by using the IRR function of the financial calculator. To calculate the crossover
rate first we need to subtract the cash flows of Project Hype from the cash flows of Project Delta as
demonstrated in the following table. Finally, we can determine the crossover rate with the financial
calculator as [CF0= -250,000, CF1= 150,000, CF2=80,000, CF3=80,000,CF4=40,000, CPT => IRR = 18.99%]
Difference between CFs
CF- Year 0 -$250,000
CF- Year 1 $150,000
CF- Year 2 $80,000
CF- Year 3 $80,000
CF- Year 4 $40,000
Crossover Rate (IRR) 18.99%
4. Cosmic Wave Inc. has delegated the budgeting task of its new production facility to Markus Branson,
a freelance project manager. Assuming the estimates of cost and cash flows provided to Markus in
the following table are accurate, then the required rate of return is closest to:
Account (in million $)
Plant Cost $7.20
Installation cost $0.50
Land surveyor cost $3.20
Land cost $12.40
Consultation & Research cost $1.20
Cash flow in year 1 $5.50
Cash flow in years 2 to 4 $3.20
Cash flow in year 5 $9.00
NPV $0.18
A. 5.5%.
B. 6%.
C. 6.8%.
Answer:
CF0=-20.1; CF1=5.5; CF2=3.2 F=3; CF3=9; I=5.5; CPT => NPV = 0.18278]
At the required rate of 5.5%, the NPV is $0.18278 million. If the NPV was not equal to $0.18278 million,
we would simply try the same calculation by changing the I=5.5 to I=6 (and then I=6.8) and see if the
NPV would be equal to $0.18278 million.
Further explanation on the calculator steps:
First, we must clear the cash flow registers first. In this case, we need to press (CF) (2nd) (CE/C).
Press (CF) then (-20.1) (Enter). This means the CF0 is -$20.1 million.
Press the down arrow once and then (5.5) (Enter). This means the CF1 is $5.5 million.
Press the down arrow twice and then (3.2) (Enter). Then press the down arrow and enter (3) for F02.
This means the CF2 is $3.2 million for 3 periods.
Press the down arrow once and then (9) (Enter). This means the CF3 is $9 million.
Now, press (NPV) and you will be prompted for the interest rate "I =". Type (5.5) (Enter) and then press
the down arrow and you will see NPV = 0.00. To get the present value of the cash flows, press (CPT)
and you should see 0.18278.
5. Assuming the initial cash outlay of a commercial real estate project is $7 million, and the project
generates identical cash flows of $5 million for 3 years, then estimate the required rate of return if
the NPV of the project is $5.816 million.
A. 6.7%
B. 9.5%
C. 8.3%
Answer:
Since the project has identical cash inflows the required rate of return can be estimated using the TVM
function of the financial calculator. As the NPV is equal to the PV of Cash inflows minus the PV of Cash
outflows, then the PV of the project is $5.816 (NPV) + $7 (PV of Cash outflow) = $12.816.
The required rate of return of the project is 8.3% (N=3, PV=12.816, PMT=5, FV=0, CPT=I).
Note: The required rate of return can also be estimated by using the trial and error method.
6. Simpsons Company is undertaking a solar plant project that will be evenly financed with debt and
equity. The initial outlay of the project is $200 million, and the project is expected to generate cash
inflows of $40 million for each of the next 8 years. Choose the most appropriate discount rate from
the following table and estimate the net present value (NPV) of the project.
Required Return on Equity 13%
Cost of Debt 10.83%
Beta of Similar Project 0.7
Risk-free rate 5%
Tax rate 40%
Weight of debt 50%
A. $25.144 million
B. -$8.05 million
C. $15.35 million
Answer:
Since the project is evenly financed with debt and equity the required rate of return of the project is
equal to the WACC.
WACC = Return on Equity * Weight of Equity + Cost of Debt * Weight of Debt * (1 - Tax rate)
= 13% * 50% + 10.83% * 50% * (1 - 40%) = 9.75%
The NPV of the project is calculated with the help of financial calculator as CF0=-200; CF1=40; F=8;
I=9.75; CPT -> NPV = $15.35 million.
7. Ankara Ceramics Company is interested in a project that will require two cash outlays of $25 million
each, at the initiation (year 0) and in the 4th year of the project (year 4). Assuming that the project
is expected to generate annual cash flows of $8.5 million for 6 years (year 1 to year 6), then calculate
the NPV of the project using a discount rate of 9%.
A. -$10.60 million
B. -$4.58 million
C. $13.13 million
Answer:
NPV of Ankara Ceramic's project can be estimated using the financial calculator. Since the project
requires two cash outlay of $25 million, at initiation and in the 4th year of the project, the net cash
outflow of the project in the 4th year will be $16.5 million (4th year outflow (-$25) + 4th year cash inflow
($8.5)).
The NPV of the project using the required rate of return of 9% is calculated as -$4.58 million using the
following table.
(in million $)
CF = 0 -$25.00
CF = 1 $8.50
CF = 2 $8.50
CF = 3 $8.50
CF = 4 -$16.50
CF = 5 $8.50
CF = 6 $8.50
Required rate 9%
NPV -$4.58
8. Muhammad is a project manager at D.A. Corp. He has been asked to choose some of many proposed
projects that maximize the shareholders' value. Assuming the budget is $1,000,000, which of the
following projects provided in the following table should he undertake?
East Project West Project South Project Central Project

Investment $500,000 $300,000 $250,000 $1,000,000
Cash Flows $230,000 $170,000 $200,000 $310,000
No. of Years 5 6 5 7
Required Rate of Return 8% 5% 9% 10%
A. East Project and West Project
B. West Project and South Project
C. Central Project
Answer:
Muhammad will only choose Project West and South as it only costs $450,000 to undertake both
projects and they maximize the NPV. The following solution demonstrates the capital rationing.
East Project West Project South Project Central Project

Investment $500,000 $300,000 $250,000 $1,000,000
Cash Flows $230,000 $170,000 $200,000 $310,000
No. of Years 5 6 5 7
Required Rate 8 5 9 10
NPV $418,323 $562,867 $527,930 $509,210
9. The rate at which a 9-year project with an initial investment of $540,000 and incremental cash
inflows of $74,000 per year will result in a positive Net Present Value (NPV) is closest to:
A. 4.48%.
B. 3.74%.
C. 7.10%.
Answer:
To find out the rate that will result in a positive NPV among the three rates given, we will have to
determine the project's IRR. We can do this using the cash flow function of the financial calculator:
CF0=-540,000; CF1=74,000; F01=9; CPT -> IRR
Alternatively, we can use the PV/FV function of the calculator as:

N=9; PV=-540,000; MT=74,000; FV=0;
CPT -> I/Y = 4.4132
That gives an IRR value of 4.41%. What does that imply?

Any rate below 4.41% will result in a positive NPV, while a rate above 4.41% will result in a negative NPV.
From our choices, we only have one value that's less than 4.41%, i.e., 3.74%
We can solve the NPV at 3.74% with the cash flow function of the financial calculator as:
CF0=-540,000; CF1=74,000; F01=9; I=3.74; CPT -> NPV
NPV = $16,792
You can as well use the other two rates in place of 3.74% just to test the validity of the IRR argument.
10. Red Construction Co. is planning to invest CAD 91,500,000 in an infrastructure project in Montreal.
The project is expected to generate CAD 3,200,000 in perpetuity. Assuming a discount rate of 3.4%,
the Internal Rate of Return (IRR) of the project is closest to:
A. 3.2%.
B. 3.49%.
C. 3.61%.
Answer:
The Internal Rate of Return (IRR) of a project that generates cash inflow of CAD 3,200,000 in perpetuity
is calculated as Perpetual Cash flow/Cash outflow = 3,200,000/91,500,000 = 3.49%.
Alternatively, we can calculate the IRR of a perpetuity with the Financial Calculator by assuming the
frequency of cash flow as 1000 times.
[CF0= - 91,500,000, CF1= 3,200,000, F01=1000, I=3.4%, CPT=>NPV, CPT=>IRR]
11. As an analyst you're evaluating two projects, Mi6 and Ci7, using the data provided in the following
table. Assuming that both projects are independent and that the discount rate is 8.09%, which of
the following projects is/are most likely to be selected according to the NPV rule?
Project Mi6 Project Ci7
Year 0 -$40,300,000 -$109,400,000
Year 1 $9,700,000 $18,000,000
Year 2 $9,700,000 $11,500,000
Year 3 $9,700,000 $17,700,000
Year 4 $9,700,000 $21,300,000
Year 5 $9,700,000 $27,000,000
Year 6 $9,700,000 $35,000,000
Year 7 - $38,500,000
A. Project Mi6
B. Project Ci7
C. Project Mi6 & Project Ci7
Answer:
As calculated in the following table, both Project Mi6 and Ci7 have positive NPVs. Since both
independent projects generate positive NPVs, both projects can be accepted as per the NPV Rule.
CF 0 -$40,300,000 -$109,400,000
CF 1 $9,700,000 $18,000,000
CF 2 $9,700,000 $11,500,000
CF 3 $9,700,000 $17,700,000
CF 4 $9,700,000 $21,300,000
CF 5 $9,700,000 $27,000,000
CF 6 $9,700,000 $35,000,000
CF 7 $38,500,000
Discount rate 8.09% 8.09%
NPV $4,419,763.92 $9,294,716.90
Note: To calculate this using the financial calculator for Project Ci7:
Go to the cash flow register by pressing (CF). Next clear prior data in that function by pressing (2nd) (FV)
(2nd) (CE/C).
Press (CF) then -109,400,000 (make sure the sign is negative) "Enter" (down arrow)
18,000,000 "Enter" (down arrow) (down arrow)
11,500,000 "Enter" (down arrow) (down arrow)
...
38,500,000 "Enter"
Press "NPV" to display I = 0.0000. Enter the required rate of return in decimal format 'as-if' there is a
percentage sign following: 8.09
Press "Enter". Press the down arrow key, then press "CPT" to display the dollar amount of the NPV.
12. As an analyst you're evaluating two projects, Mi6 and Ci7. The data related to both projects is given
in the following table:
Year 0 -$40,300,000 -$109,400,000
Year 1 $9,700,000 $18,000,000
Year 2 $9,700,000 $11,500,000
Year 3 $9,700,000 $17,700,000
Year 4 $9,700,000 $21,300,000
Year 5 $9,700,000 $27,000,000
Year 6 $9,700,000 $35,000,000
Year 7 - $38,500,000
Assuming that both projects are independent and that the discount rate is 8.09%, which of the
following projects is/are most likely to be selected according to the IRR rule?
A. Project Mi6
B. Project Ci7
Answer:
As calculated in the following table, the IRRs of Project Mi6 and Ci7 are greater than the discount rate
(or opportunity cost). Since the IRRs of both independent projects are greater than the discount rate,
both projects can be accepted as per the IRR rule.
The easiest way to do the calculations is by using the financial calculator with the following inputs, and
then compute the IRR:

CF 0 -$40,300,000 -$109,400,000
CF 1 $9,700,000 $18,000,000
CF 2 $9,700,000 $11,500,000
CF 3 $9,700,000 $17,700,000
CF 4 $9,700,000 $21,300,000
CF 5 $9,700,000 $27,000,000
CF 6 $9,700,000 $35,000,000
CF 7 $38,500,000
NPV $4,419,763.92 $9,294,716.90
CPT -> IRR 11.63% 10.13%
13. As an analyst you're evaluating two projects, Mi6 and Ci7, using the data provided in the following
table. Assuming for this question only that both projects are mutually exclusive and that the discount
rate is 8.09%, which of the following projects is/are most likely to be selected considering both the
IRR and the NPV rule?

Year 0 -$40,300,000 -$109,400,000
Year 1 $9,700,000 $18,000,000
Year 2 $9,700,000 $11,500,000
Year 3 $9,700,000 $17,700,000
Year 4 $9,700,000 $21,300,000
Year 5 $9,700,000 $27,000,000
Year 6 $9,700,000 $35,000,000
Year 7 - $38,500,000
A. Project Mi6
B. Project Ci7
Answer:
As it is calculated in the following table, Project Mi6 generates an NPV of $4,419,763.92 and an IRR of
11.63%. Project Ci7 generates an NPV of $9,294,716.9 and an IRR 0f 10.13%. Since it is assumed for this
question that both the projects are mutually exclusive, the project that generates the greater NPV will
be accepted. In this case, it is Project Ci7.

CF 0 -$40,300,000 -$109,400,000
CF 1 $9,700,000 $18,000,000
CF 2 $9,700,000 $11,500,000
CF 3 $9,700,000 $17,700,000
CF 4 $9,700,000 $21,300,000
CF 5 $9,700,000 $27,000,000
CF 6 $9,700,000 $35,000,000
CF 7 $38,500,000
NPV $4,419,763.92 $9,294,716.90
IRR 11.63% 10.13%
14. A 3-year construction project generates semi-annual cash inflows of $79,200. Assuming that the
project has a net present value (NPV) of $18,578 at the cost of capital of 7.5%, then the initial cash
outlay of the project is closest to:
A. $418,577.67.
B. $400,000.
C. $353,174.
Answer:
The question can be solved using the financial calculator:
N=6; I=7.5/2; PMT=79,200; FV=0; CPT -> PV = 418,578
Initial cash outflow = PV of cash inflows - Net present value = $418,578 - $18,578 = $400,000
15. The owners of Glass LLC are considering automating their pin factory with the purchase of a
$300,000 machine. The total cost of shipping and installation would be $4,000. The owners have
calculated that automation would result in savings of $30,000 a year due to reduced scrap and
$20,000 a year due to reduced labor costs. If the machine has a useful life of 4 years and the
estimated final salvage value of the machine is $80,000, then the incremental cash outflow at period
0 is closest to:
A. $300,000.
B. $304,000.
C. $274,000.
Answer:
$300,000 + $4,000 = $304,000
16. A project requires an initial investment of $5 million and a second investment of $2 million at the
end of the 3rd year. The expected cash flows from the project for the next 5 years are given in the
following exhibit.
Exhibit: 5-year Project - Cash Inflows
End of the 1st year $0.5 million

End of the 3rd year $8 million
End of the 4th year $4 million
End of the 5th year $1 million
If the discount rate for the project is 10%, then the net present value (NPV) of the project is closest
to:
A. $3.31 million.
B. $4.31 million.
C. $3.50 million.
Answer:
The cash flows from the entire project are given in the following table:
Year Outflow Inflow Net flows

Beginning of 1st year 5 million 0 -5 million
End of 1st year 0 0.5 million +0.5 million
End of 2nd year 0 0 0
End of 3rd year 2 million 8 million +6 million
End of 4th year 0 4 million +4 million
End of 5th year 0 1 million +1 million
(All $ values in million)
NPV(project) = PV0 + PV1 + PV2 + PV3 + PV4 + PV5
PV0 = -5 million
PV1 = +0.5 / (1+10%)1 = 0.45
PV2= 0
PV3= 6 / (1+10%)3 = 4.51
PV4= 4 / (1+10%)4 = 2.73
PV5 = 1/ (1+10%)5 = 0.62
NPV = -5 + 0.45 + 4.51 + 2.73 + 0.62= 3.31
17. Clark Inc.'s $10 par value preferred stock just paid its $1 per share annual dividend. The current
market price of the preferred stock is $9 per share. The company's tax rate is 35% and the firm plans
to maintain its current capital structure relationship into the future. The component cost of
preferred stock to Clark Inc. would be closest to:
A. 7%.
B. 7.22%.
C. 11.11%.
Answer:
Dps=$1
P=$9
Rps = $1/$9 = 11.11%
18. BestMilk Company is considering a project that calls for an initial cash outlay of $40,000. If the
expected net cash inflows from the project are $6,139 for each of the 9 years, then the IRR of the
project is closest to:
A. 7%.
B. 8%.
C. 9%.
Answer:
40,000 = 6,139 * Present Value Interest Factor (PVIFA) of the annuity at i% of 10 year
Present Value Interest Factor (PVIFA) of the annuity at i% of 10 year = 40,000 / 6,139 = 6.515
From the PVIFA table, 6.515 is 7% with a 9 year period.
19. A project has the following expected cash flows:

Year 0: -20,000
Year 1: 9,000
Year 2: 8,000
Year 3: 5,000
The profitability index (PI) at an 8% discount rate for this project is closest to:
A. 0.858.
B. 0.958.
C. 1.058.
Answer:
PV = 9,000*1/1.081 + 8,000*1/1.082 + 5,000*1/1.083 = 19.161
PI = 19,161/20,000 = 0.958
20. The payback period in which the expected cash flows are discounted with the help of the project's
cost of capital is the:
A. discounted payback period method.
B. discounted rate of return method.
C. discounted cash flows method.
Answer:
The payback period in which the expected cash flows are discounted with the help of the project cost of
capital is the discounted payback period method.
21. Net present value, profitability index, payback and discounted payback are methods to:
A. evaluate cash flows.
B. evaluate projects.
C. evaluate capital budgeting.
Answer:
They are all methods to evaluate the profitability of a project.
22. Bike company purchase equipment that has a useful life of 7 years. The yearly net cash inflow is
$20,000. Its salvage value is zero and the rate of return is 20%. What is the cost of the equipment?
A. $70,000
B. $75,000
C. $72,100
Answer:
PV of outgo = PV of income
PV of outgo = 20,000/1.2 +20,000/1.2^2 + ... + 20,000/1.2^7
Notice that the right-hand side (RHS) is a 7-year annuity with regular payments of 20,000.
Thus, we can use the formula for the PV of an annuity to get the solution to the RHS, instead of adding
up the values manually:
PV of outgo = 20,000[1 - 1.2-7]/0.2 = 20,0000 × 3.605 = 72,100
23. Which of the following is least likely an administrative step of the capital budgeting process?
A. Generating an idea
B. Creating a firm-wide capital budget
C. Hiring a new team for project management
Answer:
The four steps of the capital budgeting process are:
1) Idea generation
2) Analyzing the project proposal
3) Creating a firm-wide capital budget
4) Monitoring the decision and conducting a post-audit
24. ABC Corp has a new oil drilling project that will cost the firm $1.5 million today. With the rising price
of oil, the firm's financial department predicts that this projects will yield cash flows of $400,000 for
the first three years and $500,000 in the subsequent three years. What is the payback period for
this oil drilling project?
A. 3.6 years
B. 5 years
C. 5.25 years
Answer:
Years 0: -1,500,000
Years 1: 400,000 - 1,500,000 = -1,100,000
Years 2: 400,000 - 1,100,000 = -700,000
Years 3: 400,000 - 700,000 = -300,000
Years 4: 300,000 / 500,000 = 0.6
Between 3 and 4 years.
3 + 0.6 = 3.6 years
25. China Gold Corp is planning to open a project. The cost to build the new mine is $1.3 million (paid
at the end of the first year) and the mine should bring cash inflows of $400,000 over the next six
years (year 2 to 7). The cost to close down the mine over the following year (year 8) is going to be
$250,000.
What should the minimum price for this property be if China Gold Corp wishes to sell it now, given
a 15% required rate of return?
A. $104,181.59
B. $105,509.31
C. $185,907.03
Answer:
Years 0 = $0
Year 1 = -1,300,000 * 1.15-1 = -1,130,434.78
Year 2 = 400,000 * 1.15-2 = 302,457.47
Year 3 = 400,000 * 1.15-3 = 263,006.49
Year 4 = 400,000 * 1.15-4 = 228,701.30
Year 5 = 400,000 * 1.15-5 = 198,870.69
Year 6 = 400,000 * 1.15-6 = 172,931.04
Year 7 = 400,000 * 1.15-7 = 150,374.82
Year 8 = -250,000 * 1.15-8 = -81,725.44
= $104,181.59
26. Which of the following project proposals is most likely categorized under the capital budgeting
process?
A. Replacing pencils by buying a new brand of pencils for the employees in the head office of a
textile manufacturing firm
B. Increasing the internet data package of a car cleaning service provider company for a temporary
period of 4 months
C. Replacing the current engines of the Istanbul airplanes fleet to reduce carbon dioxide
emissions
Answer:
Replacing the engines will generate cash flows beyond the 1 year period, and it is a mandatory project
as the government requires to reduce the CO2 emission of airlines.
Option A) is incorrect as replacing pencils does not generate any cash flows.
Option B) is also incorrect as the project is increasing costs and will last for less than 1 year.
27. Which of the following projects is most likely an example of a mandatory project?
A. Installing trees along a plastic manufacturing facility to reduce pollution due to new
environmental laws
B. Launching a new product line for remote villages of Spain
C. Replacing delivery trucks for more oil-efficient new vehicles
Answer:
Option A) is an example of a mandatory project. From the perspective of the company, it's the new
environmental laws that the company has to oblige by that makes option A) the mandatory project.
Options B) and C) are examples of a new product development project and a cost reduction project,
respectively.
28. Which of the following is the appropriate principle of the capital budgeting process?
A. Cash flows are analyzed on a before-tax basis.
B. Financing costs of projects are deducted separately.
C. Cash flows are based on opportunity costs.
Answer:
Cash flows are based on opportunity costs.
A) and B) are incorrect because cash flows are analyzed on an after-tax basis and financing costs are
reflected in the required rate of return.
29. Mehmet Khali is a project analyst at Excel Investments. He is analyzing two independent - Project A
and Project Z. Both projects have positive net cash flows but the cash flows of Project A are greater
than the cash flows of Project Z. Which project should Khali accept?
A. Project Z
B. Project A
C. Project A and Z
Answer:
Since both projects are independent, he can accept both projects that have positive net cash flows or
positive NPV.
30. An oil exploration company recently observed that the net present value (NPV) of one of its oil
drilling project turned out to be -$5.6 million. If the company decides to abandon the project:
A. the value of the firm will remain unchanged.
B. the value of the firm will increase by $5.6 million.
C. the value of the firm will decrease by $5.6 million.
Answer:
The firm’s value, while the company was pursuing the oil drilling project, was (x - $5.6) million.
When the company abandons the project, the firm’s value then goes to x.
Therefore, when the company abandons the project, the firm’s value increases by $5.6 million.
Quiz 3 – Sources of Capital
1. An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the
results to the industry averages:
Based on the above data, which of the following can the analyst conclude? Iridescent
Carpeting:
A. has better short-term liquidity than its competitors.
B. has stronger profitability than its competitors.
C. is most likely a younger company than its competitors.
Answer:
Based on the data provided, the analyst can conclude that
• Iridescent Carpeting has weaker profitability than its competitors based on the net
profit margin and return on equity.
• The analyst can also conclude that the company has less financial leverage (risk) than
the industry average based on the total debt / total capital and the times interest
earned ratios.
• The analyst can conclude that the company has better short-term liquidity than the
industry average (i.e., its competitors) based on the current ratio.
2. Which of the following most accurately represents the cash conversion cycle?
A. average days of receivables + average days of inventory + average days of payables.
B. average days of payables + average days of inventory - average days of receivables.
C. average days of receivables + average days of inventory - average days of payables.
Answer:
The cash conversion cycle, also called the net operating cycle is:
The cash conversion cycle measures the length of time required to convert a firm’s cash
investment in inventory back into cash resulting from the sale of the inventory. A short cash
conversion cycle is good because it indicates a relatively low investment in working capital.
3. A firm records the following cash flows on the same day: $250 million from debt proceeds;
$100 million funds transferred to a subsidiary; $125 million in interest payments; and $30
million in tax payments. The net daily cash position:
A. worsened.
B. improved.
C. remained the same.
Answer:
Improving a firm's net daily requires more inflows than outflows. Debt proceeds are cash
inflows while funds transferred to a subsidiary, interest and dividend payments, and tax
payments are outflows. The net cash change for the day is $250 - $100 - $125 - $30 = -$5
million.
4. An example of a primary source of liquidity is:

A. filing for bankruptcy.
B. using trade credit from vendors.
C. renegotiating debt agreements.
Answer:
Primary sources of liquidity include cash resulting from selling goods and services, collecting
receivables, generating cash from other sources and sources of short-term funding such as
trade credit from vendors and lines of credit from banks. Filing for bankruptcy and
renegotiating debt agreements are secondary sources of liquidity.
5. A private company is facing issues to meet its short-term financing needs. As the inflation
has constantly been increasing and the central bank is expected to raise interest rates, the
management of the company is hesitant to take any decision on their own. They have
proposed three financing options to the board of the company to vote on. Which of the
following will be the least costly financing option?
A. The company should sell some of its equipment to finance its short-term needs and
buy back the equipment when required.
B. The company should borrow a short-term loan from a bank regardless of the
expected rise in interest rates.
C. The company should issue an Initial Public Offering (IPO).
Answer:
Option B) is the least costly option.
Option A) is more costly for two reasons.
1. As the inflation has been increasing the cost of new equipment will be higher than the one
that the company already owns.
2. The company will have to pay higher interests to finance the new equipment.
Option C) is also a costly option, since Initial Public Offering requires time and incur large
costs.
6. A firm has average days of receivables outstanding of 22 compared to an industry average

of 29 days. An analyst would most likely conclude that the firm:
A. may have credit policies that are too strict.
B. has better credit controls than its peer companies.
C. has a lower cash conversion cycle than its peer companies.
Answer:
The firm's average days of receivables should be close to the industry average. A significantly
lower average days receivables outstanding, compared to its peers, is an indication that the
firm's credit policy may be too strict and that sales are being lost to peers because of this. We
can not assume that stricter credit controls than the average for the industry are "better." We
cannot conclude that credit sales are less, they may be more, but just made on stricter terms.
The average days of receivables are only one component of the cash conversion cycle.
7. Which of the following sources of liquidity is the most reliable?

A. Revolving line of credit.
B. Uncommitted line of credit.
C. Committed line of credit.
Answer:
• A revolving line of credit is typically for a longer term than an uncommitted or
committed line of credit and thus is considered a more reliable source of liquidity.
• With an uncommitted line of credit, the issuing bank may refuse to lend if conditions
of the firm change.
• Both committed and revolving lines of credit can be verified and can be listed in the
footnotes to a firm's financial statements as sources of liquidity.
8. Atletico Inc. is a Spanish logistics company that is considering taking some measures to
manage its working capital more effectively. However, due to a recent increase in interest
rates, the banks are reluctant to lend money to Atletico's institutional clients, which is the
reason why Atletico's inventory is taking longer to sell. In order to speed up the sale of
inventory, Atletico has decided to offer longer collection terms to its debtors. Considering
the measures that were taken by Atletico, is the firm's liquidity position being weakened
by 'drags' or 'pulls' on liquidity?
A. These measures signal 'drags' on liquidity.
B. These measures signal 'pulls' on liquidity.
C. These measures signal both 'drags' and 'pulls' on liquidity.
Answer:
Atletico's liquidity position is weakened by liquidity drags. Liquidity drags include factors such
as delayed collection of accounts receivable, bad debts, tight credit terms, and obsolete
inventory.
9. Based on the data provided in the following table, the operating cycle of Shalak Inc. is
closest to:
Sales $3,800,000
Gross Profit $2,000,000
Credit Sales 100%
Purchases $1,600,000
Avg. Acc. Payables $310,000
Avg. Acc. Rec. $430,000
Avg. Inventory $290,000
A. 29 days.
B. 112 days.
C. 100 days.
Answer:
Operating cycle = Days of Inventory in hand + Number of days of Receivables
Days of inventory on hand = [365 Days / (COGS/Avg. Inventory)] = [365 / $1,800,000 /

$290,000] = 58.8 days
Days of receivables = [365 Days / Sales / Avg. Acc. Rec.] = [365 / $3,800,000 / $430,000] =
41.30 days
Operating cycle = 58.8 days + 41.30 days = 100.1 days
10. White Steel Co. is the market leader in the steel industry in Malaysia. White Steel has
introduced many innovative products which have successfully penetrated the market
time and time again. Compared to the industry, White Steel Co. has a shorter cash
conversion cycle as shown in the following table:
Steel Industry White Steel Co.
Days of Inventory 55 39
Days of Receivables 93 111
Days of Payables 60 70
Operating Cycle 48 150
Cash Conversion Cycle 88 80
Which of the following is the most appropriate justification for White's shorter cash
conversion cycle?
A. White Steel's inventory is obsolete.
B. White Steel has tighter terms with its debtors.
C. White Steel's payment terms are unfavorable for its creditors.
Answer:
White Steel's days of payables are longer than that of the industry, which is unfavorable for
its creditors but favorable for White Steel.
11. Which of the following conditions will most likely improve the liquidity position of a
company;
A. Delaying accounts payable.
B. An increase in obsolete inventories.
C. An increase in uncollected receivables.
Answer:
A delay in paying accounts payable can slow the cash outflows and improve a company's
liquidity position.
An increase in obsolete inventories and receivables will slow the cash inflows, which will
weaken the liquidity.
12. Ahmed Ali is an associate at a stock brokerage firm analyzing the liquidity position of one
of its portfolio companies. He has gathered the following relevant information:
Using the data given in the table, the receivable turnover ratio of the portfolio company
for liquidity purposes is closest to:
A. 1.33
B. 2.0
C. 3.33
Answer:
The correct answer is: B).
A is incorrect. It assumes the following calculation in determining the receivable turnover

ratio;
C is incorrect. It assumes the following calculations;

13. Using the data given for the portfolio company in the following table, calculate the
number of days of receivables.
A. 110 days.
B. 183 days.
C. 274 days.
Answer:
Answer B is correct.
Alternatively
Answer A is incorrect:
Answer C is incorrect
14. Which of the following would most likely make the number of days of inventory too high?
A. Obsolete inventory
B. Inadequate stock on hand.
C. Very little capital was invested in the inventory.
Answer:
The correct answer is: A).
The number of days of inventory is defined as the number of days a company takes to
transform its inventory (raw materials and work in progress) into finished goods for sale.
A very high number of days of inventory would suggest that too much capital is tied up in
inventory, and the inventory is possibly obsolete.
B is incorrect. Inadequate stock at hand indicates a higher inventory turnover, which is better
since high inventory turnover typically means a company is selling goods quickly. There is
considerable demand for their products.
C is incorrect. If little capital is invested in the inventory, it indicates low stock quantities,
decreasing inventory days.
15. Which of the following most appropriately measures the length of time it takes to convert
a firm's cash into inventory and back into cash in the form of collections from the
inventory sales?
A. Sales cycle.
B. Operating cycle.
C. Net operating cycle.
Answer:
The correct answer is: C).
The cash conversion cycle or net operating cycle measures the length of time it takes to
convert a firm's cash into inventory and back into cash in the form of collections from
inventory sales.
Cash Conversion cycle=Number of receivables days+Number of inventory days−Number of
payable days
A is incorrect. The sales cycle is the set of events from the moment a salesperson first engages
with a prospective buyer to when the sale is made.
B is incorrect. The operating cycle does not include the number of days of payables. It
measures the time between the purchase of raw materials and the sale of the finished
product.
Question Bank – Sources of Capital
1. An analyst is given the task to evaluate the liquidity position of three firms that operate in
the chemical sector: Jupiter Co., Saturn Corp., and Pluto Inc. The balance sheet accounts
of the 3 firms are given in the following table:
Balance Sheet Account (amount in million $)

Jupiter Co. Saturn Corp. Pluto Inc.
Cash 2.7 8 7
Accounts receivable 1.2 20 11
Inventory 3.3 12 17
Investment in associates 3 22 0
Plant 12.5 42 22
Equipment 8.5 13 13
Account payables 2.6 18 28
Short-term debt 1.2 25 6
Long-term debt 10.7 48 30
Common equity 14 19 4.5
Retained earnings 3.5 11.5 1.5
A. Jupiter Co.
B. Saturn Corp.
C. Pluto Inc.
Answer:
Jupiter's current ratio = (2.7 +1.2+3.3)/(2.6 + 1.2) = 1.89
Saturn's CR = (8 + 20 + 12)/(18 + 25) = 0.93
Pluto's CR = (7 + 11 + 17)/(28 + 6) = 1.03
Based on the Current ratio and Working capital as measures of liquidity, Jupiter Co. is the
most liquid firm with a Current ratio of 1.89, followed by Pluto Inc., with a current ratio of
1.03.
Note: investments in associates are non-current assets.
closest to:
Sales $3,800,000
Gross Profit $2,000,000
Credit Sales 100%
Purchases $1,600,000
Avg. Acc. Payables $310,000
Avg. Acc. Rec. $430,000
Avg. Inventory $290,000
A. 29 days.
B. 112 days.
C. 100 days.
Answer:
Operating cycle = Days of Inventory in hand + Number of days of Receivables
Days of inventory on hand = [365 Days / (COGS/Avg. Inventory)] = [365 / $1,800,000 /

$290,000] = 58.8 days
Days of receivables = [365 Days / Sales / Avg. Acc. Rec.] = [365 / $3,800,000 / $430,000] =
41.30 days
Operating cycle = 58.8 days + 41.30 days = 100.1 days
3. White Steel Co. is the market leader in the steel industry in Malaysia. White Steel has
introduced many innovative products which have successfully penetrated the market time
and time again. Compared to the industry, White Steel Co. has a shorter cash conversion
cycle as shown in the following table:
Steel Industry White Steel Co.
Days of Inventory 55 39
Days of Receivables 93 111
Days of Payables 60 70
Operating Cycle 148 150
Cash Conversion Cycle 88 80
Which of the following is the most appropriate justification for White's shorter cash
conversion cycle?
A. White Steel's inventory is obsolete.
B. White Steel has tighter terms with its debtors.
C. White Steel's payment terms are unfavorable for its creditors.
Answer:
White Steel's days of payables are longer than that of the industry, which is unfavorable for
its creditors but favorable for White Steel.
4. Thrift Store is a wholesaler that sells commodities like olive oil and wine to local shopping
marts. Thrift Store maintains a receivable schedule to manage its accounts receivables.
Using the information provided in the following aging schedule, determine what
percentage of receivables were outstanding for 61 to 90 days in April.
Receivables Schedule
Days Outstanding Apr-17 Average Collection Days
< 30 days $180,000 18
31 - 60 days $230,000 33
61 - 90 days $155,000 76
> 91 days $65,000 145
A. 89.68 %
B. 24.60%
C. 75.40%
Answer:
According to the aging schedule, $155,000 worth of Acc. Receivables were outstanding for 61
to 90 days in April which is 24.60% of total outstanding receivables.
5. GFX Copper purchases copper ores from a Brazilian supplier who offers a large trade
discount to GFX. The annual purchases of GFX are $24,550, and the Accounts Payables are
$6,500. Using the given information, calculate the Average Daily Purchases.
A. 67.26
B. 96.63
C. 17.80
Answer:
Average Daily Purchases = Annual Purchases/365 days = $24,550/365 days = 67.26 days
6. Exhibit 1 shows some parameters of inventory management for three companies.
Exhibit 1: Inventory Management
ASD Pvt. Limited QWE Pvt. Limited YYH Pvt. Limited

Number of days of inventory 60 50 40
Number of days of receivables 45 48 30
The firm most likely to have the highest quick ratio is:
A. ASD Pvt. Limited.
B. QWE Pvt. Limited.
C. YYH Pvt. Limited.
Answer:
The table below furnishes the operating cycle of each company:
Company Operating Cycle

ASD Pvt. Limited 60 + 45 = 105
QWE Pvt. Limited 50 + 48 = 98
YYH Pvt. Limited 40 + 30 = 70
Operating cycle is the measure of the time needed to convert raw material into cash. The
companies which have higher operating cycle will need higher liquid assets to compensate
for the additional time needed to convert raw materials into cash.
ASD Pvt. Limited has the highest operating cycle and, therefore, the highest liquidity ratios.
7. Which of the following is least likely a short-term type of security in which a company can
invest to manage its cash?
A. U.S. Treasury bonds.
B. Bank certificate of deposits.
C. Money market mutual funds.
Answer:
A company can invest its cash balance in U.S Treasury bills, not bonds, to manage its short-
term cash balances.
U.S. Treasury bonds have maturities of more than ten years.
B is incorrect. A bank certificate of deposit can have a 6-month term and are typically common
with investors looking for interest rates on deposits that are higher than more liquid financial
products, such as a standard savings account.
C is incorrect. A money market mutual fund is a type of mutual fund, which invests its
shareholders' money in short-term, high-quality debt.
8. Which of the following statements is most accurate for a firm with a very large inventory?
A. No effect on inventory turnover ratio.
B. A decreased number of days of inventory.
C. An increased number of days of inventory.
Answer:
A large amount of inventory implies that inventory will take longer before it is completely
sold, resulting in an increased number of days of inventory and a decreased inventory
turnover ratio.
A is incorrect. Large inventories lead to a decreased turnover ratio.
B is incorrect. A decrease in the number of days of inventory is affected by increased sales of

stock.
9. Which of the following is most likely a non-bank source of short-term funding?

