CFA Practice Test 1 — Questions and Answers

Question 1: The formula will most likely be used to calculate the value of an existing single-family home utilized for residential purposes:

income approach
sales comparison approach. (Correct answer)
cost approach

Correct answer: sales comparison approach.

The sales comparison approach is the most appropriate method for valuing existing single-family homes. This approach estimates value by comparing the subject property to similar properties that have recently sold in the same market, making adjustments for differences. The income approach is for income-generating properties, and the cost approach is typically for new construction or unique properties.

Question 2: Which of the following alternative investments is the best fit for a high-net-worth individual with a long time horizon and a need for immediate income?

Multi-strategy hedge funds.
Commercial real estate. (Correct answer)
Venture capital.

Correct answer: Commercial real estate.

Commercial real estate is an excellent fit for a high-net-worth individual with a long time horizon and a need for immediate income. It typically generates stable rental income, providing immediate cash flow, and offers potential for capital appreciation over the long term. Venture capital involves high risk and long horizons with no immediate income, while multi-strategy hedge funds may offer some liquidity but are not primarily focused on immediate income.

Question 3: Utilized buyout finance is assessing Siena Company relative to its peer companies. Siena is most likely a great candidate for an administration buy-in in the event that it has:

higher cash flow and more capable managers than its peers.
higher cash flow and less capable managers than its peers. (Correct answer)
lower cash flow and more capable managers than its peers.

Correct answer: higher cash flow and less capable managers than its peers.

A company is most likely a great candidate for a management buy-in (MBI) if it has higher cash flow, as this cash flow is crucial for servicing the debt used in a leveraged buyout. Additionally, less capable existing managers present an opportunity for the new management team to improve operations and unlock value, making the target more attractive for an MBI.

Question 4: A REIT's funds from operations (FFO) are most likely computed as follows:

Net income plus depreciation less capital expenditures.
Net income less gains from sales of real estate plus losses from sales of real estate.
Net income plus depreciation less gains from sales of real estate plus losses from sales of real estate. (Correct answer)

Correct answer: Net income plus depreciation less gains from sales of real estate plus losses from sales of real estate.

Funds From Operations (FFO) is a key metric for REITs that adjusts net income to better reflect cash flow from operations. It is calculated by adding back depreciation and amortization to net income, and then adjusting for non-recurring gains or losses from the sale of real estate. This provides a clearer picture of a REIT's ongoing operational performance by removing non-cash expenses and non-operating income/losses.

Question 5: Consider the following propositions: <br/> Phrase1: Commodities have generally had a higher Sharpe ratio than bonds but a lower Sharpe ratio than stocks. <br/> Phrase 2: Commodity price volatility is typically higher than reported consumer price inflation volatility. <br/> Which of these is the most likely case?

Only Statement 1 is incorrect. (Correct answer)
Both statements are correct.
Only Statement 2 is incorrect.

Correct answer: Only Statement 1 is incorrect.

Historically, commodities have generally exhibited lower Sharpe ratios compared to both stocks and bonds, making Statement 1 incorrect. However, commodity prices are known for their significant volatility, which is typically higher than the smoother, more stable reported consumer price inflation volatility, making Statement 2 correct. Therefore, only Statement 1 is incorrect.

Question 6: The spot price of a commodity market is in contango if it is:

equal to futures prices.
lower than futures prices (Correct answer)
higher than futures prices.

Correct answer: lower than futures prices

A commodity market is in contango when the futures price is higher than the current spot price. This market structure typically reflects the costs of holding the physical commodity over time, such as storage costs and insurance, exceeding any convenience yield. The opposite condition, where futures prices are lower than spot prices, is called backwardation.

Question 7: Which of the following is the least likely source of profit from a commodity futures position with collateral?

Storage costs (Correct answer)
Spot price return
Collateral yield

Correct answer: Storage costs

Profit from a commodity futures position with collateral typically comes from the spot price return (or roll return) and the collateral yield (interest earned on the collateral). Storage costs, however, are an expense associated with holding physical commodities, not a source of profit from a futures position itself. In fact, storage costs contribute to contango, making futures prices higher than spot prices.

