Wiley 2016 HELPFUL ANSWER RATIONALES

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2 Top Questions You Must Master for the Level I CFA Exam Preparing for the Level I exam is tough, but you can make life easier with an effective study plan. If you have yet to get a plan, Wiley s adaptive Ditigal Exam Planner in our Platinum, Gold, Silver and Self-Study review courses will help you create a personalized plan down to the day, provide a dashboard to keep on track and track your progress every step of the way. But first, here are some questions to test your knowledge of typical, fundamental topics that are likely to appear on the actual exam. Mastering time value of money (TVM) problems at Level I is a must; be familiar with your financial calculator and how to easily attack questions with different frequencies of compounding. TIP: Underlining key pieces of information keeps you focused on what s necessary to answer the question. 1. An investor has $100,000 held in a two-year bank CD earning four percent with weekly compounding. The terms impose a 10 percent penalty for early withdrawal. How much will the investor receive if he redeems the CD after 18 months? A. $95,563 B. $97,502 C. $106,181 Recognize this is a basic TVM question. (A) is the correct answer. To solve with a financial calculator: -100,000 [PV]; 4/ [I/Y]; [N]; [CPT][FV] 106,181. Apply the 10 percent penalty for early withdrawal, and the investor should receive $106, $95,563. PV is a cash outlay, therefore use the negative sign. Identify the interest rate and the compounding you will need to adjust your inputs accordingly. 4% compounded weekly 4/52 and notice the question asks how much the investor receives ; therefore, the number of compounding periods must reflect 18 months (not the two-year term of the investment): 52 x This question requires you to know your TVM calculator functions and how to capture the necessary information in the question and ignore what you do not need. TIP: Set the P/Y setting on your calculator to 1 so the I/Y represents the interest rate per compounding period and N is the number of compounding periods. Remember before starting a new TVM problem clear the TVM worksheet and reset to default values: [2ND][QUIT] [2ND][CLR TVM] CFA Exam Calculator Guide Access Time-Saving Tips and Settings for your BA II Plus Calculator 2nd INV HYP COMPUTE ENTER SET DEL INS BGN RAD QUIT CPT ENTER ON OFF 2ND xp/y K HYP INV LN ROUND STO RCL CLR WORK CE C SET DEL INS CF SIN ( ) DATA 7 DEPR NPV IRR P/Y AMORT BGN CLR TVM N I/Y PV PMT FV % COS TAN STAT BOND npr 8 9 BRKEVN DATE ICONV PROFIT MEM FORMAT RESET 0. e % 2 1/ RAND! ncr ANS

3 Level I candidates must understand the concepts of net present value (NPV) and internal rate of return (IRR). These concepts cross topics and levels so building a strong foundation now, will pay off in the long run. Remember the NPV / IRR rules: NPV rule: +NPV projects shareholder wealth accept; -NPV projects shareholder wealth reject For mutually exclusive projects accept the highest +NPV IRR the discount where NPV 0 IRR rule: IRR > r accept; IRR < r reject For mutually exclusive projects, if NPV and IRR rules conflict use NPV rule. 2. Company X has committed to investing $2,000,000 in a project with expected cash flows of $500,000 at the end of every year for the next 5 years. The appropriate discount rate is 12%. The NPV and IRR of the project are closest to: NPV IRR A. (197,612) 7% B. (197,612) 8% C. (142,612) 8% (B) is the correct answer. Again, take advantage of your financial calculator. For NPV: [CF] [2ND][CEǀC] [2,000,000][+ ǀ-] [ ][500,000] [ ][5] [NPV][12] Enters the Cash Flow function Clears the CF memory CF0 value use the negative sign because this is an outflow C01 value this is an inflow F01 value the frequency of the CF, it is received 5 times I value the interest rate [ ][CPT] Calculates NPV NPV -197,612 For IRR: [IRR][CPT] Calculates IRR for same NPV calculation IRR 7.93% or approximately 8% TIP: Should this project be accepted? No, remember the NPV rule, only accept positive NPV projects. 3. A firm must choose between two mutually exclusive projects. The firm s opportunity cost of capital is 9.5 percent. After performing both NPV and IRR analyses, the data shown in the table below was collected. Project NPV IRR A $36, % B $15, % Which project should be undertaken? A. Project A because it has the highest NPV. B. Project B because it has the highest IRR. C. Both projects because their NPVs are positive. (A) is the correct answer. Go back to the NPV and IRR rules. When projects are mutually exclusive (only one may be undertaken), the best choice is to accept the one with the highest net present value (NPV) because it represents the actual value added by the project. Free CFA Video Lesson Net Present Value & Internal Rate of Return