A. Commercial paper.
B. A banker's acceptance.
C. An uncommitted line of credit
Answer:
Commercial paper is a non-bank source of short-term funding. Commercial paper is issued by

creditworthy companies on a short-term basis through a dealer or is sold directly to the
investor. Another non-bank source of short-term financing is non-bank financing companies.
Bank sources of short-term financing are;
Uncommitted and regular lines of credit.
Overdraft lines.
Revolving credit agreements.
Collateralized loans.
Discounted receivables.
Banker's acceptances.
Factoring.
10. Assuming that the average industry norm for the number of days of receivables is 110 days,
and a specific company operating in this industry has 182.5 days as its number of days of
receivables, then which of the following choices is most likely correct?
A. The data given is insufficient to make an assumption.
B. The company is slower than the industry at collecting receivables.
C. The company is quicker than the industry at collecting receivables.
Answer:
The number of receivables days tells us the time a company takes to receive money from its
customers.
Since the industry norm for the number of receivables days is lower (better) than the portfolio
company, the portfolio company is too slow at collecting receivables.
A is incorrect. The data is sufficient in that it indicates the company's average number of days
of receivables of 182.5 days is higher than the average industry norm of 110 days; therefore,
the company takes a long time to realize their receivable payments.
C is incorrect. The company is slower in realizing receivables payments than the requisite
industry average.
11. Which of the following lines of credit is a bank's most appropriate source of short-term
funding?
A. A revolving line of credit.
B. A committed line of credit.
C. An uncommitted line of credit.
Answer:
A revolving line of credit is the most reliable among all three lines of credit provided by a bank.
A revolving line of credit can be for longer terms (up to a year), and it is included in the
financial statement footnotes as a source of liquidity.
B is incorrect. A committed line of credit is stronger than an uncommitted line of credit

because of the presence of a formal bank commitment but less reliable than a revolving line
of credit.
C is incorrect. An uncommitted line of credit is the weakest form of borrowing that involves
no formal commitment from the banks.
12. Atletico Inc. is a Spanish logistics company considering taking measures to manage its
working capital more effectively. However, due to a recent increase in interest rates, the
banks are reluctant to lend money to Atletico's institutional clients, which is why Atletico's
inventory is taking longer to sell. To speed up the sale of inventory, Atletico has decided to
offer longer collection terms to its debtors.
Considering Atletico's measures, is the firm's liquidity position most likely weakened by
'drags' or 'pulls' on liquidity?
A. These measures signal 'drags' on liquidity.
B. These measures signal 'pulls' on liquidity.
C. These measures signal both 'drags' and 'pulls' on liquidity.
Answer:
A company's liquidity position is significantly affected by the timing of cash flows and cash
disbursements.
Atletico's liquidity position is weakened by liquidity drags. Decreased cash receipts, especially
after payments are made, lead to decreased availability of funds which causes a "drag on
liquidity."
"Drags on liquidity" include;
Delayed collection of accounts receivable.

Bad debts.
Tight credit terms.
Obsolete inventory.
B is incorrect. A "pull on liquidity" occurs when disbursements are paid early; companies are
forced to spend money before receiving it from sales which could cover their obligations.
"Pulls on liquidity" include;
Making early payments.
Reduced credit limits.
Limits on short-time lines of credit.
Low liquidity positions.
C is incorrect. The measure only signals a drag on liquidity and not a pull on liquidity.
13. An analyst is given the task to evaluate the liquidity position of three firms that operate in
the chemical sector: Jupiter Co., Saturn Corp., and Pluto Inc. The balance sheet accounts
of the three firms are given in the following table:
Based on the provided balance sheets of all three firms, the most likely liquid company is:
A. Pluto Inc.
B. Jupiter Co.
C. Saturn Corp.
Answer:
A company's liquidity is measured by the extent to which it has current assets that can be
readily used to satisfy its short-term obligations.
The two most popular liquidity ratios are the current and quick ratios.
The information given is sufficient to calculate both ratios. We shall, therefore, calculate both
ratios then compare the answers.
Based on the Current ratio Jupiter Co.Jupiter Co. is the most liquid firm with a Current Ratio
of 1.89, followed by Pluto Inc., with a current ratio of 1.03. Saturn is the least liquid firm with
a current ratio of 0.93.
Based on the quick ratio: Jupiter is the most liquid firm with a quick ratio of 1.026, followed
by Saturn with a quick ratio of 0.651. Pluto is the least liquid firm with a quick ratio of 0.529.
Based on working capital management: Jupiter is the most liquid firm with a working capital
of 3.4, followed by Pluto with 1. Saturn is the least liquid firm with a working capital of -3.
Note: investments in associates, i.e., an entity in which an investor has significant but not full
control, are non-current assets.
14. A factory cash manager is exploring ways to benefit from stretching its payables. The
average payables of the company aggregate to $600,000. If the company incurs a
borrowing cost of 8%, then the benefit derived from extending the payables for ten days
is closest to:
A. $1,050.90
B. $1,315.07
C. $1,380.50
Answer:
Ten additional days without incurring borrowing costs. If the company had borrowed an
amount of $600,000 for ten days, the borrowing cost incurred would be:
$600,000×10/365×8%=1,315.07
15. If a company has an inventory turnover ratio of 10, then the number of days of inventory
for the company is closest to:
A. 36.50
B. 38.50
C. 40
Answer:
Number of days of inventory =365/Turnover ratio
=365/10
=36.50
16. AWAII Corp. follows the principle of Just-in-Time (JIT) inventory management to manage
its inventory. As compared to comparable firms in the same industry that don't use Just-
in-Time (JIT) inventory management systems, AWAII is more likely to have a:
A. Higher current ratio.
B. Lower current ratio.
C. The same current ratio.
Answer:
Current ratio=Current assets/Current liabilities
Current assets include inventories when a company uses the JIT method of inventory
management. Hence, the company holds a lesser amount of inventory on its balance sheet,
thereby reducing the value of current assets. As the current assets of AWAII are lower, its
current ratio will also be lower compared to other firms in the industry.
A is incorrect. Just in time is a method of managing inventory that minimizes in-process

inventory stocks, leading to a lower current ratio and not a higher current ratio.
C is incorrect. Just in time management, inventory cannot lead to the same current ratio.
17. If a company has an inventory turnover ratio of 8, and 90% of sales are on credit, then the
number of days of inventory for the company is closest to:
A. 9 days.
B. 41 days.
C. 46 days.
Answer:
Number of days of inventory =365/Turnover ratio

=365/8=45.63 ≈46days
The fact that 90% of sales are on credit does not affect the calculation. Sales on credit affect
the number of days of receivables and not the number of days of inventory.
18. A private company is facing issues to meet its short-term financing needs. As inflation has
constantly been increasing and the central bank is expected to raise interest rates, the
company's management is hesitant to take any decision. They have proposed three
financing options to the board of the company to vote on. Which of the following will be
the least costly financing option?
A. The company should issue an Initial Public Offering (IPO).
B. The company should borrow a short-term loan from a bank regardless of the
expected rise in interest rates.
C. The company should sell some of its equipment to finance its short-term needs and
buy back the equipment when required.
Answer:
Option B is the least costly option.
A is incorrect. It is also a costly option since Initial Public Offering requires time and incurs
large costs.
C is incorrect. It is more costly for two reasons.
As inflation has been increasing, the cost of new equipment will be higher than the one that
the company already owns.
The company will have to pay higher interest to finance the new equipment.
closest to:
A. 29 days.
B. 112 days.
C. 100 days.
Answer:
We know that, Operating cycle = Days of inventory in hand + Number of days of receivables
Where,
and
therefore,
20. Olper's is a condensed milk distribution firm whose number of days of receivables, number
of days of inventory, and number of days of payables are 110 days, 85 days, and 92 days
respectively. Olper's operating cycle is closest to:
A. 195 days.
B. 103 days.
C. 287 days.
Answer:
Operating cycle = Number of days of receivables + Number of days of inventory

Olper's operating cycle = 110 + 85 = 195 days
Note: We only include the number of days of payables when calculating the net operating
cycle. Net Operating Cycle=Number of days of inventory+Number of days of receivables -
Number of days of payables
Quiz 4 – Cost of Capital
1. Which of the following is the appropriate definition of the cost of capital?

A. The cost of capital or cost of the components under the liabilities and equity portion
of the balance sheet
B. The cost paid to the underwriter to help organize an IPO for raising capital
C. The cost paid to the supplier of capital goods
Answer:
It is the cost of capital or cost of the components under the liabilities and equity portion of
the balance sheet such as debt, equity, preferred stock, etc.
2. Which of the following is least likely included in the calculation of the weighted average
cost of capital (WACC)?
A. After-tax cost of equity
B. After-tax cost of debt
C. Weightage of debt
Answer:
The after-tax cost of equity is not included in the calculation of the WACC. WACC = (Cost of
equity * Weight of equity) + (After-tax cost of debt * Weight of debt)
3. Which of the following is equal to the cost of debt?

A. Coupon rate on existing debt
B. Yield-to-maturity on existing bond
C. CAPM
Answer:
The cost of debt is the rate at which a firm can issue new debt, which is equal to the yield-to-
maturity on existing debt.
4. When financing a new project by raising capital, in which of the following situations will a
company most likely increase the value of its firm?
A. The value of the firm will increase when the return from the project is positive.
B. The value of the firm will increase only when the weighted average cost of capital
(WACC) is greater than the return on the project.
C. The value of the firm will increase only when the return on the project is greater
than the weighted average cost of capital (WACC).
Answer:
The WACC is considered as an opportunity cost for the firm. Therefore, a company can create
value by producing returns that are greater than the cost of capital (WACC).
Options B and C are incorrect because taking on projects whose returns are below the WACC
will decrease the value of the firm. For example, a one-year project that would return 1%
when the cost of capital is 10% would decrease the value of the firm.
5. Calculate the cost of capital of DATA Corp using the market value and the cost of
components given in the following table. Assume that the tax rate is 40%.
Cost
Market value of debt $50,000,000 8%
Market value of equity $35,000,000 15%
Market value of preferred stock $15,000,000 10%
A. 11.5%
B. 9.15%
C. 14.5%
Answer:
Weights of debt: 50,000,000/100,000,000 = 0.5
Equity: 35 million/100 million = 0.35
Preferred stock: 15 million/100 million = 0.15.
The after-tax cost of debt is 8% (1-0.4) = 4.8%.
Now, we can calculate the WACC: (4.8%*0.5 + 15%*0.35 + 10%*0.15) = 9.15%
6. The intersection of the investment opportunity schedule and the cost of capital curve
denotes which of the following?
A. Profitability index
B. Cost of capital
C. Optimal Capital Budget
Answer:
The optimal capital budget is at the intersection of the investment opportunity schedule and
the cost of capital curve.
7. Assuming a 37% tax rate, the after-tax cost of debt with a coupon rate of 8% and a yield-
to-maturity of 10% is closest to:
A. 6.3%
B. 5.04%
C. 8.5%
Answer:
The cost of debt is calculated using the YTM and not the coupon rate. After-tax cost of debt
is 10%*(1 - 0.37) = 0.063 or 6.3%
8. Damascus Trading Corp. is a shoe manufacturer in Syria. Calculate the cost of capital of
Damascus if the risk-free rate is 5%, the market return is 10% and the Beta is 1.2.
A. 11%
B. 8.5%
C. 17%
Answer:
CAPM or cost of capital of stocks of Damascus is: Risk-free rate + Beta*(Market risk - Risk-free
rate)
E[r]=5% + 1.2(10% - 5%) = 11%
9. The stock of AutoClear Corp. sells at $36 and is expected to pay a dividend of $1.2 next
year. Assuming a return on equity of 10% and a dividend payout ratio of 50%, the cost of
equity of AutoClear Corp. is closest to:
A. 7.34%.
B. 9.73%.
C. 8.34%.
Answer:
To calculate the cost of equity, we need to calculate growth rate.
R=D1/P0 + g
g = RoE * Retention rate
g = 10% * (1 - 0.5) = 5%
Now, we can calculate the return on equity:
Cost of equity = 1.2/36 + 0.05 = 0.0834
10. Which of the following risk does the project's Beta indicate?
A. Unsystematic risk
B. Inflation risk
C. Market risk
Answer:
The project's beta is the measure of systematic or market risk.
Exercises – Cost of Capital
1. Cinnamon Company recently issued 5-year zero-coupon bonds for a total face value of
$100 million at the price of $74.72 million to raise 50% of its capital. The company's cost
of equity is 13%, and the firm earned before tax income of $16 million last year. Assuming
that the company distributed all of its earning in dividends of $1.28 to its 10 million
common shareholders, then Cinnamon's weighted average cost of capital is closest to:
A. 8.9%.
B. 12.5%.
C. 9.5%.
Answer:
Weighted Average Cost of Capital (WACC) = [(After-tax cost of Debt * Weight of Debt) + (Cost
of Equity * Weight of Equity)]
Since Cinnamon issued $100 million in debt to raise 50% of its capital, the capital of the firm
(weights) consists of 50% debt and 50% equity.
The cost of debt is not provided in the question, but since the price of zero-coupon bonds is
given, we can derive the cost of debt with the help of the financial calculator's TVM function.
Cinnamon's cost of debt is 6% (N=5; PV=-74.72; PMT=0; FV=100; CPT => I/Y = 6%).
To calculate the WACC, we need the after-tax cost of debt which is again not provided in the
question. However, the question mentions that the firm earned pre-tax income (or EBT) of
$16 million, out of which the firm distributed all its earning as a dividend of $1.28 to its 10
million shareholders which means the total dividend (or total after-tax earnings) is $12.8
million.
Given this information we can calculate the firm's tax as (EBT - EAT)/EBT = ($16 million - $12.8
million)/$16 million = 0.2 or 20%.
Lastly, using the WACC formula we can calculate the cost of capital as:
WACC = [After-tax cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity] = 6%*(1
- 0.2)*0.5 + 13%*0.5 = 8.9%
2. A French wine factory recently issued a 3-year 5% coupon bond with a face value of $100
at the price of $89. The company's cost of equity is 10%, which does not include taxes of
30%. Assuming that the Debt-to-Equity ratio of the firm is 0.4, then the firm's Weighted
Average Cost of Capital (WACC) is closest to:
A. 9.82%.
B. 9.02%.
C. 8.62%.
Answer:
Weighted Average Cost of Capital (WACC) = [(After-tax cost of Debt * Weight of Debt) + (Cost
of Equity * Weight of Equity)]
Since the cost of debt is not provided in the question we can derive the cost of debt with the
help of the financial calculator's TVM function as 9.37% (N=3, PV=89, PMT=5, FV=100, CPT=>I
= 9.37%), and the after-tax cost of debt as (1 - 0.3) * 9.37% = 6.56%.
Since the Debt-to-Equity ratio is 0.4, the weight of the debt is Debt/(Debt + Equity) = 0.4/(0.4
+ 1) = 28.57%, and the weight of equity is 71.43%.
WACC = [After-tax cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity] =
6.56%*28.57% + 10%*71.43% = 9.017%
Further explanation on weights
D/E = 0.4, which implies that D = 0.4E
Thus, weight of debt = D/(D + E) = 0.4E/(0.4E + E)
If you look at this closely, you will notice that E will cancel out, i.e.,
weight of debt = 0.4(E)/[E(0.4 + 1)]
Thus, weight of debt = 0.4/(0.4 + 1) = 28.53%
Weight of equity = 100% - 28.53% = 71.43%
3. Lunar Airways is a US-based airline operator that is being valued by an investment firm
based in Paris. The details regarding the capital structure of Lunar Airways is provided in
the following table. Assuming that in addition to current debt, the firm is in the process
of issuing additional debt of $50 million at par, then the cost of capital of Lunar is closest
to:
Share Price $70
Market value of debt $200 million
No of common shares outstanding 5 million
After-tax cost of debt 8%
Cost of equity 12%
Current debt-to-equity ratio 0.57
A. 9.72%.
B. 10.55%.
C. 10.33%.
Answer:
The cost of capital of Lunar Airways is calculated using the WACC. In the calculation of the
WACC, we take the target capital structure. If the target capital structure is not provided only
then we can proceed with the given current capital structure.
Since Lunar is in process of issuing additional debt of $50 million the total weight of debt will
be Total Debt/(Equity + Total debt) = $250/($70*5 + $250) = 41.67% and the weight of equity
will be 58.33%.
As the target capital structure is calculated, we can now calculate the WACC of Lunar Airways
as [After-tax cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity] = 8%*41.67%
+ 12%*58.33% = 10.33%
4. Long-Life Insurance Company recently issued a 4-year 7% coupon bond with a face value
of INR 1 billion for the price of INR 935.20 million. Assuming the risk-free rate in India is
5% and the market risk premium is 3%, then the cost of equity of Long-Life Insurance
Company is closest to:
A. 8%.
B. 12%.
C. 14%.
Answer:
Since the beta of the stock is not provided, we cannot calculate the cost of equity using the
CAPM method. However, we can calculate the cost of equity using the bond yield plus the risk
premium approach with the given data. The bond yield is calculated using the financial
calculator as 9% (N=4, PV=935.20, PMT=70, FV=1000, CPT -> I = 9%).
The cost of equity using the bond yield plus risk premium approach is Bond yield + Risk
premium = 9% + 3% = 12%.
5. An analyst has gathered the following information for RRW & Associates:
Book Value of Debt $300 million
Book Value of Equity $500 million
Book Value of Preferred stock $200 million
Market value of debt $270 million
Share price $25
Preferred share price $35
Preferred dividend $5
Expected dividend on common shares $2
After-tax cost of debt 8%
Growth rate 5%
No. of common shares outstanding 20 million
No. of preferred shares outstanding 10 million
Using the information provided in the table, the total cost of capital of RRW & Associates
is closest to:
A. 12.20%.
B. 10.05%.
C. 11.5%.
Answer:
The cost of capital of the firm is calculated using the WACC. In the calculation of the WACC,
we take the market value of debt and equity.
Weight of debt = MV of Debt/Total Capital = $270 million/$1,120 million = 24.10%

Weight of common equity = MV of Equity/Total Capital = ($25 per share * 20 million
shares)/$1,120 million = 44.64%
Weight of preferred shares = MV of Pref. shares/Total Capital = ($35 per share * 10 million
shares)/$1,120 million = 31.25%
Cost of preferred shares = Pref. Dividend/Preferred share price = $5/$35 = 14.29%
The cost of common equity can be derived using the dividend discount model as Expected
dividend/Price + Growth rate = $2/$25 + 5% = 13%.
Finally, with this information we can calculate the cost of capital as [After-tax cost of Debt
(8%) * Weight of Debt (24.1%) + Cost of Equity (13%) * Weight of Equity (44.64%) + Cost of
Preferred shares (14.29%) * Weight of Preferred shares (31.25%)] = 12.20%
6. A US-based auto parts supplier is assessing its cost of equity for the current year in which
it earned income of $80,000 and distributed $55,000 in dividends to its 10,000
shareholders. The firm owns total assets of $1,700,000, total liabilities of $1,000,000 and
the beta of the firm is 1.1. Assuming that the firm's current share price is $42, and that
there are 10,000 shares outstanding, the auto parts supplier's cost of equity is closest to:
A. 16%.
B. 17%.
C. 18%.
Answer:
The cost of equity can be calculated using the dividend discount method but before that, we
need to determine the growth rate. The growth of a firm is calculated by multiplying the
Retention rate by the Return on Equity.
Growth = Retention rate * Return on Equity = Retained earnings/Net income * Net
income/Total equity = 25,000/80,000 * 80,000/(1,700,000 - 1,000,000) = 3.57%
Since the growth rate is now determined we can calculate the cost of equity using the
dividend discount method as (Expected dividend/Share Price) + Growth rate = ($5.5 *
1.0357)/$42 + 3.57% = 17.13%.
7. An analyst is analyzing Core Corp. to determine its asset's beta. Core has Debt of $366
million and Equity of $525 million with a tax rate of 25%. If its equity beta is 0.8, Core's
asset beta is closest to:
A. 0.52.
B. 0.80.
C. 1.22.
Answer:
The asset beta of a firm can be derived using the pure-play method.
First, we need to determine the Debt-to-Equity ratio of Core Corp. = Debt/Equity = $366
million/$525 million = 0.7
Beta of asset = Equity Beta/[1 + (1 - tax rate)*D/E] = 0.8/[1 + (1 - 0.25)*0.7] = 0.52
8. An analyst is interested in determining the project beta of a new robotic arm

manufacturing project for Galaxy Inc. that has a debt-to-equity ratio of 1.5, a tax rate of
25%, and a bond yield of 9%. Another public company that operates in the same industry
has an equity beta of 1.1, a debt-to-equity of 2, and a tax rate of 25%. Using the above
information, which of the following is the most accurate estimate of the project's beta an
analyst could get?
A. 0.44
B. 1.10
C. 0.93
Answer:
We need to start off with the following equation:
BetaEquity = BetaAsset*[1 + (1 - tax rate)*D/E]
Therefore, the asset beta of the public company = Equity Beta/[1 + (1 - tax)*D/E] = [1.1/(1 +
(1 - 0.25)*(2)] = 0.44
Once the asset beta is estimated, we can calculate the project beta by using the asset beta of
the comparable public company as Asset Beta*[1 + (1 - tax rate)*D/E] = (0.44)*[1+ (1 -
0.25)*(1.5)] = 0.935
Note: Asset Beta measures the riskiness of the business that a firm is in and is often called
unlevered beta. Similarily, Levered beta is the same as equity beta. The formula can also be
written as:
BetaLevered = BetaUnlevered*[1 + (1 - tax rate)*D/E]
9. A transportation firm is considering to start an underwater tramway system in Ethiopia.

Due to the underdeveloped status of the country, the foreign companies usually charge a
country risk premium of 2.2% on all their investments. Assuming a risk-free rate in
Ethiopia of 5%, a project beta of 1.3, an expected market return of 7.5% and a bond yield
of 8%, the cost of equity for the Ethiopian tramway project is closest to:
A. 11.11%.
B. 12.1%.
C. 10.2%.
Answer:
Since Ethiopia is a less developed country and firms are charging a country risk premium, we
will add the country risk premium to the CAPM to come up with the cost of equity of the
project.
E(ri) = Risk-free rate + Project beta*[Expected market return - Risk-free rate + Country risk
premium] = 5% + 1.3[7.5% - 5% + 2.2%] = 11.11%
10. A pharmaceutical company has raised equity capital of $500 million to introduce a new
drug that can make patients immune from air pollution-related allergies. The drug is
expected to generate cash inflows of $90 million for each of the next 8 years. Assuming
that the company's cost of capital is 6.5%, and flotation costs are 6%, then the Net Present
Value (NPV) of the new drug project is closest to:
A. -$8.92 million.
B. $47.99 million.
C. $17.99 million.
Answer:
As the new drug-related project is fully financed by equity capital, the flotation costs of the
common equity = Common equity * Flotation cost = $500 million * 6% = $30 million
We can calculate the NPV of the project after adjusting this initial cash outlay for flotation
costs.
NPV of the project can be calculated using the financial calculator as CF0=-$530 million;
CF1=90 million; F=8; I=6.5%; CPT => NPV = $17.99 million.
11. A former project associate at Hamilton Investments has estimated an 11.2% cost of equity
using the data presented in the following table. Soon after the initiation of the project,
the associate left the firm and now it is the new associate's job to determine which
method the former associate use to determine the cost of equity. The method used was
most likely the:
Current Dividend 1.5
Share price 25
Total Equity $700,000
Net Income $84,000
No. of common shares outstanding 20,000
Company's D/E 1.5
Return of Equity 12%
Dividend payout ratio 35.71%
Project's beta 0.9
Equity Market Return 11%
Risk-Free Rate on Long-Term Bonds 4%
Beta of Similar Company 1.1
Similar company's D/E ratio 1.2
Country risk Premium 1%
A. dividend discount model.
B. bond yield plus risk premium model.
C. country risk premium model.
Answer:
Using the country risk premium, the cost of equity can be calculated as [Risk-free rate +
Project beta (Expected market return - Risk-free rate + Country risk premium)] = 4% +
(0.9)(11% - 4% + 1%) = 11.2%.
12. The current stock price of ZZEN is $72, the expected dividend for next year is $6.4 and the
long-term dividend growth is assumed to be 10%. The cost of equity of ZZEN is closest to:
A. 18.9%.
B. 15.4%.
C. 16.6%.
Answer:
Cost of equity = D1/P0+g = 6.4/72+0.1 = 0.189 or 18.9%.
13. AX & Y Company's capital structure is as follows:

Debt 40%
Preferred stock 15%
Equity 45%
Before-tax cost of debt 7%
Cost of preferred stock 9%
Cost of equity 17%
Marginal tax rate 30%
The company's weighted average cost of capital is closest to:
A. 11%.
B. 10.4%.
C. 11.8%.
Answer:
WACC = wdrd*(1-T) + wsrs + wprp
WACC = 0.4*0.07*(1-0.3) + 0.15*0.09 + 0.45*0.17 = 0.1096 or 10.96%
14. What is a company's cost of equity, if the risk-free rate is 3%, the equity risk premium is
8% and the equity beta is 1.8?
A. 17.4%
B. 14.4%
C. 12.8%
Answer:
Cost of equity = Risk free rate of return + Beta * (Market rate of return - Risk free rate of
return)
Equity premium = Market rate of return - Risk free rate of return = 8%
Cost of Equity = 3% + 1.8 * 8% = 17.4%
15. If XXV Corp. issues a 7-year, 4% semi-annual coupon bond, and the bond sells for $108,
then the company's before-tax cost of debt is closest to:
A. 1.2804%.
B. 1.3701%.
C. 2.7402%.
Answer:
PV=108; FV=100; PMT=0.04*100/2=2; n=2*7=14
Using the financial calculator, we find i=1.3701, which is the six-month yield.
Therefore, the before-tax cost of debt is 2 * 1.3701 = 2.7402%.
16. A company has a target capital structure of 40% debt and 60% equity. The company is a
constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and
has a growth rate of 8%. The company's bonds pay 10% coupon (semi-annual payout),
mature in 20 years, and sell for $849.54. The company's stock beta is 1.2. The company's
marginal tax rate is 40%. The risk-free rate is 10%. The market risk premium is 5%.
The cost of equity using the capital asset pricing model (CAPM) approach and the
discounted cash flow approach is:
CAPM Discounted cash flow
A. 16.6% 15.4%
B. 16.0% 15.4%
C. 16.0% 16.0%
Answer:
CAPM approach:
10 + (5)(1.2) = 16%.
Discounted cash flow approach:
Next-period dividend = 2(1.08) = 2.16
(2.16 / 27) + 0.08 = 16%
17. Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services
company based in the U.S. Stolzenbach's management team is considering opening new
stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach's
investment in Mexico. Winfield has researched bond yields in Mexico and found that the
yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury
bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All
Share Index stock index and the S&P 500 index was 38% and 20% respectively. The
annualized standard deviation of the Mexican dollar-denominated 10-year government
bond over the last year was 26%. Winfield has also determined that the appropriate beta
to use for the project is 1.25, and the market risk premium is 6%. The risk free interest
rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the
cost of equity that Winfield should use in his analysis?
Country Risk Premium for Mexico Cost of Equity for Project
A. 4.53% 17.36%
B. 5.89% 17.36%
C. 4.53% 19.06%
Answer:
CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized
standard deviation of sovereign bond market in terms of the developed market currency)
= (0.077 - 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%
Cost of equity = RF + β[E(RMKT) - RF + CRP]
= 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36%
Note that you are given the market risk premium, which equals E(RMKT) - RF.
Quiz 5 – Capital Structure
1. Which stage in a company’s lifecycle is most likely characterized by slowing revenue growth,
positive cash flow, and low cost of debt?
A. Start-up.
B. Growth.
C. Mature.
Answer:
The mature phase of a company’s lifecycle is characterized by slowing revenue, positive and
predictable cash flows, low business risk, high availability of debt, low cost of debt, a capital structure
with 20%+ debt capital.
A is incorrect.The startup lifecycle stage is characterized by beginning revenue growth, negative cash
flows, high business risk, very limited debt, high cost of debt, and close to 0% debt capital.
B is incorrect.The growth lifecycle stage is characterized by rising revenue growth, improving cash
flows, medium business risk, improving availability of debt, medium cost of debt, and debt capital
structure of between 0%-20%.
2. Which of the following is least likely a reason for a mature company’s de-leveraging?
A. Share buybacks.
B. Increase in equity value over time.
C. Increasing cash flow generation that reduces debt capital.
Answer:
Share buybacks reduce the shares outstanding and consequently the equity in the capital structure.
B and C are incorrect. Mature companies experience a reduction in debt in their capital structure over
time due to increasing cash flow generation used to reduce debt capital and the increase in the value
of equity over time.
3. Which of the following is most likely a reason why share buybacks are attractive to companies?
A. They are not an actual expense to the company.
B. They reduce the share prices and per share metrics.
C. They offer greater flexibility compared to dividends.
Answer:
Share buybacks are an expense to the company since it uses its cash reserves to purchase its shares in
the market. However, companies consider them attractive because they offer greater flexibility. After
all, shareholders do not expect companies to take part in share buybacks every period compared to
cash dividends.
A is incorrect. Share buybacks are an expense to the company.
B is incorrect. Share buybacks reduce the number of shares outstanding and improve a company’s
per-share metrics such as EPS.
4. Which of the following would most likely be an effect of higher financial leverage on equity, under
the Modigliani–Miller proposition II without taxes?
A. Higher financial leverage raises the cost of equity.
B. Higher financial leverage reduces the cost of equity.
C. Costs of equity remain the same regardless of financial leverage.
Answer:
Under the Modigliani–Miller proposition II without taxes, higher financial leverage raises the cost of
equity. The cost of equity is a linear function of a company’s debt-to-equity ratio; an increase in debt
increases the cost of equity but does not change the firm's value.
5. Which of the following is most likely a direct cost of financial distress?

A. Reputational risk.
B. Foregone investment opportunities.
C. Expenses of the bankruptcy process.
Answer:
The direct costs of financial distress include expenses related to a bankruptcy process, such as legal
fees.
A and B are incorrect. Indirect costs of financial distress include foregone investments, impaired ability
to conduct business, reputational risks, and costs from conflicts between debtholders and managers.
6. Which of the following is least likely a reason why a company’s target capital structure may differ
from its optimal capital structure?
A. Lack of floatation costs.
B. Market value fluctuations.
C. Management trying to exploit short-term opportunities.
Answer:
Floatation costs, not a lack of it, are a reason why a company's optimal capital structure may differ
from the actual capital structure. T hese costs may make it impractical for a company to attempt to
adjust its capital structure continually. T hese costs include legal fees and the cost of issuing
new securities.
7. Which of the following is least likely a method analysts use to estimate a company’s target capital
structure?
A. Assume a company’s target capital structure from its stage in its life cycle.
B. Assume a company’s current capital structure is its target capital structure.
C. Use comparables of comparable companies to infer a company’s target capital structure.
Answer:
Assuming a company’s target capital structure from its stage in its life cycle is not a method used to
estimate a company’s target capital structure. There are unique situations where companies may
deviate from the lifecycle capital structure expectations, such as capital-intensive businesses, cyclical
industries, and capital-light businesses.
B and C are incorrect. The method used by analysts to estimate a company’s target capital structure
include:
i. Assuming a company’s current capital structure is its target capital structure.
ii. Examine trends in the industry or statements by management to infer the target capital
structure.
iii. Use averages of comparable companies’ capital structures.
8. Which of the following factors will least likely affect the capital structure and the use of leverage
by management?
A. Capital investment financing.
B. Equal distribution of information.
C. Capital structure policies and targets.
Answer:
The lack of equal distribution of information between management and stakeholders affects the
capital structure and the use of leverage by management.
A and C are incorrect. Other factors that may affect capital structure include:
Capital structure policies and targets: These are guidelines set by management and the board based
on a company’s risk appetite.
Capital investment financing: Investment opportunities or lack of opportunities will affect a company’s
need to seek financing and financing options.
Market conditions: Interest rates of debt and market prices of shares will affect how much and what
type of capital a company can raise.
Asymmetric information: This is the unequal distribution of information that arises from the fact that
managers have more information about a company’s performance than outsiders. Providers of debt
demand higher returns from companies with higher information asymmetry.
9. Under the pecking order theory, which source of capital would managers most likely prefer to
use?
A. Debt.
B. Equity.
C. Internally generated funds.
Answer:
Managers' first preference for financing is one with the least potential information content, i.e.,
internally generated funds.
A and B are incorrect.The lowest preference is given to the one with the most potential information
content, i.e., equity offering. This is because equity offerings are closely scrutinized. According to the
pecking order theory, managers prefer internally generated funds, then debt, and finally equity.
10. Which of the following stakeholders will most likely benefit from a reduction in a company’s
leverage?
A. Debtholders.
B. Equity shareholders.
C. Management.
Answer:
A debt reduction will most likely benefit debtholders as they have a limited return while the risk is not.
For this reason, they will favor activities that reduce a company’s leverage and financial risk.
B is incorrect. Equity shareholders have limited downside risk, but the upside potential is unlimited.
They will therefore prefer higher levels of leverage that offer greater potential returns.
C is incorrect. Management can also benefit from the greater potential returns through equity-based
compensation.
11. Consider the following information for company XYZ Plc. that is being valued using the projected
cash flows from its new projects:
The weights that should apply when estimating XYZ’s cost of capital for debt and equity,
respectively, are:
A. 0.3605 and 0.6395.
B. 0.3636 and 0.6364.
C. 0.4444 and 0.5556.
Answer:
Using the table above we have:
Market values should be used when calculating the cost of capital. Given the cost of capital that will
be applied to the projected cash flows from new projects, forecasted market values will be used.
12. Which of the following is least likely a safeguard used by debtholders to protect their interests?
A. Debt covenants.
B. Financial distress costs.
C. Decisions that increase a company’s leverage.
Answer:
Equity shareholders prefer decisions that increase a company's financial leverage, while debtholders
prefer decisions that reduce a company's financial leverage.
A and B are incorrect. Safeguards used by debtholders to protect their interests include:
i. Debt covenants. These are restrictions lenders put on borrowers to restrict the actions the
borrowers can take.
ii. Companies need to maintain and improve their creditworthiness by maintaining a good
repayment record and banking relationships. Failure to do this will impact its credit rating and
cost of borrowing.
iii. The cost of financial distress can be substantial, such as the high cost of debt, legal fees, the
need to pay for goods and services upfront, loss of employee morale and productivity.
13. According to the Modigliani–Miller Proposition I with corporate taxes, which of the following is
most likely true?
A. The cost of equity is a linear function of the company’s debt-to-equity ratio.
B. The market value of a company is not affected by the capital structure of the company.
C. The market value of a levered firm is equal to the value of an unlevered firm plus the value
of the debt shield.
Answer:
According to Modigliani–Miller Proposition I with corporate taxes, the market value of a levered firm
is equal to the value of an unlevered firm plus the value of the debt shield. Interest payments on
certain debts are a tax-deductible expense acting as a debt shield, also often called a tax shield.
A is incorrect. According to Modigliani–Miller Proposition II without taxes, the cost of equity is a linear
function of the company’s debt-to-equity ratio.
B is incorrect. According to Modigliani–Miller Proposition I without taxes, the market value of a
company is not affected by the company's capital structure.
14. Which of the following is least likely a characteristic of preferred shares?

A. Fixed preferred dividend payment with no maturity date.
B. Priority of dividend payment before common shareholders.
C. Failure to pay a preferred dividend is considered a default.
Answer:
Failure to pay preferred dividends is not considered a default, as it would be the case with debt.
A is incorrect. When compared to bondholders, preferred shareholders provide long-term capital with
no maturity date. Additionally, the preferred dividends are not guaranteed or fixed; however,
common shareholders cannot receive their dividends before preferred dividends are paid.
B is incorrect. Preferred shareholders rank above common shareholders but below debtholders in
terms of security and priority of dividends.
15. Which of the following sources of information do public market debtholders least likely rely on
when making investment decisions?
A. Public information.
B. Credit rating agencies.
C. Access to company management.
Answer:
According to the reading, only banks and private lenders have direct access to company management
and non-public information about the company reducing information asymmetry.
A and B are incorrect. Public market debt holders rely on public information and credit rating agencies
when making their investment decisions.
Quiz 6 – Measures of Leverage
1. An analyst has gathered the following expenditure information for three different firms, each of
which has a sales level of $4 million.
Costs for firms under consideration (in millions)
Firm A Firm B Firm C
Variable Costs $2.00 $2.60 $2.40
Fixed Costs $1.00 $1.30 $1.40
Interest Expense $0.20 $0.00 $0.20
Which firm has the highest degree of operating leverage (DOL)?
A. Firm A.
B. Firm B.
C. Firm C.
2. Which of the following factors is least likely to affect business risk?
A. Demand variability.
B. Interest rate variability.
C. Operating leverage.
3. Which of the following is a key determinant of operating leverage?
A. The competitive nature of the business.
B. The tradeoff between fixed and variable costs.
C. Level and cost of debt.
4. Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and
labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units
must King Mattress sell to break even?
A. 2,708.
B. 8,125.
C. 40.
5. Veko Plastic is a plastic manufacturing company that has the maximum capacity to manufacture
150,000 plastic bags per year. Currently, Veko operates at 70% of its maximum capacity in order
to generate revenues of $525,000, as shown in the following table:
Revenue $525,000
Total Variable cost $315,000
Fixed Operating Cost $85,000
Fixed Financing Cost $25,000
Not taking into account fixed financing costs, the operating breakeven quantity of bags Veko has
to produce is closest to:
A. 105,000 bags.
B. 55,000 bags.
C. 42,500 bags.
6. A small cement company based in Srilanka produces 96,250 kg of cement to achieve its operating
breakeven quantity. Due to the constant rise in housing prices in Srilanka, the construction
industry is booming. This effect has sky-rocketed cement prices to $13/kg, and the variable costs
have also increased to $5/kg. Assuming fixed finance costs of $430,000, the fixed operating costs
of the company are closest to:
A. $1,200,000.
B. $340,000.
C. $770,000.
7. When Core Enterprises' sales increased by 10%, its operating profit increased by 19%. Assuming
the firm has neither interest costs nor tax expenses, then Core's change in net income given a
10% increase in sales is closest to:
A. 29%.
B. 1.9%.
C. 19%.
8. Which of the following will lead to a greater change in a firm's operating earnings given a
change in the firm's sales?
A. Financing leverage
B. Operating leverage
C. Accrual leverage
9. Optimus Corporation has recently started selling its first batch of electric cars. Using the data
given in the following table, calculate the degree of financial leverage (DFL) of Optimus if the
quantity sold is 20,000 units.
Price 6
Variable cost 3
Fixed cost 20,000
Interest expense 20,000
A. 1.5
B. 3.2
C. 2
10. Using the data given in the following table for the degree of financial leverage (DFL), analyze the
impact of a 10% increase in EBIT if the firm sold 20,000 units.
Price 6
Variable cost 3
Fixed cost 20,000
A. A 10% increase in EBIT will increase EPS by 20%.
B. A 10% increase in EBIT will increase Sales by 20%.
C. A 10% increase in EBIT will increase EPS by 10%.
11. Which of the following appropriately defines leverage?