Question 8: In 20x7, an investment in a hedge fund with a 2-and-20 fee structure rose in value each period, yielding an 8 percent net return net of management fees. Which of the following provisions would have the highest incentive fees for 20x7?

6% soft hurdle rate and a high water mark provision. (Correct answer)
7% hard hurdle rate and no high water mark provision.
5% hard hurdle rate and a high water mark provision.

Correct answer: 6% soft hurdle rate and a high water mark provision.

Given an 8% net return after management fees, we compare incentive fees for each option. A soft hurdle rate means incentive fees are applied to the entire profit if the hurdle is met. Option A's 6% soft hurdle means 20% of the full 8% return is taken as incentive fee (1.6%). Options B and C have hard hurdle rates, meaning fees are only on profits *above* the hurdle (8%-7%=1% for B, 8%-5%=3% for C), resulting in lower incentive fees (0.2% and 0.6% respectively). Therefore, the soft hurdle rate in option A yields the highest incentive fees.

Question 9: Which of the following alternative investments would be best for a high-net-worth individual with a long time horizon and a need for immediate income?

Venture capital.
Multi-strategy hedge funds.
Commercial real estate. (Correct answer)

Correct answer: Commercial real estate.

Commercial real estate is the best alternative investment for a high-net-worth individual seeking a long time horizon and immediate income. It offers potential for capital appreciation over time and generates consistent rental income, fulfilling the need for immediate cash flow. Venture capital and multi-strategy hedge funds typically focus on capital growth rather than immediate income generation.

Question 10: The esteem of an existing single—family domestic utilized for private purposes will most likely be calculated utilizing the:

income approach.
sales comparison approach. (Correct answer)
cost approach.

Correct answer: sales comparison approach.

The sales comparison approach is the most appropriate and commonly used method for valuing existing single-family residential properties. This approach estimates value by comparing the subject property to similar properties that have recently sold in the same market, making adjustments for differences. The income approach is for income-generating properties, and the cost approach is typically for new construction or unique properties.

Question 11: Kate Smith, CFA, is thinking about diversifying her typical investment portfolio with hedge funds. Werner calculates the diversification benefits of investing 5% of a portfolio's assets to hedge funds based on historical mean and standard deviation of hedge fund index results, as well as their association with traditional investment returns. Werner is most likely to:

accurately estimate the potential diversification benefits to the portfolio.
overestimate the potential diversification benefits to the portfolio. (Correct answer)
underestimate the potential diversification benefits to the portfolio.

Correct answer: overestimate the potential diversification benefits to the portfolio.

Using historical hedge fund index results to estimate diversification benefits often leads to overestimation due to several biases. These include survivorship bias (failed funds are removed, inflating returns), backfill bias (funds report past good performance upon joining an index), and liquidity bias (smoothed returns underestimate true volatility and correlation). These biases make hedge funds appear to have higher returns, lower volatility, and lower correlation with traditional assets than they actually do, thus overstating their diversification potential.

Question 12: In a leveraged buyout (LBO), the mezzanine finance part is most likely to:

have seniority over other bonds issued to finance the LBO.
be convertible to equity or include warrants. (Correct answer)
represent committed capital.

Correct answer: be convertible to equity or include warrants.

Mezzanine finance in a leveraged buyout (LBO) is a hybrid form of capital that combines debt and equity features. It is typically subordinated to senior debt but ranks above equity. A key characteristic is that mezzanine finance often includes an equity kicker, such as warrants or convertibility into equity, allowing lenders to participate in the company's upside potential if the LBO is successful.

Question 13: The component of a long-only commodity futures position's yield that is not affected by whether the contract is in contango or backwardation is the:

roll yield.
convenience yield
collateral yield. (Correct answer)

Correct answer: collateral yield.

The collateral yield is the return earned on the cash collateral posted to secure a futures position, typically invested in low-risk assets like T-bills. This yield is independent of the relationship between spot and futures prices, which defines contango or backwardation. In contrast, the roll yield is directly affected by whether the contract is in contango (negative roll yield) or backwardation (positive roll yield).

