CFA Exam Level 1 Commented Questions
Question 1
1-May-2019 (Level 1)
Q: When calculating the cost of capital, which component cost is normally the lowest?
a) The cost of debt.
b) The cost of preferred stock.
c) The cost of common equity.
Correct Ans: a
Explanation:
Debt capital usually has the lowest cost, as a result of the tax deductibility of interest.
Choice “b” is incorrect. The cost of preferred stock capital is usually the second lowest cost, as it does not have the tax benefit associated with debt.
Choice “c” is incorrect. The cost of common equity is usually the highest cost, because it has the highest risk.
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Question 2
2-May-2019 (Level 1)
Q: Which security type trades in multiple currencies?
a) International ETFs.
b) Global Registered Shares.
c) Global Depository Receipts.
Correct Ans: b
Explanation:
Global Registered Shares represent an actual ownership interest in the company and can be traded in local currency. Currency conversions are not needed to purchase or sell them.
Choice “a” is incorrect. ETFs only trade in the domestic currency of the exchange they are listed on.
Choice “c” is incorrect. Global Depository Receipts are usually denominated in U.S. dollars, but can also be issued in pound sterling and Euros. However, they can only be traded in the currency they were originally issued in.
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Question 3
3-May-2019 (Level 1)
Q: If an investor invests solely in stocks of companies that are domiciled in the investor's own country, the investor does not have to be concerned with:
a) Business risk.
b) Financial risk.
b) Currency risk.
Correct Ans: c
Explanation:
Currency risk is the risk that the currency in which the security is denominated may decline relative to the investor’s home currency. If investments are only made in domestic companies, then there is no currency risk.
Choice “a” is incorrect. The investor should analyze business risk for each firm under consideration, whether it is domiciled in the investor’s own country or not.
Choice “b” is incorrect. The investor should analyze financial risk for each firm under consideration, whether it is domiciled in the investor’s own country or not.
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Question 4
4-May-2019 (Level 1)
Q: Preference shares are generally less risky than common shares because:
a) They are not callable.
b) Their dividends are known and fixed.
c) Their dividends only account for a small portion of the preference shares' total return.
Correct Ans: b
Explanation:
Known and fixed dividends translate in less uncertain future cash flows and, therefore, lower risk.
Choice “a” is incorrect. Preference shares can be callable or putable, similar to common shares.
Choice “c” is incorrect. Preference share dividend returns represent a higher portion of the preference shares’ total return than in the case of common stock. Common stock returns have not only the current dividend yield component, but also a capital gain component dependent to some extent on expected future dividends.
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Question 5
5-May-2019 (Level 1)
Q: Compared to non–callable common shares, callable common shares:
a) Trade at a higher price.
b) Generally pay a lower dividend.
c) Have limited potential future total returns, an additional source of risk.
Correct Ans: c
Explanation:
The strike price provides a ceiling for the price at which investors can sell their shares; if the stock price rises above the strike price, the company will call the shares and pay the strike price, realizing a profit at the expense of the investor. Because both types of shares can go to zero, and thus have a similar downside, a lower upside translates to an additional source of risk for callable shares.
Choice “a” is incorrect. Callable shares can trade at a price below, equal to, or above that of their non-callable counterparts, depending on the difference in dividends and the strike price.
Choice “b” is incorrect. To compensate investors for their higher risk, callable shares usually pay a higher dividend.
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Question 6
Q: Which of the following is the LEAST LIKELY reason for a public company to raise additional equity capital?
a) Ensure debt covenants are met.
b) Fulfill regulatory requirements.
c) Finance a share repurchase.
Correct Ans: c
Explanation:
Share repurchases reward equity holders by distributing future excess earnings among fewer ownership interests. Thus, share repurchase should be financed with internally generated funds or through debt issuance. Issuing new shares to replace old shares only adds an expense to maintaining the same number of outstanding shares.
Choice “a” is incorrect. Capitalizing the company to improve liquidity ratios and meet additional covenants of debt holders is a valid reason for companies to issue additional equity securities.
Choice “b” is incorrect. Meeting regulatory requirements can require companies to reach certain capital adequacy ratios and is also a valid reason for companies to access primary equity markets.
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Question 7
Q: Which of the following is the LEAST LIKELY reason for a company to access primary equity markets?
a) Increase liquidity.
b) Lack of access to secondary equity markets.
c) Provide an additional currency to make acquisitions.
Correct Ans: b
Explanation:
Primary and secondary markets serve different purposes and are not substitutes for each other. Primary markets are used to raise capital, whether when first taking a company public through an IPO or when companies issue additional shares through underwriting. Secondary equity markets exist for investors to trade shares between themselves and for companies to repurchase existing shares rather than to raise capital.