A. The amount of fixed costs out of a firm's total costs
B. The amount of variable costs over the firm's total costs
C. The flexibility of making payments
12. Identify the appropriate formula for calculating the degree of operation leverage.
A. Changes in net income divided by changes in sales
B. Changes in operating earnings divided by changes in sales
C. Changes in operating earning multiplied by changes in sales
13. Which of the following is the appropriate interpretation of a degree of operation leverage (DOL)
ratio of 2.25 for a 10% increase in sales?
A. A degree of operation leverage (DOL) ratio of 2.25 suggests that a 10% increase in sales will
result in a 2.25% increase in EBIT.
B. A degree of operation leverage (DOL) ratio of 2.25 suggests that a 10% increase in sales will
result in a 22.5% increase in EBIT.
C. A degree of operation leverage (DOL) ratio of 2.25 suggests that a 10% increase in sales will
result in a 2.25% increase in net income.
14. What type of risk is the combination of sales risk and operating risk?
A. Business risk
B. Operating risk
C. Financial risk
15. The Degree of Financial Leverage (DFL) is 1.0. What is the relationship between the operating
breakeven point and the breakeven point?
A. The operating breakeven point is higher than the breakeven point.
B. The operating breakeven point is lower than the breakeven point.
C. The operating breakeven point is equal to the breakeven point.
Exercises – Measures of Leverage
1. Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor
clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets.
Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her
booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth
rental fee. This year, she decided to make all blankets for the Expo out of high-tech
waterproof/breathable material that is more expensive to produce, but that she believes she can
sell for a higher profit margin. Information on the two types of blankets is as follows:
Per Unit Last Year's (Basic) Blanket This Year's (New) Blanket
Sales Price $25 $40
Variable Cost $20 $33
Assuming that Korotkin remains most interested in covering the booth cost (which has increased
to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth
cost? To cover this year's booth costs, Korotkin needs to sell:
A. 42 fewer blankets than last year.
B. 42 more blankets than last year.
C. 30 fewer blankets than last year.
Answer:
To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven
Quantity, and calculate the difference.
Step 1: Determine Last Year's (Basic Blanket) breakeven quantity:
QBE = (Fixed Costs) / (Sales Price per unit − Variable Cost per unit) = 750 / (25 − 20) = 150
Step 2: Determine This Year's (New Blanket) breakeven quantity:
QBE = (Fixed Costs) / (Sales Price per unit - Variable Cost per unit) = 840 / (40 − 33) = 120
Step 3: Determine Change in Units:
DQ = QThis Year - QLast Year = 120 − 150 = −30. Korotkin needs to sell 30 fewer blankets.
2. If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt,
then what is its degree of operating leverage?
A. 5.0.
B. 4.2.
C. 4.7.
Answer:
Upon first glance, it appears there is not enough information to complete the problem. However when
one realizes DTL = (DOL)(DFL) it is possible to complete this problem.
DTL = %∆EPS/%∆Sales = 5
DFL = EBIT/(EBIT-I) = 1.
(DOL)(1) =5
DOL= 5.
3. As an analyst, you have been given the task to analyze the financial statements of Turk & Co., a
fast-growing Turkish company in the packaging sector. To achieve its growth forecast, senior
management has made a few changes over the past year. The degree of operating leverage (DOL)
of Turk & Co. based on data provided in the following table for the year 2018 is closest to:
2018 2017
Revenue $880,000 $800,000
COGS $250,000 $200,000
Gross Proft $630,000 $600,000
Operating Expense $112,500 $150,000
Operating Profit $517,500 $450,000
Interest Exp. $114,300 $90,000
Net Income $403,200 $360,000
A. 1.5.
B. 1.0.
C. 1.2.
Answer:
The degree of operating leverage (DOL) is defined as the percentage change in operating income
(EBIT) that results from a given change in sales.
DOL = Change in EBIT/Change in Sales
Change in EBIT for 2018 = 2018 EBIT/2017 EBIT - 1 = 517,500/450,000 - 1 = 15%

Change is Sales for 2018 = Sales 2018/Sales 2017 - 1 = 880,000/800,000 - 1 = 10%.
DOL = Change in EBIT/Change in sales = 15%/10% = 1.5
4. As an analyst, you have been given the task to analyze the financial statements of Turk & Co., a
fast-growing Turkish company in the packaging sector. To achieve its growth forecast, senior
management has made a few changes over the past year. Given the following table, gauge the
change in earnings for Turk & Co. in 2018 if the revenue of the firm had increased by 20% in 2018.
2018 2017
Revenue $880,000 $800,000
COGS $250,000 $200,000
Gross Proft $630,000 $600,000
Operating Expense $112,500 $150,000
Operating Profit $517,500 $450,000
Interest Exp. $114,300 $90,000
Net Income $403,200 $360,000
A. A 30% change in earnings given a 20% change in revenue.
B. A 24% change in earnings given a 20% change in revenue.
C. A 16% change in earnings given a 20% change in revenue.
Answer:
As the DOL measures the change in EBIT given a change in sales and the DFL measures the change in
earnings given a change in EBIT, we will use DTL (DOL * DFL) to measure the change in earnings given
the change in Revenue of the firm.
Note: DOL * DFL can also be written as Change in EBIT/Change in Sales * Change in Earnings/Change
in EBIT; if Change in EBIT is canceled from both equation we get Change in Earnings/Change in Revenue
or DTL.
Since the DTL of the Turk & Co. in 2018 is DOL * DFL = 1.5 * 0.8 = 1.2 , the given change in earnings
will be 24% given a 20% change in Revenue (1.2 * 20% = 24%).
5. In which of the following capital structures will a firm have the greatest rate of change in terms of
Return on Equity?
A. A firm that is fully financed by debt.
B. A firm that is partially financed by debt and partially financed by equity.
C. A firm that is fully financed by equity.
Answer:
A firm that uses debt and equity (i.e.: a firm that uses financial leverage) to finance its assets will have
a higher level of ROE, and will also have a greater rate of change in ROE.
Note: This is what we see in practice. Firms use financial leverage to maximize their ROE. Most big
companies are neither fully financed by debt nor fully financed by equity. Also, a firm fully financed
by debt would have an ROE of 0%.
6. Veko Plastic is a plastic manufacturing company that has the maximum capacity to manufacture
150,000 plastic bags per year. Currently, Veko operates at 70% of its maximum capacity in order to
generate revenues of $525,000, as shown in the following table:
Revenue $525,000
Total Variable cost $315,000
Fixed Operating Cost $85,000
Fixed Financing Cost $25,000
Using the information provided in the table, the minimum number of bags Veko has to produce to
breakeven is closest to:
A. 55,000 bags.
B. 105,000 bags.
C. 42,500 bags.
Answer:
As the firm only operates at 70% of its maximum capacity, the firm only produces 105,000 plastics
bags (150,000 bags * 70% operating capacity).
Breakeven quantity taking into account fixed financing costs = (Fixed operating costs + Fixed financing
costs) /(Price - Variable cost)
= (85,000 + 25,000)/(525,000/105,000 - 315,000/105,000) = 55,000 bags
7. ABC Corp produces calculators. Its fixed costs are $500,000 per year. It sells its calculators for $40
and the cost of each one of them for the company is $33.5. What is ABC Corp's operating breakeven
quantity?
A. 12,500 units
B. 14,925 units
C. 76,923 units
Answer:
Operating breakeven quantity = F / ( P - V) = 500,000 / (40 - 33.5) = 76,923
8. Using the data given in the following, what will be the degree of total leverage (DTL) if Interim
sells 100,000 units of hoverboards?
Selling price 10
Variable costs per unit 6
Building cost 150,000
A. 3.27
B. 2.67
C. 2.2
Answer:
DOL = Qty*(Price - Variables costs) / (Qty*(Price - Variables costs) - Fixed costs)
= 100,000*(10 - 6)/(100,000*(10-6)-150,000) = 1.6
DFL = EBIT/(EBIT - Int. Exp) = 250,000/(250,000 - 100,000) = 1.67
DTL = DOL * DFL= 1.6 * 1.67 = 2.67
9. Which of the following will lead to a greater change in a firm's net income given a change in
operating earnings?
A. Financing leverage
B. Operating leverage
C. Accrual leverage
Answer:
Financial leverage will lead to a greater change in a firm's net income given a change in
operating earning.
10. The information regarding a new product that Pivot Inc. is planning to launch is given below:
Price 5
Variable cost 2
Fixed cost 50,000
Assuming that Pivot sells 30,000 units in the first year, the degree of operating leverage of the new
product is closest to:
A. 3.35
B. 2.25
C. 1.8
Answer:
DOL = Qty*(Price - Variables costs) / (Qty*(Price - Variables costs) - Fixed costs)
= 30,000 units * ($5 - $2) / (30,000 units * ($5 - $2) - $50,000) = 2.25
11. If the contribution margin per unit is $20, fixed costs are $20,000, interest costs are $5,000, and
taxes are $5,000, then the operating breakeven point is closest to:
A. 1,000 units.
B. 1,200 units.
C. 900 units.
Answer:
Operating breakeven point = Fixed cost/Contribution margin per unit = 20,000/20 = 1,000 units
12. The contribution margin per unit for product A is $20 and the firm's fixed costs of production up
to 500,000 units is $400,000. The degree of operating leverage (DOL) at 300,000 units is closest
to:
A. 1.10.
B. 1.01.
C. 1.07.
Answer:
DOL = Contribution margin/(Contribution margin - Fixed cost)= 20*300,000/(20*300,000 - 400,000)
= 1.071
13. AYK Corp. reported the following:
Revenues: $300,000
Fixed costs: $100,000
Variable costs: $100,000
Interests: $20,000
Taxes: $15,000
The degree of financial leverage of AYK Corp. is closest to:

A. 1.
B. 1.5.
C. 1.25.
Answer:
DFL = EBIT / (EBIT - Interest)
EBIT = $300,000 - $100,000 - $100,000 = $100,000
DFL = EBIT / (EBIT - Interest) = $100,000 / ($100,000 - $20,00) = 1.25
14. Calculate the degree of operating leverage from the following data.
Revenues: $300,000
Fixed costs: $100,000
Variable costs: $100,000
Interests: $20,000
Taxes: $15,000
A. 1.
B. 2.
C. 2.5.
Answer:
DOL = Contribution margin/(Contribution margin - Fixed cost) = ($300,000 - $100,000)/($300,000 -
$100,000 - $100,000) = 2
15. Fixed operating costs / (Price - Variable cost per unit) is the:
A. breakeven quantity.
B. payables turnover ratio.
C. operating breakeven quantity.
Answer:
Operating breakeven quantity = Fixed operating costs / (Price - Variable cost per unit)
16. The risk related to the uncertainty of revenues is most likely called:
A. business risk.
B. sales risk.
C. income risk.
Answer:
Sales risk is the risk related to the uncertainty of revenues.
17. QQY Pens Limited is a leading manufacturer of designer pens. The company’s cost breakup is
given in the following exhibit.
Exhibit: QQY Pens Limited

Fixed Cost $500
Variable cost per unit $15
If the selling price of a pencil is $25, then the breakeven point of the company is closest to:
A. 50 units.
B. 75 units.
C. 80 units.
Answer:
Breakeven point = Fixed cost / (Selling price -Variable cost)
= 500 / (25 - 15) = 50
18. The cost structure of a company is given in the following exhibit.
Exhibit: Cost Structure

Fixed Cost $55,000
Price per unit $180
Financing cost $10,000
If the total number of units sold is 20,000, then the degree of financial leverage is closest to:
A. 1.01.
B. 1.00.
C. 1.23.
Answer:
DFL=Q(P−V)−F/Q(P−V)−F−C
Q = Quantity sold
P = Price per unit
V = Variable cost per unit
F = Totalquad fixed costs
C = Financing cost
DOL=20,000∗(180−100)−55000 / 20,000∗(180−100)−55000−10000 =1.01
19. Accro Limited is a leading manufacturer of designer glasses. The company’s cost breakup is
given in the following exhibit.
Exhibit: Accro Limited

Fixed Cost $500
If the selling price of a pair of glasses is $22, then the contribution margin is closest to:
A. $10.
B. $12.
C. $14.
Answer:
Contribution margin = Selling price - Variable cost
= $22 - $12 = $10
20. LLQ Labs Limited, a pharmaceuticals company, recently launched a new drug which received
positive reviews from the medical community. Pharmaceuticals companies generally invest huge
amounts in research and development facilities in order to produce drugs more efficiently.
Recently, the government announced stringent regulations for companies operating in the
pharmaceutical space. The announcement is likely to increase barriers to entry for new
pharmaceutical companies.
In view of the above-mentioned announcement, the degree of operating leverage of LLQ Labs
Limited is most likely to:
A. increase.
B. decrease.
C. remain unchanged.
Answer:
The increase in barriers to entry will reduce competition for existing pharmaceutical companies which
is likely to increase the sales of LLQ Labs Limited. With this increase in sales, the DOL is likely to
decrease.
Quiz 7 – Portfolio Management : An Overview
1. A portfolio approach to investing provides which of the following benefits?

A. The highest investment returns
B. Protection against investment losses
C. A reduction in risk during normal market conditions
Answer:
A diversified portfolio reduces risk without needing to compromise on investment returns but will not
completely protect against investment losses during times of market turmoil.
2. Excess reserves held by banking institutional investors are usually invested is:
A. Emerging market equities and other high-growth stocks
B. Money-market and fixed income instruments
C. Real estate and other tangible assets
Answer:
Banks invest their excess reserves in conservative and liquid assets such as fixed income and money-
market instruments.
3. Select the correct sequence of portfolio management steps.

A. Equity valuation, portfolio performance assessment, trade execution
B. IPS creation, portfolio rebalancing, top-down analysis
C. IPS creation, portfolio construction, monitoring and rebalancing
Answer:
The portfolio management process must begin with the creation of an investment policy statement in
the planning step, then move to analysis and portfolio construction in the execution step and finally
rebalance, performance measurement and monitoring must be carried out in the feedback step.
4. Promised payments to pension beneficiaries are a responsibility of the plan sponsor in:
A. both a defined benefit plan and a defined contribution plan.
B. a defined contribution plan only.
C. a defined benefit plan only.
Answer:
In a defined benefit plan the promised payments to beneficiaries are a responsibility of the firm
sponsoring the plan. In a defined contribution plan no fixed payments are promised to beneficiaries.
5. A pool of investment assets owned by a government is best described as a(n):

A. state managed fund.
B. sovereign wealth fund.
C. official reserve fund.
Answer:
A sovereign wealth fund is a pool of investment assets owned by a government.
6. The top-down analysis approach is most likely to be employed in which step of the portfolio
management process?
A. The execution step.
B. The planning step.
C. The feedback step.
Answer:
Top-down analysis would be used to select securities in the execution step.
7. A mutual fund that invests in short-term debt securities and maintains a net asset value of $1.00
per share is best described as a:
A. balanced fund.
B. money market fund.
C. bond mutual fund.
Answer:
Money market funds invest primarily in short-term debt securities and are managed to maintain a
constant net asset value, typically one unit of currency per share.
A bond mutual fund typically invests in longer-maturity securities than a money market fund.
A balanced fund invests in both debt and equity securities.
8. Which of the following investors has a portfolio perspective in his investment strategy?
I. Investor A has been investing in the shares of Max Mart for the last 10 years. He always earns
above-market returns because he regularly evaluates the risk and return of his single asset
portfolio.
II. Investor B holds a Ph.D. in Economics and, due to his sound knowledge of different sectors of
the economy, he keeps shares from different firms from different sectors and evaluates the
combined risks and returns of these assets in a portfolio.
III. Investor C is a new investor who recently started investing in some large-cap stocks. His
investment strategy involves evaluating the risks and returns of his portfolio shares in
isolation.
A. Investor A only
B. Investor B only
C. Investors B & C
Answer:
Investor B has a portfolio perspective as he evaluates the combined risks and returns of each asset in
his portfolio.
Investor A invests in a single stock, so there is no portfolio perspective in his strategy. Investor C
evaluates each share of his portfolio in isolation. Therefore, he does not have a portfolio
perspective.
9. The portfolio of a pension plan consists of 6 stocks whose risk and return profiles are provided in
the following table. Suppose that the equally weighted standard deviation of the portfolio is 13%,
then which of the following stocks provides the highest diversification ratio?
A. Alpha Co.
B. Gama Corp.
C. HeroCorp.
Answer:
Diversification ratio = Standard deviation of portfolio/Standard deviation of Stock = 13%/17% = 0.76
10. Which of the following is least likely true regarding insurance companies?
A. Insurance companies invest customer claims with the objective of funding customer
premiums.
B. Property insurance companies have short-term investment horizons.
C. Insurance companies have high liquidity needs as compared to endowments funds.
Answer:
Option A is least likely true, as insurance companies invest customer premiums with the objective of
funding claims.
11. Which of the following is most likely a type of investor with a high-risk tolerance and low liquidity
needs?
A. Banks
B. Defined benefit pension plans
C. Insurance companies
Answer:
Defined benefit pension plans have high-risk tolerance and low(er) liquidity need. Banks and insurers
have low-risk tolerance and high liquidity needs.
12. Which of the following is the most appropriate income need of a bank as an investor?
A. Pay interests
B. Finance daily expenses
C. Pay pension benefits to its employees
Answer:
Banks invest mostly to pay interest to the depositors.
13. Wrap n Roll is a food chain based in Nevada. The company is respected in its industry for the
treatment of its employees. Wrap n Roll has decided to invest in a pension plan where employee
payouts are computed using a formula that considers factors such as length of employment and
salary history. Considering Wrap n Roll's requirement, which of the following is the most
appropriate pension plan?
A. Defined contribution plan
B. Defined benefit plans
C. Fixed asset pension plan
Answer:
A defined benefit pension plan promises to pay certain benefits to its employees. In defined benefit
plans, the employer assumes the investment risk of the plan.
14. Which of the following statements regarding the Portfolio Management Process are accurate?
I. The planning step begins with the formation of an Investment Policy Statement (IPS).
II. The execution step includes a top-down analysis of assets.
III. The feedback step deals with the bottom-up analysis.
A. Statements I & II only
B. Statements I & III only
C. Statements I, II & III.
Answer:
The Portfolio Management Process has three steps:
I. The planning step begins with the formation of an Investment Policy Statement.
II. The execution step deals with asset allocation using a top-down or bottom-up analysis.
III. The feedback step involves monitoring and rebalancing the portfolio.
Quiz 6 – Portfolio Management : An Overview
1. Determine the most appropriate Net Asset Value (NAV) formula used by the mutual fund
industry to value mutual funds.
A. Present value of fund's asset divided by the number of fund's shares
B. Total value of funds assets divided by the number of fund's shares
C. Net asset value of funds assets divided by the number of fund's shares
Answer:
The NAV of mutual funds is calculated as Net asset value of funds assets/Number of fund's shares.
2. Which of the following mutual funds gives an investor the option to invest additional funds
without additional fees?
A. Closed-end front-load fund
B. Open-end front-load fund
C. Open-end no-load fund
Answer:
Open-end funds allow investors to invest additional funds in the mutual fund. No-load funds do not
charge additional fees on the purchase of additional fund shares or redemption of shares.
3. Which of the following is/are the most likely correct statements regarding similarities and
differences between exchange-traded funds and closed-end funds?
I. Both types of funds are passively managed to match a particular index.
II. In both types of funds, the market price of shares and the net asset value (NAV) can differ
significantly.
III. Both types of funds can be sold and purchased on the open market.
A. III only
B. I & III only
C. I & II only
Answer:
ETFs and closed-end funds are sold and purchased on the open market rather than from the fund
itself.
Options I & II are incorrect. ETFs are passively managed to match the index while closed-end funds
are actively managed. In closed-end funds, the market price of shares and the NAV differ
significantly, whereas ETFs are designed to keep their share price close to the NAVs.
4. Which of the following hedge fund strategies invest in the stocks of those companies which are
likely to participate in mergers and acquisitions?
A. Convertible bond arbitrage fund
B. Event-driven fund
C. Buyout funds
Answer:
Event-driven funds invest in the stocks of companies that participate in mergers and acquisitions.
Convertible arbitrage is a trading strategy that typically involves taking a long strategy in a
convertible security and a short position in the underlying common stock, in order to capitalize on
pricing inefficiencies between the convertible and the stock.
A buyout is the purchase of a company's shares in which the acquiring party gains controlling
interest of the targeted firm.
5. Which of the following is least likely a similarity between buyout funds and venture capital
funds?
A. They both seek to only acquire a minority stake in the firms they invest in.
B. They both make investments with finite investment horizon (usually 3 to 5 years).
C. They both take control of the board of the companies in which they invest.
Answer:
Similar to buyout funds, venture capital funds typically have finite investment horizons (usually 3 to
5 years). Also, they both take control of the board of the companies in which they invest. However,
buyout funds almost always buy 100% of a company, whereas venture capital firms only acquire a
minority stake - less than 50%. Therefore, option A is the least likely answer.
6. Which of the following statements is least likely accurate regarding a defined contribution plan?
A. Individual accounts are set up for participants and benefits are based on the amounts
credited to these accounts.
B. Future benefits to the account are guaranteed.
C. Future benefits fluctuate on the basis of investment earnings.
Answer:
In a defined contribution plan, only contributions to the account are guaranteed, not the future
benefits.
7. Which of the following is the best definition of mutual funds?

A. Funds from many individual investors that are aggregated for the purposes of investment.
B. A type of professionally managed investment fund that pools money from many investors
to purchase securities.
C. A limited partnership of investors that uses high-risk methods, such as investing with
borrowed money, in hopes of realizing large capital gains.
Answer:
A mutual fund is a type of professionally managed investment fund that pools money from many
investors to purchase securities.
Note: Option A) is a pooled fund and Option C) is a hedge fund.
8. The process of evaluating individual investments in terms of their risk and return contributions
to the portfolio is referred to as:
A. passive portfolio analysis.
B. portfolio rebalancing.
C. portfolio perspective.
Answer:
Portfolio perspective refers to evaluating individual investments in terms of their risk and return
contribution to the portfolio.
9. The metric for measuring the diversification benefit of adding an investment into a portfolio is
known as the:
A. diversification ratio.
B. standard deviation.
C. Beta.
Answer:
The diversification ratio measures the diversification benefit of an investment in a portfolio.
10. The University of Bursa wants to establish a dedicated fund to provide financial support for its
ongoing expansion of its artificial intelligence research center building. Identify the appropriate
fund for the project.
A. Foundation fund
B. Endowment fund
C. Hedge fund
Answer:
Endowment funds are set to provide financial support for ongoing programs.
11. A society of doctors wants to establish a fund for the support of new doctors to carry out a
research on Ebola. Suggest an appropriate fund for this purpose.
A. Foundation fund
B. Endowment fund
C. Open-end fund
Answer:
Foundation funds are charitable funds set to support ongoing research-related activities.
12. The government of Canada and the government of Turkey want to establish a fund that will
invest in small-medium enterprises in Turkey. Which of the following funds will they choose?
A. Sovereign Fund
B. Mutual Fund
C. Endowment Fund
Answer:
Sovereign funds are established by governments for investment purposes.
13. Which of the following have the highest risk tolerance and lowest liquidity needs?
A. Insurance companies
B. Endowment funds
C. Banks
Answer:
Endowment funds have a higher risk tolerance and lower liquidity needs than insurance companies
and banks.
Usually, endowment funds have long-term horizons with relatively low liquidity needs. For this
reason, funds can tolerate short- and intermediate-term volatility provided that long-term returns
meet or exceed investments objectives. Consequently, endowment funds may take advantage of
less liquid investments, such as private equity, hedge funds, and other partnerships vehicles, which
typically offer higher risk-adjusted return potential as compensation for forfeiture of liquidity.
14. Liquidity needs of defined benefit plans:

A. are low.
B. are high.
C. can not be ascertained.
Answer:
Defined benefit plans have a high-risk tolerance, a long horizon, and low liquidity needs.
15. KDM Inc. has a pension plan for its employees where it contributes a certain amount to the plan
without any certainty about the future value of the plan. This fund is most likely a/an:
A. defined benefit plan.
B. defined contribution plan.
C. insurance fund.
Answer:
In a defined contribution plan, the future value of the plan is not promised.
16. The standard deviation of return of an equally weighted investment portfolio in various
securities is most likely:
A. more than the average of the standard deviation of the individual securities.
B. equal to the average of the standard deviation of the individual securities.
C. less than the average of the standard deviation of the individual securities.
Answer:
The standard deviation of an equally weighted investment portfolio offers a lower standard
deviation than the average of its individual components due to the correlations or interactions
between the individual securities.
17. Which of the following parties assumes the investment risk of a defined benefit plan?
A. The employees
B. The employer
C. The investment managers
Answer:
Since the future value or benefits of the plan are promised, the investment risk of a defined benefit
plan is assumed by the employer.
18. Which of the following portfolio management steps requires a detailed investment policy
statement?
A. Execution step
B. Planning step
C. Feedback step
Answer:
An investment policy statement (IPS) details the analysis of the investor's objectives and constraints.
19. Which of the following institutional investors are the major participant in the investment market
in the countries that are part of the Organization for Economic Co-operation and Development
(OECD) as outlined in the OECD report: "Recent Trends in Institutional Investor Statistics" (2008)?"
A. Insurance companies
B. Investment funds
C. Pension funds
Answer:
Based on the OECD's "Recent Trends in Institutional Investor Statistics" (2008), investment funds are
the major participant in the investment market with the highest annual average growth.
20. Roy Smith wants to invest in equities of emerging markets for the purpose of buying a new car
with the returns. Which of the following will provide these details about Smith?
A. The investment policy statement
B. The prospectus of the investment fund
C. The brochure of the investment company
Answer:
The investment policy statement (IPS) is a detailed analysis of the investor's objectives and
constraints.
Quiz 8 – Portfolio Risk and Return: Part I
1. For the past 5 year, an investor has had the following returns: 6%, 2.5%, -3%, 8%, and -6%. Which
of the following statements is most likely accurate?
A. The geometric mean return is equal to the arithmetic return.
B. The geometric mean return is smaller than the arithmetic return.
C. The geometric mean return is greater than the arithmetic return.
Answer:
When returns vary, the geometric mean is smaller than the arithmetic mean.
Arithmetic return = (6% + 2.5% - 3% + 8% - 6%) / 5 = 1.5%

Geometric mean = (1.06 * 1.025 * 0.97 * 1.08 * 0.94)1/5 -1 = 1.36%
2. TexCo is a textile firm in Shanghai. The stock of Tex Co has been closing higher every year for the
past 7 years. Using the stock data provided in the following table, calculate the Holding Period
Return on TexCo's stock for the year 2011.
A. 19.64%
B. 18.85%
C. 15.20%
Answer:
Holding Period Return = (Closing Price + Dividend - Opening Price)/Opening Price = (30.50 + 2 -
28.21)/28.21 = 15.20%
𝑃𝑡 − 𝑃𝑡−1 + 𝐷𝑡 𝑃𝑡 − 𝑃𝑡−1 𝐷𝑡
𝑅= = +
𝑃𝑡−1 𝑃𝑡−1 𝑃𝑡−1
= Capital gain + Dividend yield
3. Calculate the money-weighted rate of return of an investor if he purchased one share of XRW
(data provided in the following table) for the last 5 years starting from Year 0 and sold all 5
shares at the end of the 5th year. Assume that the company paid a dividend of $1 per share from
the second year onwards.
Year Purchasing Price

0 $10.00
1 $8.95
2 $7.45
3 $8.50
4 $9.85
5 $10.15
A. 13.71%
B. 14.35%
C. 11.37%
Answer:
Money weighted return : CF0 = -10; CF1 = -8.95; CF2 = -5.45; CF3 = -5.5; CF4 = -5.85; CF5 = 55.75;
CPT -> IRR = 13.71
The values for the calculation are provided below:

Year Purchasing Price Dividend Cash Flow
0 $10.00 text0 -10 + 0 = -10
1 $8.95 text0 -8.95 + 0 = -8.95
2 $7.45 text2 (-7.45 + 2) = -5.45
3 $8.50 text3 (-8.5 + 3) = -5.5
4 $9.85 text4 (-9.85 + 4) = -5.85
5 $10.15 text5 (10.15 × 5 + 5) = 55.75
4. Which of the following return measures will most likely be the lowest?
A. Gross return
B. Net return
C. Pre-tax nominal return
Answer:
Net return is calculated after deducting the commission and management fees.
Gross return does not deduct taxes or commission.
5. An investor is interested in knowing the real return his portfolio has earned over a certain
period. Assuming that the nominal return of his portfolio is 18%, the CPI is 6%, and the tax rate is
38.9%, then the real return of the portfolio is closest to:
A. 19.08%
B. 11.32%
C. 6.92%
Answer:
Real rate of return= (1 + Nominal rate) / (1 + Inflation) - 1 = (1.18 / 1.06) - 1 = 11.32%
6. Which of the following statements is most appropriate?

A. Returns on large-cap stocks are negatively correlated with the standard deviation of returns.
B. Large-cap stocks have a greater standard deviation of returns as compared to small-cap
stocks due to longer maturities.
C. Theoretically, small-cap stocks should post greater returns than large-cap stocks.
Answer:
Small-cap stocks usually have higher returns and higher standard deviations as compared to large-
cap stocks.
Option A) is incorrect because risk and returns are positively correlated.

Option B) is incorrect because stocks do not have maturities.
7. Which of the following is least likely an interpretation of the correlation coefficient?

A. A correlation coefficient of +1 means that the mean returns of two assets move
proportionately in the same direction.
B. A correlation coefficient of -1 means that the mean returns of two assets move
proportionately in a negative direction.
C. A correlation coefficient of -1 means that the mean returns of two assets move
proportionately in opposite directions.
Answer:
A positive correlation or correlation of +1 means that the returns move in the same direction with
the same proportion while a perfectively negative correlation of -1 suggests that the deviation in
returns of two assets are inversely proportionate.
8. Stock A has a standard deviation of 10.00. Stock B also has a standard deviation of 10.00. If the
correlation coefficient between these stocks is - 1.00, what is the covariance between these two
stocks?
A. 1.00.
B. 0.00.
C. -100.00.
Answer:
Covariance = correlation coefficient × standard deviationStock 1 × standard deviationStock 2 = (-
1.00)(10.00)(10.00) = - 100.00.
9. As the correlation between the returns of two assets becomes lower, the risk reduction
potential becomes:
A. smaller.
B. decreased by the same level.
C. greater.
Answer:
Perfect positive correlation (r = +1) of the returns of two assets offers no risk reduction, whereas
perfect negative correlation (r = -1) offers the greatest risk reduction.
10. Which of the following is the most appropriate formula for the variance of a portfolio of two
assets if the assets are perfectly correlated?
A. Portfolio Variance = (Weight of Asset 12 + Weight of Asset 22) * Std. Dev. Asset 1 or 2
B. Portfolio Variance = (Weight of Asset 1 * Std. Dev. Asset 1 + Weight of Asset 2 * Std. Dev.
Asset 2)2
C. Portfolio Variance = (Weight of Asset 12 * Std. Dev. Asset 12) + (Weight of Asset 22 * Std. Dev.
Asset 22)
Answer:
The formula for the variance of a portfolio of two assets with a correlation of +1 (or perfect correlation)
is (Weight of Asset 1 * Std. Dev. Asset 1 + Weight of Asset 2 * Std. Dev. Asset 2)2
11. What are the arithmetic mean and geometric mean, respectively, of an investment which
returns 8%, -2% and 6% each year for three years?
A. Arithmetic mean = 5.3%; Geometric mean = 5.2%
B. Arithmetic mean = 4.0%; Geometric mean = 3.6%
C. Arithmentic mean = 4.0%; Geometric mean = 3.9%
Answer:
Arithmetic mean=8%+(−2%)+6%3=4%
Geometric mean=[(1+8%)×(1+(−2%))×(1+6%)]1/3−1=3.9%
Question Bank – Portfolio Risk and Return Part 1
1. Determine the correlation between the shares of Glam Corp. and Duncan Inc. if the covariance
of the assets is 0.04, the standard deviation of Glam Corp. is 32% and the standard deviation of
Duncan Inc. is 41%.
A. 0.304
B. 0.005
C. 0.11
Answer:
Correlation = Covariance/(Standard deviation A * Standard deviation B) = 0.04 / (0.32*0.41) = 0.304
2. A junior fund manager at Dapper Assets Management is constructing a portfolio consisting of

two large-cap stocks that trade on the London stock exchange. Using the data given in the
following table, calculate the standard deviation of stock A.
Year Stock A Return Stock B Return
1 17% 45%
2 21% 20%
3 -8% -2%
4 -1% 2%
5 4% -19%
6 19% 2%
7 -7% 13%
A. 12.46%
B. 1.33%
C. 7.56%
Answer:
Mean return = (0.17 + 0.21 - 0.08 - 0.01 + 0.04 + 0.19 - 0.07)/7 = 0.064
Variance = ((0.17 - 0.064)2 + (0.21 - 0.064)2 + (-0.08 - 0.064)2 + (-0.01 - 0.064)2 + (0.04 - 0.064)2 + (0.19
- 0.064)2 + (-0.07 - 0.064)2)/6 = 0.0133
As the variance of Stock A is 155.2857, the standard deviation = √0.0133 = 0.1246
3. Over the long term, the annual returns and standard deviations of returns for major asset classes
have shown:
A. a positive relationship.
B. a negative relationship.
C. no clear relationship.
Answer:
In most markets and for most asset classes, higher average returns have historically been associated
with higher risk (standard deviation of returns).
4. Risk aversion means that if two assets have identical expected returns, an individual will choose
the asset with the:
A. shorter payback period.
B. lower risk level.
C. higher standard deviation.
Answer:
Investors are risk averse. Given a choice between assets with equal rates of expected return, the
investor will always select the asset with the lowest level of risk. This means that there is a positive
relationship between expected returns (ER) and expected risk (Eσ) and the risk return line (capital
market line [CML] and security market line [SML]) is upward sloping.
Standard deviation is a way to quantify risk. The payback period is used to evaluate capital projects,
not investment returns.
5. Two assets are perfectly positively correlated. If 30% of an investor's funds were put in the asset
with a standard deviation of 0.3 and 70% were invested in an asset with a standard deviation of
0.4, what is the standard deviation of the portfolio?
A. 0.426.
B. 0.151.
C. 0.370.
Answer:
σ portfolio = [W12σ12 + W22σ22 + 2W1W2σ1σ2r1,2]1/2 given r1,2 = +1
σ = [W12σ12 + W22σ22 + 2W1W2σ1σ2]1/2 = (W1σ1 + W2σ2)2]1/2
σ = (W1σ1 + W2σ2) = (0.3)(0.3) + (0.7)(0.4) = 0.09 + 0.28 = 0.37
6. The optimal portfolio in the Markowitz framework occurs when an investor achieves the
diversified portfolio with the:
A. highest return.
B. highest utility.
C. lowest risk.
Answer:
The optimal portfolio in the Markowitz framework occurs when the investor achieves the diversified
portfolio with the highest utility.
7. Which one of the following portfolios cannot lie on the efficient frontier?
Portfolio Expected Return Standard Deviation
A 20% 35%
B 11% 13%
C 8% 10%
D 8% 9%
A. Portfolio C.
B. Portfolio A.
C. Portfolio D.
Answer:
Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.
8. A fund manager is constructing a portfolio consisting of two stocks. Which of the following
equations can the manager use to calculate the correlation coefficient if the covariance is 0.0168,
the standards deviation of stock A is 0.125 and the standard deviation of stock B is 0.2?
A. 0.0168/(0.125*0.2)2
B. 0.0168/(0.125*0.2)
C. 0.0168/(0.1252*0.22)
Answer:
Correlation = Covariance/(Standard deviation A * Standard deviation B) = 0.0168/(0.125 * 0.2)
9. Hakim Ahmed has recently joined Lampard Investment Inc. He was given the data related to the
assets of a portfolio provided in the following table. If the weight of Asset X is 35% and the weight
of Asset Z is 65%, then the variance of the portfolio is closest to:
Variance Asset X 0.1225
Variance Asset Z 0.3721
Covariance 0.19
A. 0.3712.
B. 0.1156.
C. 0.2587.
Answer:
Portfolio Variance= (Weight of Asset X2 * Std. Dev. Asset X2) + (Weight of Asset Z2* Std. Dev. Asset Z2)
+ 2 * Weight of X * Weight of Z * Cov of XZ
= (0.1225*0.1225) + (0.4225*0.3721) + (2*0.35*0.65*0.19) = 0.2587
10. Hakim Ahmed has recently joined Lampard Investment Inc. He has been given data related to
the assets of a client's portfolio provided in the following table:
Variance Asset X 0.1225
Variance Asset Z 0.3721
Covariance 0.19
If the weight of Asset X is 35% and the weight of Asset Z is 65%, then the correlation coefficient
of the portfolio is closest to:
A. 0.8899.
B. 0.0469.
C. 4.168.
Answer:
Standard deviation of X = 0.12251/2 = 0.35
Standard deviation of Z = 0.37211/2 = 0.61
Correlation coefficient = Covariance(X,Z)/(Standard deviation of X * Standard deviation of Z) =
0.19/(0.35 * 0.61) = 0.8899
Note: The correlation coefficient does not take into account the weights.
11. Jane Sonam is a value investor who recently started investing in tech companies. As her financial
adviser, you're given a task to calculate the money-weighted return of her investments in Solar
Inc. At the beginning, Jane Sonam purchases 10 shares of Solar Inc. at $110. One year later, she
purchased an additional 5 shares at $120. Assuming that the stock paid a dividend of $2 per share
each year, calculate the money-weighted return if she sold all 15 shares for $122 at the end of the
second year.
A. 6.31%
B. 10.58
C. 12.35%
Answer:
The money-weighted return of the portfolio can be calculated using the Cash Flow function of the
financial calculator.
As presented in the following table, the money-weighted return or IRR is: CF0 = -1,100, CF1 = -580,
CF2 = 1,860, CPT=>IRR = 6.31%
12. A small investment fund presents its monthly returns in both the Money-Weighted Rate of Return
(MWRR) and the Time-Weighted Rate of Return (TWRR). Recently an institutional investor has
withdrawn a large sum of money from the fund. Which of the following measures of portfolio
return is/are most affected?
A. Time-Weighted Rate of Return (TWRR)
B. Money-Weighted Rate of Return (MWRR)
C. Both at the same rate
Answer:
The Money-Weighted Rate of Return (MWRR) puts a greater weight on cash inflows and cash outflows
of the fund. Therefore, the Money-Weighted Rate of Return (MWRR) is most likely to be affected by
the cash withdrawal.
13. A university endowment fund invests in emerging market economies to fund its research and
development projects. The value of the fund's assets is provided in the following table. Assuming
all cash flows occur at the beginning of the year, the time-weighted return of the fund is closest
to:
A. 7.7%.
B. 5.4%.
C. 1.9%.
Answer:
To compute the annualized time-weighted return for the year, we first compute each year’s holding
period return:
Where MVBt and MVEt are the market values at the beginning and end of year t, respectively.
14. An investor purchased 1,000 shares of Indian Transport Co. for INR 33.23 per share and received
a dividend of INR 0.41 per share. Assuming that the investor sold the shares for INR 33.92,
calculate the Holding Period Return (HPR) of the investment.
A. 1.04%
B. 3.31%
C. 10.33%
Answer:
HPR = (Ending Value + Dividend - Beginning Value)/Beginning Value
= (33,920 + 410 - 33,230)/33,230 = 3.31%
15. A small investor purchased 100 shares of stock HHL at $10 per share on January 4th, 2014. A year
later, he purchased an additional 200 shares at $15 per share. If the investor sold all 300 shares at
$17 per share on January 4th, 2016, then the annualized time-weighted return of the investment
is closest to:
A. 27.5%.
B. 30.38%.
C. 21.11%.
Answer:
Annualized time-weighted return = (HPR year 1 * HPR year 2)1/n - 1 = ($15/$10 * $17/$15)1/2 - 1 =
30.38%
16. Alan West, a portfolio manager, created the following portfolio:

Security Security Weight (%) Expected Standard deviation(%)
A 20 4
B 80 10
If the correlation of returns between the two securities is 0.60, then the expected standard
deviation of the portfolio is closest to:
A. 8.10%.
B. 8.50%.
C. 9.50%.
Answer:
Standard deviation of portfolio = [ (0.2)2 (4%)2 + (0.8)2 (10%)2 + 2(0.2)(0.8)(0.6)(4%)(10%) ]0.5 = 8.50%
17. Raul Perez, a portfolio manager, created the following portfolio:
Security Security Weight (%) Expected Standard deviation(%)
A 40 7
B 60 12
If the covariance of returns between the two securities is -0.004, then the expected standard
deviation of the portfolio would be :
A. 6.36%.
B. 6.56%.
C. 6.10%
Answer:
18. Tina Fer, a portfolio manager, created the following portfolio:

Security Expected Return (%) Expected Standard deviation(%)
A 11 9
B 18 16
If the two securities are unrelated, the expected standard deviation of this equal-weighted
portfolio is closest to:
A. 9.18%.
B. 9.81%.
C. 8.91%.
Answer:
[ (0.5)2 (9%)2 + (0.5)2 (16%)2 + 2(0.5)(0.5)(0.00)(9%)(16%) ]0.5 = 9.18%
19. Which of the following curve is referred to as the Markowitz efficient frontier?
A. The curve that lies below and to the left of the global minimum-variance portfolio.
B. The curve that lies above and to the right of the global minimum-variance portfolio.
C. The curve that lies above and to the left of the global minimum-variance portfolio.
Answer:
The curve that lies above and to the right of the global minimum-variance portfolio is referred to as
the Markowitz efficient frontier because it contains all portfolios of risky assets that rational, risk-
averse investors will choose.
20. Which of the following statements is most accurate in the context of the minimum-variance
frontier?
A. A risk-averse investor will always choose to invest in a portfolio that lies on the right to the
minimum-variance frontier.
B. A risk-averse investor will always choose to invest in a portfolio that lies on the minimum-
variance frontier.
C. Neither of the above.
Answer:
A portfolio on the minimum-variance frontier can give the same return but at a lower risk.
21. Calculate the standard deviation of two equally weighted risky assets in a portfolio if the standard
deviations of the two assets are 12% and 15% and the correlation between the two assets is 0.5.
A. 11.71%
B. 23%
C. 9%
Answer:
22. What does the utility function represent?
A. Investors preference in terms of risk and return
B. Different combinations of risk and return
C. Minimum variance portfolios
Answer:
The utility function represents the investor's preference in terms of risk and return.
23. Which of the following indifference curves will a risk-averse investor have?
A. Upward sloping curve
B. Downward sloping curve
C. A downward straight line
Answer:
A risk-averse investor will have an upward sloping curve because they will only take additional risk
for additional returns.
24. Which of the following statements is most accurate about correlations?

A. The higher the correlation between assets, the higher the diversification benefit is.
B. The lower the correlation between assets, the lower the diversification benefit is.
C. The higher the correlation between assets, the lower the diversification benefit is.
Answer:
A high correlation between assets creates lower diversification benefits. If the correlation is
negative, the portfolio risk can be eliminated.
25. Calculate the fifth year return if the arithmetic mean return for a stock that earned 2%, 9%,-3%
and 13% is 2.8%.
A. 10%
B. 21%
C. -7%
Answer:
(2% + 9% - 3% + 13% + x)/5 = 2.8%
(2% + 9% - 3% + 13% + x) = 14%
x = 14% - 2% - 9% + 3% - 13%
x = -7%
Quiz 9 – Portfolio Risk and Return: Part 2
1. The correlation of returns on the risk-free asset with returns on a portfolio of risky assets is:
A. negative.
B. zero.
C. positive.
Answer:
The risk-free asset has zero correlation of returns with any portfolio of risky assets.
2. A portfolio to the right of the market portfolio on the capital market line (CML) is created by:
A. holding both the risk-free asset and the market portfolio.
B. holding more than 100% of the risky asset.
C. fully diversifying.
Answer:
Portfolios that lie to the right of the market portfolio on the capital market line are created by
borrowing funds to own more than 100% of the market portfolio (M).
The statement, "holding both the risk-free asset and the market portfolio" refers to portfolios that lie
to the left of the market portfolio. Portfolios that lie to the left of point M are created by lending
funds (or buying the risk free-asset). These investors own less than 100% of both the market portfolio
and more than 100% of the risk-free asset. The portfolio at point Rf (intersection of the CML and the
y-axis) is created by holding 100% of the risk-free asset. The statement, "fully diversifying" is incorrect
because the market portfolio is fully diversified.
3. Which of the following statements about risk is NOT correct?

A. Total risk = systematic risk - unsystematic risk.
B. Unsystematic risk is diversifiable risk.
C. The market portfolio consists only of systematic risk.
Answer:
Total risk = systematic risk + unsystematic risk
4. The market model of the expected return on a risky security is best described as a(n):
A. arbitrage-based model.
B. single-factor model.
C. two-factor model.
Answer:
The market model is a single-factor model. The single factor is the expected excess return on the
market portfolio, or [E(Rm) - RFR].
5. An analyst has developed the following data for two companies, PNS Manufacturing (PNS) and
InCharge Travel (InCharge). PNS has an expected return of 15% and a standard deviation of 18%.
InCharge has an expected return of 11% and a standard deviation of 17%. PNS's correlation with
the market is 75%, while InCharge's correlation with the market is 85%. If the market standard
deviation is 22%, which of the following are the betas for PNS and InCharge?
Beta of PNS Beta of InCharge

A. 0.66 0.61
B. 0.61 0.66
C. 0.92 1.10
Answer:
Betai = (si/sM) × rI, M
BetaPNS = (0.18/0.22) × 0.75 = 0.6136
BetaInCharge = (0.17/0.22) × 0.85 = 0.6568
6. The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return
is 5%, what is the expected return of the market?
A. +3.5%.
B. +3.0%.
C. -1.0%.
Answer:
RRStock = Rf + (RMarket − Rf) × BetaStock,
where RR = required return, R = return, and Rf = risk-free rate
A bit of algebraic manipulation results in:
RMarket = [RRStock − Rf + (BetaStock × Rf)] / BetaStock
= [8 − 5 + (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%
7. An unleveraged portfolio is constructed of two assets, including a risky asset with a standard
deviation of 18% and a risk-free asset. If the weight of the risk-free asset in the portfolio is 35%,
then the standard deviation of the portfolio is closest to:
A. 18%.
B. 6.3%.
C. 11.7%.
Answer:
A risk-free asset has a standard deviation of zero.
Standard deviation of the portfolio = Weight of risky asset * Standard deviation of risky asset
= 0.65 * 18% = 11.7%
8. Which of the following is the most appropriate explanation of the Capital Allocation Line (CAL)?
A. The Capital Allocation Line presents the investor's risk tolerance given risky assets and risk-
free assets.
B. The Capital Allocation Line demonstrates the set of portfolios within the investor's budget.
C. The Capital Allocation Line presents the possible risk and return combinations of risky
assets and risk-free assets.
Answer:
The Capital Allocation Line (CAL) is a graph created by investors to measure the risk of risky and risk-
free assets. The graph displays the return to be made by taking on a certain level of risk. Its slope is
known as the "reward-to-variability ratio."
9. Which of the following is most likely an assumption of the Modern Portfolio Theory?
A. All investors prefer optimal portfolios made up of risk-free assets.
B. All investors have homogeneous expectations related to the risk and return of portfolios.
C. All investors have the same efficient frontier but different Capital Allocation Lines.
Answer:
The basic assumption of the Modern Portfolio Theory is that all investors have homogeneous
expectations which means they all have the same estimates of risk and return of risky and risk-free
assets.
10. Which of the following is referred to as the capital market line?

A. The capital allocation line that considers only the risky portfolio as the optimal risky
portfolio.
B. The capital allocation line that uses the market portfolio as the optimal risky portfolio.
C. The capital allocation line that uses the risk-free portfolio as the optimal risky portfolio.
Answer:
The capital market line is a special case of the capital allocation line, where the optimal risky portfolio
is the market portfolio. The S&P 500 is a proxy of the market portfolio, which is the optimal risky
portfolio.
11. Which of the following statements is least likely accurate?
A. When assets are perfectly correlated, an investor can diversify its risk.
B. Firm-specific risk can be decreased with diversification.
C. Risk that can not be diversified is called systematic risk.
Answer:
Only assets that are not perfectly correlated can diversify a portfolio. Statements B) and C) are true.
12. A manager is valuing a project that is to be financed with 58% equity and 42% debt at the cost of
8.4%. Suppose the market premium is 5%, the risk-free rate is 6.5%, and the beta is 0.8, then the
market return is closest to:
A. 9.6%.
B. 11.5%.
C. 10.5%.
Answer:
The question is asking to estimate the return of the market. The risk premium is calculated by
deducting the risk-free rate from the market return.
Market return = Market premium + Risk-free rate = 11.5%
13. A manager is valuing a project that is to be financed with 60% equity. Suppose the market premium
is 4%, the risk-free rate is 5%, the cost of debt is 7%, and the beta is 0.9, then the rate used for
calculating the net present value (NPV) of the project is closest to:
A. 7.96%.
B. 8.60%.
C. 9.68%.
Answer:
The NPV of a project is calculated using the discount rate or weighted average cost of capital
(WACC).
First, we will calculate the cost of equity using the CAPM.

Cost of equity = Risk-free rate + Beta (Market premium) = 5% + 0.9(4%) = 8.6%
WACC = Weight of debt * Cost of debt + Weight of equity * Cost of equity = ((1-0.6) * 7%) +
(0.6*8.6%) = 7.96%
14. The expected return of the Karachi Stock exchange is 17%, and the rate on Pakistan's risk-free
bonds is 7.5%. Suppose the beta of Bata Corporation shares is 0.75, then the required rate of return
on Bata Corporation's shares is closest to:
A. 14.63%.
B. 20.25%.
C. 16.73%.
Answer:
The required rate of return on shares is calculated using the Capital Asset Pricing Model (CAPM).
Required rate of return = Risk-free rate + Beta (Market Return - Risk-free rate) = 7.5% +
0.75*(17%7.5%) = 14.63%
15. Shares of Fition Corp. are trading at $67 today while analysts expect the price of the shares to reach
$72 in 1 year and pay a dividend of $1.5. Given a required rate of return of 14%, Shares of Fition
Corp. are most likely:
A. Underpriced by $2.53.
B. Overpriced by $2.53.
C. Underpriced by $3.84.
Answer:
Price = $72/1.14 + $1.5/1.14 = $64.47
Since the current value of the stock is $67, the stock is overpriced by $2.53.
Question Bank – Portfolio Risk and Return: Part 2
1. Which of the following portfolios is/are most appropriately priced?

I. A portfolio with an estimated return above the securities market line (SML).
II. A portfolio with an estimated return plotted on the SML.
III. A portfolio with an estimated return below the SML.
A. Portfolios I & II
B. Portfolio II
C. Portfolios II & III
Answer:
The portfolio is underpriced if the portfolio's estimated return is above the SML. Conversely, a
portfolio with an estimated return below the SML is overpriced.
The portfolio with an estimated return plotted on the SML is properly priced.
2. If the covariance between the market portfolio and Arthemisca's shares is 0.46, the standard
deviation of Arthemisca's shares is 0.9, and the standard deviation of market returns is 0.7, then
Arthemisca's shares beta is closest to:
A. 0.94.
B. 0.57.
C. 1.3.
Answer:
Beta = Covariance between stock and market / Market variance = 0.46 / 0.72 = 0.938
3. Which of the following measures of risk-adjust returns is least likely to use beta?
A. Treynor measure
B. Jensen's alpha
C. M-squared measure
Answer:
M-squared and Sharpe ratio measures of risk-adjust returns use standard deviation or total risk.
Treynor and Jensen's alpha use beta or systematic risk.
4. A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky asset with
an expected return of 14% and a standard deviation of 22%, and asset B is a risk-free asset with an
expected return of 9%. If the portfolio manager increases the weight of the risky asset to 130%,
then the expected return of the portfolio is closest to:
A. 18.2%.
B. 15.5%.
C. 16.7%.
Answer:
Expected return of the portfolio = (Weight of Asset A * Return of Asset A) + (Weight of Asset B * Return
of Asset B) = (1.3 * 14%) + (-0.3 * 9%) = 15.5%
5. Amy Stevenson, CFA, has recently emigrated to Germany. She believes the German stock markets
are information efficient. Which of the following is least likely going to be her investing strategy?
A. Passive investing
B. Investing in index funds
C. Active investing
Answer:
Since Amy believes the markets are information efficient i.e. all the information is already reflected in
the market prices, then active investing is going to perform worse than passive investing after
commissions.
6. A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky asset with
an expected return of 14% and a standard deviation of 22% whereas asset B is a risk-free asset with
a return of 9%. Suppose the portfolio manager increases the weight of the risky portfolio to 130%,
then the risk of the portfolio is closest to:
A. 28.6%.
B. 22%.
C. 53.4%.
Answer:
The risk or the standard deviation of the portfolio = Weight of risky asset * Standard deviation of risky
asset = 1.3 * 22% = 28.6%
7. Which of the following is not a characteristic of an active portfolio?

A. The portfolio contains positive weighting for assets that are undervalued, or have a chance of
offering above-normal returns.
B. The portfolio generally has high costs as a significant effort is made in valuing securities.
C. The portfolio mostly replicates and tracks market indices, constructed on the basis of market
prices and market capitalizations.
Answer:
Active investors do not rely on market valuations and invest more in undervalued securities or
securities offering above-normal returns on the basis of their own estimate of cash flows, growth rates
and discount rates.
8. Which of the following situations is referred to as the leveraged position in the risky portfolio?
A. When there is a positive amount invested in the risk-free asset and in the risky asset.
B. When there is no amount invested in the risk-free asset.
C. When there is a negative investment in the risk-free asset.
Answer:
When an investor borrows money at the risk-free rate of interest and then invests his available wealth
with the borrowed funds in the risky portfolio, this borrowing portfolio is referred to as the leveraged
position in the risky portfolio.
9. Two portfolios have the following characteristics:

Portfolio Return Beta
A 8% 0.7
B 7% 1.1
Given a market return of 10% and a risk-free rate of 4%, calculate Jensen's Alpha for both portfolios
and comment which portfolio has performed better.
A. -0.2% and -3.6% respectively
Portfolio A has performed better than Portfolio B.
B. -0.2% and -3.6% respectively
Portfolio B has performed better than Portfolio A.
C. 0.2% and 3.6% respectively
Portfolio B has performed better than Portfolio A.
Answer:
Jensen's Alpha is calculated as follows:
Jensen's Alpha = Rp - [Rf + Bp (Rm - Rf)]
Jensen's AlphaPortfolio A = 0.08 - [0.04 + 0.7(0.1 - 0.04)] = -0.002
Jensen's AlphaPortfolio B = 0.07 - [0.04 + 1.1(0.1 - 0.04)] = -0.036
Jensen's Alpha is -0.2% and -3.6% for A and B respectively. A higher Alpha indicates that a portfolio
has performed better.
10. Which of the following portfolio has a systematic risk equivalent to its total risk?
A. A diversified portfolio
B. An unachievable portfolio
C. A borrowing portfolio
Answer:
Total risk and systematic risk are equal only for portfolios that have no diversifiable risk remaining
i.e., fully diversified portfolios which are the most efficient and achievable portfolios.
11. Which of the following portfolio performance evaluation measures provides the extent of the
performance of a particular portfolio?
A. Sharpe ratio
B. Treynor ratio
C. Jensen's alpha
Answer:
Both Sharpe and Treynor ratios allow the ranking of portfolios, but neither ratio gives any information
about the extent of the performance, whereas Jensen's alpha and M-Squared both provide such
results.
12. Which of the following portfolio performance evaluation measures is based on systematic risk?
A. Sharpe ratio
B. Treynor ratio
C. M-Squared (M2)
Answer:
The Sharpe ratio uses the total risk of the portfolio and the M-Squared is an extension of the Sharpe
ratio in that it is based on total risk. On the other hand, the Treynor ratio uses beta (systematic risk).
13. With respect to security selection using SML, a rational investor is more likely to invest in points:
A. directly lying on the SML.
B. above the SML.
C. below the SML.
Answer:
The asset will have a low level of risk relative to the amount of expected return and would be a good
choice for investors.
14. Which of the following is most likely the intercept of the security characteristics line (SCL)?
A. Jensen's alpha
B. Beta
C. M-Squared (M2)
Answer:
The security characteristic line (SCL) is a regression line, plotting performance of a particular security
or portfolio against that of the market portfolio at every point in time. The slope of the SCL is the beta,
and the intercept is its Jensen's alpha.
15. Which of the following securities has the highest expected return calculated using a capital asset
pricing model if the market risk premium is 8%?
Security Beta
A 0.75
B 0.12
C 1.30
D 1.70
A. Sesurity B
B. Security D
C. It depends on the risk-free rate
Answer:
Regardless of the risk-free rate, Security D has the highest expected return using the following
formula:
Ri = Rf + Bi [Rm - Rf]
As the beta of Security D is the highest, it will have the highest return, regardless of the risk-free
rate.
16. What is the standard deviation of an equally weighted portfolio consisting of one risky asset and
one risk-free asset if the standard deviation of the risky asset is 36%?
A. 0.18
B. 0.36
C. 0.0648
Answer:
Since the standard deviation of the risk-free rate is zero, the standard deviation of the portfolio is
the weight of the risky asset multiplied by the standard deviation of the risky asset:
σP = 0.5*36% + 0.5*0 = 18%
17. Investors who believe market prices are informationally efficient will most likely follow which of
the following investment strategy?
A. Passive investment strategy
B. Bottom-up strategy
C. Active investment strategy
Answer:
Passive investors believe market prices are informationally efficient which is why they match the
weights of indices.
18. Calculate the asset beta when the standard deviation of market returns is 21% and the
covariance of assets return with the market return is 0.039.
A. 1.3
B. 0.70
C. 0.88
Answer:
Beta of asset = covariance of assets return / variance of market returns
0.039/0.212 = 0.88
19. Which of the following is least likely an assumption of the capital pricing model?
A. Investors require higher returns with higher risks.
B. Investors are subject to taxes and transaction costs.
C. All investors have the same one-period time horizon.
Answer:
CAPM assumes there are no taxes and no transaction costs.
Assumptions of the model include:

There are no transaction costs
There are no taxes
Assets are infinitely divisible
Unlimited short-selling is permissible
All assets are marketable/liquid
Investors are price takers whose individual buy and sell transactions have no effect on the price
Investors’ utility functions are based solely on expected portfolio return and risk
The only concern among investors is the risk and return over a single period and this single period is
the same for all investors
20. Which of the following assets has the highest systematic risk?
A. Shares of a Flight High Luxury Jets
B. Shares of Bank of Detroit
C. Shares of Smart-Mart Utilities Store
Answer:
Shares of luxury goods items are highly correlated with market risk. Hence, they have higher
systematic risk.
21. The expected return of a portfolio is 17% and the return on risk-free assets is 8%. The beta of the
portfolio is 1.2, and the standard deviation of the portfolio is 5.5%. Assuming that an investor
invests 115% of his savings in this portfolio, his expected return is closest to:
A. 18.35%.
B. 19.55%.
C. 12.5%.
Answer:
Since the weight of the market portfolio is more than 100%, the investor is borrowing 15% of funds
at the risk-free rate and investing 115% in the market portfolio.
E[r] = (-15%)(8%) + (115%)(17%) = 18.35%
22. Which of the following return generating models uses macroeconomic indicators such as GDP
growth, inflation along with fundamental factors like earnings, and earnings growth?
A. Market model
B. Multifactor model
C. Revenue model
Answer:
The multifactor model uses macroeconomic indicators such as GDP growth, inflation along with
fundamental factors like earnings, earnings growth, etc.
23. Kate Williams is a portfolio risk analyst for Hampton Funds. She is assigned to calculate the beta
of Lion Inc. shares. What is its beta if the standard deviation of market returns is 19% and the
covariance of Lions returns with the market return is 0.163?
A. 0.85
B. 4.51
C. 0.0451
Answer:
Beta = Covariance of Asset's return with market return / Variance of market returns
Beta = 0.163/0.0361 = 4.51
24. What is the expected return of a stock if the expected market return is 11%, the risk-free rate is
9%, and the stock's beta is 0.91?
A. 11%
B. 19.91%
C. 10.82%
Answer:
According to CAPM:
Expected return of stock = Risk-free rate + beta (Market risk - Risk-free rate)
E[r] = 9% + 0.91(11%-9%) = 10.82%
25. What is the covariance of an asset's returns with the market if the beta of the asset is 1.7 and the
variance of market returns is 20%?
A. 0.34
B. 0.85
C. 0.12
Answer:
Covariance of asset returns with the market = Beta * Variance of market returns = 1.7 * 0.20 = 0.34
Quiz 10 – Basics of Portfolio Planning and Construction
1. Which statement best describes the reasons for an Investment Policy Statement?
A. The IPS ensures there is clear communication between the client and the advisor of the
client's investment objectives.
B. The IPS allows for transparency on the fees levied by the advisor for investment work.
C. The IPS sets out which assets the advisor should buy and sell on behalf of the client.
Answer:
The Investment Policy Statement is the written document governing the portfolio planning process
that ensures the client's investment objectives and constraints are clearly communicated.
2. Which portion of the investment policy statement is likely to contain information on leverage
limits, maximum derivative exposure and the exclusion of stocks from a particular industry?
A. The procedures section
B. The investment guidelines
C. The evaluation and review section
Answer:
The investment guidelines section contains information on how the investment policy should be
executed and includes the permissibility and exclusion of assets.
3. Which of the following would least likely be considered a minimum requirement of an IPS? A(n):
A. investment strategy based on client circumstances and constraints.
B. benchmark portfolio.
C. target return figure.
Answer:
An IPS does not necessarily, or even typically, require a target return because future market
movements are either difficult or impossible to predict with any degree of accuracy. At a minimum
the IPS should contain a clear statement of client circumstances and constraints, and investment
strategy consistent with these, and a benchmark portfolio or instrument against which to evaluate
portfolio returns.
4. Which of the following is least likely a component of an Investment Policy Statement (IPS)?
A. Duties and responsibilities of the investment manager
B. Procedures to update the IPS
C. Investment expertise of the investment manager
Answer:
An IPS does not carry information regarding investment areas or the investment focus of the
management firm as this information is provided in the firm's investment brochure.
5. Which of the following best demonstrates an absolute risk objective and a relative return
objective?
A. Target a maximum annual portfolio volatility of 1.5x the S&P 500 and returns of ±4% of the
S&P 500 annual return
B. Target a maximum portfolio drawdown of 10% with 95% confidence and annual returns of
12%
C. Target a maximum portfolio loss of $100 000 with 95% confidence and annual returns within
2% of the MSCI World Index
Answer:
An absolute objective does not key off a benchmark or index whereas a relative objective is with
respect to a benchmark, index or peer group.
6. Which of the following is least likely an example of an absolute risk objective?

A. The portfolio must not decrease in value by more than 4% at any point in a quarter.
B. The portfolio must not have greater than a 10% probability of a loss of $100,000 in 12 months.
C. The portfolio must not have greater than a 5% probability of returns less than 95% of the
S&P 500's returns in 6 months.
Answer:
Option C) infers that the returns must not be less than 95% of the returns earned by the S&P 500.
Therefore, it is a relative risk measure. Options A) and B) are examples of absolute risk measures.
7. Given the following client scenario, which best describes the ability to take on risk and willingness
to take on risk?
The client has a high-paying executive position for a large multi-national company. The client's
lifestyle is relatively conservative and as a result, the client has accumulated $5 million in savings
and has paid off the mortgage over a property. The client will reach retirement age in 15 years.
The client believes that "cash is king" and the financial markets are "just a gamble."
A. Ability: low; Willingness: high
B. Ability: high; Willingness: low
C. Ability: low; Willingness: low
Answer:
The client's wealth is relatively substantial and exceeds its lifestyle requirement and financial
obligations. The earnings are expected to continue for 15 years, a fairly long time horizon and as such,
the ability to bear risk is high.
However, the client demonstrates a low willingness to take on investment risk perceiving the financial
markets to be "a gamble." Therefore the willingness to take on risk is low.
8. Which of the following least likely depicts the investor's ability to take risk?
A. Seventy percent of the investor's home mortgage has already been paid.
B. The investor has net assets of $470,000 and an investment horizon of 14 years.
C. The investor is a Ph.D. in Economics and understands the risk associated with the stock
markets.
Answer:
Option C) depicts the investor's willingness to take risk; not its ability to take risk.
Longer time horizons, greater net assets, having a secure job, and insurance of assets provide
information regarding the investor's ability to take risk.
9. In which of the following situations should an investment manager educate the investors?
A. High willingness but low ability to take risk
B. High ability but low willingness to take risk
C. Low willingness and low ability to take risk
Answer:
An investment manager should educate an investor who has a high ability but no willingness to take
risk. When the investor has a high willingness but low ability to take risk, the ability of the investor
will prevail the investor's assessment.
10. Which of the following is the appropriate definition of a relative risk objective?
A. A relative risk objective states the probability by which a portfolio can assume risk.
B. A relative risk objective defines the percentage by which a fund can lose value.
C. A relative risk objective mentions a percentage by which a portfolio can take risk as
compared to a benchmark.
Answer:
Relative risk objectives define a percentage of value that a fund can lose as compared to its
benchmark. For example, 'no greater than a 5% probability of returns more than 3% below the return
of the PSX in 12 months' would be a relative risk objective.
11. Which of the following statements about risk and return is NOT correct?
A. Return objectives should be considered in conjunction with risk preferences.
B. Return objectives may be stated in dollar amounts.
C. Return-only objectives provide a more concise and efficient way to measure performance
for investment managers.
Answer:
Return-only objectives may actually lead to unacceptable behavior on the part of investment
managers, such as excessive trading (churning) to generate excessive commissions.
12. Which of the following statements is NOT consistent with the assumption that individuals are
risk averse with their investment portfolios?
A. Many individuals purchase lottery tickets.
B. There is a positive relationship between expected returns and expected risk.
C. Higher betas are associated with higher expected returns.
Answer:
Investors are risk averse. Given a choice between two assets with equal rates of return, the investor
will always select the asset with the lowest level of risk. This means that there is a positive relationship
between expected returns (ER) and expected risk and the risk return line (capital market line [CML]
and security market line [SML]) is upward sweeping. However, investors can be risk averse in one area
and not others, as evidenced by their purchase of lottery tickets.
13. An individual investor specifies to her investment advisor that her portfolio must produce a
minimum amount of cash each period. This investment constraint is best classified as:
A. liquidity.
B. unique circumstances.
C. legal and regulatory.
Answer:
Liquidity constraints arise from an investor's need for spendable cash.
14. When developing the strategic asset allocation in an IPS, the correlations of returns:
A. within an asset class should be relatively low.
B. among asset classes should be relatively high.
C. within an asset class should be relatively high.
Answer:
Asset classes are defined such that correlations of returns within an asset class are relatively high.
Low correlations of returns among asset classes increase the benefits of diversification across asset
classes.
15. A portfolio manager who believes equity securities are overvalued in the short term reduces the
weight of equities in her portfolio to 35% from its longer-term target weight of 40%. This decision
is best described as an example of:
A. rebalancing.
B. strategic asset allocation.
C. tactical asset allocation.
Answer:
Tactical asset allocation refers to deviating from a portfolio's target asset allocation weights in the
short term to take advantage of perceived opportunities in specific asset classes. Strategic asset
allocation is determining the target asset allocation percentages for a portfolio. Rebalancing is
periodically adjusting a portfolio back to its target asset allocation.
Question Bank – Basics of Portfolio Planning and Construction
1. Which of the following investment policy statements is the most appropriate IPS?
A. Amir Khan aims to earn significant returns on its portfolio of $2 million in 4 years.
B. The goal of Jack Wilson, a high net worth individual, is to earn a 20% return on its portfolio
from oil sector stocks within the time frame of 5 years.
C. Michael Trott's investment goal is to beat the Dow Jones Industrial index by 3%.
Answer:
Option B) is correct because it is the most appropriate IPS among the three. Jack Wilson's IPS defines
the return goal and the time frame clearly. However, it doesn't express the risk goals.
Amir Khan's IPS does not define the return or risk goals of the client.
Michael Trott's IPS provides return goals, but it doesn't provide any time frame.
2. Which of the following investors has the highest ability to take risk?
A. A 24-years old unemployed finance graduate with student loans amounting to $80,000 but in-
depth knowledge of financial markets.
B. A 55-years old war veteran with $400,000 in savings and medical insurance but no
knowledge of investments.
C. A married couple in their 30's with 4 kids and contractual jobs.
Answer:
The 55-years old war veteran has the highest ability to take risk as he has savings and medical
insurance which means he does not expect any liability in the future. His lack of financial knowledge
depicts a lower willingness to take risk.
A 24-years old finance graduate only has high knowledge and willingness to take risk but his ability is
limited as he does not have a stable income.
A couple in their 30's with contractual jobs and 4 kids probably have future liabilities (medical,
children's education, etc.). Therefore, the couple's ability to take risk is limited.
3. The process of determining the specific percentage to be allocated to specific sectors after
analyzing the investor's objectives and constraints is called:
A. security selection.
B. passive management.
C. strategic asset allocation.
Answer:
Strategic asset allocation is the process that involves determining the specific percentage to be
allocated to each specific asset class after analyzing the investor's objectives and constraints.
4. The manager of a pension fund recently deviated from the predetermined weights of asset classes
of the pension fund portfolio to take short-term opportunities. This strategy of varying weights is
known as:
A. technical asset allocation.
B. tactical asset allocation.
C. risk budgeting.
Answer:
Tactical asset allocation is the process by which a manager deviates from the strategical asset
allocation weights to capitalize on short-term expected returns.
5. A 40-years old manager at one of the biggest law firms in New York with net assets of $1,070,000
and basic social security believes that investing in stocks is most profitable when the stock is less
volatile because the stock market is rigged. Using the above assumptions, determine the ability
and the willingness of the investor.
A. High ability and high willingness to take risk
B. High ability and low willingness to take risk
C. Low ability but high willingness to take risk
Answer:
As the investor has a longer time-frame, i.e., 20 years to his retirement, sound savings and social
security, his ability to take risk is high. However, as per his beliefs, it seems his knowledge of the stock
market is limited. Therefore, his willingness to take risk is also limited.
6. A hedge-fund manager based in Dubai overweights the media sector stocks as compared to the
medical sector stocks from the Dubai Index. This process of overweighting a specific asset class or
sector is most likely referred to as:
A. tactical asset allocation.
B. strategic asset allocation.
C. securities selection.
Answer:
Securities selection is the process of determining which financial securities are included in a specific
portfolio. Therefore, the process of overweighting/underweighting a specific asset class or the process
of deviating from index weights of specific individual securities within an asset class is known as
securities selection.
Option A is incorrect. Tactical asset allocation (TAA) is a dynamic investment strategy that actively
adjusts a portfolio's asset allocation targeting short-term gains.
Option B is incorrect. Strategic asset allocation refers to setting target allocations for various asset
classes and rebalancing periodically.
Note: It can sometimes be confusing to differentiate between strategic asset allocation and securities
selection. However, remember that strategic asset allocation involves the rebalancing of the different
asset classes we have previously chosen, whereas securities selection is simply the process of selecting
the securities.
7. Which of the following is least likely a component of an Investment Policy Statement?

A. The description of the client
B. Investment constraints
C. The manger's investment style
Answer:
The manager's portfolio management style is not mentioned in an IPS.
8. An Investment Policy Statement (IPS) component regarding performance evaluation contains

which of the following?
A. The objectives of the manager
B. A benchmark
C. The standard deviation of the portfolio
Answer:
The evaluation of the performance component of an IPS provides a benchmark for portfolio return
comparison.
9. Which of the following is the appropriate reason for writing an Investment Policy Statement (IPS)?
A. It provides the investor's return goals and risk tolerance.
B. It provides details regarding the investment style of the manager.
C. It provides details of policies regarding fund management.
Answer:
An IPS provides details regarding the investor's goal in terms of risk and return.
10. Which portion of the investment policy statement is likely to contain information on leverage
limits, maximum derivative exposure and the exclusion of stocks from a particular industry?
A. The procedures section
B. The investment guidelines
C. The evaluation and review section
Answer:
The investment guidelines section contains information on how the investment policy should be
executed and includes the permissibility and exclusion of assets.
11. Which of the following is a relative risk objective?

A. Returns should not go below 18% in 6-months.
B. The total loss on the portfolio should not be more than $8 million in 6-months.
C. The returns should not be below 10% of the returns on the S&P 500 index.
Answer:
Relative risk objectives provide a relative measure of risk relative to the S&P 500, the LIBOR, etc.
12. Which of the following can not be an investment constraint for an investor?
A. Tax situation
B. Legal and regulatory constraints
C. Management fees
Answer:
Investment constraints consist of liquidity, tax situation, time horizon, legal and unique circumstances.
13. An investor directs his portfolio manager not to invest in shares of DC Oil Transporting Company
which has been accused of releasing chemical waste in the ocean. Which type of investment
constraint is it?
A. Legal and regulatory
B. Unique circumstance
C. Anti-dumping tax
Answer:
Unique circumstances constraints specify the special requirements of investors.
14. Which of the following specifies the percentage of each asset included in each asset class?
A. Investment Policy Statement (IPS)
C. Strategic asset allocation
Answer:
The strategic asset allocation specifies the percentage of each asset included in asset classes.
15. Which of the following is appropriate for a manager who deviates from strategic asset allocation
weights to take advantage of short-term opportunities?
A. Strategic asset allocation
B. Tactical asset allocation
C. Opportunistic selection
Answer:
In tactical asset allocation, the manager deviates from strategic asset allocation weights to take
advantage of short-term opportunities.
16. During the strategic asset allocation, which of the following leads to greater diversification
benefits?
A. Low correlation within the asset classes
B. Low correlation between asset classes
C. High correlation between the asset classes
Answer:
A low correlation between asset classes leads to greater diversification benefits.
17. A practice that limits the overall risk of a portfolio and allocates the portion of permitted risk to
different asset allocation strategies is known as:
A. risk budgeting.
B. risk mitigating.
C. risk seeking.
Answer:
Risk budgeting is the process that limits the overall risk of a portfolio and allocates the portion of
permitted risk to different asset allocation strategies.
18. Shaikh Hamid is 20 years old self-made millionaire who has $1 million of annual income with no
mortgages. Because of the high volatility in small-cap stocks, Hamid is unsure about his
investments in small-cap stocks. As the investment manager of Hamid, analyze his risk tolerance.
A. Hamid has a high risk ability and a high willingness to take risk.
B. Hamid has a low risk ability and a high willingness to take risk.
C. Hamid has a high risk ability and a low willingness to take risk.
Answer:
The ability to take risk depends on financial circumstances and the willingness to take risk depends on
the investor's attitude. Hamid has a high risk ability and a low willingness to take risk.
19. With respect to the Investment Policy Statement (IPS), which of the following statements is least
likely accurate?
A. The IPS is a one-time exercise undertaken at the beginning of the portfolio construction.
B. The IPS typically includes the client's investment objectives and the constraints that apply to
the client's portfolio.
C. Maintaining an IPS or any other similar document for the clients may be required by the laws
and regulations of a particular country.
Answer:
Although the IPS is the starting point of the portfolio management process, it should be reviewed on
a regular basis to ensure its consistency with the client's circumstances and requirements.
20. Which of the following sections of an Investment Policy Statement (IPS) provides relevant
information on specific types of assets that have been excluded from the portfolio?
A. Investment objectives
C. Investment guidelines
Answer:
The investment guidelines section of an IPS provides information about how the policy should be
executed and on specific types of assets excluded from the investment, if any.
21. With respect to return objectives, which of the following is the least likely accurate?
A. Return objective should be consistent with risk objective and also with the current economic
and market environment.
B. For taxable investors, only after-tax bases should be used for analyzing return.
C. Return objectives should be stated only on an absolute basis.
Answer:
Return objectives may be stated on an absolute or a relative basis. An example of an absolute objective
is achieving a particular rate of return. For a relative objective, it may be stated as relative to a
benchmark return such as the S&P 500.
22. According to the capital market theory, the optimal risky portfolio:
A. has the highest expected return
B. is the market portfolio
C. has the lowest expected variance
Answer:
The capital market theory assumes that investors employ a uniform approach while assessing various
assets on the market. It assumes that all investors have homogeneous expectations and use the same
probability distributions, inputs, and the same analytical methodologies. As a result, their valuations
are identical, and all of them invest in the optimal risk portfolio - the market portfolio.
23. Illiquid and risky investments are more suitable for an investor with which of the following
requirements?
A. The investor's huge tax liability payment is due for in six months.
B. The investor's main purpose of investment is to plan for retirement.
C. The investor has to incur expenses for his children's education in a short span of time.
Answer:
The investment objective of retirement suggests a greater time horizon as compared to the other two
options. Illiquid and risky investments may not be suitable for an investor with a short time horizon
because the investor may not have enough time to recover from losses.
24. Which of the following constitutes a legal or regulatory constraint and should be noted down in
the Investment Policy Statement (IPS) of an investor?
A. The investor has personal objections to certain companies due to the environmental impact
of business activities of those companies.
B. The investor is the director of the company and has access to material non-public
information.
C. The investor has a huge liability to outside parties and there are chances that he might be
declared insolvent in a short time.
Answer:
When an individual has access to material non-public information about a particular security, this
situation forms a legal constraint depending upon the laws of the specific country.
25. Apart from the exposures to systematic risk factors specified in the strategic asset allocation, the
returns of an investment strategy depend on which of the following other sources?
A. Tactical asset allocation
B. Security selection
C. Both A) and B)
Answer:
Both the tactical asset allocation and the selection of security play an important role in determining
the return of an investment strategy.
Quiz 11 - An Introduction to Risk Management
1. The process of adjusting the risk being taken towards the risk to be taken with the goal of
maximizing the portfolio's value is called:
A. risk measurement.
B. risk exposure.
C. risk management.
Answer:
Risk management is the process of adjusting the risk being taken towards the risk to be taken with
the goal of maximizing the company's or portfolio's value or the individual's overall utility.
2. Which of the following is least likely a goal of the risk management process?
A. Identifying the risk
B. Taking the risk to maximize the company's value
C. Minimizing the risk
Answer:
The risk management process includes identifying the risk and adjusting the risk being taken toward
the goal of maximizing the company's value. It doesn't include minimizing the risk.
3. Which of the following key factors of the risk management framework involves the quantitative
assessment of potential sources of risk and the organization's risk exposure?
A. Risk analysis and integration
B. Risk identification and measurement
C. Risk infrastructure
Answer:
Risk identification and measurement is the key element of the risk management framework that
involves the quantitative assessment of potential sources of risk and the organization's risk exposure.
4. An objective of the risk management process is to:

A. identify the risks faced by an organization.
B. eliminate the risks faced by an organization.
C. minimize the risks faced by an organization.
Answer:
The risk management process should identify an organization's risk tolerance, identify the risks it
faces, and monitor or address these risks. The goal is not to minimize or eliminate risks.
5. Features of a risk management framework least likely include:

A. establishing risk governance policies and processes.
B. taking corrective actions against employees who exceed their risk budgets.
C. monitoring the organization's risk exposures.
Answer:
Corrective actions against individuals are not specifically part of a risk management framework.
Features of a risk management framework include establishing risk governance policies, determining
risk tolerance, identifying and measuring risks, managing or mitigating risks, monitoring exposures to
risks, performing strategic risk analysis, and communicating risk levels through the organization.
6. The first step in managing an organization's risks should be to determine:

A. the organization's risk tolerance.
B. the organization's risk exposures.
C. a risk budget for the organization.
Answer:
Risk governance begins with determining the organization's overall risk tolerance.
7. Which of the following is least likely an element of the risk management framework for an
individual?
A. Risk communication
B. Risk identification and measurement
C. Risk monitoring
Answer:
As the individual is its own governance body, there is no need for risk communication. Therefore,
option A) is least likely an element of the risk management framework for an individual.
8. An organization's risk budgeting process is least likely to:

A. limit the organization's exposures to the equity, fixed income, and commodity markets.
B. use specific metrics to ensure the organization's allocation of risks remains within its overall
risk tolerance.
C. determine whether the organization needs to purchase additional insurance.
Answer:
Risk budgeting refers to allocating the total risk an organization chooses to accept among its various
assets, investments, or activities. Specifying methods for dealing with particular risks is typically
outside the scope of a risk budgeting process.
9. Examples of financial risks include:

A. credit risk, market risk, and liquidity risk.
B. solvency risk, credit risk, and market risk.
C. market risk, liquidity risk, and tax risk.
Answer:
Credit risk, market risk, and liquidity risk are examples of financial risk. Solvency risk and tax risk are
classified as non-financial risks.
10. The most likely risk tolerance activity that is conducted by the risk governance body of an
organization is:
A. selecting portfolios of acceptable risk activities.
B. producing the highest returns at any given risk level.
C. establishing the organization's risk appetite.
Answer:
Establishing the organization's risk appetite is the important risk tolerance activity conducted by the
risk governance body of an organization.
Selecting portfolios of acceptable risk activities and producing the highest returns at any given risk
level are activities that are usually conducted by the management of the organization.
11. Which of the following is the most appropriate risk tolerance definition from the enterprise risk
management perspective?
A. From the enterprise risk management perspective, risk tolerance identifies the extent to
which the enterprise is willing to lose money and incur opportunity costs.
B. From the enterprise risk management perspective, risk tolerance provides the organization-
wide risk metrics for identifying the risk tolerance level of the investors.
C. From the enterprise risk management perspective, risk tolerance is defined as quantifying and
allocating the tolerable risk using specific metrics.
Answer:
From the enterprise risk management perspective, the risk tolerance activity identifies the extent to
which the enterprise is willing to experience losses, incur opportunity costs, and fail to meet its
financial objectives.
12. Which of the following metrics measures the sensitivity of a security's returns to the returns of
the market portfolio?
A. Delta
B. Beta
C. Gamma
Answer:
Beta is the metric that measures the sensitivity of a security's returns to the returns of the market
portfolio.
13. Which of the following metrics measures the sensitivity of derivative prices to small changes in
the value of the underlying asset?
A. Beta
B. Delta
C. Vega
Answer:
Delta measures the sensitivity of derivative prices to small changes in the value of the underlying
asset.
14. An analyst has recently read a research paper developed at a renowned university which says
that the prices of derivatives are also sensitive to the changes in interest rates. If the analyst is
interested in measuring such changes, then the best metric he should use is:
A. Rho.
B. Gamma.
C. Delta.
Answer:
Rho measures the changes in the prices of derivatives given the changes in interest rates.
15. Which of the following metrics measures the sensitivity of fixed income instruments to changes
in interest rates?
A. Rho
B. Vega
C. Duration
Answer:
Duration measures the interest rate sensitivity of a fixed income instrument while Rho measures the
interest rate sensitivity of derivatives.
16. Which of the following is most appropriate for controlling the risk management function of the
organization?
A. Head of the risk committee
B. Head of the audit committee
C. Chief Financial Officer (CFO)
Answer:
The Chief Risk Officer (CRO) and the Risk Management Committee are the most appropriate for
handling the risk management functions of large organizations.
17. Which of the following is the appropriate explanation of the term ''financial risk''?
A. Financial risks are those risks that have monetary consequences.
B. Financial risks are those risks that arise from the finance department of the firm.
C. Financial risks are those risks that originate from financial markets.
Answer:
Financial risks are those risks that originate from financial markets whereas non-financial risks are
those risks that arise within the organization. Both financial and non-financial risks have monetary
consequences.
18. Which of the following is least likely a type of financial risk?

A. Credit risk
B. Solvency risk
C. Liquidity risk
Answer:
The types of financial risks include: market risk, credit risk, and liquidity risk.
Solvency risk is categorized as a non-financial risk.
19. Which of the following risks arises from a change in interest rates?
A. Credit risk
B. Solvency risk
C. Market risk
Answer:
Market risk arises from the movement in interest rates, stock prices, commodity prices, and
exchange rates.
20. Which of the following is the risk associated with an organization unable to meet its long-term
financial commitments?
A. Solvency risk
B. Credit risk
C. Liquidity risk
Answer:
Solvency refers to an enterprise's capacity to meet its long-term financial commitments.
Option B is incorrect. Credit risk refers to the risk of default on a debt that may arise from a
borrower failing to make required payments.
Option C is incorrect. Liquidity refers to an enterprise's ability to pay short-term obligations.
Question Bank - An Introduction to Risk Management
1. Which of the following statements appropriately describes the risk drivers?

I. Risk drivers are factors that influence industries and economies.
II. Risk drivers are customized frameworks for mitigating organizational risks.
III. Risk drivers are statistical metrics that measure risk.
A. Statement I only
B. Statements I & II only
C. Statements I, II & III
Answer:
Risk drivers are defined as fundamental factors that influence macro economies and industries.
2. Which of the following statements is/are least appropriate?

I. Metrics in the context of risk refer to the quantitative measures of risk exposure.
II. Probability is the measure of relative frequency with which one would expect a series of
outcomes.
III. Standard deviation is a measure of interdependence of variable quantities.
A. Statement I only
B. Statement II & III only
C. Statement III only
Answer:
Statement III is incorrect because standard deviation is defined as the measure of the dispersion in a
probability distribution.
3. Which of the following risk metrics is considered a second-order risk metric?

A. Delta
B. Vega
C. Gamma
Answer:
Gamma is considered a second-order risk metric because it reflects the rate of change in an option's
Delta per 1-point move in the underlying asset's price
4. Which of the following is the first-order risk measure of the change in the option price for a
change in the volatility of the underlying asset?
A. Gamma
B. Rho
C. Vega
Answer:
Vega is the risk metric that measures the change in the derivative's price for a change in the volatility
of the underlying asset.
5. Which of the following are two important areas in which governing bodies drive the risk
framework?
A. Defining the risk tolerance of the organization and self-insuring the governing body
B. Determining the organization's goals and defining the risk appetite/tolerance of the
organization
C. Determining the organization's goals and driving the organization away from taking risks
Answer:
The two important areas in the governing body that drive the risk framework are determining the
organization's goals and defining the risk appetite/tolerance of the organization.
6. Which of the following statements concerning risk assembling activities is most likely an example
of risk budgeting?
A. The portfolio must not include more than 55% of equities and 45% of real assets.
B. The beta of the portfolio must not be above 0.85.
C. The portfolio must invest 50% of its funds in value stocks and 50% in fixed assets with
maturities longer than 3-years.
Answer:
In risk budgeting, the risk is allocated or restricted by some risk measures like beta or VaR instead of
limiting the risk by allocating the amount of money spent.
7. Which of the following statements is/are least appropriate?

I. Metrics in the context of risk refer to the quantitative measures of risk exposure.
II. Probability is the measure of relative frequency with which one would expect a series of
outcomes.
III. Standard deviation is a measure of interdependence of variable quantities.
A. Statement I only
B. Statement II & III only
C. Statement III only
Answer:
Statement III is incorrect because standard deviation is defined as the measure of the dispersion in a
probability distribution.
8. Which of the following metrics measures the sensitivity of a security's returns to the returns of
the market portfolio?
A. Delta
B. Beta
C. Gamma
Answer:
Beta is the metric that measures the sensitivity of a security's returns to the returns of the market
portfolio.
9. Which of the following three elements are measured with the VaR risk metric?
A. The amount at risk of the total portfolio, the time period to maturity and the probability of
default
B. The amount at risk, the time period and the probability
C. The amount at risk, the time period and the sensitivity of price to the changes in volatility
Answer:
The three elements measured by the VaR are the amount at risk, the time period and the probability.
10. Which risk is most likely to disappear when you have a diversified portfolio?
A. Interest rate risk
B. Systematic risk
C. Unsystematic risk
Answer:
Unsystematic risk: The risk that is specific to an industry or firm.
Systematic risk: Also called market risk
Diversifying will not change interest rate risk.
11. A portfolio consisting of perfectly positive correlated assets:

A. has no effect of diversification.
B. minimizes unsystematic risk.
C. minimizes systematic risk.
Answer:
A portfolio consisting of perfectly positive correlated assets has no effect of diversification.
12. Which of the following is least likely an activity of the risk management framework?
A. Performing strategic risk analysis
B. Predicting expected political risk
C. Establishing risk governance policies
Answer:
Predicting political risk is NOT one of the several activities provided by the risk management
framework.
13. Risk communication across the organization is most likely part of the:
A. risk management process.
B. risk management framework.
C. risk governance.
Answer:
Risk communication concerns across the organization is one of the several activities defined in the
risk management framework.
14. Nisha Mazhar is a risk analyst, and she has been given the task to identify the factor that helps
measure her organization's risk tolerance. Which of the following factors will help Mazhar
complete her task?
A. Market demand
B. Financial strength
C. Interest rates
Answer:
Factors that determine the risk tolerance of an organization are: financial strength, ability to bear
losses, regulatory environment, ability to respond negative events and expertise in the current line
of business.
15. The process of allocating resources to different assets of an organization after considering their
risk characteristics is called:
A. risk budgeting.
B. risk analysis.
C. risk mitigation.
Answer:
Risk budgeting refers to the process of allocating resources to assets after determining its risk
characteristics.
16. Which of the following metrics is not used for risk budgeting?
A. Value at risk
B. Portfolio duration
C. Risk aversion
Answer:
Risk aversion (or neutrality) is not a metric used for risk budgeting.
17. The purpose of risk governance is to seek to manage risk in order to achieve:
A. organizational goals.
B. senior management's goals.
C. shareholders' goals.
Answer:
Risk governance seeks to manage risk to achieve the goals of the whole organization.
18. The risk associated with the uncertainty regarding the fulfillment of a contractual obligation by a
counterparty is called:
A. market risk.
B. credit risk.
C. liquidity risk.
Answer:
Credit risk is the uncertainty about whether counterparties will fulfill their obligations.
19. The non-financial risk associated with organizations is most likely called:
A. market risk.
B. tax risk.
C. interest rate risk.
Answer:
Governmental, political and tax risks are part of non-financial risks.
20. Which of the following is least likely a type of financial risk?
A. Credit risk
B. Accounting risk
C. Liquidity risk
Answer:
Financial risk is divided into three subcategories i.e. credit risk, market risk, and liquidity risk.
21. The risk that arises from incorrectly concluding that extreme events are least likely to occur than
they actually are is called:
A. environmental risk.
B. risk of natural disasters.
C. tail risk.
Answer:
It shows the risk of extreme events that are shown in the tails of the distribution are more likely to
happen than predicted.
22. Which of the following is used to measure the price sensitivity of bonds to the changes in market
interest rates?
A. Duration
B. Yield-to-maturity
C. Beta
Answer:
Duration is used to measure the price sensitivity of debt securities to the interest rate.
23. BCG Bank has a one-month Value at Risk (VaR) of $600 million with the probability of 7%, which
means:
A. a one-month maximum loss of $600 million will occur 7% of the time.
B. a one-month minimum loss of $600 million will occur 7% of the time.
C. a loss of $600 million will occur one month from now.
Answer:
VaR does not provide a maximum loss amount. It is used as a capital requirement measure for
banks.
24. Which of the following "Greeks" measures the amount that an option contract's price changes in
reaction to a change in the implied volatility of the underlying asset?
1. Rho
2. Vega
3. Gamma
Answer:
Derivatives risk measures are also referred to as "Greeks." Vega measures the sensitivity of
derivatives value to the volatility of prices of underlying assets.
25. GammaMatt Frank is an equity analyst at the Istanbul Income Fund who wants to measure the
benefits of diversification in equities portfolios. Which of the following measures serves the
purpose of measuring diversification?
A. Beta
B. Standard deviation
C. Delta
Answer:
Beta considers the benefit of diversification of equities.
Quiz 12 – Technical Analysis
1. Which of the following assumptions are true regarding technical analysis?

I. Technical analysis assumes that the Efficient Market Hypothesis holds.
II. Market prices reflect both informed and uninformed investors.
III. Technical analysis assumes that price trends and patterns tend to repeat over time.
A. Assumptions I & II
B. Assumptions II & III
C. Assumptions I & III
Answer:
Assumptions II & III are true. Assumption I is incorrect because Technical Analysis implies that the
Efficient Market Hypothesis does not hold.
2. Which of the following chart is least likely to present high and low prices along with opening and
closing prices for each specific period?
A. Candlestick charts
B. Bar charts
C. Line charts
Answer:
Line charts are the simplest charts that only shows the closing price for a specific period as a
continuous line. Bar charts and Candlestick charts show opening and closing prices with the high and
low prices for each specific period.
3. A technical analyst analyzing a stock's chart notices an increase in price but a decrease in volume.
Which of the following interpretations is he most likely to make?
A. The rally in the stock's price will persist as few sellers are willing to short-sell the stock even
at higher prices.
B. The rally in the stock's price will soon end as fewer buyers are willing to purchase at higher
prices.
C. The rally in the stock's price will persist as a new cycle of buyers will keep buying the stock
after a brief period of consolidation.
Answer:
The trading volume decreasing as prices increase is a sign that the rally will likely soon end as there
are fewer and fewer potential buyers interested in the stock at an elevated price. The trading
volume does not give any indication about the level of short selling activity and a consolidation
would only happen after a short, downward trend in the trading price of the stock.
4. Which of the following is the least likely a reversal pattern?

A. Head and shoulders pattern
B. Double top pattern
C. Triangle pattern
Answer:
A triangle pattern is a continuation pattern. Ascending triangles show an increasing trend in prices
while descending triangles show a decreasing trend in prices.
Head and shoulders patterns and double top patterns are types of reversal patterns.
5. An analyst is analyzing the relative strength of Cherry Computer's stock against the Tech 100 index.
Which of the following is the most appropriate interpretation if the relative strength has fallen
from 0.028 to 0.018?
A. Cherry Computer stock's prices are falling.
B. Cherry Computer is underperforming the Tech 100 index.
C. Cherry Computer's volume is declining in comparison to the Tech 100 index.
Answer:
The relative strength is calculated as the ratio of stock prices to some index or benchmark. A decrease
in relative strength ratio implies that the stock has underperformed the benchmark and an increasing
relative strength ratio implies that the stock has overperformed the benchmark.
6. Which of the following oscillators is most likely a momentum oscillator?

A. Bollinger Band
B. Relative Strength Index
C. Moving Average
Answer:
The relative strength index (RSI) is a momentum oscillator as it is used to determine market sentiments
regarding overbought and oversold assets.
Bollinger bands and Moving averages are price oscillators and are used to determine a trend in price.
7. Calculate the Short Interest Ratio of White Hat Inc. shares if 7,648,444 shares were sold short on
the first day of a week and the average daily trading volume is 5,699,232 shares. Assume the total
paid-up capital of White Hat is 8 million shares with a stock price of $1.
A. 0.95
B. 1.4
C. 1.34
Answer:
Short Interest Ratio = Short Interest/Average Daily trading volume = 7,648,444/5,699,232 = 1.34
8. Using the data given in the following table, calculate and interpret the TRIN ratio for KSE 100 Index.
A. The TRIN is 0.56 and it suggests there is more activity in declining stocks.
B. The TRIN is 0.69 and it suggests there is more activity in rising stocks.
C. The TRIN is 0.69 and it suggests there is more activity in declining stock.
Answer:
TRIN = (Number of advancing issues/Number of declining issues ) / (Volume of advancing
issue/Volume of declining issues) = (233/412) / (233,785,122,807/285,622,874,961) = 0.69.
Since the value is below 1, there is more activity in rising stocks.
9. Which of the following charts displays a box bounded by the opening and the closing prices?
A. Bar charts
B. Candlestick charts
C. Point and figure charts
Answer:
Candlestick charts use the same data as bar charts but display a box bounded by the opening and the
closing prices.
10. Which of the following refers to the lines based on the standard deviation of the closing prices
over the last 'n' periods?
A. Bollinger bands
B. Candlestick charts
C. Elliott wave patterns
Answer:
Bollinger bands are the lines based on the standard deviation of the closing prices over the last 'n'
periods.
11. Which of the following charts depicts a continuous line that connects the closing prices for each
period?
A. Line chart
B. Bar chart
C. Candlestick chart
Answer:
A line chart is a continuous line that connects the closing prices for each period.
12. When the prices are reaching higher highs and higher lows, this is a case of a (an):
A. uptrend.
B. downtrend.
C. neither A) nor B).
Answer:
In an uptrend, prices are reaching higher highs and higher lows.
13. If a stock's relative strength ratio increases, the stock is most likely:
A. outperforming its benchmark.
B. increasing in price.
C. increasing on high volume or decreasing on low volume.
Answer:
Relative strength is a ratio of a stock price performance to a market average (index) performance. If a
stock's relative strength ratio increases, the stock is outperforming its benchmark. This does not
necessarily mean that the stock is increasing in price. Volume is not a factor of the relative strength
ratio.
14. A momentum indicator which is based on the ratio of price increases to price decreases over the
last 30 days is most likely to be a:
A. rate of change oscillator.
B. relative strength index.
C. stochastic oscillator.
Answer:
The relative change index is calculated from the ratio of total price increases to total price decreases
over a chosen number of days.
15. An equity trader notices that the put/call ratio of stock HGE increased significantly in the last two
days. The equity trader is most likely to:
A. sell the stock.
B. buy the stock.
C. hold the stock.
Answer:
An increase in the put/call ratio indicates a bearish sentiment on the underlying asset.
Question Bank – Technical Analyses
1. Which of the following trends is most likely to exists if the prices are declining but closing at lower
highs?
A. Uptrend
B. Downtrend
C. Breakout trend
Answer:
If the prices are declining and reaching lower highs it is referred to as a downtrend.
Note: If the prices are reaching new highs and closing at higher lows, the trend is referred to as an
uptrend.
2. Which of the following statements holds true if the body of a candlestick chart is white?
I. The closing price is higher than the opening price.
II. The opening price is higher than the closing price.
III. The opening price is equal to the high price.
A. I only
B. II only
C. I & III only
Answer:
If the body of a candlestick chart is white, it implies that the closing price is higher than the opening
price.
Statement III is incorrect because if the opening price is equal to the high price, then all other prices
(including the closing price) are below the high price. The body of the candlestick must then be dark.
3. In which of the following situations will a contrarian investor purchase a security based on a
Bollinger bands analysis?
A. When the security price reaches the upper band of the Bollinger bands.
B. When the security price reaches the lower band of the Bollinger bands.
C. When the range between the upper band and the lower band of the Bollinger bands becomes
wider.
Answer:
A contrarian investor acts contrary to the market trend. When the prices of security reach the upper
band of the Bollinger bands, a contrarian sells the security, and he buys the security when the price of
the security reaches the lower band of the Bollinger bands.
4. Using the positive and negative changes in the stock price given in the following table, calculate
the Relative strength index (RSI) of the stock.
A. The RSI is 70.42 and the stock is oversold.
B. The RSI is 20 and the stock is oversold.
C. The RSI is 29.58 and the stock is overbought.
Answer:
RSI = 100 - 100 / (1 + RS)
Where RS = Average gain of up periods during the specified time frame / Average loss of down periods
during the specified time frame
Average gain of up periods during the specified time frame = ($0.09 + $0.13 + $0.05 + $0.25 + $0.14 +
$0.02 + $0.08 + $0.21 + $0.17 + $0.07)/10 = 0.12
Average loss of down periods during the specified time frame = ($0.68 + $0.42 + $0.54 + $0.31 + $0.06
+ $0.21 + $0.54 + $0.12)/8 = 0.48
RSI = 100 - 100 / (1 + 0.12/0.48) = 20
As the RSI is below 30, the stock is assumed to be oversold.
5. Which of the following most likely depicts the effect of options prices on the CBOE Volatility Index
(VIX)?
A. If Investors anticipate a decline in the general market, they increase the bid price on put
options which increases the VIX level.
B. If Investors anticipate a decline in the general market, they decrease the bid price on put
C. If Investors anticipate a decline in the general market, they increase the bid price on call
Answer:
If market participants are fearful of a decline in the overall market, they increase the bid price on puts
in order to hedge their portfolios. This increase in put options prices increases the put/call ratio and,
therefore, increases the level of the VIX.
6. As a technical analyst, you have been given the following information regarding the stock of New
Nirja Ltd.:
1. The 20-day moving average crosses the 90-day moving average of a stock price from above.
2. The TRIN ratio is 1.1.
3. The RSI is 73.42.
The most likely investment strategy for the given asset is to:
A. buy the asset.
B. short-sell the asset.
C. hold the asset.
Answer:
The 20-day moving average crossing the 90-day moving average from above implies a death cross
which suggests a bearish trend. The TRIN ratio above 1 suggests that there is more activity in declining
stocks than in advancing stock which again depicts a bearish trend. An RSI above 70 also implies a
bearish trend. Since all indicators suggest a bearish trend, an analyst should sell the asset.
7. An equity analyst computes the moving averages for three different time periods– the 5-day
exponential moving average, the 20-day simple moving average, and the 50-day simple moving
average. Which of the following statements is most accurate?
A. When the 5-day exponential moving average crosses the 50-day simple moving average
from below, it indicates an uptrend in the stock.
B. When the 50-day simple moving average crosses the 20-day simple moving average from
below, it indicates an uptrend in the stock.
C. When the 5-day exponential moving average crosses the 20-day simple moving average from
above, it indicates an uptrend in the stock.
Answer:
Whenever a smaller period moving average crosses a larger period moving average from below, it
indicates an uptrend. Conversely, whenever a smaller period moving average crosses a larger period
moving average from above, it indicates a downtrend.
8. An inverted head-and-shoulders pattern signals a:

A. reversal pattern, and the security price is likely to increase.
B. reversal pattern, and the security price is likely to decrease.
C. continuation pattern, and the security price is likely to increase.
Answer:
A head-and-shoulders is a reversal pattern, and the security price is likely to decrease. An inverted
head-and-shoulders pattern is also a reversal pattern, but it suggests that the security price is likely to
increase.
9. If the Relative Strength Index (RSI) indicates a high value, then:

A. it is an indication to go long.
B. it is an indication to go short.
C. none of the above.
Answer:
A high RSI index indicates that the market is overbought, and the share prices may fall.
10. Which of these is not a commonly used technical analysis pattern?

A. Head and shoulders
B. Ascending flag
C. Short buffalo wings
Answer:
''Short buffalo wings'' is not a technical analysis pattern.
11. Select the correct statement:
A. A candlestick chart displays the opening and closing price.
B. A candlestick chart displays the opening and closing price as well as the highest and lowest
price.
C. A candlestick chart displays the highest and lowest price.
Answer:
A candlestick chart displays opening and closing prices as well as the highest and lowest price of a
stock for a particular time frame.
12. A change in polarity happens:

A. when a stock trends downwards and then starts trending upwards, or vice-versa.
B. when a resistance level or support level is breached, they reverse their role, or vice-versa.
C. when a resistance level or support level is met, it is always breached.
Answer:
A change in polarity happens when a resistance level or support level is breached, they reverse their
role, or vice-versa.
13. A technical analyst finds that ABC stock has a head and shoulders pattern with the peak being at
$75, the neckline at $66 and shoulders around $70. On today's trading session, the stock breaches
$66 to the downside. What is the most probable outcome the analyst predicts for the stock?
A. The stock will rebound to $70
B. The stock will rebound to $75
C. The stock will keep going down to $57
Answer:
Once the stock breaches the neckline in a head and shoulders pattern, the size of the down move is
believed to be equal to the difference between the peak (head) and the neckline.
Given that ($75 - $66 = $9), the stock will most likely keep going down to ($66 - $9) = $57.
14. In the last three months, ABC stock has gone up four times to 100 but has never breached it. A
technical analyst would say 100 in ABC is a:
A. resistance level.
B. support level.
C. change in polarity.
Answer:
A resistance level is a chart point or range that caps an increase in the level of a stock or index over a
period of time.
Quiz 12 – FinTech in Investment Management
1. Fintech is most accurately described as:

A. the application of technology to the financial services industry.
B. the replacement of government-issued money with electronic currencies.
C. the clearing and settling securities trades through distributed ledger technology.
Answer:
Fintech refers to the application of technology to the financial services industry and to companies
that are involved in developing and applying technology for financial services. Cryptocurrencies and
distributed ledger technology are examples of fintech-related developments.
2. Which of the following technological developments is most likely to be useful for analyzing Big
Data?
A. Machine learning.
B. High-latency capture.
C. The Internet of Things.
Answer:
Machine learning is a computer programming technique useful for identifying and modeling patterns
in large volumes of data. The Internet of Things refers to the network of devices that is one of the
sources of Big Data. Capture is one aspect of processing data. Latency refers to the lag between
when data is generated and when it is needed. (LOS 43.b)
3. A key criticism of robo-advisory services is that:

A. they are costly for investors to use.
B. the reasoning behind their recommendations can be unclear.
C. they tend to produce overly aggressive investment recommendations.
Answer:
One criticism of robo-advisory services is that the reasoning behind their recommendations might
not be readily apparent to customers. Recommendations from robo-advisors tend to be
conservative rather than aggressive. Low cost is a primary advantage of robo-advisors. (LOS 43.c)
4. Which of the following statements about distributed ledger technology is most accurate?
A. A disadvantage of blockchain is that past records are vulnerable to manipulation.
B. Tokenization can potentially streamline transactions involving high-value physical assets.
C. Only parties who trust each other should carry out transactions on a permissionless
network.
Answer:
By enabling electronic proof of ownership, tokenization has the potential to streamline transfers of
physical assets such as real estate. The high cost and difficulty of manipulating past records is a
strength of blockchain technology. Permissionless networks do not require trust between the parties
to a transaction because the record of a transaction is unchangeable and visible to all network
participants.
5. Alternative data refers to:
A. Data used for investment analysis arising from external sources, including financial
statements and management presentations of comparable entities
B. Data used by investors to evaluate a company or product that is not related to financial
statements
C. Data used by investors for investment analysis that is not within their traditional sources
Answer:
Alternative data, also known as non-traditional data, refer to data types generated by the use of
electronic devices, social media, satellite and sensor networks, and company exhaust. Alternative
data helps investors get more granular and faster insights into company performance compared to
traditional data sources.
6. What are the required elements for distributed ledger technology to work?
A. A block chain to provide secure and valid achievement
B. Peer-to-peer network
C. Clearly defined asset classes for exchange
Answer:
A distributed ledger (also called a shared ledger, or referred to as distributed ledger technology) is
digital data that is consensually replicated, shared, and synchronized across multiple sites, countries,
or institutions. The elements required for DLT to work include a digital ledger, a peer-to-peer network,
and a consensus algorithm used to confirm new entries. A block chain system is a form of distributed
ledger design in which information, such as changes in ownership is recorded sequentially within
blocks that are then linked through cryptography. But not all distributed ledgers have to employ a
chain of blocks to attain consensus and synchronization.
7. In machine learning, overfitting describes a situation where:

A. A statistical model describes random error or noise instead of the underlying relationship
B. A statistical model reveals false or unsubstantiated patterns that lead to prediction errors
C. All of the above
Answer:
In machine learning, when a statistical model describes random error or noise instead of the
underlying relationship, "overfitting" occurs. In other words, the model has been "overtrained" and
treats random error or noise as a true parameter that has a significant effect on the output. As a result,
the model may discover false relationships or unsubstantiated patterns that will lead to prediction
errors and incorrect output forecasts.
8. Supervised learning differs from unsupervised learning in that supervised learning requires
A. at least one input attribute.
B. input attributes to be categorical.
C. at least one output attribute.
Answer:
In supervised learning, computers learn to model relationships based on labeled training data. Both
inputs and at least one output are labeled, or identified, for the algorithm. In unsupervised learning,
computers are not given labeled data but instead are given only data from which the algorithm seeks
to describe the data and their structure.
9. Supervised learning and unsupervised learning both require at least one

A. hidden attribute.
B. output attribute.
C. input attribute.
Answer:
In supervised learning, computers learn to model relationships based on labeled training data. Both
inputs and at least one output are labeled for the algorithm. In unsupervised learning, computers
are not given labeled data but instead are given only input data. The algorithm then seeks to
describe the data and its structure.
Further Explanation:
Supervised learning is where you have input variables (x) and an output variable (Y) and you use an
algorithm to learn the mapping function from the input to the output.
Y = f(X)
The goal is to approximate the mapping function so well that when you have new input data (x) that
you can predict the output variables (Y) for that data.
Unsupervised learning is where you only have input data (X) and no corresponding output variables.
The goal for unsupervised learning is to model the underlying structure or distribution in the data in
order to learn more about the data.
10. The big data revolution witnessed in the last 50 years is down to:
A. Exponential increase in the amount of data available
B. Increase in computing power and data storage capacity, at affordable cost
C. All of the above
Answer:
The growth in big data and the machine learning revolution can be traced down to:
The availability of new datasets previously unavailable, such as sensor data from satellites,
online activity of individuals, and the internet of things.
Advancement in computing power and data storage capacity (From kilobytes to petabytes)
Advancement in Machine Learning methods to analyze complex datasets, including
programming languages such as Python, Java, SQL, etc.
11. Which of the following is an application of NN (Neural Network)?

A. Credit card fraud detection
B. Stock Market Prediction/Stock Market Index Prediction
C. All of the above
Answer:
Neural networks are algorithms that try to emulate certain aspects of the functioning of the human
brain. The basic structure of an ANN consists of artificial neurons that are grouped into layers. This
gives them unique self-training ability to make forecasts based on historical data. Also, by studying
historical credit card charges, these algorithms can detect abnormal charges (fraudulent
deductions).
12. Richard Gove, CFA, wishes to undertake an extensive analysis of companies in the petroleum
industry in an attempt to identify suitable investment opportunities. At hand are company
filings, quarterly earnings calls, written reports, audio records of investor briefings, and social
media posts. Which of the following forms of analysis is he most likely to undertake?
A. Deep learning
B. Text analytics
C. Supervised learning
Answer:
Text analytics is the use of computer programs to analyze and derive meaning typically from large,
unstructured text- or voice-based datasets. By structuring the input text, the analyst will be able to
derive patterns and trends. That way, the best performing entities can be singled out.
13. Which of the following applications of Distributed Ledger Technology is best suited to streamline
real estate transactions?
A. Tokenization
B. Blockchain
C. Cryptocurrencies
Answer:
Through tokenization, ownership of real estate assets can be converted into digital tokens that can
facilitate trading and recording of all transactions.
14. A correct description of artificial intelligence is that:

A. It encompasses more advanced systems that are able to analyze information and make
decisions based on machine-learning logic.
B. Its goals are very different from those of machine learning.
C. It terminates the need for human input in investment analysis.
Answer:
Fintech encompasses more advanced systems that are able to analyze information and make
decisions based on machine-learning logic. Machines that "learn" how to perform tasks over time
have been developed. The use of such systems has brought about high levels of inefficiency that
surpass human capabilities.
Option B is incorrect. Fintech encompasses both Artificial intelligence (AI) and machine learning
(ML), and the two have goals that are largely similar - chief among them being to create new and
innovative products and services.
Option C is incorrect. It’s widely accepted that AI and ML techniques are not self-sufficient. Human
input is still an integral part of investment analysis.
Quiz 13 - Market Organization and Structure
1. The main functions of the financial system least likely include:

A. preventing investors from generating abnormal profits by trading on information.
B. bringing together savers and borrowers.
C. allocating financial resources to their most productive uses.
Answer:
One of the purposes of the financial system is to allow investors to trade on (public) information.
Other purposes of the financial system include allocating financial capital to its most productive
uses, and bringing together those who wish to save with those who wish to borrow.
2. A securities exchange where traders buy and sell long-term government bonds from and to other
traders would best be described as part of the:
A. capital market.
B. primary market.
C. money market.
Answer:
The exchange can be described as part of the secondary capital markets. A security is first issued in
the primary market, and then it trades among investors in the secondary market. The money market
refers to the market for short-term debt instruments (usually with maturities of less than one year)
such as T-bills.
3. In contrast with a typical forward contract, futures contracts have:

A. greater counterparty risk.
B. standardized terms.
C. less liquidity.
Answer:
Futures are forward contracts that trade on exchanges and have standardized terms, in contrast
with forward contracts, which are customized instruments. A futures clearinghouse reduces
counterparty risk by guaranteeing the performance of buyers and sellers. Futures contracts trade on
organized exchanges and are more liquid than forward contracts.
4. Financial intermediaries that issue securities which represent interests in a pool of similar
financial assets are best characterized as:
A. block brokers.
B. securitizers.
C. arbitrageurs.
Answer:
Securitizers are financial intermediaries that assemble large pools of similar financial assets, such as
mortgages or loans, and issue securities that represent interests in the pool.
Block brokers assist their clients with large trades of securities.
Arbitrageurs simultaneously buy and sell the same asset in different markets to take advantage of
different prices for the same asset.
5. An investor can profit from a stock price decline by:
A. selling short.
B. purchasing a call option.
C. placing a stop buy order.
Answer:
Short selling provides a way for an investor to profit from a stock price decline. In order to sell short,
the broker borrows the security and then sells it for the short seller. Later, if the investor can replace
the borrowed securities by repurchasing them at a lower price, then the investor will profit from the
transaction.
6. Which of the following statements about securities markets is least accurate?
A. In a continuous market, a security can trade any time the market is open.
B. A market that features low transactions costs is said to have operational efficiency.
C. Initial public offerings (IPOs) are sold in the secondary market.
Answer:
IPOs are sold in the primary market.
7. A market that directs capital to its most productive use is best described as:
A. operationally efficient.
B. informationally efficient.
C. allocationally efficient.
Answer:
Markets are said to be allocationally efficient when capital is directed to its most productive uses.
Operationally efficient markets are those that have low trading costs. Informationally efficient
markets are those in which security prices reflect all information associated with fundamental value
in a timely fashion.
8. An objective of financial market regulation is to:

A. reduce information gathering costs by requiring common financial reporting standards.
B. prevent uninformed investors from participating in financial markets.
C. ensure that inside information is made public in a timely manner.
Answer:
One of the objectives of market regulation is to require firms to report their financial performance
according to a single set of standards, such as those of the IASB or FASB, thereby reducing market
participants' cost of gathering information. Market regulation is not designed to prevent uninformed
investors from trading, but to protect unsophisticated investors and thereby preserve trust in the
financial markets. An objective of market regulation is to prevent those with non-public information
from profiting at the expense of other investors, but not necessarily to make all inside information
public.
9. Which of the following least likely reduces the hedging benefits of forward contracts?
A. Counterparty risk
B. Illiquidity
C. Market risk
Answer:
Forward contracts are exposed to counterparty risk. Additionally, forward contracts have low
liquidity. These two features reduce the hedging benefits of forward contracts.
10. As the portfolio manager of an equity fund, you decide to allocate a percentage of the fund’s
capital to invest in the common stock of ABC after its share price plummeted on lower-than-
expected earnings. You believe that ABC’s stock is currently undervalued due to an overreaction
of the market to the earnings announcement. In this instance, you were using the financial system
for:
A. Saving
B. Managing Risk
C. Information-Motivated Trading
Answer:
You were acting as an information-motivated trader because you traded with the intention of
earning excess profit from information that had not been priced into the market.
11. A direct investment in an industrial warehouse is an example of a:

A. Contract
B. Security
C. Real asset
Answer:
Since the investment is in a tangible property (real estate), it would be considered a real asset.
12. Louis Reed, a wheat farmer, wants to protect himself against the risk of falling wheat prices
without sacrificing all the upside if wheat prices spike. What should Reed most likely do to
achieve this goal?
A. Sell futures contracts
B. Buy call options
C. Buy put options
Answer:
The sale of futures contracts would successfully hedge against declining wheat prices but would
obligate Louis Reed to sell at the agreed-upon price even if market prices were higher at the time.
The purchase of call options would allow him to capture more upside if wheat prices increased while
still leaving him fully exposed if prices fell. The purchase of put options would allow Reedto sell his
wheat at a set price without obligating him to do so in the event that the market price exceeded the
strike price at the time of maturity.
13. If a corporation wants to protect against potential losses from fire damage to a newly constructed
factory, it would most likely make use of what financial intermediaries?
A. Arbitrageurs
B. Investment banks
C. Insurance companies
Answer:
The corporation could effectively hedge against this risk by buying a fire insurance policy from an
insurance company.
14. A trader submits a buy order at the beginning of the day on 10,000 shares of a stock trading at
$48 per share. The stock gradually rises to $52 per share by market close. The trader acquired
5,000 shares of the stock over the day at a price between $50 and $51 per share, and the order
was still valid when the market opened the next day. What order did the trader most likely
submit?
A. Day, stop 50, limit 51 buy order
B. GTC, stop 48, limit 51buy order
C. GTC, stop 50, limit 51 buy order
Answer:
Since no shares were purchased at prices between $48 per share and $50 per share, it’s unlikely the
trader had a stop order at $48. Given that the order was not canceled at the end of the day, it could
not be a day order. Therefore, the most likely option is GTC, stop 50, limit 51 buy order.
15. What market would an art collector use to sell a number of valuable paintings?
A. Quote-driven market
B. Order-driven market
C. Brokered market
Answer:
Since there would not be enough liquidity for unique art pieces to have a quote-driven or order-
driven market, the paintings would need to be sold in a brokered market.
16. An investor bought a stock on margin. The margin requirement was 60%, the current price of the
stock is $80, and the stock price was $50 one year ago. If margin interest is 5%, how much equity
did the investor have in the investment at year-end?
A. 60.6%.
B. 73.8%.
C. 67.7%.
Answer:
Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1.
Equity % = [Value - (margin debt + interest)] / Value
$80 - $21 / $80 = 73.8%
17. An investor sold a stock short and is worried about rising prices. To protect himself from rising
prices he would place a:
A. stop order to sell.
B. limit order to buy.
C. stop order to buy.
Answer:
A limit order to buy is placed below the current market price.
A limit order to sell is placed above the current market price.
A stop (loss) order to buy is placed above the current market price.
A stop (loss) order to sell is placed below the current market price.
A stop order becomes a market order if the price is hit.
18. An investment bank offers its customers the option to carry out leveraged trades. If the investors
are required to maintain a margin of 20% and pay a commission of 0.25% of the trade value, then
the leverage ratio for the trade is closest to:
A. 5.
B. 4.94.
C. 5.06.
Answer:
Leverage ratio = 1/(Margin requirement) = 1/20% = 5
19. An equity analyst tracks the Information Technology (IT) sector. His analysis indicates that Value
Information Technology Limited has excellent growth prospects. However, he concludes that its
shares are currently slightly overvalued. If the analyst wants to buy the shares, he is most likely
to place a:
A. limit order.
B. market order.
C. immediate or cancel order.
Answer:
The analyst concludes that the stocks are currently overvalued; therefore he is most likely to
place a limit buy order so that the shares can be acquired at a lower price.
20. An investment bank offers its customers the option to carry out leveraged trades. The investors
are required to maintain a margin of 30% and pay a commission of 0.25% of the trade value. If
an investor intends to carry out a trade of 2,000 shares, each with a price per share of $30, the
total investment required for the trade is closest to:
A. $16,150.
B. $17,150.
C. $18,150.
Answer:
Total funds required to acquire the shares = 2,000 * $30 = $60,000
Margin required for the trade = $60,000 * 30% = $18,000
Commission = $60,000 * 0.25% = $150
Total investment required for the trade = $18,000 + $150 = $18,150
Question Bank - Market Organization and Structure
1. When investing in the stock markets, what is most likely the initial margin?
A. The minimum amount of equity required by an investor
B. The total value of the investment
C. The total value of the portfolio
Answer:
The initial margin is the minimum amount of equity required by an investor.
2. A stop-sell order is often placed when a trader:

A. wants to limit the loss on a long position.
B. wants to enter a long position.
C. wants to double down on a long position.
Answer:
With a stop order, your trade will be executed only when the security you want to buy or sell reaches
a particular price (the stop price). Also known as a "stop-loss order," this allows you to limit your
losses.
Tip: You could think of a stop-sell order as a stop-loss.
3. An investor buys 100 shares of a stock on margin at $146 a share using an initial leverage ratio of
2. At what stock price will he receive a margin call if the maintenance margin requirement for
the position is 40%?
A. $58.40
B. $116.80
C. $121.67
Answer:
Leverage ratio = 1/2 = 0.5
Initial equity per share = 0.5 * $146 = $73
($73 + P - $146)/P = 0.40
$73 + P - $146 = 0.40P
$73 - $146 = -0.60P
-$73 = -0.60P
P = 121.67
4. A stock is selling for $50. An investor's valuation model estimates its intrinsic value to be $40.
Based on his estimate, he would most likely place a:
A. short-sale order.
B. stop order to buy the security.
C. market order to buy the security.
Answer:
If the investor believes the stock to be overvalued, the investor should place a short-sale order.
5. Which assets give its owner the right to buy or sell an asset at a specific exercise price at some
specified time in the future?
A. An option contract
B. A swap contract
C. A forward contract
Answer:
An option contract gives its owner the right to buy or sell an asset at a specific exercise price at some
specified time in the future.
6. Which of the following does not act as a financial intermediary?

A. Brokers
B. Insurance companies
C. Issuers
Answer:
Broker and insurance companies act as financial intermediaries, but not issuers.
7. A financial intermediary buys a stock and then resells it a few days later at a higher price. Which
intermediary would this most likely describe?
A. A broker
B. A dealer
C. An arbitrageur
Answer:
A dealer buys an asset for its inventory in the hopes of reselling it later at a higher price. Notes: Brokers
stand between buyers and sellers of the same security at the same location and time.
Arbitrageurs trade the same security simultaneously in different markets.
8. Which of the following would least likely be an objective of market regulations?

A. Reducing accounting standards
B. Making it easier for investors to compare the performance of different firms
C. Preventing investors from using inside information in securities trading
Answer:
Market regulation should require financial reporting standards so that information gathering is less
expensive and the informational efficiency of the markets is enhanced.
9. Which of the following is most similar to a short position in the underlying asset?
A. Buying a put
B. Writing a put
C. Buying a call
Answer:
Buying a put is most similar to a short position in the underlying asset because the put increases in
value if the underlying asset value decreases.
10. Which of the following orders would most likely go unexecuted?

A. A marketable limit order
B. A short sale order above the market price
C. A market order
Answer:
A short sale above the market would least likely be executed because if the price doesn't rise, the
order will go unexecuted.
Note: A market order will always be executed and a marketable limit order is most likely to be
executed than option B).
11. A small investor just bought 100 shares of UYA on margin. The share price of UYA at the time of
purchase was $50, the initial margin requirement is 50%, and the maintenance margin is 30%.
Given this information, the margin call trigger price is closest to:
A. $31.25.
B. $79.
C. $35.71.
Answer:
Trigger price = Initial purchase price * ((1 - Initial margin) / (1 - Maintenance margin))
= ($50 * (1 - 0.5)) / (1 - 0.3) = $35.71
The investor will receive a margin call when the stock price falls to $35.71.
12. What is the 'leverage ratio' in equity investments?

A. The ratio of the amount borrowed over the book value of the investment.
B. The ratio of the value of the position to the value of the equity investment in it.
C. The ratio of the long position over the total value of the position.
Answer:
The maximum leverage ratio for a position financed by a margin loan equals one divided by the
minimum margin requirement.
13. Which of the following is least accurate regarding efficient markets?
A. In an efficient market, securities may be mispriced, and trading these securities can offer
positive risk-adjusted returns.
B. In an efficient market, it is difficult to find inaccurately priced securities.
C. In an efficient market, the time frame required for security prices to reflect any new
information is very short.
Answer:
An informationally efficient market (an efficient market) is one where security prices adjust rapidly to
reflect any new information. Option A) reflects an inefficient market. In such a market, an active
investment strategy may outperform a passive strategy on a risk-adjusted basis.
14. Which of the following statements is most likely accurate?

A. Fill or kill (FOK) orders are the same as good-on-close orders.
B. Immediate or cancel (OIC) orders are good only unless they are immediately placed by the
investor.
C. Good-on-close orders are also called market-on-close orders.
Answer:
Immediate or cancel orders are also known as fill or kill orders in some markets. They are good only
upon receipt by the broker or exchange. Good-on-close orders are also called market-onclose orders.
They can be filled at the close of trading.
15. Which of these agents provide brokerage services to large traders?

A. Block Brokers
B. Large Enterprise Brokers
C. Trade Brokers
Answer:
Block Brokers provide brokerage services to large traders. It is sometimes difficult to fulfill large orders,
as there are not many potential counterparties for large trades. In order to induce counterparties to
trade, large buy orders generally execute at a premium, while large sell orders generally trade at a
discount to market prices.
16. Which of the following is least likely a function of the financial system?
A. Allocate capital efficiently
B. Determine inflation rates
C. Allow entities to save and borrow money
Answer:
The three main functions of the financial system are to allow entities to save and borrow money,
allocate capital efficiently and determine the interest rates, not inflation rates.
17. When is a financial system best at performing its roles?

A. When the markets are illiquid
B. When transaction costs are low
C. When information is not readily available
Answer:
A financial system performs at its best when markets are liquid, transaction costs are low, and
information is readily available.
18. Markets of immediate delivery are referred to as:

A. spot markets.
B. secondary markets.
C. capital markets.
Answer:
Spot markets are markets of immediate delivery.
19. Which of the following statements regarding block brokers is correct?

A. Block brokers are involved in placing large orders.
B. Block brokers do not conceal the intentions of their clients which helps in moving the market.
C. Both statements A) and B) are correct
Answer:
Block brokers help with the placement of large trades. They conceal the clients' intentions, so the
market does not move against them.
20. An oil producer is worried that the price of crude oil may decrease in the near future. To hedge
his risk, the crude oil producer must:
A. sell a forward crude oil contract.
B. buy a forward crude oil contract
C. buy a futures crude oil contract.
Answer:
As the oil producer anticipates a drop in oil prices, he must sell a forward contract to secure today’s
oil price.
21. Which of the following will buy the asset from one market and sell it in another market without
taking any risk?
A. A primary dealer
B. An arbitrageur
C. A broker-dealer
Answer:
Arbitrageurs will buy assets from one market and sell them in another market without taking any
risk.
Discrepancies in prices can occur due to time differences or geographic differences in markets.
22. A trade in which an investor borrows funds from a broker to buy assets is called a:
A. short position.
B. long position.
C. leveraged position.
Answer:
In a leveraged position, an investor borrows funds from its broker to buy assets. The interest rate paid
on these funds is called the call money rate.
23. Muhammad Umar is a fund manager who wants to purchase 5,000 stocks of Wellington Inc. at
the current price of $92. If the initial margin required to open up a leveraged position is 35%,
calculate the leverage ratio.
A. 3.10
B. 2.86
C. 4.45
Answer:
The leverage ratio is calculated by dividing 1 by the initial margin required to execute leverage trade.
Leverage ratio: 1/0.35 = 2.86.
24. An equity analyst tracks the Information Technology (IT) sector. His analysis indicates that Value
Information Technology Limited has excellent growth prospects. However, he concludes that its
shares are currently slightly overvalued. If the analyst wants to buy the shares, he is most likely to
place a:
A. limit order.
B. market order.
C. immediate or cancel order.
Answer:
The analyst concludes that the stocks are currently overvalued; therefore he is most likely to place a
limit buy order so that the shares can be acquired at a lower price.
25. Which of the following least likely reduces the hedging benefits of forward contracts?
A. Counterparty risk
B. Illiquidity
C. Market risk
Answer:
Forward contracts are exposed to counterparty risk. Additionally, forward contracts have low
liquidity. These two features reduce the hedging benefits of forward contracts.
Quiz 14 - Security Market Indices
1. Which of the following is least likely required when defining a security market index? The:
A. target market the index will represent.
B. number of securities in the index.
C. weighting method for the index.
Answer:
A market index does not necessarily have to consist of a fixed number of securities. For example,
some indices are defined to include all the stocks that trade on a certain exchange, a number that
can vary over time.
2. Which of the following weighting schemes will produce a downward bias on the index due to the
occurrence of stock splits by firms in the index?
A. Market-cap weighted series.
B. Equal weighted price indicator series.
C. Price-weighted series.
Answer:
The price-weighting scheme sums the market price of each of the stocks contained in the index and
then divides this sum by the number of stocks in the index. Thus if a firm executes a stock split thereby
reducing its share price, this will cause a downward bias in the index.
3. The most appropriate benchmark for measuring the relative performance of an investment
manager is:
A. an index that closely matches the manager's investment approach.
B. a broad market index.
C. the risk-adjusted return on the market portfolio.
Answer:
An index chosen as a benchmark for an investment manager's performance should include securities
in the manager's investment universe. For example, the performance of an emerging market bond
fund manager should be measured relative to the performance of an emerging market bond index.
4. Which of the following weighted indices is most likely yo be rebalanced every period?
A. Market capitalization weighted index
B. Equal-weighted index
C. Price-weighted index
Answer:
Equal weighted index needs rebalancing every period with unequal changes in the security prices.
The market capitalized weighted indices and price-weighted indices get rebalanced automatically
with the change in prices.
5. An index was recently begun with the following two stocks:

Company A - 50 shares valued at $2 each.
Company B - 10 shares valued at $10 each.
Given that the value-weighted index was originally set at 100 and Company A's stock is currently
selling for $4 per share while Company B's stock is still at $10 per share, what is the current value
of the price-weighted index and the market-cap-weighted index?
Price-weighted Market-cap-weighted
A. 8 150
B. 7 150
C. 7 300
Answer:
Price weight = [(4) + (10)] / 2 = 7
Market-cap weight =
[(4)(50) + (10)(10)] / [(2)(50) + (10)(10)](100) = 150
6. An equity index comprised of value stocks, identified by their price-to-earnings ratios, is best
described as a:
A. style index.
B. sector index.
C. fundamental weighted index.
Answer:
An index of value stocks is an example of a style index. Sector indexes measure the performance of
securities in specific industries or industry sectors. Fundamental weighting is used to weight indexes
by a factor such as the size of the firms or economies represented in the index.
7. Ken Miller, CFA, wants to compare the returns on government agency bonds to the returns on
corporate bonds. Peg Egan, CFA, wants to compare the returns on high yield bonds in developed
markets to the returns on investment grade bonds in emerging markets. Which of these analysts
is most likely able to use bond indexes for their analysis?
A. Only one of these analysts.
B. Both of these analysts.
C. Neither of these analysts.
Answer:
Because of the wide universe of bonds that trade in financial markets, indexes are available (or can
be constructed) based on virtually any feature or classification of bonds.
8. A Finance student wants to create an index with the stock he bought in a paper trading account.
The notes from his record show the following:
Initial price - Stock A: $10; Stock B: $15
Current price - Stock A: $15; Stock B: $30
Assuming an initial index value of 105, the equal-weighted index value for the two stocks is now
closest to:
A. 150.
B. 183.75.
C. 125.5.
Answer:
Price change in Stock A: (15 - 10) / 10 = 50%
Price change in Stock B: (30 - 15) / 15 = 100%
Percentage change in the index: (50% + 100%) / 2 = 75%
New index value = 105 * (1 + 75%) = 183.75
9. Which of the following is least likely the use of a market index?

A. A benchmark for measuring the performance of portfolios
B. A measure of beta and risk-adjusted returns
C. A reflection of the management's sentiment of the companies whose securities are included
in the index
Answer:
The market index reflects the confidence of investors, not the confidence of the management.
10. A stock is said to be overvalued if its market price is:

A. less than its book value.
B. less than its intrinsic value.
C. greater than its intrinsic value.
Answer:
A security with a market price greater than its intrinsic value is overvalued.
11. Adjusting the weights of the constituent securities in the index is known as:
A. reconstitution.
B. rebalancing.
C. readjustment.
Answer:
This is to maintain the weight of each security consistent with the index's weighting method.
12. Which of the following is least likely used in the calculation of the return on security market
indices?
A. Price returns
B. After-tax returns
C. Total returns
Answer:
Index returns are calculated using price indices or return indices. Price indices only consider prices of
constituent securities and return indices include the price and the income from constituent securities.
13. Determine the most likely disadvantage of price-weighted indices.

A. Its construction is too simple.
B. The percentage changes in the price of low-priced securities have a greater impact.
C. The percentage changes in the price of high-priced securities have a greater impact.
Answer:
The drawback of a price-weighted index is percentage changes in the price of high-priced securities
have a greater impact on index values than percentage changes in the price of lowpriced securities.
14. Which of the following index weighting method is based on earnings, dividend or cash flow?
A. Price weighting
B. Fundamental weighting
C. Equally weighting
Answer:
Fundamental weighting uses weights based on fundamentals like earnings, dividend or cash flow.
15. Which of the following activities involves adding and subtracting the securities that make up an
index?
A. Rebalancing
B. Reconstructing
C. Repricing
Answer:
The reconstruction of an index is the process of periodically adding and subtracting securities that
make up the index.
Those securities that no longer meet the criteria of the index are replaced by new ones.
Question Bank – Security Market Indices
1. Last year, the S&P 500 has had the following returns: 2% in the first quarter, -3% in the second
quarter, 5% in the third quarter, and 11% in the last quarter of the year. The S&P 500's yearly
return is closest to:
A. 11%.
B. 14.2%.
C. 15.31%.
Answer:
Yearly return = (1 + 2%)(1 - 3%)(1 + 5%)(1 + 11%) - 1 = (1.02)(0.97)(1.05)(1.11) - 1 = 15.31%
2. A Dow Jones ETF was $117 exactly one year ago. It is now at $128 and has paid a $3 dividend. The
Dow Jones ETF's price return is closest to:
A. 8.6%.
B. 9.4%.
C. 11.9%.
Answer:
Price return doesn't include dividend payment. (Only the total return includes it)
(128-117)/117 = 9.4%
3. A price-weighted index is composed of 3 stocks. Stock A is trading at $221, stock B at $51 and
stock C at $42. One year later, stock A is now worth $159, stock B is $71, and stock C is $45. The
total return for this index is closest to:
A. -14.18%.
B. -12.42%.
C. 14.18%.
Answer:
T0 = ($221 + $51 + $42) / 3 = 104.6667
T1 = ($159 + $71 + $45) / 3 = 91.6667
Total return = (91.6667 - 104.6667) / 104.6667 = -12.42%
4. An equal-weighted index is composed of 3 stocks. Stock A is trading at $53, stock B at $75 and
stock C at $81. One year later, stock A is now worth $41, stock B is $76, and stock C is $128. The
total return for this index is closest to:
A. 12.34%.
B. 81.99%.
C. 166.50%.
Answer:
In an equal-weighted index, we assume that we put the same amount of money in each stock.
Stock A's return = (41 - 53) / 53 = -22.64%
Stock B's return = (76 - 75) / 75 = 1.33%
Stock C's return = (128 - 81) / 81 = 58.02%
Equal-weighted return = (-22.64% + 1.33% + 58.02%) / 3 = 12.34%
5. A capitalization-weighted index is composed of 2 stocks. Stock A is trading for $75, and stock B is
trading for $51. If there are 6 million shares outstanding in stock A, and 13 million shares
outstanding in stock B, then the index value is closest to:
A. 47.59.
B. 58.58.
C. 60.70.
Answer:
Stock A's market capitalization = $75 × 6,000,000 shares = $450,000,000
Stock B's market capitalization = $51 × 13,000,000 shares = $663,000,000
Index value = $75 × 450,000,000 / (450,000,000 + 663,000,000) + $51 × 663,000,000 /
(450,000,000 + 663,000,000)
Index value = 30.32 + 30.38 = 60.70
6. An index provider maintains a price index and a total return index for the same 40 stocks.
Assuming both indexes begin the year with the same value, the total return index at the end of
the year will be:
A. less than the price index if the price index increases and greater than the price index if the
price index decreases.
B. equal to the price index if the constituent stocks do not pay dividends.
C. greater than the price index.
Answer:
A price index only includes the prices of the constituent securities in the calculation of the index
value. A total return index includes the prices and the dividends paid in the calculation of the index
value. If all of the constituents are non-dividend paying stocks, then the total return index will be the
same as the price index at the end of the year. Otherwise the total return index will be greater than
the price index.
7. James Investments is calculating an equally weighted index on a four stock portfolio.

Stock Number of Shares Initial Cost Current Cost
W 100 5.00 5.00
X 1,000 10.00 12.50
Y 500 7.50 10.00
Z 1500 5.00 8.00
If the initial index value is 100, the current index is closest to:
A. 129.5.
B. 137.9.
C. 142.6.
Answer:
First calculate the return relatives and then find the mean of the relatives. The number of shares is
irrelevant in this question.
5/5 = 1
12.5/10 = 1.25
10/7.50 = 1.33
8/5 = 1.60
(1 + 1.25 + 1.33 + 1.60) / 4 = 1.295
100 × 1.295 = 129.5
8. The market float of a stock is best described as its:

A. total outstanding shares.
B. shares that are available to domestic investors.
C. outstanding shares excluding those held by controlling shareholders.
Answer:
The market float represents shares available to the investing public and excludes shares held by
controlling shareholders.
9. The returns of hedge fund indices are most likely:

A. biased upward.
B. biased downward.
C. similar to other indices.
Answer:
Voluntary performance reporting may lead to survivorship bias and poorer performing hedge funds
will be less likely to report their performance.
10. When creating a security market index, the target market:

A. determines the investment universe and the securities available for inclusion in the index.
B. is usually a broadly defined asset class.
C. determines the number of securities to be included in the index.
Answer:
The target market determines the investment universe and the securities available for inclusion in the
index.
11. Given the following information:
Stock A
Beginning price: 10$
Ending price: 14$
Total dividend in the period: 1$
The total return of the index is closest to:
A. 40%.
B. 10%.
C. 50%.
Answer:
(14+1-10)/10 = 50%
12. Given the following information for a 2-stock index for the year 2016:
Stock A
Ending price: 14$
Stock B
Ending price: 13$
The price return of the index is closest to:
A. 40%.
B. 35%.
C. 50%.
Answer:
In the price return method of calculating the return on an index, the income generated by the assets
in the portfolio, in the form of interest and dividends, is ignored.
Stock A = (14 - 10) / 10 = 40%
Stock B = (13 - 10) / 10 = 30%
Price return of the index = (30% + 40%) / 2 = 35%
13. Given the following information for a 3-stock index for the year 2016:
Stock A
Ending price: 14$
Stock B
Ending price: 13$
Stock C
Ending price: 12$
The total return of this equal-weight index is closest to:
1. 40%.
2. 35%.
3. 50%.
Answer:
The total return takes into account the income generated by the assets in the portfolio, in the
form of interest and dividends. Also, equal-weight is a type of weighting that gives the same
weight, or importance, to each stock in a portfolio or index fund.
Stock A: (14 + 1 - 10) / 10 = 50%
Stock B: (13 + 1 - 10) / 10 = 40%
Stock C: (12 + 1 - 10) / 10 = 30%
The total return for the index = (30% + 40% + 50%) / 3 = 40%
14. The value of a price return index and a total return index consisting of identical equal weighted
dividend paying equities will be equal:
A. only at inception.
B. at inception and on rebalancing dates.
C. at inception and on reconstitution dates.
Answer:
At inception, the values of the price return and total return versions of in index are equal.
15. What is the simplest method to weight an index and the one used by Charles Dow to construct
the Dow Jones Industrial Average?
A. Price-weighting
B. Market-capitalization weighting
C. Fundamental weighting
Answer:
In the price weighting method, the weight assigned to each constituent security is determined by
dividing its price by the sum of all the prices of the constituent securities.
16. Which of the following is not a drawback of equal-weighting?

A. Securities that constitute the largest fraction of the target market value are
underrepresented.
B. After the index is constructed and the prices of constituent securities change, the index is no
longer equally weighted.
C. It results in arbitrary weights.
Answer:
Choices A and B are disadvantages of Equal Weighting. In Choice C, a stock split in any one security
causes arbitrary changes in the weights of all the constituents' securities.
17. Which of the following is a primary disadvantage of market capitalization-weighting?

A. Constituent securities whose prices have risen the most (or fallen the most) have a greater
(or lower) weight in the index.
B. Constituent securities are held in proportion to their value in the target market.
C. Its simplicity and failure to take into account other factors such as the volume of shares sold.
Answer:
As a security's price rises relative to other securities in the index, its weight increases; and as its price
decreases in value relative to other securities in the index, its weight decreases. Therefore, if a security
goes from $10 to $100, its market capitalization (price * number of shares available) will have
increased 10 times, making the index less representative of other securities included in the index.
18. What do you call this method that attempts to address the disadvantages of marketcapitalization
weighting by using measures of a company's size that are independent of its security price?
A. Fundamental Weighting
B. Optimal Weighting
C. Market-capitalization weighting method
Answer:
This method includes measures such as book value, cash flow, revenues, earnings, dividends, and
number of employees.
19. A price-weighted index is composed of 2 stocks. Stock A sells for $256 and has 25,400 shares
outstanding, and stock B sells for $57 and has 232,000 shares outstanding. If stock A splits its stock
2-for-1, then the new price-weighted index value is closest to:
A. 92.2.
B. 156.5.
C. 185.
Answer:
When a split happens in a price-weighted index, it does not affect the price weights. We calculate
the index value as if the split had not occurred:
Price index value = (256 + 57) / 2 = 156.5
20. Which of the following statement regarding reconstitution is most likely accurate?
A. Reconstitution is necessary because the weights of the constituent securities change as their
market prices change.
B. Reconstitution does not create turnover in an index.
C. Reconstitution is similar to a portfolio manager deciding to change the securities in his or
her portfolio.
Answer:
Reconstitution is the process of changing the constituent securities in an index.
Option A) refers to rebalancing.
Option B) is incorrect because reconstitution does, in fact, create turnover in a number of different
ways.
21. Which of the following is not one of the major uses of market indices?
A. A measure of the overall performance of the economy as a whole
B. Proxies for measuring and modeling returns
C. Proxies for asset classes in asset allocation models
Answer:
It may not accurately reflect the overall attitude of investors or the 'market' because it only consists
of a few of the stocks traded in the market.
22. A security market index represents the:

A. risk of a security market.
B. value of the security market as a whole.
C. value of a given security market, market segment, or asset class.
Answer:
A security market index represents the value of a given security market, market segment, or asset
class.
23. Which of the following questions is least likely considered in the construction and management
of market indices?
A. What is the target market the index is intended to measure?
B. Which securities among the high performing securities should be included?
C. How often should the index be rebalanced?
Answer:
Not only high performing securities should be included in the index. If so, then the index will be
biased upward.
24. Most of the widely used global security indices are:

A. price-weighted.
B. equal-weighted.
C. market-capitalization weighted.
Answer:
Most global security indices are market- capitalization weighted with a float adjustment to reflect the
number of shares available to investors.
25. Which of the following is most likely a market-capitalization weighted index?

A. S&P 500 Composite Index
B. Financial Times Ordinary Share Index
C. Dow Jones Industrial Average
Answer:
The Financial Times Ordinary Share Index is an equally weighted index and the Dow Jones Industrial
Average is a price-weighted index.
Quiz 17 - Market Efficiency
1. Which of the following statements regarding market efficiency is least likely accurate?
A. In an efficient market, prices of stocks will slowly adjust to new information.
B. An efficient capital market reflects all of the information about its securities, including risk.
C. There are three forms of market efficiency: weak, semi-strong and strong.
Answer:
Here, we are looking for the least accurate statement. Option A is least accurate since, in an efficient
market, prices of stocks will adjust INSTANTANEOUSLY to new information.
Option B is an accurate statement. An efficient capital market reflects all of the information about its
securities, including risk.
Option C is an accurate statement. There are three forms of market efficiency: weak, semi-strong and
strong.
2. Which of the following is least likely accurate about intrinsic values?

A. Intrinsic values are uncertain.
B. Intrinsic values are higher than the market value.
C. Intrinsic values keep on changing.
Answer:
Intrinsic value is the perceived value of an asset, an investment, or a company. Intrinsic values can be
higher or lower than the market prices depending on the market's efficiency and/or the characteristics
of the asset in consideration.
3. When the number of investors in a market increase, the market becomes:

A. less efficient.
B. more efficient.
C. as efficient as before/no change.
Answer:
Markets generally behave more efficiently as the number of participants increase. More participants
increase the chance of new information getting absorbed quickly and efficiently.
4. In the case of emerging markets, the market prices are less efficient because:
A. there are fewer participants.
B. there are fewer securities to choose from.
C. there is fewer information in the market.
Answer:
Emerging markets have fewer information and, thus, have less efficient markets. In the case of
developed countries, more information disclosed leads to a higher level of market efficiency.
5. An investor can achieve positive risk-adjusted returns on average by using fundamental analysis
in which of the following forms of market efficiency?
A. Weak form efficiency only
B. Weak and semi-strong form efficiency only
C. Strong form efficiency only
Answer:
Semi-strong and strong forms of efficiency imply that neither fundamental nor technical analysis
can be used to achieve superior gains.
6. Fundamental analysis is based on which of the following?

A. Cost of information
B. Trading and analysis
C. Earnings and dividends
Answer:
Fundamental analysis is based on public information such as earnings and dividends. It is not based
on technical indicators.
7. If you believe the per-share intrinsic value of Ford Motor Company (F) is $14.00 and it is currently
selling at a market price of $12.75, you think the stock is:
A. Undervalued.
B. Overvalued.
C. Fairly valued.
Answer:
Due to your belief that Ford stock is worth $1.25/share more than it is currently selling for, you
believe that the stock is being undervalued by the market.
8. In which form(s) of market efficiency does the market price reflect past market data, public
information and private information?
A. Strong form
B. Semi-strong and strong form
C. Semi-strong form
Answer:
Markets are strong form efficient when prices reflect all relevant information at any point in time,
including private information.
9. Which of the following statements is most accurate regarding the weak form of market efficiency?
A. Security prices fully reflect all past market data.
B. Security prices reflect all publicly known and available information.
C. None of the above.
Answer:
The weak form of the EMH asserts that stock prices reflect all the information that can be derived by
examining market trading data such as the historical prices. Choice B reflects the semi-strong form of
market efficiency.
10. Which of the following is defined as the examination of publicly available information and the
formulation of forecasts to estimate the intrinsic value of assets?
A. Historical analysis
B. Fundamental analysis
C. Technical analysis
Answer:
Fundamental analysis is defined as the examination of publicly available information and the
formulation of forecasts to estimate the intrinsic value of assets.
Question Bank – Market Efficiency
1. Price changes are independent from one period to another in which form(s) of market efficiency?
A. Weak, semi-strong and strong form efficiency
B. Semi-strong and strong form efficiency only
C. Strong form efficiency only
Answer:
Past prices and volume information will have no productive power on the future direction of security
prices in all forms of market efficiency.
2. Net of fees in efficient markets, passive management is likely to perform:

A. Worse than active management.
B. Better than active management.
C. The same as active management.
Answer:
The gross performance of active and passively managed funds, in the long run, should be roughly
equal. Since actively managed funds, on average, charge higher fees for investing in a given asset
class, the net performance of passive management in a perfectly efficient market is likely to be
better than active management.
3. As more market participants opt for passive management over active management, market
efficiency is likely to:
A. Increase.
B. Decrease.
C. Remain unchanged.
Answer:
Passive management does not generally try to exploit market inefficiency but instead assumes that
the market is highly efficient and passive investors will ultimately earn higher returns by reducing
management fees as much as possible. At least, in theory, the popularity of active over passive
management has an inverse relationship to its effectiveness. Therefore, as passive management
becomes more common, there are fewer active market participants to find and profit from price
inefficiencies, and market efficiency is likely to decrease.
4. If an ape throwing darts, an experienced technical analyst, skilled fundamental financial analyst,
and an insider trader all earn the same long-run risk-adjusted returns, what form of market
efficiency is likely to apply?
A. Weak form
B. Semi-strong form
C. Strong form
Answer:
Since the insider trader can’t even earn higher risk-adjusted returns than the ape, the market must be
strong-form efficient. If the trader could earn abnormal returns, the market would be semi-strong
efficient. If both the financial analyst (utilizing public company information) and the insider trader
could earn abnormal returns, then the market would be weak-form efficient.
5. Which of the following statements is true?

A. In a weak-form efficient market, active management will always outperform passive
management net of fees.
B. In a semi-strong form efficient market, fundamental analysis can earn abnormal returns,
but technical analysis cannot.
C. In a semi-strong form efficient market, no rational investor would invest in an actively
managed fund.
Answer:
While active management should be able to outperform passive management gross of fees in a weak-
form efficient market, its ability to outperform net of fees depends on how high abnormal returns are
relative to additional management fees. Also, an investor would not be capable of earning abnormal
returns by investing in an actively managed fund in a semi-strong efficient market, but the actively
managed fund may still be a rational choice to achieve other financial goals. Finally, since historical
prices, but not all public information, are reflected in semi-strong market prices a fundamental analyst
could earn abnormal returns that a technical analyst could not.
6. What characteristic used for stock screening is the least likely to result in any abnormal profits due
to market anomalies?
A. Market capitalization
B. Earnings per share
C. P/E ratio
Answer:
Screening for stocks with larger market capitalizations and P/E ratios may arguably allow the investor
to take advantage of abnormal returns based on cross-sectional anomalies. However, stocks with
low/high earnings per share alone (without considering price per share) have not been shown to
generate abnormal returns.
7. A scientist runs a series of unweighted coin-flipping experiments with Bob, Bill, and Jane as test
subjects. The scientist first invites Bob to wager $1 on the result of the coin flip, offering $3 if Bob
is correct. Bob refuses. Bill, however, is willing to pay $1 for the chance to win $1.50 ($0.50 profit)
on correctly calling heads or tails because he recently lost $5 in the casino and it is important that
he break even on gambles for the day. Finally, the scientist does not ask Jane to wager money but
instead offers her a choice of taking $0.50 or winning $1.00 if the next coin flip comes up heads.
Jane takes the $0.50.
Which investor has acted rationally?
A. Bob
B. Bill
C. Jane
Answer:
Bob is likely affected by loss aversion as a 50% chance to win $3 is worth $1.50, but he wasn’t willing
to wager $1. On the other hand, Bill is likely doing mental accounting because his previous losses are
sunk costs and shouldn’t motivate him to make bets with a negative expected value (a 50% chance to
win $1.50 is only worth $0.75). Jane would have made a perfectly rational decision as she should be
indifferent between the two options. By taking the sure $0.50, she may have acted out of risk aversion,
which is often accounted for in standard financial models and not irrational behavior.
8. Semi-strong form of markets in developed countries are:

A. effcient.
B. inefficient
C. can not be ascertained.
Answer:
Event study evidence proves that the semi-strong market forms are efficient in developed countries.
9. Which of the following calendar anomalies don't exist anymore?

A. Turn-of-the-year effect
B. Turn-of-the-month effect
C. Both turn-of-the-year and turn-of-the-month effects
Answer:
Research shows that the turn-of-the-month effect does no longer appear.
10. What is the effect called when we find out that firms with poor stock returns over previous 3-5
years have better subsequent returns than firms that had high stock returns over prior periods?
A. Anomaly effect
B. Overreaction effect
C. Momentum effect
Answer:
This pattern has been attributed to investor overreactions on both unexpected good and bad news.
11. Investors have the tendency to be:

A. less risk-averse when faced with potential gains.
B. more risk-averse when faced with potential gains.
C. less risk-averse when faced with potential losses.
Answer:
Loss aversion refers to the tendency of the investors to be more risk-averse when faced with potential
losses and less risk-averse when faced with potential gains.
12. Which of the following statement regarding market efficiency is most likely accurate?
A. Investors will usually accept market prices as accurately reflecting intrinsic values.
B. Investors may try to develop an independent estimate of intrinsic value.
C. In efficient markets, the investor will often use the dividend discount model.
Answer:
In efficient markets, the investors will usually accept market prices as accurately reflecting intrinsic
values. In relatively inefficient markets, the investor will use different models to determine the
intrinsic value of the securities.
13. If markets are inefficient, the difference between the intrinsic value and the market value of a
company's security:
A. is zero.
B. depends if the stock is overvalued or undervalued.
C. is always positive.
Answer:
If markets are inefficient, the difference between the intrinsic value and the market value of a
company's security would largely depend if the stock is overvalued or undervalued.
14. 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. equal.
Answer:
In a semi-strong form efficient market, passive portfolio strategies should outperform active portfolio
strategies on a risk-adjusted basis.
15. Which of the following is the appropriate definition of an informationally efficient capital market?
A. It is one in which security prices fully reflect all the available information about the security.
B. It is one in which security prices fully reflect all the available and inside information about the
security.
C. It is one in which security prices fully reflect all the publicly available information about the
security.
Answer:
In an informationally efficient capital market, securities fully, rationally and quickly reflect all the
publicly available information about the security.
16. Fatima Al-Mukhtar is an investment manager who invests in the informationally efficient capital
market of Libya. Which of the following investment styles should result in the highest returns if
Al-Mukhtar only invests in mid-cap Libyan stocks?
A. Active management
B. Passive management
C. Both methods will result in the same net returns
Answer:
In an informationally efficient capital market, investors should use a passive management style
because an active management strategy has high transaction and execution costs which is why actively
managed investments should underperform.
In other words, assuming informationally efficient, active and passive should net the same returns.
However passive investing should be more cost-efficient, so it should have the highest net returns.
17. Identify the form of market hypothesis which suggests current market prices fully reflect all
information from public and private sources.
A. Weak form market efficiency
B. Semi-strong form market efficiency
C. Strong form market efficiency
Answer:
The strong form of efficient market hypothesis suggests that current security prices reflect all the past,
publicly available and private (inside) information.
18. According to the efficient market hypothesis (EMH), in which of the following forms of market
efficiencies can an investor achieve positive risk-adjusted returns on average by using
fundamental analysis?
B. Semi-strong from market efficiency
Answer:
The semi-strong form of efficiency suggests that current security prices reflect all the past security
market information and all publicly available information. An investor can not achieve positive risk-
adjusted returns on average by using fundamental analysis in the semi-strong and strong form of
market efficiency.
An investor can only achieve positive risk-adjusted returns on average by using fundamental analysis
in the weak form of market efficiency.
19. Technical analysis is used to test if a market is weak-form efficient. Determine the data set
required to conduct technical analysis.
A. Current earnings, dividends, and accounting ratio data
B. Past (historic) prices and volumes data
C. Non-public material data
Answer:
Technical analysis is based on past (historic) prices and volumes data. If technical analysis produces
abnormal results, the market is not even weak form efficient.
20. Joe Timberlake is a trader who trades equities in the United Arab Emirates (UAE). Timberlake is
consistently able to earn abnormal profits by using fundamental data, but when he uses only
technical analysis, he isn't profitable. Evaluate the market efficiency of the UAE.
A. The UAE's market is strong form efficient.
B. The UAE's market is semi-strong form efficient.
C. The UAE's market is weak form efficient.
Answer:
If a trader can earn abnormal profits by using either fundamental or technical analysis, then the
market is not even semi-strong form efficient. Therefore, the market is weak form efficient.
21. In which form of market efficiency can active management consistently earn abnormal profits?
B. Semi-strong form market efficiency
Answer:
When markets are semi-strong or strong form efficient, security prices reflect all public and private
information and no one has monopolistic access to information. Therefore, active management
cannot consistently earn abnormal profits.
22. The process of investigating data until a statistically significant relationship is found is least likely
referred to as:
A. market anomaly.
B. data mining.
C. data snooping.
Answer:
The process of investigating data until a statistically significant relationship is found is called data
mining or data snooping.
23. Identify the cross-sectional anomalies among the following.
A. Value effect
B. Day-of-the-week effect
C. Earning surprises
Answer:
Cross-sectional anomalies are value effect (anomaly suggests that value stock outperforms growth
stocks) and size effect (anomaly suggests that small-cap stocks outperform large-cap stocks).
24. Which of the following is the result of uninformed or less informed traders that watch and mimic
the actions of other investors?
A. Loss aversion
B. Momentum effect
C. Information cascade
Answer:
Information cascade is the result of uninformed or less informed traders that watch and mimic the
actions of other investors.
25. The most likely explanation of the “January Effect” is that:
A. tax-loss selling occurs in the month of December.
B. tax-loss selling occurs in the month of January.
C. The selling of profitable securities occurs in December in an attempt to show higher profits in
annual reports.
Answer:
One of the likely explanations of the “January Effect” is selling off loss-making securities in December
by portfolio managers to book capital losses to reduce tax liabilities. The same securities are then
purchased back in January. The supply of securities increases in December which results in a price fall
while, in January, the price increases as the demand increases.
26. The efficient market hypothesis assumes that:

A. successive stock price changes are independent of each other.
B. investors behave irrationally.
C. investors mostly invest in single stocks.
Answer:
One of the assumptions of the efficient market hypothesis is that successive stock price changes are
independent. It also assumes that the forecasts made are unbiased. Therefore, investors invest in
portfolios, so a single stock may not have the influence to greatly influence the market.
27. For the efficient market conditions to hold:

A. every market participant must be well informed.
B. a few market participants must be well informed.
C. the majority of market participants must be well informed.
Answer:
The efficient markets hypothesis states that the price of securities in a market fully reflects all the
information. For the efficient market hypothesis to hold, not all market participants need to be well
informed; even if only a few market participants are well informed; any profit-making opportunity will
be exploited.
28. If the efficient market hypothesis holds, then an investor must:

A. frequently churn his portfolio to generate an abnormal return.
B. follow a "buy and hold" strategy.
C. invest in high beta stocks to generate abnormal returns.
Answer:
If the efficient market hypothesis holds, then an investor must follow a "buy and hold" strategy.
29. If the markets are strong-form efficient, then:

A. abnormal returns can be generated based on public information.
B. abnormal returns can be generated based on private/insider information
C. abnormal returns cannot be generated based on private/insider information.
Answer:
Practitioners of strong form efficiency believe that not even insider information can give an investor
an advantage.
30. The efficient market hypothesis requires that:

A. every market participant must be rational.
B. the overall market must be rational.
C. only a few market participants must be rational.
Answer:
The efficient market hypothesis requires that the overall market must be rational rather than each
market participant. All that is required by the EMH is that investors' reactions be random and follow
a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to
make an abnormal profit, especially when considering transaction costs (including commissions and
spreads).
Quiz 17 – Introduction to Industry and Company Analysis
1. In a given industry, if barriers to entry are low and barriers to exit are high, then the firms will:
A. have a higher pricing power.
B. have a lower pricing power.
C. be able to make abnormal profits.
Answer:
The low barriers to entry will ensure that more and more firms enter the industry quickly, while high
barriers to exit will result in overcapacity. Both factors will lower the pricing power of the firms.
2. Identify the factor that will increase the profitability of a firm.

A. Low barriers to entry
B. An industry with a greater market concentration.
C. Low bargaining power of suppliers
Answer:
Low bargaining power of suppliers gives higher pricing power to the firm which will help lower costs
and increase profitability.
3. Company ROIC WACC

Company A 30% 32%
Company B 8% 3%
Company C 16% 13%
ROIC: Return on invested capital
WACC: Weighted average cost of capital
Which company is generating the most economic profit as a percentage of capital invested?
A. Company A
B. Company B
C. Company C
Answer:
Economic profit as a percentage of capital invested is essentially the difference between the return
on capital and the cost of capital. Company A is earning negative economic profit (30% – 32% = -2%)
despite having the highest return on invested capital. Company C has a higher return on invested
capital than Company B, but is only earning three cents of economic profit (16% – 13%) for every dollar
invested. Company B, however, is earning five cents of economic profit per dollar (8% – 3%).
4. The newspaper industry has been shrinking for years in the shadow of the internet and 24-hour
cable news networks. What is the life-cycle stage that best fits the newspaper industry?
A. Shakeout
B. Mature
C. Decline
Answer:
The newspaper industry has long ago moved past the shakeout stage and has more recently shifted
into a period of decline against the increasing popularity of the internet.
5. A high-tech industry only has 3 large firms operating in it. This is most likely a:
A. concentrated industry.
B. fragmented industry.
C. low-cost industry.
Answer:
A concentrated industry has a few large firms that shape its direction and evolution. Note: A
fragmented industry is one in which no major companies drive the direction of the industry.
Fragmented industries typically result because a lot of small companies exist in the sector, and it is
difficult for one company to establish a large or robust operation.
6. Slow growth, declining profitability and intense competition are characteristics of which industry
life cycle phase?
A. Embryonic stage
B. Growth phase
C. Shakeout phase
Answer:
Slow growth, declining profitability and intense competition are characteristics of the shakeout phase.
NOTE: The growth phase has low competition.
7. Excess capacity is a characteristic of which industry life cycle phase?

A. Growth phase
B. Mature phase
C. Decline phase
Answer:
Excess capacity is a characteristic of the decline phase.
8. High costs are experienced during which stage?

A. Growth stage
B. Embryonic stage
C. Shakeout stage
Answer:
During the embryonic stage, the volumes necessary for economies of scale are not reached. Therefore,
costs of production are high.
9. What happens in a situation of under capacity?

A. Demand is smaller than supply at the current prices.
B. Demand is always equal to supply in the market.
C. Demand is superior to supply at the current prices.
Answer:
The undercapacity stage leads to high returns on investment and high pricing power as the demand is
greater than the supply. In other words, Undercapacity is a situation in which companies in an industry
are making and supplying fewer products than customers buy or are expected to buy.
10. Which of the following steps is least likely included in a thorough industry analysis guidance?
A. Analyze industry prospects based on strategic groups.
B. Classify the life-cycle stage of the industry.
C. Analyze the independence of board members.
Answer:
Analyzing the independence of board members come under the corporate governance analysis,
not the industry classification.
Question Bank – Introduction to Industry and Company Analysis
1. Which of the following market participants is unlikely to benefit from industry analysis?
A. A loan underwriter at a bank performing due diligence in response to a loan application
received from a startup app development firm.
B. A technical analyst tracking price movements and investing across a wide variety of
industries.
C. A data analyst working for an investment consulting firm working on a performance
attribution analysis of an actively-managed fund within a client’s portfolio.
Answer:
The loan underwriter can benefit from industry analysis to better understand the risks of lending to
the app development firm, and the data analyst can extract the amount of outperformance or
underperformance attributable to industry or sector selection. While the technical analyst invests in
different industries, investment decisions are made based on historical price movements and not
industry fundamentals.
2. Drof, a fictional company that manufactures and sells cars, and Snov, a fictional company that
owns grocery stores across the United States, are grouped together using one classification
approach. Drof’s earnings are closely tied to the strength of the economy, while Snov’s earnings
are much less dependent on the business cycle. Despite the differences, the daily stock price
movements of Drof and Snov over the last ten years have been strongly correlated. What
classification approach is the most likely to group these two companies together?
A. Products and/or services supplied
B. Business-cycle sensitivities
C. Statistical similarities
Answer:
The companies have few similarities in terms of products supplied or business-cycle sensitivities, but
their statistical similarities would be likely to include them in the same group.
3. What is NOT a use of company descriptors?

A. Determining stocks that will perform similarly in the future
B. Determining which companies may experience a significant decline in earnings in the event of
a recession
C. Understanding a fund manager’s general investment approach
Answer:
The business-cycle sensitivities classification is likely to help an investor develop an idea of which
companies are more protected from recessions and which companies are not. A statistical similarities
grouping is likely to help an investor break down a fund manager’s holdings to understand their
general approach. While statistical analysis groups companies based on past performance similarities,
it is not very useful in determining future performance.
4. What is least likely to be useful when attempting to identify a peer group for a subject company?
A. Looking through the subject company’s annual reports
B. Analyzing other firms within the subject company’s industry group
C. Screening for companies with similar financial ratios
Answer:
The subject company’s annual report will likely contain direct mentions of competitors and there are
likely to be a number of relevant peers within the subject company’s industry. While peer companies
may have similar financial ratios, using a financial ratio screen is a poor way to first identify a
company’s peer group. There may be similar competitors facing the same demand environment that
are far different in terms of efficiency, profitability, leverage, etc.
5. What is most likely to be covered in a thorough industry analysis?

A. A comparison of the stock price performance of various firms within the industry
B. A detailed history of the industry, including analysis of firms that used to compete in the
industry, but have since gone out of business or have been acquired
C. The current positioning of the industry and the various entities that may be a catalyst for
change within the industry in the future
Answer:
Stock price performance and historical understanding may certainly be relevant in analyzing an
industry at times, but the focus of the analysis will typically be on the industry’s present positioning
and future prospects.
6. Which company is the most likely to face fierce price competition?

A. A company that sells a differentiated product within an industry with high barriers to entry
B. A company within a concentrated industry that requires minimal capital expenditures
C. A company within an industry characterized by high barriers to entry and exit
Answer:
Generally, concentrated industries or industries with high barriers to entry are less price-competitive.
A differentiated product and less capital intensive industries help companies maintain pricing power.
However, high barriers to exit usually cause unprofitable firms to continue competing on price.
7. What is an example of a demographic influence?

A. The housing industry benefitting from the Fed’s decision to lower interest rates
B. The decline of the traditional brick-and-mortar video rental industry facing competition from
online-only rivals
C. High growth in the healthcare sector partially due to an increasing number of seniors as a
proportion of the United States’ population
Answer:
The Fed’s decision to lower interest rates could be considered both a macroeconomic influence and
governmental influence. The decline of traditional video stores was largely caused by technological
influences. The shifting proportion of the US population towards the older end of the age spectrum
represents a demographic influence.
8. Which of the following characteristics is the most important for a company following a low-cost
strategy?
A. A management team with proper incentives
B. A unique set of products or services
C. Brand loyalty
Answer:
While unique products/services and brand loyalty can usually be beneficial to a cost-leader, a
management team that is well motivated to keep costs low is usually very important in successfully
becoming a cost-leader within an industry.
9. Which of the following statements related to the cost leadership strategy is/are accurate?
I. The cost leadership strategy is used to decrease production costs.
II. The cost leadership strategy is used to increase sales.
A. I only
B. II only
C. Both I & II
Answer:
Firms engaging in cost-leadership strategy seek to combine low per-unit profit with large sales to make
a profit. Typically, but not always, they tend to market to a large population base or a niche with a
high demand volume. Perhaps the most famous cost leader is Wal-Mart, which has used a cost-
leadership strategy to become one of the largest companies in the world.
10. How is the demand for consumer goods affected when the education level of the workers is low?
A. Demand decreases
B. Demand increases
C. It has no relation with the demand
Answer:
The education of workers is a structural economic factor. Less education means low productivity which
implies low real wages and thus less demand.
11. Declining profitability is a characteristic of which industry life cycle stage?
A. Embryonic stage
B. Shakeout stage
C. Mature stage
Answer:
Declining profits are experienced during the shakeout stage due to overcapacity.
12. Return on capital will most likely be higher in which of the following cases?
A. If the firm has 50% of the market share and another firm has the other 50%.
B. If the firm has a 10% market share and all other firms have less than 5% of the market share.
C. Return on capital is not affected by market shares.
Answer:
Return on capital will be higher if the firm has a greater market share than all other firms.
Note: Absolute market share doesn't affect the return on capital as much as the firm's relative market
share.
13. Drug stores can be classified as a:

A. cyclical industry.
B. growth industry.
C. defensive industry.
Answer:
Drug stores are classified as a defensive industry as it has a stable demand.
14. Which of these characteristics best describe commodity goods?

A. High competition and high profitability.
B. High competition and low profitability.
C. Low competition and high profitability.
Answer:
Commodity goods have intense competition and low profitability because of the threat of substitute
products and the elasticity of the demand.
15. How does the oil the industry most likely maintain a premium pricing strategy?
A. The threat of substitutes
B. The bargaining power of the buyers
C. Significant barriers of entry
Answer:
Significant barriers make it costly for newcomers to enter and, thus, less competition helps them to
maintain premium pricing.
16. Electricity is part of which industrial classification sector?

A. Energy
B. Utilities
C. Technology
Answer:
The utilities sector includes basic amenities like electricity, gas, and water.
17. The industry rotation (sector rotation) is based on the:

A. future phase of the business cycle.
B. past phase of the business cycle.
C. current phase of the business cycle.
Answer:
The industry rotation (sector rotation) is overweighting or underweighting industries on the basis of
the current business cycle.
18. Which of the following is not one of the uses of Industry Analysis?
A. Understand a company's business and business environment
B. Identify active investment opportunities
C. Determine the performance of a company based on industry standards
Answer:
Determining the performance of a company based on industry standards is one of the uses of
Benchmarking Analysis.
19. Which of the following is least likely one of the three major approaches to industry classification?
A. Market capitalization
B. Products and/or services supplied
C. Statistical similarities
Answer:
The three major approaches to industry classification are products and/or services supplied, business-
cycle sensitivities and statistical similarities.
20. Which of the following is a company whose profits are strongly correlated with the strength of the
overall economy?
A. Cyclical company
B. Positively correlated company
C. Defensive growth company
Answer:
A cyclical company is a company whose profits are strongly correlated with the strength of the overall
economy. Such companies experience wider than average fluctuations in demand and/or subject to
greater than average profit variability.
21. Which of the following is a disadvantage of a business-cycle classification?

A. It uses historical data
B. Different countries and regions of the world frequently progress through the various stages
of the business cycle at different times
C. This method often results in non-intuitive groups of companies
Answer:
A and C are disadvantages of the Statistical Similarities Approach. Choice B is one of the disadvantages
of a Business-Cycle Approach.
22. Which of the following groups tend to exhibit a relatively high degree of economic sensitivity?
A. Consumer discretionary
B. Consumer staples
C. Energy
Answer:
Consumer discretionary companies derive a majority of their revenue from the sale of
consumerrelated products or services for which demand tends to exhibit a relatively high degree of
economic sensitivity. Examples are automotive, apparel, hotel, and restaurant industries.
23. Which of the following is a commercial industry classification system in which each company is
assigned in a sub-industry based on its principal business activity?
A. Global Industry Classification Standard
B. Industry Classification Benchmark
C. Russell Global Sectors
Answer:
The Global Industry Classification Standard (GICS) is used as a basis for S&P and MSCI financial market
indexes in which each company is assigned to a sub-industry, and to a corresponding industry, industry
group and sector, according to the definition of its principal business activity.
24. Which of the following is not one of the Michael Porter's Five Forces?
A. Threat of substitute products
B. Bargaining power of customers
C. Government regulations
Answer:
Porter's five forces are: threat of substitute products, bargaining power of customers, bargaining
power of suppliers, threat of new entrants and intensity of rivalry.
25. Which of the following is most likely a limitation of the statistical method of industry classification?
A. Historical correlation may change in the future.
B. The grouping of firms may differ by time period and region of the world.
C. This method of classification is susceptible to statistical error.
Answer:
One of the limitations of the statistical method of industry classification is that it results in nonintuitive
groups of companies. The grouping of firms under this method can differ over time and across
countries.
26. The global industry classification system is the method of grouping firms into an industry-based
on the firm's:
A. size.
B. principal business activity.
C. industry life cycle.
Answer:
The global industry classification system is the method of grouping firms into an industry based on the
firm's products and services or principal business activity.
27. Sui Gas is a firm that provides gas to the households. Which of the following is the appropriate
industry for Sui Gas?
A. Energy
B. Utilities
C. Basic Material processing
Answer:
Electricity, gas, and water sectors are classified under the utilities industry.
28. Which of the following is most likely a cyclical industry?

A. Financial services
B. Telecommunication
C. Consumer staples
Answer:
Financial services is the most cyclical industry because its earning are highly dependent on the phase
of the business cycle.
Telecommunication and consumer staples industries are non-cyclical industries.
29. An industry where a small number of firms control a large portion of the market share is known
as:
A. an industry with greater market fragmentation.
B. an industry with greater market concentration.
C. a disruptive industry.
Answer:
An industry where a small number of firms control a large portion of the market share is known
as an industry with greater market concentration. In contrast, a large number of firms each with
the small market share would be an example of an industry with greater market fragmentation.
30. Identify the factor that will increase the profitability of a firm.
A. Low barriers to entry
B. An industry with a greater market concentration.
C. Low bargaining power of suppliers
Answer:
Low bargaining power of suppliers gives higher pricing power to the firm which will help lower costs
and increase profitability.
31. Which of the following is the most appropriate statement regarding the under capacity of an
industry?
A. Under capacity results in lower pricing power
B. Under capacity results in higher return on capital
C. Under capacity results in excess supply
Answer:
Under capacity is a situation where demand exceeds supply. It results in a higher pricing power and a
higher return on capital.
32. In which of the following cost strategies does a firm decrease its prices to drive out competitors
and later increase its prices?
A. Price differentiation strategy
B. Switching cost strategy
C. Predatory pricing strategy
Answer:
A predatory pricing strategy is a situation in which a firm decreases its prices to drive out competitors
and later increase the price.
Note: This strategy is prohibited by law in a number of jurisdictions.
33. Identify the business lifecycle stage which has the following characteristics: slow growth, large
investment requirements, a high failure risk, and high prices.
A. Mature stage
B. Growth stage
C. Embryonic stage
Answer:
The embryonic stage of business life-cycle is characterized by slow growth, large investment
requirements, high prices, and a high risk of failure.
34. Due to increased air pollution, a government recently announced subsidies for electric cars. What
is the most likely impact of the announcement on the electric car manufacturing industry?
A. Increase in the threat of substitute products
B. Increase in the threat of new entrants
C. Decrease in the bargaining power of customers
Answer:
The government subsidies will reduce the capital required for setting up electric car manufacturing
units. This will attract more players in the electric car segment and will, therefore, increase the threat
of new entrants.
35. The experience curve is downward-sloping because:

A. as production increases, fixed costs decrease.
B. as production increases, variable costs increase.
C. as production increases, variable costs decrease.
Answer:
The experience curve shows the direct cost per unit of goods or services produced. It is downward-
sloping because, as production increases, the per-unit cost decreases as the fixed costs are spread out
across a larger number of units.
Quiz 16 – Overview of Equity Securities
1. LagRos Ltd. has total assets of $3.2 million and liabilities of $1.2 million. If its shares trade for $25,
and there are 70,000 shares outstanding in the open market, then LagRos' book value is closest
to:
A. $1,750,000.
B. $2,000,000.
C. $2,857,140.
Answer:
Book value = Total assets - Total liabilities
Book value = $3.2 million - $1.2 million = $2,000,000
Book value doesn't take into account market prices.
2. Given callable common shares:

A. the company has the right to buy back the shares at a pre-established price.
B. the shareholder has the right to sell back the shares at a pre-established price.
C. the shareholder has the right to buy more shares at a pre-established price.
Answer:
Callable common shares reserve the company the right to buy back the shares should it become
trategically beneficial.
3. Which of these is/are not common characteristics of private equity securities?

I. Illiquid
II. Giving the company's management time to focus on long-term value creation
III. Liquid
A. I & II only
B. II & III only
C. III only
Answer:
Private equity securities are highly illiquid and investors in these are focusing on long-term value
creation.
4. American Depository Receipts (ADR) are listed on:

A. exchanges based in the United States.
B. established non-U.S. markets by American companies.
C. established non-U.S. markets by non-American companies.
Answer:
American Depository Receipts (ADR) are listed on exchanges based in the United States.
5. An American Depository Receipt (ADR) Level II means that:

A. shares are unlisted.
B. shares are listed.
C. new shares are issued and listed.
Answer:
An American Depository Receipt (ADR) Level II means that shares are listed.
6. Which of the following statements is least likely accurate?

A. Management actions can directly influence book value.
B. Management actions have an indirect impact on market value.
C. Management actions do not influence book value or market value.
Answer:
Management actions can directly influence book value and have an indirect impact on market value.
7. Putable common shares will mostly benefit the:
A. firm.
B. brokers.
C. shareholders.
Answer:
Putable common shares have the effect of placing a floor under the share values. They give
investors/shareholders the option or right to sell their shares (i.e., “put” them) back to the issuing
company at a price that is specified when the shares are originally issued. Investors will generally sell
their shares back to the issuing company when the market price is below the prespecified put price.
We could view puts as an escape route for shareholders in case things take a turn for the worse down
the road. Puts limit their potential loss.
8. YULU Company floats 1000 callable common shares in 2014. In 2015, the company exercises its
call options on 200 shares at $15. If the current price is $18, how will this benefit the firm?
A. This will reduce the dividends the company has to pay in subsequent years.
B. The firm will be able to reissue shares at a higher price.
C. Both A) and B)
Answer:
The company exercised its call option and has to pay dividends on 800 shares. Also, the market price
is higher than the call price. Thus, the firm has an advantage.
9. The market value of a firm's equity reflects:

A. its financial decisions.
B. its operating results.
C. expectations of its future performance.
Answer:
Operating results and financial decisions reflect the firm's book value whereas the firm's market value
reflects expectations of its future performance.
10. The risk in the case of equity shares is calculated by the:

A. standard deviation of earnings.
B. standard deviation of returns.
C. standard deviation of profit.
Answer:
The risk is calculated on the data collected from the returns from previous years and by taking the
standard deviation of these returns. This gives investors an idea of the returns they will receive.
Question Bank – Overview of Equity Securities
1. In the case of a share denominated in foreign currency, the appreciation of the foreign currency
will:
A. increases the returns.
B. decreases the returns.
C. not affect the returns.
Answer:
If the foreign currency appreciates, the shares denominated in that currency will have higher returns
as they are affected by the change in the exchange rates.
2. Which of the following is an appropriate statement regarding the ownership interest of common
shareholders?
A. Common shareholders have a residual claim after debt holders and before preferred
shareholders.
B. Common shareholders have a residual claim before debt holders and preferred shareholders.
C. Common shareholders have a residual claim after debt holders and preferred shareholders.
Answer:
The claim of common shareholders comes after the claims of debt holders and preferred shareholders.
Common shareholders have a claim over residual income.
3. Global Depository Receipts (GDR) are denominated in:

A. the local currency of the buyer.
B. USD.
C. the local currency of the firm.
Answer:
GRDs are not listed on the US exchanges but are denominated in USD and sold to US institutional
investors.
4. Which of the following parties benefits the most from callable shares when the market price is
greater than the call price?
A. Callable equity holders
B. Callable equity issuing firms
C. Debtholders of callable equity issuing firms
Answer:
Callable equities give the firm the right to repurchase the equity at a call price. The firm benefits the
most from callable options on equity if the shares are called at the call price which is below the current
market price.
5. Which of the following is the most likely similarity between common shares and preferred shares?
A. Both can have put and call features
B. Both make fixed periodic payment
C. Both have voting rights
Answer:
Common shares and preferred shares can have put and call features. Unlike common shares, preferred
shares make fixed periodic payments and do not have voting rights.
6. What is most likely the appropriate advantage of participating preferred shares?

A. Investors in participating preferred shares receive an extra dividend if the firm's profits
exceed a specified limit.
B. Any dividends that are not paid for participating preferred shares accumulate for next period.
C. Participating preferred shares can be exchanged for common stocks at the conversion ratio.
Answer:
Investors in participating preference shares receive an extra dividend if firm profits exceed the
specified limit. The feature of accumulating non-paid dividend is related to cumulative preference
shares. Convertible preference shares can be converted into common equity at conversion ratio.
7. Which of the following is least likely a characteristic of private equity?
A. Share price is negotiated between the firm and investors.
B. Private equity is more liquid than public equity.
C. Private equity has a limited financial disclosure obligation.
Answer:
Compared to public equity, private equity is less liquid, its share price is negotiable, and its reporting
cost is less due to limited financial disclosure obligations.
8. Stratton VCs is a venture capital firm that invests in different stages of a firm. In which of the
following stages will Stratton least likely invest its funds?
A. Seed investing stage
B. Mezzanine financing stage
C. Late stage
Answer:
Venture capital firms make private equity investments to finance the seed or startup stage, early
stage, and mezzanine financing stage of a firm.
9. Arabco is an oil exploring public limited company that is facing financial distress due to declining
oil prices. In order to receive quick financing, Arabco has decided to sell part of its equity to private
investors. Which of the following types of investment procedures best describes this situation?
A. Leveraged buyout (LBO)
B. Mezzanine financing
C. Private investment in public equity (PIPE)
Answer:
In a private investment in public equity, a public firm that is in need of quick financing sells private
equity to investors. The firm most likely has growth opportunities or distress.
10. Farah Jan is an investment analyst. She is evaluating methods of investing in nondomestic equity
securities, and she has identified some of the obstacles of direct financing. Which of the following
is least likely an obstacle to direct financing?
A. The foreign stock exchange may be illiquid.
B. Investments and returns are denominated in the local currency of the investor.
C. Investors must be familiar with the regulations of foreign markets.
Answer:
The obstacle of direct investing in foreign equity securities are:
1. The foreign stock exchange may be illiquid.
2. Investments and returns are denominated in foreign currency.
3. Investors must be familiar with the regulations of foreign markets.
4. Reporting requirements of foreign exchanges may be limited.
11. Which of the following depository receipts is issued outside of the United States and are
denominated in U.S. dollars?
A. American Depository Receipt
B. Global Depository Receipt
C. Basket of listed depository receipts
Answer:
Global Depository Receipts are issued outside of the U.S. and are denominated in U.S. dollars.
12. Which of the following is the least risky type of equity for an investor?
A. Preferred stock with a put feature
B. Preferred stock with a call feature
C. Non-cumulative common stock
Answer:
Preferred stocks with a put feature give an investor the right to sell the stock at the put price. Note:Call
features give the firm the right to repurchase stock.
13. Harry Olsen holds 200 shares of Enric Corporation which allow cumulative voting. If there are two
vacancies on Enric Corporation’s board, then the maximum number of votes that Olsen can cast
for a single nominee for the board of directors is closest to:
A. 100.
B. 200.
C. 400.
Answer:
A cumulative voting election permits voters in an election for more than one seat to put more than
one vote on a preferred candidate. Given that the total number of votes available to James is (200 *
2 =) 400, the entire vote can be directed towards a particular member.
14. A firm acquired through a leveraged buyout gets converted into a:

A. private company.
B. public company.
C. debt-free company.
Answer:
A leveraged buyout (LBO) is a financial transaction in which a company is purchased with a
combination of equity and debt. LBOs mostly occur in private companies, but can also be employed
with public companies (in a so-called PtP transaction – Public to Private).
15. Which of the following American depositary receipts (ADRs) does not require SEC registration?
A. LEVEL II sponsored
B. LEVEL III sponsored
C. RULE 144A
Answer:
An American depositary receipt is a negotiable security that represents securities of a non-U.S.
company that trades in the U.S. financial markets. An SEC Rule 144A ADR does not require SEC
registration. Instead, foreign companies are able to raise capital by privately placing these depository
receipts with qualified institutional investors. An American depositary receipt is a negotiable security
that represents securities of a non-U.S. company that trades in the U.S. financial markets. An SEC Rule
144A ADR does not require SEC registration. Instead, foreign companies are able to raise capital by
privately placing these depository receipts with qualified institutional investors.
16. An exchange-traded fund (ETF) can most likely be classified as a/an:

A. active investment instrument.
B. American depository receipt.
C. passive investment instrument.
Answer:
An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks,
which most often tracks an index, such as a stock index or bond index. Therefore, it is classified as a
passive investment instrument.
17. What is the most likely reason for an investor to choose a company’s preference shares over its
common shares?
A. The preference shares give the investor more exposure to the company’s upside potential.
B. The preference shares offer a guaranteed dividend payment.
C. The preference shares have a higher dividend yield than the common shares.
Answer:
Since even participating preference shares offer limited upside potential, common shares should offer
investors more exposure on the upside. While preference shareholders hope to receive fixed dividend
payments, the dividend payments are not guaranteed by the issuing company. Finally, while the
dividend yield on preference shares won’t always exceed the dividend yield on common shares, this
is often the case.
18. What type of preference share is likely to give the investor the most exposure to a company’s
upside potential?
A. Cumulative
B. Participating
C. Convertible
Answer:
Cumulative preference shares may help an investor recover lost income if a company is returning to
profitability, but ultimately shareholders capture minimal returns on the upside. Similarly,
participating shares are limited to a fixed bonus dividend on the upside. However, there is no limit to
the potential upside of convertible preference shares since they are convertible to common shares at
a fixed ratio.
19. Why might a pension fund decide to increase its allocation to private securities and reduce its
allocation to public securities?
A. To increase the fund’s liquidity in order to pay out future short-term obligations
B. To reduce overall transaction costs and management fees
C. To increase the fund’s expected return
Answer:
A move to more investments in private securities would likely reduce the fund’s liquidity and increase
transaction costs and management fees. However, most investors expect higher returns from their
private security investments than public security investments.
20. You’re an investor based in the US who wants to invest in non-domestic equity securities without
exchanging your US dollars for foreign currency. What type of investment should you avoid?
A. Direct investments
B. American depository receipts (ADR)
C. Global registered shares (GRS)
Answer:
You can buy ADRs and GRSs with your US dollars, but cannot make direct investments in foreign
equities without first converting your currency.
21. A US investor makes a direct investment in a foreign equity security with a current dividend yield
of 2.5%. If the investor holds the stock for ten years, how many components are likely to make up
the investor’s total return?
A. One
B. Two
C. Three
Answer:
The investor should earn a total return made up of capital appreciation, dividend income, and foreign
exchange (gains or losses).
22. ABC Corp generated a 15% return on equity during 2015. The 2015 beginning and ending book
values of equity were the same. In 2016, ABC Corp reported a 15% increase in net income and a
15% increase in the book value of equity from one year prior. Using the average book value of
equity approach, what was ABC’s 2016 return on equity?
A. Greater than 15%
B. Less than 15%
C. 15%
Answer:
Since return on equity is being based on the average book value of equity, the full 15% increase in
the book value of equity is not being accounted for in the denominator. Because the beginning and
ending book values are averaged together, the average book value used in the calculation would
only be 7.5% higher than the same figure in 2015. Net income, however, increases exactly 15%. The
2015 return on equity was 15%, and 2016 net income increased more than the average book value
of equity so therefore 2016 ROE is greater than 15%.
Quiz 18 – Equity Valuation : Concept and Basic Tools
1. A share of Apple stock is currently selling for $117. An analyst calculates a share of Apple to be
worth approximately $115 to $130.
The analyst thinks that Apple’s stock is currently:
A. Fairly valued
B. Overvalued
C. Undervalued
Answer:
The current price of $117 per share fits into the analyst’s estimated valuation of $115 to $130.
2. At the beginning of 2016, stocks in the air transport industry had a trailing price-to-earnings ratio
of approximately 12. An analyst believes that Fly2U, a publicly-traded air transport company, is
undervalued primarily because its shares are trading at only 8 times trailing earnings.
The analyst is primarily using what type of model to estimate Fly2U’s share value?
A. Present value
B. Multiplier
C. Asset-based
Answer:
The analyst calculates estimated value based on the company’s share price multiple of trailing
earnings.
3. The following is taken from an analyst’s valuation of CBA, Inc:

CBA, Inc.
Current Price $8.50
Expected Year 1 Dividend $1.00
Expected Year 2 Dividend $1.15
Expected Sale Price (End of Year 2) $8.75
The analyst’s required return is 8%. Based on the analyst’s estimates and using the dividend
discount model, the stock price of CBA, Inc. is currently:
A. Fairly Valued
B. Overvalued
C. Undervalued
Answer:
Based on the given inputs, the stock’s estimated value is equal to year 1 cash flows ($1.00/1.08 =
$0.93) plus year 2 cash flows (($8.75 + $1.15)/1.082 = $8.49), or approximately $9.41. Because the
stock’s estimated value exceeds its current price, the stock is undervalued.
4. ABC’s 5% preferred shares have a par value of $100. The required rate of return on preferred
shares with the same rating is 7% as of the valuation date. The preferred shares will mature in ten
years.
All else being equal, if the preferred shares instead matured in 15 years, how would the intrinsic
value of ABC’s preferred shares change?
A. The longer maturity would increase current valuation.
B. The longer maturity would decrease current valuation.
C. The longer maturity would not change current valuation.
Answer:
Since the required rate of return as of the valuation date is higher than the dividend yield (as a % of
par value) of ABC’s preferred shares, the current valuation of ABC’s preferred shares declines as
maturity increases. If ABC’s preferred shares instead yielded 9%, their current value would move in
the same direction as maturity.
5. Calculate the present value of a stock if the stock is expected to pay dividends of $1.50 and $2 for
the next two years and, at the end of the second year, the stock is expected to sell for $25,
assuming a required return of 12%.
A. $24.50
B. $22.86
C. $26.36
Answer:
Using the dividend discount model, the stock value is (1.5/1.121) + ((2+25)/1.122) = $22.86
6. An equity valuation model that estimates the intrinsic value as the present value of expected
future benefits is most likely:
A. a multiplier model.
B. a present value model.
C. an asset-based model.
Answer:
The present value model, or discounted cash flow model (DCF), is a valuation method used to estimate
future free cash flow projections and discounts them to arrive at a present value estimate.
7. What will happen to the value of a stock if the difference between the return on the stock and the
constant growth rate widens?
A. The value of the stock will increase.
B. The value of the stock will decrease.
C. There will be no change.
Answer:
This is because the estimated stock value is very sensitive to the denominator.
8. Which of the following is not an assumption of the Gordon model?

A. Dividends are appropriate measures of shareholder's wealth.
B. The growth rate of the dividend is increasing.
C. The return on the stock is greater than the constant dividend growth rate.
Answer:
In the Gordon model, the growth rate of the dividend is constant.
9. A stock is expected to pay a $2 dividend this year. Next year's dividend is expected to be 20%
higher. The stock is expected to sell at $18.25 at the end of next year, and the required return is
20%. The stock's estimated value, assuming a two-year investment horizon, is equal to:
A. 17.21
B. 2
C. 16.00
Answer:
10. Some firms do not currently pay dividends but are expected to pay dividends in the future. Which
of the following methods should an analyst most likely use for analysis?
A. Asset-based models
B. Gordon Growth Model
C. Dividend discount models
Answer:
The Gordon Growth Model should be used when a firm does not currently pay dividends but is
expected to pay dividends in the future. This is because the parameters are highly uncertain, so the
analysts should use the estimates from the Gordon Growth Model in his analysis.
Question Bank – Equity Valuation : Concept and Basic Tools
1. Which of the following is a disadvantage of price multiple valuations?

A. Lagging price multiples reflect the past.
B. Price multiples can not be used in time series and in cross-sectional comparisons.
C. Both A) and B)
Answer:
Price multiples can be used in time series and cross-sectional comparisons. However, they reflect the
past.
2. In which of the following methods do analysts adjust book values of the firm's assets and liabilities
to their fair values?
A. Asset-based models
B. Discounted cash flow models
C. Market multiple models
Answer:
The intrinsic value of a common stock is estimated as the total asset value minus liabilities and
preferred stocks. It is essential to asset-based models.
3. The economic principle guiding the price multiple comparables method is:
A. the law of one price.
B. the constant growth rate.
C. none of the above.
Answer:
The economic principle guiding the price multiple comparables method is the law of one price which
asserts that two identical assets should sell at the same price.
4. As per following information:

Corporation Business Expected Expected Long-
Sensitivity 3yr Growth Rate Term Growth Rate
Corporation A Defensive 5.0% 2.0%
Corporation B Cyclical 3.0% 3.0%
Corporation C Defensive 6.0% 6.0%
Which one of the corporations above would most likely be the best fit for a valuation using the
Gordon (constant) growth DDM?
A. Corporation A
B. Corporation B
C. Corporation C
Answer:
Due to its insensitivity to the business cycle and a short-term growth rate that corresponds to its long-
term growth rate, Corporation C would probably be the most appropriate candidate for valuation
using the Gordon (constant) growth DDM. A multistage model would likely be appropriate for
Corporation A due to the significant variance between short-term and long-term growth rates. A
constant growth model valuation may also be appropriate for Corporation B, but accuracy is less likely
due to the cyclical nature of its business.
5. All else equal, a decrease in which of the following will cause an increase in the justified forward
P/E multiple?
A. Payout ratio
B. Required rate of return
C. Growth rate
Answer:
Due to the inverse relationship between the required rate of return and the justified P/E, a decrease
in the required return will justify a higher forward P/E. This should make sense intuitively since
investors are willing to pay a higher price for assets as they relax their return requirements.
6. Which one of the following statements is most accurate?
A. If a company’s price-to-sales ratio increases from its value one year prior, the price-to-
earnings ratio must have also increased.
B. A high price-to-book ratio usually implies the company is in financial turmoil.
C. A low price-to-earnings ratio usually implies the company has relatively few growth
prospects.
Answer:
While a rising stock price may increase both P/S and P/E over time, the two ratios can move in different
directions as profit margins fluctuate. A low, not high, P/B usually implies the company may be close
to or in the midst of financial distress. While a low P/E doesn’t always mean the company has minimal
growth prospects, expected future growth and relative P/E tend to move in the same direction.
7. A junior analyst made a number of mistakes when performing an analysis of Confuzzled, Inc., a
soft drink manufacturer as of year-end 2015. The analyst accidentally used the company’s 2014
book value of debt ($200 million) instead of the 2015 book value of debt ($150 million) when
calculating relevant financial ratios.
The analyst also overstated the company’s marketable securities by $20 million and understated
EBITDA by $25 million. All else equal, the correction of which one of these errors on its own will
cause a decrease in the analyst’s calculation for Confuzzled’s EV/EBITDA multiple?
A. Book value of debt

B. Cash equivalents
C. EBITDA
Answer:
The book value of debt should not be used in calculating enterprise value. Thus, the correction should
have no effect on the EV/EBITDA multiple. In correcting the marketable securities error, cash
equivalents would be reduced by $20 million causing a corresponding increase in enterprise value and,
therefore, an increase in the EV/EBITDA multiple. Finally, correctly increasing EBITDA by $25 million
would, in fact, decrease the calculated EV/EBITDA for Confuzzled, Inc.
8. Which of the following famous investing approaches made the most use of asset-based valuation?
A. Charlie Munger’s/Warren Buffett’s investment approach targeting great companies at good
prices. This approach focuses heavily on companies with sustainable moats (competitive
advantages) generally achieved with a valuable brand (intangible) and competent
management.
B. Joel Greenblatt’s “Magic Formula” approach, which screens for stocks with low P/E ratios that
also achieve high returns on invested capital.
C. Ben Graham’s “Net-Net” or “Cigar Butt” approach of finding companies selling for less than
their net working capital.
Answer:
Since Ben Graham’s approach focuses solely on current assets and liabilities, asset-based valuation is
a core part of the strategy. While Warren Buffett made a number of Cigar Butt investments in his day,
the investment approach that he is best known for (thanks in large part to Charlie Munger) strays from
asset-based valuation towards valuations that take valuable intangibles into account. Joel Greenblatt’s
Magic Formula is based on a multiplier valuation because of its use of the P/E ratio.
9. What is the third step from a valuation using the multistage dividend discount model?
A. Estimate the standard dividend that will grow at a constant rate.
B. Estimate the dividends during high growth periods.
C. Project the size and the duration of the high initial dividend growth rate.
Answer:
A) is step 5 and C) is step 2
10. Which of the following is not one of the common price multiples used for valuation?
A. Price to dividend
B. Price to earnings
C. Price to book value ratios
Answer:
B) and C) are used as common price multiples.
11. The expected P/E ratio of a stock is 10, and the actual P/E ratio is 10.8. What can we say about
the stock?
A. The stock is overvalued.
B. The stock is undervalued.
C. We can not say anything about the stock.
Answer:
Since Expected P/E ratio < Actual P/E ratio, the stock is overvalued.
12. Which of the following valuation models estimates a stock's value as the present value of cash
flows distributed to shareholders?
A. Dividend discount model
B. Multiplier models
C. Asset-based models
Answer:
The discounted cash flow model or dividend discounted model estimates a stock's value as the present
value of cash distributed to shareholders.
13. Using the Gordon (constant) growth dividend discount model and assuming that r>g>1%, what
would be the effect of a 1% decrease in both the required rate of return and the constant growth
rate on the stock’s current valuation? Assume there is no change to current dividend payment
(D0).
A. Current valuation would increase
B. Current valuation would decrease
C. Current valuation would remain unchanged
Answer:
If both the required rate of return and growth rate are decreased by the same amount, the
denominator should remain unchanged. However, to calculate the current value, the current dividend
must be rolled ahead one year by multiplying D0 by (1+g). While the current dividend payment is
unchanged in this instance, D1 will decrease slightly when g is decreased by 1% thus making the current
valuation lower than it was previously.
14. Texas Corp. is a calculator manufacturing firm which is expected to pay a dividend of $2 next year
that will grow at the rate of 5% for two more years. If the stock is expected to sell for $30 at the
end of the third year, and the required rate of return is 11%, then the present value of the stock
is closest to:
A. $25.00
B. $31.50
C. $27.05
Answer:
Using the dividend discount model the stock value will be estimated as:
Expected price = (2/1.111) + (2.1/1.112) +((2.205+30)/ 1.113) = $27.05
15. Which of the following is the most appropriate formula for calculating free cash flow to equity?
A. FCFE = Net income + Depreciation - Increase in net working capital - Increase in net fixed
investment + Net borrowing
B. FCFE = CFO + Net borrowing
C. FCFE = CFO - Increase in fixed income - Net borrowing
Answer:
Free cash flow to the equity = Net income + Depreciation - Increase in net working capital -
Increase in net fixed investment + Net borrowing
or FCFE = CFO - Fixed capital investment + Net borrowing
16. Core Inc. has preferred stocks outstanding priced at $70 that pay a fixed yearly dividend of $3.50.
Assuming an annual required rate of return of 8%, the value of the preferred stock of Core is
closest to:
A. $20.
B. $63.80.
C. $43.75.
Answer:
The value of a preferred stock is calculated by dividing the dividend by the required rate of return:
Value of Core's preferred stock = $3.5/$0.08 = $43.75
17. Which of the following is least likely an assumption of the constant growth model?
A. Dividends are appropriate measures of shareholders' wealth.
B. The rate of return and the growth rate are constant.
C. The growth rate will always be greater than the required rate of return.
Answer:
The constant growth or Gordon Growth Model assumes dividends are appropriate measures of
shareholders wealth, the rate of return and the growth rate are constant, and the required rate of
return will always be greater than the growth rate.
18. Stocks of MZJ Inc. recently paid a dividend of $2. If the dividend is expected to grow at the constant
the rate of 4%, the value of the stock assuming an 11% required rate of return is closest to:
A. $29.7.
B. $35.
C. $19.65.
Answer:
Using the constant growth model, the value of MZJ's stock will be:
P = D1 / (r - g)
Price of MZJ = (2 * 1.04) / (0.11 - 0.04) = $29.71
19. Which of the following conditions will most likely increase the value of a stock?
A. Increasing the required rate of return and the growth rate.
B. Decreasing the required rate of return and increasing the growth rate.
C. Increasing the required rate of return and decreasing the growth rate.
Answer:
The value of a stock using the constant growth model will increase with a decrease in the required
rate of return and an increase in the growth rate.
A stock value is positively correlated with the growth rate and inversely correlated with the required
rate of return.
20. Galaxy Ceramics is a ceramic and tiles manufacturing company based in Palo Alto. Some
information regarding the stock of the company is given in the following table:
Required rate of return 12%
Return on equity 10%
Earnings per share $5
Dividend $1.50 per share
Assuming the dividend was paid last year, the growth rate of Galaxy's is closest to:
A. 3%.
B. 6%.
C. 7%.
Answer:
Growth rate = Retention rate * Return on equity
Dividend payout ratio = 1.5 / 5 = 30%
Retention rate = 1 - 0.3 = 0.7
Growth rate = 0.7 * 10% = 7%
21. Galaxy Ceramics is a ceramic and tiles manufacturing company based in Palo Alto. Assuming the
dividend was paid last year and using the data given in the following table, calculate the value of
Galaxy's stocks using the constant growth model.
Required rate of return 12%
Return on equity 10%
Earnings per share $5
Dividend $1.50 per share
A. $30
B. $32.10
C. $25.75
Answer:
The sustainable growth rate of a firm, SGR, is given by:
SGR = ROE × retention ratio
where retention ratio = 1 - dividend payout ratio = 1 - 1.5/5 = 1 -0.3.
The growth rate for Galaxy is thus 0.7 * 10% = 7%.
Stock value according to the constant growth model = D1/(k - g)
where D1 is the expected annual dividend per share for the following year, k is the required rate of return and
g is the SGR.
Stock value = 1.5(1.07)/(0.12 - 0.07) = $32.10.
22. The price-to-earnings ratio based on fundamentals is known as:

A. historical P/E.
B. market P/E.
C. justified P/E.
Answer:
The price-to-earnings ratio based on fundamentals is known as Justified P/E.
23. Which of the following is most likely a disadvantage of the discounted cash flow valuation model?
A. They are widely accepted.
B. Value estimates are very sensitive to input values.
C. They are based on lagging dividends.
Answer:
The values used for the valuation are very sensitive to inputs like the required rate of return and the
growth rate.
24. An IT company recently developed a piece of software that is new to the market and currently has
no competitors. However, equity research analysts believe that due to the huge market
opportunities presented by the new software, the segment would attract fierce competition
within the next 3 to 4 years. The most appropriate model to determine the intrinsic value of the
company would be the:
A. multiplier model.
B. Gordon Growth Model.
C. multistage dividend discount model.
Answer:
The Gordon Growth mMdel assumes that the dividend/earnings of a company grow at a constant rate;
however, in a multistage dividend model, the rate of growth can differ. In the above case, due to the
absence of competitors, the IT Company is expected to grow at a higher rate for 3-4 years after which
the rate of growth is likely to decline. Therefore the most appropriate model to value the company is
the multistage dividend discount model.
25. A telecom company acquired its competitor in a highly competitive bid. Subsequent to the
acquisition, the company books a ‘Goodwill’ which forms 30% of its balance sheet. An equity
analyst intends to value the company, the valuation methods least likely to be used by the analyst
are:
A. multiplier models.
B. asset-based valuation models.
C. relative valuation models.
Answer:
Asset-based valuation models are likely to be least effective in valuing companies in which intangible
assets form a major proportion of the balance sheet. In the above case, “Goodwill” forms a major
proportion of the company’s balance sheet hence asset-based valuation method must not be used to
value the company.
Questions Bank - The Behavioral Biases of Individuals
1. Which of the following statements is most accurate regarding cognitive errors? Cognitive errors :
A. are a result of flawed reasoning.
B. arise instinctively and not through sensible efforts.
C. are difficult to correct since they are a result of instincts and perceptions.
Answer:
Cognitive errors are a form of a behavioral bias that results from flawed reasoning.
B and C are incorrect. Emotional bias, not cognitive errors, arises instinctively rather than through
sensible efforts and is undesirable to the particular individual feeling them. They are difficult to correct
since they result from instincts and perceptions, and one can only adapt to them.
2. Which of the following is the most likely reason for the difficulty in correcting emotional biases?
Emotional biases:
A. mostly stem from impulses and intuitions.
B. are impossible to recognize and adjust to emotional bias.
C. cause a deviation in decisions from what is presumed by traditional finance theory.
Answer:
It is normally difficult to correct emotional biases through education, better information, and advice
since it results from impulses and intuitions.
B is incorrect. It is possible to recognize and adjust to emotional bias, which may be undesirable to
the individual. One can only adapt to emotional bias as it is difficult to correct.
C is incorrect. Both emotional biases and cognitive errors are most likely to cause a deviation in
decisions from what is presumed by traditional finance theory.
3. Which of the following is most likely a type of emotional bias?

A. Hindsight bias.
B. Conservatism bias.
C. Loss aversion bias.
Answer:
Emotional bias consists of loss aversion, overconfidence, self-control, status quo, endowment, and
regret aversion biases.
A and B are incorrect. Both hindsight and conservatism bias are examples of belief perseverance
bias.
4. Belief perseverance bias least likely include:

A. representativeness bias.
B. mental accounting bias.
C. illusions of control bias.
Answer:
Mental accounting bias is a processing error and not a belief perseverance bias. It refers to mentally
distributing money into accounts that impact decisions even though money is fungible.
A and C are incorrect. Both representativeness and illusions of control biases form part of the belief
perseverance bias.
5. Which of the following is most likely a consequence of conservatism bias? A financial market
participant (FMP) may:
A. be slow to update forecasts even in the presence of new information.
B. trade more than is practical since portfolio turnover correlates negatively with investment
returns.
C. adopt a point of view or a forecast based almost entirely on small sample size or individual,
unique data.
Answer:
One of the notable effects of conservatism bias is that the financial market participant (FMP) may be
slow to update forecasts even in the presence of new information.
B is incorrect. It relates to the effects of illusion control and not conservatism bias.
C is incorrect. It relates to the consequence of representative bias and not conservatism bias.
6. An investment analyst estimates that the stock price of major companies trading at the security
exchange market has growth potential. A portfolio manager wants to rely on the advice of the
investment analyst to diversify his portfolio by including stocks of companies trading at the
securities exchange market that indicate a rapid growth rate in revenue in the last two financial
years and with a high probability of future investments.
Based on his prior experience with companies in the banking sector and having read numerous
news articles, the investment analyst advises the portfolio manager to consider investing in the
banking sector instead of the oil sector.
The investment analyst is most likely to have displayed which of the following forms of bias?
A. Framing bias.
B. Hindsight bias.
C. Availability bias.
Answer:
The investment analysts most likely display availability bias since he only considered companies in
the banking sector as he has experience in that sector. The investment analyst should research and
consult widely to advise better the portfolio manager regarding all the major companies trading at
the security exchange.
A is incorrect. Framing bias would have occurred if the investment analyst could have answered
differently to the portfolio manager's specific question depending on how the portfolio manager
framed their question.
B is incorrect. Hindsight bias would occur if the portfolio manager only relied on the past events (last
two financial years growth rate) as being expected and rational in arriving at their investment
decision.
7. Christine Blake, an investment analyst at XYZ Ltd, presents and narrates the firm's investment
results after the COVID 19 pandemic to their clients. During her presentation, Blake states that
"the performance during the pandemic was quite evident as depicted the yield curve and other
leading indicators approximately six months prior."
The statement by Blake most likely indicates what type of bias?

A. Hindsight bias.
B. Confirmation bias.
C. Illusion of control.
Answer:
Hindsight bias is the certainty that a prior event is expected and can be reasonably expected to
occur. The COVID 19 impact on the investment returns could appear obvious but, in reality, cannot
be accurately predicted. Thus Blake's comments depict hindsight bias.
B is incorrect. Confirmation bias occurs when there is an inclination to look for and notice what
approves prior beliefs and disregard what opposes them. Blake's statement is not indicative of a
confirmation bias.
C is incorrect. The illusion of control occurs when an individual believes they can influence the
outcomes of events when in reality they cannot. This is not the case concerning Blakes's statement.
8. Which of the following statements is most accurate?

A. A cognitive dissonance is a form of behavioral bias.
B. To prevent hindsight bias, the financial market participant (FMP) should prudently record
its investment choices.
C. The effect of confirmation bias cannot be reduced by aggressively looking for data that
contest prevailing beliefs.
Answer:
To mitigate hindsight bias, the financial market participant (FMP) should prudently record its
investment choices and detail the time in which such decisions were made. This will ensure ease of
cross-referencing of prior decisions rather than trusting on recollection.
A is incorrect. Cognitive resonance, also known as belief perseverance bias, is a category of cognitive
error that results from the distress of the mind that arises when new data conflicts with prior beliefs.
Cognitive error is the form of behavioral bias and not cognitive resonance.
C is incorrect. To reduce the effect of confirmation bias, investors should aggressively seek new
information that challenges present beliefs.
9. Base rate neglect and sample size neglect are most likely types of which of the following
behavioral biases?
A. Framing bias.
C. Representativeness bias.
Answer:
Representativeness bias is a belief perseverance bias that categorizes new data based on prior
experience and groupings. The two types of representativeness bias that apply to FMPs are base rate
neglect and sample size neglect.
A is incorrect. Framing bias is a type of processing error and occurs when an individual responds to
an inquiry differently in reference to the context in which it is asked or outlined. Both base rate
neglect and sample size neglect are not classified under framing bias.
B is incorrect. Confirmation bias is a belief perseverance bias that seeks and notices what approves
past beliefs and disregards anything that opposes them. It reflects a tendency to validate what we
wish to believe and is unrelated to the base rate and sample size neglect.
10. Which of the following is least likely a type of emotional bias?

A. Endowment bias.
B. Regret-aversion bias.
C. Illusion of control bias.
Answer:
Illusion of control bias is a cognitive error categorized as a form of belief perseverance bias that
refers to the certainty that people can control or affect the conclusion when it is not possible in
reality.
A is incorrect. Endowment bias is a form of emotional bias where people tend to appreciate an asset
more when they have possession and conflicts with the standard economic theory.
B is incorrect. Regret-aversion bias is a category of emotional bias and occurs when individuals
evade making conclusions for fear that it will be incorrect. Regret-aversion bias results either in
actions that individuals take or those that they could have opted to take.
11. ABC Investments Ltd is an investment firm that handles a portfolio of investments for its clients
and prides itself in recruiting CFA charterholders. On a recent open day, CEO Kyle Walker stated,
"On average most CFA charterholders work at investment firms."
The statement by the CEO most appropriately indicates which behavioral bias?
A. Framing bias.
B. Availability bias.
C. Representativeness bias.
Answer:
The CEO is basing his observation on a limited range of experience, which is a form of availability bias,
by recruiting CFA charterholders at Kyle and Myles Investment Ltd compared to the entire cluster of
CFA charterholders recruited in other sectors.
A is incorrect. Framing bias is an information-processing bias that occurs when an individual responds
to an inquiry differently based on the context in which it was asked. It is practically possible to explain
a justification to an inquiry in more than one option. Framing bias is not applicable in the case of the
CEO statement since he was not responding to an inquiry, for example, why the firm only prefers
recruiting CFA Charterholders.
C is incorrect. Representation bias refers to the act of categorizing new information based on prior
practices. The CEO's claim that the sample size, i.e., the number of CFA Charterholders employed at
the investment firm, cannot be proven since data representing the population of CFA Charterholders
employed in other sectors is unavailable.
12. Which of the following strategies is most appropriate in mitigating self-control bias by financial
market participants (FMPs)?
A. Drafting an investment plan and introducing personal budgets.
B. Scrutinizing investments and credibly considering the likelihood of future gains and losses.
C. Developing a suitable investment policy strategy through conducting in-depth research and
scrutinizing prior investment decisions.
Answer:
Self-control bias occurs when individuals opt for short-term gratification as opposed to pursuing long-
term goals.
Lack of self-control leads to individuals prioritizing current consumption instead of saving money for
future investments, resulting in insufficient savings leading to investment decisions in risky portfolios
in anticipation of higher returns.
Lack of self-control may also result in unnecessary borrowing to fund existing consumption.
To overcome self-control bias, the financial market participants (FMP) should design, document an
investment plan and introduce a personal budget that can be reviewed regularly.
B is incorrect. It relates to preventing loss-aversion bias.
C is incorrect. It relates to mitigating availability bias.
13. Which of the following strategies would best describe the mitigation process for regret-aversion
bias? Financial market participants (FMPs) should:
A. ensure that an investment plan and personal budget are reviewed constantly.
B. properly diversify respective portfolios by accepting the appropriate risk and returns.
C. appropriately measure the risk-reducing and return enhancing changes and appropriate asset
allocation returns.
Answer:
To mitigate regret aversion bias, the financial market participants should properly diversify by
accepting the appropriate risk and returns of the respective portfolios.
A is incorrect. It indicates the measure to mitigate self-control bias.
C is incorrect. It relates to preventive measures for status quo bias.
14. The sources of availability bias applied by financial market participants (FMPs) least likely consists
of:
A. reliability of the information.
B. categorization of the information.
C. wide range of experience on the part of FMPs.
Answer:
FMPs apply a narrow range and not a wide range of experience as an availability bias.
The FMPs apply a narrow range of knowledge and not a wide range when considering an estimate.
A and B are incorrect. Both reliability and categorization are sources of availability bias.
15. Which of the following behavioral biases is least likely associated with momentum effect in a
financial market?
A. Regret bias.
B. Availability bias.
C. Overconfidence bias.
Answer:
Overconfidence bias is associated with bubbles whereby investors are more active, and trading
volume rises, reducing expected returns.
A and B are incorrect. Both regret and availability biases are associated with momentum effect.
16. Home bias anomaly is most likely to occur when:

A. investors are proactive, and an increase in trading volume resulting in low returns.
B. a favorable evaluation is extended to some characteristics of stock compared to others.
C. portfolios display a bias in favor of local securities compared to international portfolios.
Answer:
Home bias anomaly occurs when portfolios display a solid bias in favor of domestic securities
compared to global portfolios.
A is incorrect. It depicts overconfidence bias which contributes to a bubble market whereby investors
are proactive, and an increase in trading volume resulting in lower profits.
B is incorrect. It defines the halo effect in a stock value whereby favorable evaluation criteria are
applied to certain stock characteristics compared to other stocks.
17. Which of the following is least likely a form of cognitive errors?

A. Processing errors.
B. Loss aversion bias.
C. Belief perseverance bias.
Answer:
Loss aversion bias is a form of emotional bias. There are six emotional biases: loss aversion,
overconfidence, self-control, status quo, endowment, and regret aversion.
A and C are incorrect. Cognitive errors come in two forms: belief perseverance bias and processing
errors.
18. Which of the following biases most likely results from individuals tend to overweight their prior
probability of the event and underweight the new information?
A. Conservatism bias.
C. Representative bias.
Answer:
Conservatism bias is a belief perseverance bias in which people give their past beliefs too much weight
and the new knowledge too little, resulting in outcomes that are underreacting to the new knowledge.
B is incorrect. Confirmation Bias is the tendency to seek out or recognize information that supports
one's existing ideas while ignoring information that contradicts them.
C is incorrect. Representativeness bias is the tendency to categorize new information based on

previous experiences and classifications.
19. Which of the following is least likely a consequence of conservatism bias?

A. Slowness to update forecasts when presented with new information.
B. Considering only positive data and ignoring the negative about an existing investment.
C. Maintaining a previous belief rather than dealing with the stress of updating beliefs given new
data.
Answer:
Considering only positive data and ignoring the negative data about an existing investment is a
consequence of confirmation bias.
A and C are incorrect. The two consequences of conservatism bias are:
Slow to update forecasts even when presented with new information.

Maintaining a previous belief rather than dealing with the stress of updating beliefs given new data.
20. Which of the following biases is most likely represents a bias in which individuals believe that they
can control or influence outcomes when they actually cannot?
A. Hindsight bias.
B. Illusion of control bias.
C. Anchoring and adjustment bias.
Answer:
Illusion of control bias is individuals believe that they can control or influence outcomes when they
actually cannot.
A is incorrect. Hindsight bias refers to the tendency to believe that past occurrences were predictable
and reasonable to expect.
C is incorrect. Anchoring and adjustment bias refer to the practice of basing subsequent assessments,
judgments, and conclusions on an initial piece of data.
21. Which of the following is least likely a consequence of overconfidence bias?

A. Holding inadequately diversified portfolios.
B. Overestimating predicted gains and underestimating risks.
C. Choosing an investment based on the amount of advertising or press coverage.
Answer:
Choosing an investment based on the amount of advertising or press coverage is a consequence of
availability bias.
A and B are incorrect. Consequences of overconfidence bias include:
Holding inadequately diversified portfolios, leading to high downside risk;

Overestimating predicted gains and underestimating risks.
22. Which of the following is least likely a consequence of self-control bias?

A. Saving insufficiently for the future.
B. Borrow excessively to finance current spending.
C. Failing to investigate other investing opportunities.
Answer:
Failing to investigate other investing opportunities is a consequence of status quo bias.
A and B is incorrect. Consequences of self-control bias include:

Save insufficiently for the future, which may lead to portfolios taking on too much risk in the pursuit
of higher returns; Borrow excessively to finance current spending.
23. Which of the following is most likely a consequence of availability bias?

A. A lack of diversification.
B. Borrow excessively to finance current spending.
C. Overestimating predicted gains and underestimating risks.
Answer:
A lack of diversification is a consequence of availability bias. This failure may occur because individuals’
decisions are based on a limited set of experiences.
B is incorrect. Borrowing excessively to finance current spending is a consequence of self-control bias.
C is incorrect. Overestimating predicted gains and underestimating risks is a consequence of

overconfidence bias.
24. Which of the following is most likely a method of detecting and overcoming loss aversion bias?
A. disciplined investment approach.
B. Fearing that profits may diminish, selling investments in a gain position much earlier.
C. Using fundamental analysis to keep investments in a loss position for longer than necessary.
Answer:
A disciplined investment approach is a good way to alleviate the impact of the loss-aversion bias.
B and C are incorrect. Fearing that profits may diminish, selling investments in a gain position much
earlier than justified by fundamental analysis and using fundamental analysis to keep investments in
a loss position for longer than necessary in the hopes of recouping losses are consequences of loss
aversion bias.
25. Which of the following is most likely an emotional bias in which investors avoid making decisions
for fear of making a bad decision?
A. Status quo bias.
B. Endowment bias.
C. Regret-aversion bias.
Answer:
Regret-aversion bias is an emotional bias in which investors avoid making judgments for fear of making
a bad decision. It has two dimensions: actions taken by people and actions that people may have
taken.
Regret-aversion bias is an emotional bias in which investors avoid making judgments for fear of making
a bad decision. It has two dimensions: actions taken by people and actions that people may have
taken.
A is incorrect. Status quo bias is an emotional bias where people prefer to do nothing rather than
change, even when change is necessary.
B is incorrect. Endowment bias is an emotional bias where people value an asset higher when they
own it than when they don't.
26. Which of the following is least likely a belief perseverance bias?

A. Hindsight bias.
B. Conservatism bias.
C. Loss aversion bias.
Answer:
Loss aversion bias is an emotional bias. There are six emotional biases. These are loss aversion,
overconfidence, self-control, status quo, endowment, and regret aversion.
A and B are incorrect. The belief perseverance biases include conservatism, confirmation,
representativeness, illusion control, and hindsight. They are caused by the mental discomfort that
emerges when new knowledge contradicts previously held concepts, known as cognitive dissonance.
27. Which of the following is most likely a consequence of conservatism bias?

A. Properly analyzing and considering new information.
B. Slow to update forecasts even when presented with new information.
C. Developing a screening criterion while ignoring information that contradicts the validity of the
criteria.
Answer:
Conservatism bias is a belief perseverance bias in which people mistakenly incorporate new
contradicting information into their previous beliefs. The consequences of conservatism bias are:
Slow to update forecasts even when presented with new information.
Maintaining a previous belief rather than dealing with the stress of updating beliefs given new data.
A is incorrect. Properly analyzing and considering new information is a method of detecting and
overcoming conservatism bias.
C is incorrect. Developing a screening criterion while ignoring information that contradicts the validity
of the criteria is a consequence of confirmation bias

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Quiz 1 – Corporate Governance

2. To protect their interest, shareholders should ensure that:

6. Identify the duties of the nomination committee.

4. Which of the following is most likely in the best interest of shareholders?

9. Which of the following is least likely a provision of takeover defense?

Which of the following statements is most appropriate?

A. The presence of independent directors on the board ensures discussion on proposals

Should DeWalt agree or disagree with Webb's statements?

3. If two projects are mutually exclusive, a company:

6. Lane Industries has a project with the following cash flows:

10. Which of the following statements is most likely accurate?

13. Which of the following is least likely a principle of capital budgeting?

East Project West Project South Project Central Project

East Project West Project South Project Central Project

Alternatively, we can use the PV/FV function of the calculator as:

That gives an IRR value of 4.41%. What does that imply?

Project Mi6 Project Ci7

Project Mi6 Project Ci7

Project Mi6 Project Ci7

Exhibit: 5-year Project - Cash Inflows

End of the 1st year $0.5 million

Year Outflow Inflow Net flows

NPV(project) = PV0 + PV1 + PV2 + PV3 + PV4 + PV5

19. A project has the following expected cash flows:

4. An example of a primary source of liquidity is:

6. A firm has average days of receivables outstanding of 22 compared to an industry average

7. Which of the following sources of liquidity is the most reliable?

Days of inventory on hand = [365 Days / (COGS/Avg. Inventory)] = [365 / $1,800,000 /

Operating cycle = 58.8 days + 41.30 days = 100.1 days

A is incorrect. It assumes the following calculation in determining the receivable turnover

C is incorrect. It assumes the following calculations;

Balance Sheet Account (amount in million $)

Days of inventory on hand = [365 Days / (COGS/Avg. Inventory)] = [365 / $1,800,000 /

Operating cycle = 58.8 days + 41.30 days = 100.1 days

ASD Pvt. Limited QWE Pvt. Limited YYH Pvt. Limited

Company Operating Cycle

A is incorrect. Large inventories lead to a decreased turnover ratio.

B is incorrect. A decrease in the number of days of inventory is affected by increased sales of

9. Which of the following is most likely a non-bank source of short-term funding?

Commercial paper is a non-bank source of short-term funding. Commercial paper is issued by

B is incorrect. A committed line of credit is stronger than an uncommitted line of credit

Delayed collection of accounts receivable.

A is incorrect. Just in time is a method of managing inventory that minimizes in-process

Number of days of inventory =365/Turnover ratio

Operating cycle = Number of days of receivables + Number of days of inventory

1. Which of the following is the appropriate definition of the cost of capital?

3. Which of the following is equal to the cost of debt?

Weight of debt = MV of Debt/Total Capital = $270 million/$1,120 million = 24.10%

Beta of asset = Equity Beta/[1 + (1 - tax rate)*D/E] = 0.8/[1 + (1 - 0.25)*0.7] = 0.52

8. An analyst is interested in determining the project beta of a new robotic arm

BetaEquity = BetaAsset*[1 + (1 - tax rate)*D/E]

9. A transportation firm is considering to start an underwater tramway system in Ethiopia.

13. AX & Y Company's capital structure is as follows:

Equity premium = Market rate of return - Risk free rate of return = 8%

Cost of Equity = 3% + 1.8 * 8% = 17.4%

5. Which of the following is most likely a direct cost of financial distress?

14. Which of the following is least likely a characteristic of preferred shares?

11. Which of the following appropriately defines leverage?

Change in EBIT for 2018 = 2018 EBIT/2017 EBIT - 1 = 517,500/450,000 - 1 = 15%

DOL = Change in EBIT/Change in sales = 15%/10% = 1.5

13. AYK Corp. reported the following:

The degree of financial leverage of AYK Corp. is closest to:

Exhibit: QQY Pens Limited

18. The cost structure of a company is given in the following exhibit.

Beta of asset = Equity Beta/[1 + (1 - tax rate)D/E] = 0.8/[1 + (1 - 0.25)0.7] = 0.52

BetaEquity = BetaAsset[1 + (1 - tax rate)D/E]