4 Concepts that repeat throughout the curriculum and across levels are definite must knows! Return concepts fall into this category, in particular: Holding period yield (HPY), moneyweighted and time-weighted rates of return (MWRR and TWRR), bank discount yield (BDY), effective annual yield (EAY), money market yield (MMY) and bond equivalent yield (BEY). You will need to know how to calculate and interpret these. Here again, your financial calculator is your best friend. MWRR is simply the IRR; it accounts for timing and the amount of cash flows coming in and going out. TWRR measures the compounded rate of growth over a stated period of time. Note the differences; as opposed to MWRR, TWRR averages holding period returns over time and is not affected by the timing of cash inflows or outflows. TWRR is the standard in the investment management industry. 4. An investor purchased 100 shares of Company X at $60/share. A year later she bought 50 more shares of the company at a price of $70/share. She also received a $5/share dividend at the end of Year 1. At the end of Year 2 she sold all her shares for $75/share. No dividends were paid for Year 2. Her money-weighted (MWRR) and timeweighted (TWRR) rates of return are closest to: MWRR TWRR A % 14.23% B % 14.23% C % 15.72% (C) is the correct answer. Know your financial calculator keystrokes! Calculate TWRR: Step 1: Break down the cash flows into 2 holding periods Step 2: Calculate HPR for each period Step 3: Calculate the compounded annual rate HPR (Ending value+dividends beginning value)(100) beginning value Holding Period 1 Holding Period 2 Year 1 beginning value (t 0) Year 1 dividends received (t 1) Year 1 ending value (t 1) (100)($60) $6,000 (100)($5) $500 (100)($70) $7,000 HPR1 (7, ,000)(100) 25% 6,000 Year 2 beginning value (t 1) Year 2 dividends received (t 2) Year 2 ending value (t 2) (150)($70) $10, (150)($75) $11,250 HPR2 (11,250 10,500)(100) 7.14% 10,500 [(1+HPR1)(1+HPR2)] 0.5 1[(1+0.25)( )] % Calculate MWRR: Step 1: Determine timing and nature of cash flows Step 2: Calculate IRR t 0 Purchase of first 100 shares (100)($60) - $6,000 t 1 Year 1 dividends received Purchase of next 50 shares Net cash flow at t 1 (100)($5) (50)($70) + $500 -$3,500 -$3,000 t 2 Year 2 dividends received Proceeds from sale of shares Net cash flow at t 2 0 (150)($75) $11,250 $11,250 [CF] Enters the Cash Flow function [2ND][CEǀC] Clears the CF memory [6,000][+ ǀ-] [ ][3,000][+ ǀ-] [ ][ ][11,250] [IRR][CPT] IRR 14.19% CF0 value use the negative sign because this is an outflow C01 value this is a NET out flow. $500 inflow from dividends and $3,500 outflow for new share purchase. C02 value this is an inflow (proceeds from the sale) Calculates IRR TIP: Know the steps and, if needed, create a visual timeline of the cash flows.