Choice “a” is incorrect. Raising capital through primary markets increases the liquidity of the company’s stock because a larger number of investors can trade the stock, and because trading takes place in an environment of increased transparency.
Choice “c” is incorrect. Because of its increased liquidity, the company’s publicly traded stock can be used as additional currency in making acquisition or providing stock option-based incentives to employees.
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Question 8
8-May-2019 (Level 1)
Q: Management:
a) Can directly affect the book value of the company.
b) Can directly affect the market value of the company.
c) Should maximize the difference between market and book value of the company.
Correct Ans: a
Explanation:
By using accounting techniques that influence earnings and by selling and purchasing shares, management can directly affect the book value of the company.
Choice “b” is incorrect. Management can only indirectly affect the market value of the company, since this value reflects the collective and differing expectations of investors concerning the company’s future cash flows. Even when management can predict whether the stock will increase or decrease in price as a result of a specific action, the amplitude of the change is impossible to predict.
Choice “c” is incorrect. Management can maximize the difference between market and book value by minimizing book value, but this is seldom in the best interest of investors.
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Question 9
9-May-2019 (Level 1)
Q: A company's market value is MOST LIKELY to increase because:
a) Its book value has gone up.
b) Investors expect the future cash flows of the company to be less volatile.
c) Management has more confidence in the future prospects of the company.
Correct Ans: b
Explanation:
Investors value a company based on their collective expectations of its future cash flows. Less volatile, and therefore less risky, cash flows would be discounted at a lower required rate of return and would, therefore, have a higher present value. The amount and timing of expected cash flows also influence market value.
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Choice “a” is incorrect. Book value can be manipulated by management through accounting techniques or through issuing and purchasing shares. Therefore, an increase in book value is rarely the reason for an increase in market value.
Choice “c” is incorrect. Market price is affected by the collective view of investors, not of management, with respect to the future prospects of the company.
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Question 10
10-May-2019 (Level 1)
Q: An executive of Penn William Company came across the following statement: "The before–tax cost of preferred stock may be lower than the before–tax cost of debt, even though preferred stock is riskier than debt."
He contacts Amit Patel, CFA to understand the reasoning of the above statement. Patel explains to the executive that this is because:
a) Dividends on preferred stock have higher tax deductibility than the tax deductibility of coupon interest on bonds for the issuing firm.
b) Preferred stock is generally owned by corporations, which receive 70% exclusion of dividends for tax purpose.
c) Preferred stocks have a priority of claim on assets and earnings in the event of liquidation.
Correct Ans: b
Explanation:
Because preferred dividends receive 70% tax exclusion for the company receiving the dividends, issuing firms are able to issue preferred stock with a dividend rate that is lower than the coupon rate on comparable bond issue.
Choice “a” is incorrect. Preferred stock dividends are not tax deductible for the issuing firm.
Choice “c” is incorrect. Bonds and not preferred stock have a priority of claim on assets and earnings in the event of liquidation.
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Question 11
11-May-2019 (Level 1)
Q: A company's return on equity is LEAST LIKELY to decrease as the result of:
a) Greater industry competition.
b) Increasing capital expenditures.
c) Repurchasing shares with excess cash.
Correct Ans: c
Explanation:
Return on equity using beginning equity will not be affected by share repurchase. Return on equity using average equity will increase as the result of repurchasing shares with excess cash because the denominator of the equation will decrease while net income remains unaffected.
Note that net income could decrease if the company uses debt to repurchase shares (due to interest expense); therefore, the direction of ROE change would depend on the relative percentage changes in net income (numerator) and equity (denominator). However, the outcome is still likely to be an ROE increase.
Choice “a” is incorrect. When industries become more competitive, profits decline and returns on equity are negatively impacted.
Choice “b” is incorrect. Increased capital expenditures result in higher depreciation, which reduces net income and thus return on equity.
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Question 12
12-May-2019 (Level 1)
Q: A company's before–tax cost of debt is:
a) Difficult to estimate.
b) Higher than its cost of equity.
c) Equal to the investor's minimum required rate of return on debt.
Correct Ans : c
Explanation:
All buyers of the same bond issue receive the same periodic rate of interest, so their required rate of return is the same, and is equal to the company’s before-tax cost of debt. Note that taxes reduce the effective cost of debt to the company because interest payments are generally tax-deductible.
Choice “a” is incorrect. The sum of all interest payments of a company are generally known with great accuracy.
Choice “b” is incorrect. Investors require a higher rate on return on equity than on debt, since cash flows to equity owners are riskier than interest payments on debt.
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