Question 14: Cathy Williams, CPA, is an asset manager who wants to put some of his money into alternative ventures. Williams buys a security that represents a proportional claim to a pool of loans' cash flows. Williams has most likely invested in which alternative investment category?

Private equity.
Real estate. (Correct answer)
Commodities.

Correct answer: Real estate.

Investing in a security that represents a proportional claim to a pool of loans' cash flows is characteristic of securitized debt. This often includes mortgage-backed securities (MBS) or collateralized loan obligations (CLOs) backed by real estate or other loans. Such investments fall under the broader alternative investment category of real estate, which encompasses not just direct property ownership but also related financial instruments.

Question 15: A private equity fund sells the following items to exit a portfolio company through a trade sale:

shares of a portfolio company to the public.
the portfolio company to another private equity firm.
the portfolio company to one of the portfolio company‘s competitors. (Correct answer)

Correct answer: the portfolio company to one of the portfolio company‘s competitors.

A trade sale is an exit strategy where a private equity firm sells its portfolio company to a strategic buyer, typically another operating company. Selling the portfolio company to one of its competitors is a classic example of a trade sale, as the buyer often seeks to gain market share, achieve synergies, or acquire specific assets or technologies. Selling shares to the public is an IPO, and selling to another private equity firm is a secondary sale.

Question 16: The phrase "mezzanine-stage financing" is used to characterize the financing in the context of venture capital:

to prepare for an initial public offering. (Correct answer)
that supports product development and market research.
to initiate commercial manufacturing.

Correct answer: to prepare for an initial public offering.

Mezzanine-stage financing is typically one of the later stages of venture capital funding, provided to companies that are already established and generating revenue. This capital is often used to fund expansion, prepare for an initial public offering (IPO), or position the company for an acquisition. It bridges the gap between earlier-stage venture capital and a public market exit.

Question 17: When compared to its accounting-based net asset value (NAV), a hedge fund trading NAV:

will be lower because of adjustments for illiquid positions. (Correct answer)
may be higher or lower, reflecting gains or losses on securities designated for short—term
is likely to be higher because of upward bias in model—based security values.

Correct answer: will be lower because of adjustments for illiquid positions.

A hedge fund's trading NAV is often a more conservative estimate than its accounting-based NAV, especially due to adjustments for illiquid positions. Illiquid assets, which are difficult to sell quickly without a significant price concession, may be valued at a discount to reflect potential liquidation costs or market uncertainty. This aims to provide a more realistic, albeit lower, value that the fund could realize in a sale.

Question 18: A portfolio manager is more likely to predict higher returns if a percentage of assets is allocated to alternative investments, because alternative investments:

often employ leverage. (Correct answer)
are more efficiently priced than traditional assets.
provide liquidity.

Correct answer: often employ leverage.

Alternative investments, such as hedge funds and private equity, frequently employ leverage to enhance potential returns. While leverage also amplifies risk, the ability to generate higher returns through borrowed capital is a key reason why portfolio managers allocate assets to these categories. This characteristic differentiates them from many traditional investments and contributes to their appeal for return-seeking investors.

Question 19: Which of the following assertions concerning a public company's annual reports, SEC filings, and press releases in the United States is the most accurate?

Annual reports to shareholders are typically the most factual and objective source of information about a company.
Annual and quarterly SEC filings must be audited.
Interim SEC filings typically update the major financial statements and footnotes. (Correct answer)

Correct answer: Interim SEC filings typically update the major financial statements and footnotes.

Interim SEC filings, such as Form 10-Q (quarterly reports), provide updated financial statements (balance sheet, income statement, cash flow statement) and relevant footnotes for the most recent quarter. These filings are crucial for investors to stay informed about a company's financial performance and position between annual reports. Annual reports to shareholders are often marketing documents, and only annual SEC filings (10-K) are fully audited.

Question 20: A private equity firm that wishes to obtain money from a portfolio company without giving up ownership is most likely to:

recapitalization. (Correct answer)
trade sale.
secondary sale.