5 The following return concept questions are more easily tackled if you calculate HPY first. Know the relationships between the returns. HPY is the actual annualized return to the investor over a specific holding period; EAY is the HPY annualized on a 365-day year with compounding; and MMY is the HPY annualized on a 360-day year without compounding. The bond equivalent yield (BEY) is the semiannual rate times A T-bill with the face value of $100,000 and 90 days until maturity is selling for $99,000. Its BDY, MMY, and EAY are closest to: BDY MMY EAY A. 4% 4.4% 4.16% B. 4.5% 4.04% 4.4% C. 4% 4.04% 4.16% : (C) is the correct answer. The Bank Discount Yield (BDY) is calculated as follows, where: r BD the annualized yield on a bank discount basis; D the dollar discount (face value - purchase price) F the face value of the bill t number of days remaining until maturity 360 F t 100, % BDY R BD D x 360 (100,000 99,000) x To calculate the Money Market Yield (MMY) and the Effective Annual Yield (EAY), first calculate the Holding Period Yield (HPY) where: P 0 initial price of the investment; P 1 price received from the instrument at maturity/sale D 1 interest or dividend received from the investment HPY HPY (P1 P0 D1) (P1 D1) 1 P 0 P 0 HPY (100,000) % 99,000 The MMY is HPY annualized over a 360-day period assuming simple interest. The EAY is the HPY annualized over a 365-day year assuming compound interest. 360 MMY MMY HPYx 1.01% x t ( ( % EAY EAY (1+HPY) t 1 ( ) % TIP: EAY can be converted back to HPY using the following formula: t 90 HPY (1 + EAY) ( ) % To calculate BEY, use the EAY and determine the semiannual rate; then multiple by 2. BEY is calculated as: BEY [(1+EAY) 0.5 1](2) [( ) 0.5 1](2) % Financial Reporting and Analysis (FRA) is loaded with ratios you need to be able to calculate and interpret: Activity, liquidity, solvency, profitability, and valuation ratios. In the following questions, we look at some examples of these ratio categories as well as the DuPont analysis of return of equity (ROE). Ratio analysis is a definite must know! A quick summary of ratio analysis categories: Activity ratios - measure how productive a company uses its assets and how efficiently it preforms everyday operations. Liquidity ratios measure a company s ability to meet its short-term cash requirements. Solvency ratios measure a company s ability to meet its long-term debt obligations. Profitability ratios - measure a company s ability to generate an adequate return on invested capital. Valuation ratios - measure the quantity of an asset or flow (cash/earnings) associated with ownership of a specific claim (e.g., common stock).

6 6. ABC Corporation presents the following condensed balance sheet: 20X8 ($ 000) 20X9 ($ 000) ASSETS Current Assets 26,600 31,600 Long-term Assets 259, ,900 Total Assets 286, ,500 LIABILITIES Current Liabilities 8,500 12,300 Long-term Debt 72, ,700 SHAREHOLDER S EQUITY Common Stock 100, ,000 10% Preferred Stock 75,000 75,000 Retained Earnings 31,000 42,500 Total Shareholder s Equity and Liabilities 286, ,500 ABC Corporation s liquidity position (as measured by the current ratio) and solvency position (as measured by its debt-to-assets ratio) over 2009 has most likely: Liquidity Solvency A. Improved Remained the same B. Worsened Weakened C. Remained the same Weakened : (B) is the correct answer. Liquidity as measured by the current ratio: Current Ratio 2009 Current Assets 31,600 Current Liabilities 12, Current Assets 26,600 Current Ratio Current Liabilities 8, A company s balance sheet indicates that it has sufficient cash and short-term investments. Its payables turnover ratio, however, remains low. This most likely suggests that: A. The company has a liquidity crisis. B. The company s suppliers offer it lenient credit terms. C. The company has excellent receivables collection. : (B) is the correct answer. Purchases Payables Turnover Ratio Average Trade Payables The denominator in the payables turnover ratio is average trade payables; if trade payables are high or increase, the ratio will be lower. The most likely explanation for a company with sufficient liquid assets to have low payables turnover is that management is taking advantage of lenient credit and collection terms offered by suppliers. TIP: If the preceding question required a calculation, the amount for purchases may not be explicitly stated on the income statement. It may need to be determined from footnotes or calculated using the following formula: Purchases Ending Inventory + COGS - Opening Inventory TIP: Make sure you can interpret ratios not only directionally (increase / decrease) but that you understand the logical reasons why they could occur and the impact ratios have on each other; these are popular exam items! Solvency as measured by the debt-to-assets ratio: Debt-to-Assets 2009 Total Debt 134,700 Total Assets 364, Debt-to-Assets 2008 Total Debt 72,000 Total Assets 286,

7 The DuPont analysis decomposes ROE into multiple components to facilitate a meaningful evaluation of a company s performance, and to direct management to areas that need improvement. ROE Net Income Average Total Equity The three-way decomposition is: Net Profit Margin x Asset Turnover Ratio x Financial Leverage Ratio. Net Income Revenue ROE x x Revenue Average Total Assets Average Total Assets Average Shareholders Equity 8. An analyst has compiled the following data for a company: 20X3 20X2 20X1 Net profit margin 2.7% 2.8% 2.6% Total asset turnover Financial leverage Based only on the information above, which of the following is the most appropriate conclusion for the 20X1 to 20X3 period? A. ROA and ROE have increased. B. ROA and ROE have decreased. C. ROA has decreased, but ROE has increased. (A) is the correct answer. Use the three-way DuPont decomposition. ROA is calculated by multiplying the net profit margin by the total asset turnover. The resulting ROAs for 20X1 and 20X3 are 8.58 [(0.026)(3.3)] and 9.45 [(0.027)(3.5)] percent, respectively. This shows that ROA increased during the period. ROE is equal to the ROA multiplied by the financial leverage. Given that both the ROA and the financial leverage have risen, the ROE must have increased between 20X1 and 20X3. TIP: When you are moving quickly through the exam, pay careful attention to details such as the order of the information presented. Note: The table in the preceding question presents the data in descending time order; take that into consideration when answering the question. The DuPont analysis also decomposes ROE into five components to illustrate the effects of taxes and interest. The five-way decomposition is: Tax Burden x Interest Burden x EBIT Margin x Asset Turnover Ratio x Financial Leverage Ratio. Net Income EBT EBIT ROE x x x EBT EBIT Revenue Revenue Avg. Total Assets x Average Total Assets Avg. Shareholders Equity 9. A decomposition of ROE for two companies is as follows: Company A FY13 FY12 ROE 15.1% 25.7% Tax burden Interest burden EBIT margin 7.0% 12.0% Asset turnover Leverage Company B FY13 FY12 ROE 22.2% 25.7% Tax burden Interest burden EBIT margin 11.0% 12.0% Asset turnover Leverage An analyst is most likely to conclude that Company A s lower ROE in FY13 (compared to Company B s ROE) could be due to: A. the purchase of new equipment that is being financed with debt. B. a shift in strategy by Company A to become more labor intensive and less capital intensive.

8 C. a higher tax rate, lower EBIT margin, and less efficient asset use, but these were somewhat offset by Company A s increased leverage. (A) is the correct answer. Use the five-way DuPont decomposition. If Company A purchased new equipment using debt, it would likely cause several possible outcomes. 1. Depreciation expense will increase. This is a possible reason for the lower EBIT margin. 2. Interest paid will increase. This outcome can be observed in the interest burden factor. Interest as a percentage of EBIT rose from 10 percent to 25 percent and this resulted in the interest burden factor declining from 0.90 to The effective tax rate will likely decrease due to the lower profits caused by the first two items. The tax burden factor rose from 0.70 (30 percent tax rate) to 0.80 (20 percent tax rate). 4. Asset turnover, which is revenue divided by average total assets, will fall as new assets are added. This has definitely occurred with Company A s asset turnover declining from 1.7 to 1.2, while Company B s asset turnover only declined modestly to 1.6 from If debt was used to add fixed assets, then equity is not being used to fund the additions. As a result of adding equipment, assets rise (increasing average assets), debt rises, and equity is unchanged. Hence, the leverage (average assets / average equity) will rise; as was seen for Company A. These items will combine to best explain the much larger decline in Company A s ROE relative to the decline in Company B s ROE. TIP: Do not be confused by the term burden. A higher ratio does not mean more tax or interest; it means just the opposite. A higher tax and interest burden is actually better for the company. One of many important ratios to learn is the Sharpe Ratio, which measures excess return per unit of risk. 10. Portfolio A has a mean return of 11% and a standard deviation of 3%. Portfolio B has a mean return of 17% and a standard deviation of 6%. The risk-free rate of interest is 3%. The respective Sharpe ratios of the two portfolios are closest to: Portfolio A Portfolio B A B C (B) is the correct answer. R p r f Sharpe Ratio ơ p Sharpe ratio for Portfolio A (11-3) / Sharpe ratio for Portfolio B (17-3) / Good luck and stay on track. Remember, good preparation is essential to success. For additional free resources including Wiley s ebook, How to Pass the CFA Exam, visit

CFALA/USC REVIEW MATERIALS USING THE TI-BAII PLUS CALCULATOR. Using the TI-BA2+

CFALA/USC REVIEW MATERIALS USING THE TI-BAII PLUS CALCULATOR David Cary, PhD, CFA Fall 2018. dcary@dcary.com (helpful if you put CFA Review in subject line) Using the TI-BA2+ Notes by David Cary These