Correct answer: recapitalization.

Recapitalization involves altering a company's capital structure, often by issuing new debt to fund a large dividend payment to shareholders, including the private equity firm. This allows the private equity firm to extract cash from the portfolio company without selling its ownership stake. Trade sales and secondary sales, conversely, are exit strategies that involve relinquishing ownership.

Question 21: Which of the following is most likely to happen if a company employs the weighted average cost of capital (WACC) to discount the cash flows of higher-risk projects?

Project NPVs will be understated.
The firm will reject profitable projects.
The overall risk of the firm’s investments will rise over time. (Correct answer)

Correct answer: The overall risk of the firm’s investments will rise over time.

Using the firm's overall weighted average cost of capital (WACC) to discount higher-risk projects effectively understates their true cost of capital. This leads to these projects appearing more attractive (higher NPV) than they actually are, causing the firm to accept projects that are riskier than its average. Consequently, the firm's overall risk profile will gradually increase over time as it undertakes more of these mispriced high-risk ventures.

Question 22: It is most likely that a strong corporate code of ethics will allow:

finder’s fees for merger or acquisition targets to be paid to board members.
board members to simultaneously sit on the board of another firm. (Correct answer)
the company to award consulting contracts to board members.

Correct answer: board members to simultaneously sit on the board of another firm.

A strong corporate code of ethics aims to prevent conflicts of interest and promote ethical behavior. While sitting on the board of another firm (interlocking directorship) can raise governance concerns, it is generally permissible if disclosed and managed to avoid conflicts. However, paying finder's fees or awarding consulting contracts to board members creates direct financial conflicts of interest that a robust code of ethics would typically prohibit or severely restrict to ensure independent judgment.

Question 23: The point on the company's investment opportunity schedule that best determines the amount of an appropriate the capital budget for a corporation is:

where it intersects the company's marginal cost of capital curve. (Correct answer)
where the expected return on the next potential project is at its maximum.
where the amount of new capital raised is at its minimum.

Correct answer: where it intersects the company's marginal cost of capital curve.

The optimal capital budget for a corporation is determined at the point where the investment opportunity schedule (IOS) intersects the marginal cost of capital (MCC) curve. The IOS ranks potential projects by their expected return, while the MCC curve shows the cost of raising additional capital. The firm should invest in all projects whose expected return exceeds the cost of capital, up to this intersection point, maximizing shareholder wealth.

Question 24: The form of short-term finance whose cost is most directly linked to a firm's customers' creditworthiness is:

issuing commercial paper.
an uncommitted line of credit.
factoring. (Correct answer)

Correct answer: factoring.

Factoring involves selling a company's accounts receivable to a third party (the factor) for immediate cash. The cost of factoring is heavily influenced by the creditworthiness of the firm's *customers*, as the factor assumes the risk of collecting those receivables. If the customers are less creditworthy, the factor will charge a higher fee to compensate for the increased risk of default.

Question 25: A company with S2 earnings per share decides to buy back a portion of its stock at $25 per share. The company's after-tax cost of debt is 6%, and it gets a 2% after-tax yield on its spare cash. - When the company buys back shares, the earnings per share will be:

decrease if the firm funds the repurchase with debt, but increase if the firm uses excess cash to repurchase the shares.
increase if the firm funds the repurchase with debt or uses excess cash to repurchase the shares. (Correct answer)
decrease if the firm funds the repurchase with debt or uses excess cash to repurchase the shares.

Correct answer: increase if the firm funds the repurchase with debt or uses excess cash to repurchase the shares.

A stock repurchase reduces the number of outstanding shares. If the company uses excess cash, it replaces a low-yielding asset (2% after-tax) with a higher-yielding one (implied earnings yield of $2/$25 = 8%), thus increasing EPS. If funded by debt, the after-tax cost of debt (6%) is less than the earnings yield of the repurchased shares (8%), meaning the earnings saved per share exceed the cost of financing. In both scenarios, the earnings per share will increase.

CFA Practice Test 1

The formula will most likely be used to calculate the value of an existing single-family home utilized for residential purposes: