Economic Factors, Business Info, Strategy (Investment Analysis) Flashcards Preview

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Flashcards in Economic Factors, Business Info, Strategy (Investment Analysis) Deck (175):
1

Which of the following statements best describes the risk-free rate of interest?

A) The rate of interest earned on a corporate bond that is guaranteed by a highly rated insurance company
B) Rate of interest on a municipal security
C) Rate of interest in excess of the pure time value of money
D) The rate of interest earned on short-term U.S. Treasury securities

D) The rate of interest earned on short-term U.S. Treasury securities

The rate of interest earned on short-term U.S. Treasury securities, generally the 90-day T-bill, is referred to as the risk-free rate. The rate of interest in excess of the pure time value of money is called the risk premium, not the risk-free rate.

2

The research department of an investment advisory firm forecasts that the current business cycle should reach its peak within the next 2 months. Under such circumstances, which of the following portfolio adjustments would be most suitable for the firm's customers who actively invest in common stocks?

A) Corporate bonds.
B) Cyclical stocks.
C) Defensive stocks.
D) Aggressive growth stocks.

C) Defensive stocks.

The concept of sector rotation involves moving assets from those sectors that are close to their peak and moving into those who will benefit from the next move in the business cycle. Defensive stocks such as those in the food, pharmaceuticals, and energy industries would most likely be suitable for investors who believe the cycle is near its peak. Defensive stocks are least likely to be affected by a reversal in the business cycle.

3

A client has 100 shares of GHI when the stock undergoes a split. After the split, the client has:

A) a proportionately decreased interest in the company.
B) a proportionately increased interest in the company.
C) greater exposure.
D) no effective change in the value of the position.

D) no effective change in the value of the position.

When a stock splits, the number of shares each stockholder has either increases or decreases (in the case of a reverse split). The customer experiences no effective change in position because the proportionate interest in the company remains the same.

4

Which of the following statements regarding a 2-for-1 stock split are TRUE?

1. The share price is reduced by half.
2. The total market value of the outstanding stock decreases.
3. The total market value of the outstanding stock may increase or decrease as a result of the split.
4. The number of shares doubles.

Which of the following statements regarding a 2-for-1 stock split are TRUE?

1. The share price is reduced by half.
4. The number of shares doubles.

5

Which of the following statements is TRUE?

A) A corporation is required to pay a cash dividend to stockholders if the earnings are sufficient, especially if it is of preferred stock.
B) A growth company would be more likely to pay a cash dividend than a stock dividend.
C) A stock split increases the owners proportionate share of the company.
D) Dividends have a significant influence on the value of the corporation's stock.

D) Dividends have a significant influence on the value of the corporation's stock.

Dividends play a large role in what someone is willing to pay for the stock. For example, the dividend discount model (DDM) values a stock as the discounted present value of future dividends. A company is not required to pay dividends. A growth company will tend to pay no cash dividends but rather use the money for expansion.

6

If a client has 100 shares of XYZ publicly traded stock and it undergoes a split, afterward the client will have:

A) a proportionately decreased interest in XYZ company.
B) a proportionately increased interest in XYZ company.
C) a greater role in the daily management of the company.
D) no effective change in the value of his ownership share.

D) no effective change in the value of his ownership share.

When a stock splits, the number of shares each shareholder holds increases. However, the value of each share decreases proportionately. The client experiences no effective change in the value of his ownership share.

7

If a U.S. corporation wishes to issue Eurodollar bonds, which of the following statements are TRUE?

1. The corporation will be subject to currency risk.
2. The corporation will not be subject to currency risk.
3. The issue must be filed with the SEC.
4. The issue need not be filed with the SEC.

2. The corporation will not be subject to currency risk.
4. The issue need not be filed with the SEC.

Because Eurodollar bonds are denominated in U.S. dollars, a U.S. corporate issuer will not be subject to foreign exchange risk, regardless of the country of issuance. In addition, because the bonds are issued outside the U.S., the issue is not registered with the SEC.

8

A fundamental analyst researching a stock is concerned with all of the following EXCEPT

A) the stock's market price as a multiple of the company's earnings
B) management efficiency
C) capitalization ratio
D) volume of shares traded

D) volume of shares traded

A fundamental analyst is concerned with the economic climate, the inflation rate, how an industry is performing, a company's historical earnings trends, how it is capitalized, and its product lines, management, and financial statement ratios, such as the P/E ratio. A technical analyst is concerned with trading volumes or market trends and prices.

9

Which of the following factors would be considered by an investor who uses fundamental analysis to value a company's stock?

1. The company's financial condition, as revealed by its income statement and balance sheet
2. General economic conditions, such as employment levels and changes in interest rates
3. Charts showing past movements in stock prices and trading volumes

1. The company's financial condition, as revealed by its income statement and balance sheet
2. General economic conditions, such as employment levels and changes in interest rates

Fundamental analysis attempts to value stock by examining general economic conditions and the company's financial condition and growth prospects. Technical analysis, on the other hand, tries to identify trends and predict changes in the market. Charts showing past price movements and trading volumes would be used in technical analysis but not in fundamental analysis.

10

In the assessment of a company's stock, a technical analyst takes into consideration all of the following EXCEPT:

A) earnings.
B) market price.
C) price momentum.
D) volume.

A) earnings.

A market technician (technical analyst) deals primarily with timing of activity and market trends, while a fundamental analyst centers on a particular industry or company within an industry and its relative health and market potential.

11

In the technical analysis of the value of securities, which of the following items is NOT important?

A) The amount of a company's past earnings.
B) The breadth of market volume.
C) A prevailing market trend in response to shifts in supply and demand.
D) Resistance and support levels.

A) The amount of a company's past earnings.

The amount of a company's past earnings is a factor used in the fundamental analysis of securities, but not technical analysis. Technicians rely on market trends and supply and demand factors, as well as chart indications such as resistance and support levels.

12

Which of the following statements about technical analysis are TRUE?

1. Technical analysis tries to identify trends and predict market changes.
2. Technical analysis is often accomplished by reviewing data in the form of charts.
3. Technical analysis looks primarily at past performance to predict future trends.

1. Technical analysis tries to identify trends and predict market changes.
2. Technical analysis is often accomplished by reviewing data in the form of charts.
3. Technical analysis looks primarily at past performance to predict future trends.

Technical analysts attempt to identify trends so they can predict market changes. They do this by reviewing past performance as depicted in charts and graphs. The type of analysis that attempts to value stock by examining a company's financial condition and growth potential is fundamental analysis.

13

Which of the following indices or averages is based on the prices of only 65 stocks (30 industrial, 20 transportation, and 15 utility)?

A) Value Line.
B) Wilshire 5,000.
C) Dow Jones Composite Average.
D) S&P Composite.

C) Dow Jones Composite Average.

The most widely quoted and oldest measures of changes in stock prices are the Dow Jones averages. They are also the smallest in terms of the number of stocks included in the averages with only 65 stocks.

14

If stock market indexes, such as the S&P 500 and the DJIA, are declining daily, and the number of declining stocks relative to advancing stocks is falling, a technical analyst will conclude that the market is:

A) oversold.
B) overbought.
C) becoming volatile.
D) unstable.

A) oversold.

The momentum of the market decline seems to be easing as the number of decliners to advancers is leveling out. It looks like the advance/decline line is moving in a direction away from decliners. A technical analyst would conclude that the market is oversold and approaching a bottom.

15

According to technical analysis, when the market is consolidating, a chart showing the market trendline appears to be moving:

A) downward with sporadic upswings.
B) sideways within a narrow range.
C) upward to reach a new peak.
D) downward to reach a new low.

B) sideways within a narrow range.

A consolidating market is one that stays within a narrow price range. When viewed on a graph, the trendline is horizontal and is said to be moving sideways, meaning neither up nor down.

16

A technical analyst (chartist) with a long position in a particular stock would most likely enter a sell stop order below that stock's:

A) 200-day moving average.
B) support level.
C) resistance level.
D) previous high.

B) support level.

Sell stops are entered below the market. They are used to turn an order into a market order if the current market value falls below the stop level. In technical analysis, support levels are theoretical levels where the market supports the stock price (keeps it from falling below the stated level). A technical analyst who makes investment decisions by watching the technical graphs and numbers would enter a sell stop below a support level in order to sell out if the support level is breached. A breakthrough of a support level is believed to forecast a major market price decline.

17

Proponents of which of the following technical theories assume that small investors are usually wrong?

A) Odd lot.
B) Breadth of market.
C) Short interest.
D) Volume of trading.

A) Odd lot.

Odd lots are usually traded by small investors; some analysts believe small investors are generally wrong.

18

Which of the following analyze corporate financial statements and trends in sales and income?

A) Technicians.
B) Market timers.
C) Fundamentalists.
D) Chartists.

C) Fundamentalists.

Fundamental analysts obtain information from corporate financial statements as well as other relevant sources. Technical analysts review market charts while fundamental analysts are concerned with the earnings ability of corporations derived from corporate financial statements.

19

Which of the following would be of least interest to a technical analyst?

A) PE ratio.
B) Short interest ratio.
C) Advance/decline line.
D) Trading volume.

A) PE ratio.

Technical analysts rely on price and trading trends to determine when to buy or sell stock. They are not interested in the specific financial information of an issuer; PE ratios are of greater interest to fundamental analysts.

20

A technical analyst is least likely to consider which of the following when selecting securities?

A) Trend lines.
B) Corporate earnings.
C) Short interest ratio.
D) Advance/decline line.

B) Corporate earnings.

Corporate earnings would be of least interest to a technical analyst, who is interested in market statistics indicative of future buying, market statistics that could reflect price or market trends, and trading volume.

21

All of the following statements would likely be true regarding those who are technical analysts EXCEPT they:

A) analyze market movements.
B) are more concerned with short-term trading than long-term investing.
C) would focus on the price to book value.
D) are not concerned with dividend returns.

C) would focus on the price to book value.

A technical analyst is concerned with market prices, trends, and volumes of securities, but not fundamentals such as book value and dividend returns.

22

A technical analyst is least concerned with:

A) trading volume.
B) new highs and lows.
C) open short positions.
D) declaration of increased dividends.

D) declaration of increased dividends.

A technical analyst is interested in statistics about market or price performance, not the fundamental factors, the market, or the company's dividend policy. Technical analysts are interested in trading volume as a market statistic, new highs and lows, and open short positions, which could indicate future buying potential in the security.

23

A head and shoulders bottom formation is an indication of:

A) a bearish market.
B) a bullish market.
C) the reversal of an upward trend.
D) the reversal of a downtrend.

D) the reversal of a downtrend.

A head and shoulders bottom formation is also known as an inverted head and shoulders formation. It is that part of a graph in which a downtrend has reversed to become an uptrend. It is not, however, an indicator of the bullishness or bearishness of the market as a whole. It is an indication only of the direction of a trend, which may be either short or long in duration.

24

If a chart indicates that both the DJIA and the advance/decline line have been increasing since January, and the advance/decline line continues to rise, the market should:

A) turn down sharply.
B) not change.
C) continue to rise.
D) turn down moderately.

C) continue to rise.

A rising advance/decline line indicates that more stocks are rising in price than falling; a rising advance/decline line is a bullish indicator.

25

If an economist was describing defensive issues, he would probably not include companies that produce:

A) food products.
B) clothing.
C) tobacco products.
D) building materials.

D) building materials.

Defensive issues are issues that are defensive against a downturn in the economy. Building materials are usually susceptible to downturns when the economy is bad.

26

Which of the following would be considered in the fundamental analysis of a security?

1. Support and resistance levels.
2. Trading volumes.
3. Liquidity ratios.
4. Historical earnings trends.

3. Liquidity ratios.
4. Historical earnings trends.

Fundamental analysts are concerned with information relating to the economy, industries, and individual companies. A company's liquidity ratios and past earning trends fall within these areas of concern. Concerns about the stock price and volume of trading would be of primary interest to a technical analyst.

27

Which of the following factors would be considered by an investor who uses fundamental analysis to value a company's stock?

1. The company's financial condition, as revealed by its income statement and balance sheet.
2. General economic conditions, such as employment levels and changes in interest rates.
3. Charts showing past movements in stock prices and trading volumes.

1. The company's financial condition, as revealed by its income statement and balance sheet.
2. General economic conditions, such as employment levels and changes in interest rates.

Fundamental analysis attempts to value stock by examining general economic conditions and the company's financial condition and growth prospects. Technical analysis, on the other hand, tries to identify trends and predict changes in the market. Charts showing past price movements and trading volumes would be used in technical analysis but not in fundamental analysis.

28

A fundamental analyst would be most interested in which of the following?

A) The outstanding short interest in the market.
B) A PE analysis of the stocks included in the Dow Jones Industrial Average.
C) A 200-day moving average.
D) Resistance and support levels.

B) A PE analysis of the stocks included in the Dow Jones Industrial Average.

Fundamentalists look at PE ratios; the other tools mentioned are technical.

29

Which of the following events is of the greatest importance to a technical analyst?

A) The stock's price recently penetrated its resistance level.
B) The issuer's current book value increased.
C) Standard & Poor's raised the credit rating of the issuer.
D) The company announced the resignation of its chief financial officer.

A) The stock's price recently penetrated its resistance level.

Technical analysts focus on market price patterns. Typically, a technical analyst becomes bullish when a stock's price exceeds its resistance level (it penetrates its former ceiling price). Book values, credit ratings, and the resignation of a company's senior officer are of interest to fundamental analysts.

30

A fundamental analyst would be interested in all of the following EXCEPT:

A) innovations within the automotive industry.
B) daily trading volumes on the NYSE.
C) statistics of the U.S. Department of Commerce on disposable income.
D) corporate annual reports.

B) daily trading volumes on the NYSE.

Trading volume interests the technical analyst, who looks at fluctuations in the market, not at fundamental economic values.

31

A technical analyst would be least concerned with

A) advance/decline.
B) book value per share.
C) short interest.
D) S&P 500 index.

B) book value per share.

A technical analyst is not concerned with any fundamental aspects of a company, including company financials. Open short interest theory, overall market movements, and advance/decline ratios are of concern to technical analysts.

32

An inverted Head and Shoulders Formation would mean which of the following to a chartist?

A) A bull market.
B) A bear market.
C) A reversal of an uptrend.
D) A reversal of a downtrend.

D) A reversal of a downtrend.

Head and Shoulders Formations indicate the reversal of market trends to chartists. An inverted formation would forecast the reversal of a downtrend. A Head and Shoulder's Top Formation would forecast the reversal of an uptrend.

33

If a technician believed in the importance of volume, which of the following would indicate bullish sentiment?

A) Prices increase on light volume.
B) Prices decrease on light volume.
C) Prices increase on heavy volume.
D) Prices decrease on heavy volume.

C) Prices increase on heavy volume.

Technicians watch volume changes along with price movements as an indicator of changes in supply and demand. A price increase on heavy volume relative to the stock's normal trading volume is interpreted as an indication of bullish activity.

34

A technical analyst would be most interested in which of the following?

A) Working capital.
B) 200-day moving averages.
C) Price-to-earnings ratios.
D) Capitalization ratios.

B) 200-day moving averages.

Technical analysts try to predict the market by examining price and volume trends. They expect the market to act in the future as it has in the past. Technical analysts are not interested in the fundamental aspects of a company, such as its financial statement ratios.

35

Which of the following would be of least interest to a chartist?

A) The volume of shares traded during the past month.
B) The short interest.
C) The advance-decline line.
D) The relationship between the current market price of an issuer's common stock and most recently reported earnings per share.

D) The relationship between the current market price of an issuer's common stock and most recently reported earnings per share.

A chartist is interested in the volume of shares traded, and the short interest for that particular stock. The advance-decline line is another technical indicator. The price-to-earnings ratio is used in fundamental as opposed to technical (charting) analysis.

36

An analyst interested in measuring the breadth of market movement as an indicator of future market direction would monitor the:

A) betas of the S&P 500 stocks.
B) advance/decline line.
C) DJIA.
D) Value Line Index.

B) advance/decline line.

The advance/decline line, which measures the number of stocks that have advanced versus the number of stocks that have declined, is an indicator of the breadth of the market's advance or decline.

37

Which of the following equations correctly shows the relationship between the items on a company's balance sheet?

A) Assets = liabilities + stockholders' equity.
B) Assets + liabilities = net worth.
C) Assets = stockholders' equity − liabilities.
D) Assets = liabilities − net worth.

A) Assets = liabilities + stockholders' equity.

The stockholders' equity, sometimes referred to as net worth, equals the difference between the company's assets and its liabilities (assets − liabilities = stockholders' equity). This formula is often restated as assets = liabilities + stockholders' equity.

38

Which of the following statements about balance sheets are TRUE?

1. Balance sheets provide a snapshot of a company's financial position on a given date.
2. Balance sheets represent the relationship between a company's assets, liabilities, and stockholders' equity.
3. Balance sheets provide a record of a company's earnings over a given period.

1. Balance sheets provide a snapshot of a company's financial position on a given date.
2. Balance sheets represent the relationship between a company's assets, liabilities, and stockholders' equity.

A balance sheet shows a company's assets, liabilities, and stockholders' equity on a specific date. The financial statement that reflects a company's operating activities and earnings over a period of time is the income statement.

39

Which of the following items would normally NOT be considered a current asset on a balance sheet?

A) Cash.
B) Account receivables.
C) Inventories.
D) Land.

D) Land.

A current asset is an asset that is already cash or that, in the normal course of business, will become cash within one year from the date on the balance sheet. A fixed asset, such as land, is an asset that is used over a long period in the normal course of business and that is not intended for sale.

40

All of the following appear on a corporation's balance sheet as fixed assets EXCEPT:

A) furniture.
B) computer equipment.
C) inventory.
D) real estate.

C) inventory.

Inventory is considered a current asset, not a fixed asset, because the company expects to convert its inventory into cash within a short period of time. The other choices are fixed assets and cannot be liquidated easily.

41

On a balance sheet, dividends payable would fall under the category of:

A) fixed liabilities.
B) stockholders' equity.
C) current liabilities.
D) assets.

C) current liabilities.

Dividends payable are dividends that have been declared but have not yet paid out. They are a type of current liability; that is, an obligation that will come due within one year from the date on the balance sheet.

42

Debts that will come due more than 1 year after the date on the balance sheet are known as:

A) fixed (or long-term) liabilities.
B) current liabilities.
C) accounts payable.
D) deferred charges.

A) fixed (or long-term) liabilities.

Debts that will come due more than 1 year after the date of the balance sheet are known as fixed (or long-term) liabilities. Current liabilities are debts that may come due within 1 year from the date on the balance sheet.

43

SSS Corporation's total assets amount to $780,000 of which $260,000 represents current assets. Total liabilities equal $370,000, of which $200,000 is considered long-term or other liabilities. What is SSS Corporation's shareholders' equity?

A) $170,000.00
B) $980,000.00
C) $1,150,000.00
D) $410,000.00

D) $410,000.00

Total assets minus total liabilities equals shareholders' equity ($780,000 − $370,000 = $410,000).

44

If during a given year a company has net income of $1 million and pays out dividends of $800,000, its retained earnings will:

A) decrease by $1 million.
B) increase by $1 million.
C) increase by $200,000.
D) decrease by $200,000.

C) increase by $200,000.

Retained earnings represent the net income a company has retained and not paid out in dividends. If a company has net income of $1 million and pays out only $800,000 in dividends, its retained earnings will increase by $200,000.

45

Which items would change if a company declared a cash dividend?

1. Working capital.
2. Total assets.
3. Total liabilities.
4. Shareholders' equity.

1. Working capital.
3. Total liabilities.
4. Shareholders' equity.

The key word is "declared". Liabilities increase when a dividend is declared, and total assets decrease when it is paid. A declared dividend (but not yet paid) would increase current liabilities (and would therefore decrease working capital). It would increase total liabilities (this is a pending obligation) and reduce shareholders' equity because retained earnings would be decreased by the dividend. Total assets would not be affected until the dividend is actually paid.

46

Which items change when a company pays a cash dividend?

1. Working capital.
2. Total assets.
3. Total liabilities.
4. Shareholders' equity.

2. Total assets.
3. Total liabilities.

When a dividend is paid, total assets are decreased as are total liabilities. The liabilities were increased at declaration time and are now decreased to reflect the payout. The two accounts affected would be decrease cash and decrease dividend payable.

47

The type of financial statement that shows a record of a company's operating activities and earnings over a stated period of time is a(n):

A) cash flow statement.
B) retained earnings statement.
C) income statement.
D) balance sheet.

C) income statement.

An income statement reflects a company's operating activities and earnings over a stated period of time. A balance sheet, on the other hand, provides a snapshot on a given date. A retained earnings statement shows how much of its earnings a company has retained for future growth, while a cash flow statement reflects where the company's cash flow came from and where it went.

48

KPT, Inc. is preparing to report its net income for the past year. An increase in which of the following causes a decrease in the reported net income?

1. Tax rate.
2. Cash dividend.
3. Allowance for bad debts.

1. Tax rate.
3. Allowance for bad debts.

Higher taxes mean less net income. The allowance for bad debts is an expense item; increasing it lowers operating income. Dividends are paid out of retained earnings and have no effect on the net income the company reports.

49

What is the balance sheet equation?

A) Assets = liabilities − shareholders' equity.
B) Assets = net worth.
C) Assets = shareholders' equity − liabilities.
D) Assets = liabilities + shareholders' equity.

D) Assets = liabilities + shareholders' equity.

Total assets equal total liabilities plus total shareholders' equity.

50

Which of the following best describe the balance sheet formula?

1. Assets minus liabilities equals net worth.
2. Sales minus expenses equals operating income.
3. Liabilities plus equity equals assets.
4. Dividends plus retained earnings equals net income.

1. Assets minus liabilities equals net worth.
3. Liabilities plus equity equals assets.

A balance sheet basically lists what is owned (assets) and what is owed (liabilities). The difference between these two is the net worth or equity. Sales, expenses, and dividends are all found on the income statement.

51

An individual owns assets worth $500,000 and has debts of $300,000. What is the individual's net worth?

A) $200,000.00
B) $300,000.00
C) $500,000.00
D) $800,000.00

A) $200,000.00

An individual's net worth equals the individual's assets minus his liabilities. Therefore, if someone has assets of $500,000 and debts of $300,000, the person's net worth is $200,000.

52

If the assets of a company did not change, but stockholders' equity declined, it would follow that:

A) capital surplus decreased.
B) liabilities increased.
C) liabilities declined.
D) retained earnings increased.

B) liabilities increased.

Stockholders' equity equals assets minus liabilities. If assets stay the same, then an increase in liabilities will cause a decline in equity.

53

A fundamental analyst is reviewing a company's financial statements. When attempting to determine their debt exposure, all of the following would be included EXCEPT:

A) accounts receivable.
B) accounts payable.
C) outstanding principal balance on long-term debt.
D) taxes payable.

A) accounts receivable.

Accounts receivable are assets; all of the other listings represent liabilities of the company

54

Current assets on a corporate balance sheet would include

1. accounts payable.
2. accrued wages.
3. cash.
4. inventory.

3. cash.
4. inventory.

Cash is the most obvious current asset. The general definition of a current asset is one that is expected to be turned into cash within the year. One would certainly hope that to be true of inventory. Accounts payable and accrued wages are liabilities, obligations that must be paid on a current basis.

55

Components of a company's net worth would include all of these EXCEPT:

A) operating income.
B) inventory.
C) fixed assets.
D) goodwill.

A) operating income.

Net worth is all of the company's assets minus its liabilities as found on the balance sheet. Operating income is found on the income statement and is neither an asset nor a liability.

56

A profitable company reports net income of $10 million. A cash dividend of $7 million is declared. From an accounting standpoint, the other $3 million will be credited to which balance sheet account?

A) Working capital.
B) Dividends payable.
C) Retained earnings.
D) Capital surplus.

C) Retained earnings.

Retained earnings are increased to the extent that company profits (net income) are undistributed; in essence, retained. Capital surplus comes from original investors purchasing stock at a price in excess of stated or par value. Working capital is not a balance sheet account; it is a computation. When the dividend is declared, it becomes a current liability (dividends payable), but this question is asking for the portion of the income that is not going to be paid out.

57

A corporation's balance sheet reveals cash of $100,000, accounts receivable of $20,000, and equipment of $300,000, resulting in total assets of $420,000. The document also shows accounts payable of $100,000, long-term liabilities of $200,000, and equity of $120,000. From this information you would determine the working capital to be:

A) $320,000.00
B) $20,000.00
C) $120,000.00
D) $200,000.00

B) $20,000.00

Working capital is computed by subtracting current liabilities (accounts payable) from current assets (cash plus accounts receivable). In this case, it is $120,000 − $100,000 = $20,000.

58

If an investor wanted to verify a company's working capital, she would do so by reviewing their:

A) footnotes.
B) income statement.
C) balance sheet.
D) cash flow statement.

C) balance sheet.

Working capital, current assets minus current liabilities, is determined from numbers found on the balance sheet.

59

An investment adviser reviewing a company's price to book value is using:

A) fundamental analysis.
B) technical analysis.
C) financial statement analysis.
D) point and figure charting.

A) fundamental analysis.

Fundamental analysis is using the company's financial statements to determine value. Financial statement analysis is not the proper term (even though that is what is being done). Technical analysis does not look at the company's books. Rather it focuses on charting methods such as point and figure.

60

Which of the following is NOT affected by the issuance of a bond?

A) Total liabilities.
B) Working capital.
C) Shareholders' equity.
D) Assets.

C) Shareholders' equity.

When bonds are issued, cash is received (thus increasing current assets) and long-term debt increases (increasing total liabilities). Because there is no corresponding increase in current liabilities, working capital increases. There is no effect on shareholders' equity because the increased liability is offset by the asset (cash) received.

61

If a corporation issues mortgage bonds, all of the following would be affected EXCEPT:

A) total assets.
B) total liabilities.
C) working capital.
D) shareholder's equity.

D) shareholder's equity.

When issued, the corporation receives the net proceeds in cash, increasing current assets (and thus total assets). Simultaneously, the corporation's long-term liabilities increase reflecting the debt (and thus total liabilities). Working capital increases because of the increase in current assets. Shareholder's equity, or net worth, is only affected by the sale of new equity securities or by any profit or loss generated by the corporation.

62

A corporation calls in a portion of its long term debt at 101. This will have the effect of:

1. decreasing working capital.
2. increasing working capital.
3. decreasing net worth.
4. increasing net worth.

1. decreasing working capital.
3. decreasing net worth.

Working capital is computed by subtracting current liabilities from current assets. Using a current asset, like cash, to call in the bonds, reduces those assets with no corresponding reduction to current liabilities. Whenever a bond is called at a premium, net worth is reduced by that premium.

63

Due to changes in market rates, a corporation is able to purchase some of its outstanding 20-year bonds at a discount. Which of the following is CORRECT?

1. Working capital is increased.
2. Working capital is reduced.
3. Net worth is increased.
4. Net worth is reduced.

2. Working capital is reduced.
3. Net worth is increased.

Even though the bonds are purchased for less than par value, working capital is reduced because the company is using a current asset — cash — to pay off a long-term liability. However, the fact that it is reducing its debt for less than the amount shown on the books will result in an increase to net worth.

64

Due to changes in customer preferences, a manufacturing company has decided to discontinue the operations of one of its subsidiaries. An explanation of this decision would most likely be found in the company's:

A) balance sheet.
B) income statement.
C) tax return.
D) footnotes to the financial statements.

D) footnotes to the financial statements.

Footnotes are used to explain extraordinary items such as the sale of a subsidiary.

65

Net income:

A) represents the amount of money remaining after all expenses including taxes.
B) is paid out in cash to stockholders in addition to any declared dividends.
C) reflects the operating profits of a firm only.
D) must be paid out in dividends.

A) represents the amount of money remaining after all expenses including taxes.

Net income is not a cash item that is paid out to stockholders. Dividends, both preferred and common, are generally cash distributions paid out from net income. Net income after taxes can reflect all sources of income in addition to the operating income generated by business activities. Net income also reflects investment income as well as operating income. Net income may be paid out in the form of dividends; however, most firms retain a portion of net income in order to reinvest the funds in the business.

66

Which of the following is NOT a source of cash reported on the statement of cash flows?

A) Cash flows from accounting changes.
B) Cash flows from operations.
C) Cash flows from investing.
D) Cash flows from financing.

A) Cash flows from accounting changes.

The statement of cash flows reported by U.S. companies does not contain an entry entitled "cash flows from accounting changes".

67

The total of the cash from operations, investing, and financing, as reported on the statement of cash flows, is:

A) the net change in the cash position of the firm for the reporting period.
B) reported as a separate line item on the balance sheet.
C) reported as cash income on the income statement.
D) an integral part of the footnotes to the balance sheet required by generally accepted accounting principles.

A) the net change in the cash position of the firm for the reporting period.

The total of the cash from operations, investing, and financing, as reported on the statement of cash flows, is the net change in the cash position of the firm for the reporting period. The sum total, or the net change in cash, is not reported on either the balance sheet or the income statement. It is the sum total of the entries on the statement of cash flows which is a separate financial statement.

68

Which of the following expense items increases a company's cash flow?

A) Interest on long-term debt securities.
B) Services provided through outsourcing.
C) Depreciation.
D) Contributions to the firm's qualified retirement plan.

C) Depreciation.

The basic computation for cash flow is net income plus depreciation expense for that year.

69

A customer purchased 100 shares of SNP at $38. At the time of purchase, the PE ratio was 12. Approximately what are the earnings per share of SNP?

A) $3.80.
B) $12.00.
C) $3.20.
D) $1.20.

C) $3.20.

The PE ratio is a comparison of the current market price at the close to the earnings of the company; $38 (CMV) ÷ 12 (PE ratio) = $3.16 (approximate EPS).

70

A company's working capital equals its:

A) fixed assets minus its fixed liabilities.
B) cash flow minus its retained earnings.
C) current assets minus its current liabilities.
D) current liabilities minus its current assets

C) current assets minus its current liabilities.

Working capital is a measure of how well a company can meet its current obligations. It is the amount that is left free and clear if all current debts are paid off. Working capital is calculated by subtracting current liabilities from current assets.

71

The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is the

A) dividend discount ratio
B) price-to-book value ratio
C) price-earnings (PE) ratio
D) price-sales ratio

B) price-to-book value ratio

The price-to-book value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value.

72

An analyst comparing revenues with expenses is most likely analyzing:

A) liquidity.
B) cash flow.
C) working capital.
D) capitalization.

B) cash flow.

The analyst is most likely measuring the income statement for cash flow (money coming in against money going out). Working capital analysis would involve examining the balance sheet's current assets and current liability entries, not the income statement. Capitalization analysis involves examination of long-term debt and stock issues. Liquidity analysis involves examining current assets and liabilities from the balance sheet.

73

ALFA Enterprises pays a quarterly dividend of $.15 and has earnings per share of $2.40. Assuming that payout rate is continued, what is the dividend payout ratio?

A) 6.25%.
B) 14.4%.
C) 30%.
D) 25%.

D) 25%.

Earnings per share are typically calculated for a year. If the quarterly dividend rate of $.15 is continued, that will be an annual payout of $.60 ($.15 × 4). So the annual dividend of $.60 is divided by $2.40 to calculate what percentage of earnings is paid as a dividend; or rather, the dividend payout ratio (.60 ÷ 2.40 = 25%).

74

If a company with 10 million shares outstanding with total earnings of $50 million pays a $2 dividend, the dividend payout ratio is:

A) 20%.
B) 25%.
C) 40%.
D) 4%.

C) 40%.

Dividend payout ratio is determined by dividends paid per share divided by earnings per share. In this case, earnings per share (EPS) is $50 million ÷ 10 million shares = $5 per share. The company paid out in dividends $2 for each $5 earned for a 40% payout ratio ($2 ÷ $5).

75

If a corporation has a dividend payout ratio of 70%, the undistributed earnings will:

A) increase earnings per share.
B) decrease book value.
C) increase capital surplus.
D) increase retained earnings.

D) increase retained earnings.

Retained earnings represent income that has not been paid out to shareholders.

76

Liquidity ratios measure the solvency of a firm or the firm's ability to meet short-term financial obligations. Which of the following is a liquidity ratio?

A) Dividend divided by earnings per share.
B) Current assets divided by current liabilities.
C) Gross profit divided by net sales.
D) Net income divided by average total equity.

B) Current assets divided by current liabilities.

Current assets divided by current liabilities is the current ratio, a ratio that measures the liquidity of a firm. Gross profit divided by net sales is a profitability ratio that measures the gross profitability of the firm's business operations, not its liquidity. Net income divided by average total equity is the return on stockholders' equity which measures the efficiency of common shareholders' investment or equity in the firm. Dividend amount divided by earnings per share is the dividend payout ratio which measures how much of a company's earnings are distributed to common stockholders.

77

If a company successfully gets its 7% debenture holders to exchange their 7% debentures for 7% preferred stock, what is the effect on EPS?

A) Decrease.
B) Increase.
C) No effect.
D) Not enough information.

A) Decrease.

The 7% payment is moved from a pre-tax deduction to an after-tax payment. This increases the amount of taxable income, thereby increasing the company's tax liability. The 7% payment remains the same. With an increased tax burden and everything else remaining the same, the EPS will decrease.

78

The issuance of a debenture by a company would have an immediate effect on which of the following balance sheet items?

1. Total assets.
2. Total liabilities.
3. Working capital.
4. Shareholders' equity.

1. Total assets.
2. Total liabilities.
3. Working capital.

The cash received from the sale of the bonds is a current asset of the company, and as such would increase assets and working capital on the balance sheet. The debentures are debt of the company and would increase the liabilities of the company. Shareholders' equity is only affected by gains, losses, new invested capital, and cash distributions (dividends) to shareholders.

79

Financial statement analysis frequently relies upon a review of the target company's cash flow statement. To get the most accurate indication of cash flow, an analyst will add which of the following to net income:

A) Accumulated depreciation.
B) Dividends paid.
C) Equipment sold.
D) Depreciation expense.

D) Depreciation expense.

The most common formula for the cash flow from operations computation is net income plus the depreciation expense taken for the year.

80

During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share have increased from $2.00 to $2.50 per share and their dividend payout ratio has decreased from 50% to 40%. Based on this information:

1. Kapco's P/E ratio has decreased.
2. Kapco's P/E ratio has increased.
3. an investor holding Kapco over this period would have noticed a decrease in income received.
4. an investor holding Kapco over this period would have noticed no change in income received.

1. Kapco's P/E ratio has decreased.
4. an investor holding Kapco over this period would have noticed no change in income received.

At the beginning of the period, the P/E ratio was 23.5 to 1 ($47 divided by $2.). At the end of the period, the P/E ratio was 20 to 1 ($50 divided by $2.50). Initially, Kapco was paying out 50% of its $2.00 per share earnings, or $1.00 in dividends. At the end, Kapco was paying out 40% of its $2.50 per share earnings, also $1.00 in dividends.

81

Under what circumstances will a dilution of equity occur?

A) Stock split.
B) Issue of mortgage bonds to replace debentures.
C) Conversion of convertible bonds into common stocks.
D) Stock dividend.

C) Conversion of convertible bonds into common stocks.
D) Stock dividend.

Dilution of equity occurs when stockholders experience a reduction in their percentage ownership of the company. If bonds are converted, more common shares are issued and the shareholder's equity is diluted. A stock dividend or stock split does not change a stockholder's percentage of ownership. Refunding debts has no effect on stockholders.

82

During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is:

A) 6.34%.
B) 4.26%.
C) 2.13%.
D) 2%.

D) 2%.

The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio, the annual dividend is $1.00. This dollar divided by the current market price of $50 results in a current return of 2%.

83

The dividend payout ratio of common stock is found by dividing the annual dividend per share by the

A) earnings per share.
B) book value.
C) market price.
D) capitalization per share.

A) earnings per share.

The key to the question is "ratio", which in this case is the relationship between dividends per share and their source of earnings per share.

84

FNK reported earnings of $2.47 per share last year on its stock, which is trading at 24.75. It paid a $.93 dividend on its common stock. What was its dividend payout ratio?

A) 26.6%.
B) 67%.
C) 10%.
D) 38%.

D) 38%.

The company earned $2.47 per share and paid a $.93 dividend per share, which is 38% of the earnings ($.93 ÷ $2.47 = 38%).

85

XYZ Corporation has a market price of $45 per share and earnings per share of $3 when XYZ announces a 3-for-1 split. After the split, the price-to-earnings ratio of XYZ will be:

A) 15
B) 3
C) 5
D) 45

A) 15

Before the split, the company had a P/E ratio of 15 ($45 per share ÷ $3). After the split, the price per share and the EPS drop in the same proportion, leaving the PE ratio unchanged (new price = $15, new EPS = $1).

86

Which of the following is a stock valuation ratio?

A) Operating profits to net sales.
B) Revenues to assets.
C) Price-earnings.
D) Dividend payout ratio.

C) Price-earnings.

The price-earnings (PE) ratio is a valuation ratio used to calculate the value of a stock. For example, if a stock has a PE of 20, it means that the security is priced at 20 times earnings.

87

Which of the following is most commonly used to evaluate the marketplace's perceived value of a particular stock?

A) Price-to-earnings ratio.
B) Dividend payout ratio.
C) Earnings per share.
D) Margin of profit.

A) Price-to-earnings ratio.

The price-to-earnings ratio compares the market price of a stock to the company's earnings per share. When investors are very positive regarding a stock's future, the PE ratio will generally be higher than those of other companies in the same industry.

88

Fundamental analysts give significant credence to financial ratios. Which of the following tends to give an indication of the profitability of the enterprise?

A) Price to earnings ratio.
B) Sales to earnings ratio.
C) Current ratio.
D) Debt ratio.

B) Sales to earnings ratio.

The sales to earnings ratio compares the net sales of the business to its earnings. Companies with a higher percentage of earnings from each dollar of sales are more profitable.

89

One of the valuation ratios used by fundamental analysts is the Price/Earnings ratio. The P/E ratio is the current market price of the stock divided by the:

A) earnings per share.
B) investor's cost basis per share.
C) dividends per share.
D) book value per share.

A) earnings per share.

An analyst will compute the P/E ratio by taking the current market price per share and dividing it by the earnings per share.

90

Which of the following statements about the price-earnings (PE) ratio are TRUE?

1. A company's stock will have a relatively high PE ratio if investors feel the company's earnings will grow slowly.
2. Young, fast-growing companies generally have higher PE ratios than mature, slower-growth companies.
3. A company's PE ratio may also be called its multiple.

2. Young, fast-growing companies generally have higher PE ratios than mature, slower-growth companies.
3. A company's PE ratio may also be called its multiple.

A company's PE ratio, also called its multiple, may indicate investors' expectations about the company's earnings potential. A higher PE generally indicates that investors have high expectations for the company's future growth. Young, fast-growing companies generally have higher PE ratios than mature companies.

91

Last year, ABC Corporation had earnings per share of $5 and paid a quarterly dividend of $.75 per share. It has a current market value of $75. What is its price-earnings ratio?

A) 10:01
B) 25:01:00
C) 50:01:00
D) 15:01

D) 15:01

The dividend information is irrelevant. The price-earnings ratio is the price of the stock ($75) divided by the earnings of the stock ($5), or 15:1.

92

The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is the:

A) dividend discount ratio.
B) price-to-book value ratio.
C) price-earnings (PE) ratio.
D) price-sales ratio.

B) price-to-book value ratio.

The price-to-book value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value.

93

Which of these industries would be considered defensive in the face of a recession?

A) Food producer.
B) Automobile manufacturing.
C) Real estate construction.
D) Trucking.

A) Food producer.

Defensive industries are least affected by normal business cycles. Companies in defensive industries generally produce nondurable consumer goods, such as food, pharmaceuticals, tobacco, and energy. Public consumption of such goods remains fairly steady throughout the business cycle. During recessions and bear markets, stocks in defensive industries generally decline less than stocks in other industries.

94

An investment strategy that is designed to minimize risk and preserve the investor's principal is a(n):

A) market capitalization investment strategy.
B) defensive investment strategy.
C) aggressive investment strategy.
D) growth investment strategy.

B) defensive investment strategy.

An investment strategy can be either defensive or aggressive. A defensive strategy is one that is intended to minimize risk, preserve capital, and provide a somewhat stable income. An aggressive investment strategy is designed to maximize returns and assume greater risks.

95

In an efficient market:

A) any information that could affect a stock's value is quickly reflected in its price.
B) information is disseminated slowly.
C) it is fairly easy to predict major market swings.
D) investors have a good chance of beating the market.

A) any information that could affect a stock's value is quickly reflected in its price.

An efficient market is one in which every individual can quickly obtain and use information about new events in the marketplace. Because information is disseminated quickly, any new information that could affect a stock's value is quickly reflected in its price.

96

An investor's portfolio has a beta coefficient of .85. If the overall market declined by 10% over the course of a year, the portfolio's value has likely:

A) increased by 10.85%.
B) decreased by 11.76%.
C) decreased by 8.5%.
D) increased by 8.5%.

C) decreased by 8.5%.

A beta coefficient of .85 means that the portfolio is considered to be .85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of .85 is likely to decline by only 8.5% (.10 × .85).

97

Which of the following rates of return is used by investment professionals as the risk-free rate?

A) Federal funds rate.
B) Prime rate.
C) Discount rate.
D) 90-day Treasury bill rate.

D) 90-day Treasury bill rate.

The interest rate used as the basis for a risk-free rate of return is the 90-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short-term, and the market risk is minimal.

98

If a stock has a beta of less than 1.0, the stock's price will:

A) not increase as much as the market when the market is up.
B) decrease regardless of whether the market is up or down.
C) increase more than the market when the market is up.
D) decrease more than the market when the market is down.

A) not increase as much as the market when the market is up.

Beta compares a stock's price history to the movement of a total market index for the same period. A beta of less than 1 means that the stock's price does not swing as widely, up or down, as the average for the entire market.

99

If a customer purchases a food company stock and a utility stock, the customer's portfolio is:

A) balanced.
B) defensive.
C) diversified.
D) cyclical.

B) defensive.

Food company stocks and utilities are defensive investments. Defensive investments are those that tend to hold up well in economic downturns.

100

Growth companies tend to have all of the following characteristics EXCEPT:

A) high earnings retention ratio.
B) potential investment return from capital gains rather than income.
C) low PE ratios.
D) low dividend payout ratios.

C) low PE ratios.

Growth companies have high PE ratios and a low dividend payout ratio because they retain most if not all of their earnings. Investors anticipating fast growth bid up prices so PE ratios tend to be high. Growth companies retain most of their earnings to fund future growth. Investors select growth companies for capital gain potential, not for investment income.

101

The measurement that compares a stock's price history to the movement of a total market index for the same period is known as:

A) standard deviation.
B) R-squared.
C) duration.
D) beta.

D) beta.

The measurement that compares a stock's price history to the movement of the total market index for the same period is beta. Standard deviation indicates how much an investment's returns have fluctuated from its average returns over a period of time, while R-squared measures whether an investment's returns tend to go up and down at the same time as the markets. Duration measures how sensitive a bond will be to small changes in interest rates.

102

Which of the following stocks is regarded as a defensive stock?

A) Aerospace stock.
B) Stock selling close to its support level.
C) Stock with a strong cash position and a low ratio of debt.
D) Electric utility stock.

D) Electric utility stock.

Analysts regard a defensive stock as one that is in an industry that is least affected by business cycles. Most defensive industries produce nondurable consumer goods (for example, the food industry or the utility industry).

103

Which of the following would NOT be considered a defensive security?

A) Food chain stock.
B) Steel company stock.
C) Tobacco stock.
D) Utility company stock.

B) Steel company stock.

Steel is cyclical and is not considered defensive; defensive stocks are generally less affected by the business cycle.

104

A customer's portfolio has a beta coefficient of 1.1. If the overall market increases by 10%, the portfolio's value is likely to:

A) decrease by 10%.
B) decrease by 11%.
C) increase by 11%.
D) increase by 10%.

C) increase by 11%.

A beta of 1.1 means the portfolio is considered to be 1.1 times more volatile than the overall market. If the market is up 10%, the portfolio with a beta of 1.1 is likely to be up 11%.

105

Which of the following market analysts is using the efficient market theory?

A) An analyst sells stock when he sees small investors buying.
B) An analyst picks company names out of a hat.
C) Before he invests in a company, an analyst visits its headquarters to see whether management is running the company effectively.
D) An analyst has developed a system for identifying reversals in downward trendlines.

B) An analyst picks company names out of a hat.

Efficient market theory holds that securities are efficiently priced and therefore, it makes no sense to analyze particular stocks; or rather, picking stocks out of a hat is as effective as technical or fundamental analysis.

106

In portfolio theory, the alpha of a security or a portfolio is:

A) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved.
B) the risk of the portfolio associated with the macroeconomic factors that affect all risky assets.
C) the portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio.
D) a measure of the variance in returns of a portfolio divided by its average return.

A) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved.

Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is systematic risk. The portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio is the Sharpe ratio or measure. The measure of the variance in returns of a portfolio around its average return is the standard deviation.

107

Which of the following is most likely to be regarded as a defensive stock?

A) An aerospace stock.
B) A stock selling at an extremely high PE ratio.
C) A stock with a strong cash position and little debt.
D) A food company stock.

D) A food company stock.

A defensive stock maintains future earnings that are likely to withstand an economic downturn. Typical examples are stocks of those firms that supply basic consumer necessities such as foodstuffs. A stock selling at an extremely high PE ratio is indicative of a speculative company or one that can decline in value rapidly.

108

Which of the following industries would be least cyclical?

A) Leisure products.
B) Automobile manufacturing.
C) Heavy equipment.
D) Supermarket chain.

D) Supermarket chain.

Industrial activity usually follows business cycles, which have more impact on some industries than others. The food industry is one for which the demand is not generally based on economic conditions.

109

Which of the following industries would tend to be the most cyclical?

A) Appliance manufacturers.
B) Food producers.
C) Supermarkets.
D) Tobacco producers.

A) Appliance manufacturers.

"Cyclical" refers to whether the industry is affected by business cycles of the economy. Items such as luxuries and large-ticket items (autos, homes, appliances) are normally cyclical. Food and tobacco are normally not cyclical.

110

The type of analysis that attempts to value securities by examining general economic trends and the growth potential and productivity of individual companies is:

A) holding period analysis.
B) credit analysis.
C) fundamental analysis.
D) technical analysis.

C) fundamental analysis

There are two main approaches to valuing securities. Fundamental analysis takes the approach described in this question. The other approach-technical analysis-relies on charts of past performance to forecast future price movements.

111

Which two of the following would you expect of a growth stock?

1. High price/earnings ratio.
2. Low price/earnings ratio.
3. High dividend payout ratio.
4. Low dividend payout ratio.

1. High price/earnings ratio.
4. Low dividend payout ratio.

Growth stocks are stocks of companies that plow their earnings back into further product development. They sell at a high price-earnings ratio and pay out little or nothing as a percentage of their earnings in dividends.

112

A stock has traded in a channel between 50 and 65. A technician might suggest that his client:

1. buy at 52.
2. sell at 52.
3. buy at 63.
4. sell at 63.

1. buy at 52.
4. sell at 63.

This channel represents both a support and resistance level for the stock. One should try to buy with little downside risk (close to support; in this case 50), and sell when it appears the stock is reaching a high (close to resistance; in this case 65).

113

To reduce a client's exposure to systematic risk in his equity portfolio, you would look at which of the following factors?

A) Beta.
B) Credit rating.
C) Investment return compared to the inflation rate.
D) Earnings history.

A) Beta.

Beta is a measure of a portfolio's volatility compared to the volatility of the overall market. Since systematic risk is risk associated with investing in the market, lowering the client's volatility (beta) relative to that of the market should lower his exposure to market risk. Credit rating is used to measure default risk on debt securities, and earnings history would assist you in the measurement of business risk (unsystematic risk).

114

Beta is most frequently measured against which of the following?

A) Dow Jones Industrial Average.
B) Nasdaq Composite Index.
C) S&P 100.
D) S&P 500.

D) S&P 500.

The index most commonly used to analyze the beta of an individual security or portfolio is the S&P 500. Companies (portfolios) with a beta of 1.0 would be expected to move in tandem with the market, while companies with a beta greater than 1.0 would be more volatile than the market as a whole. Companies with a beta less than 1.0 should show a rate of change less than that of the market as a whole.

115

Recent studies have shown that much of the performance of a portfolio can be attributed to which of the following factors?

A) Market timing.
B) Other factors.
C) Asset allocation.
D) Security selection.

C) Asset allocation.

A study conducted by Sharpe and Markowitz revealed that 91.5% of the returns achieved by the average investor were based upon the allocation of assets among various investment classifications. Market timing and security selection did account for some of the remaining percentages, but asset allocation proved to be the most important factor.

116

Which of the following are likely to have a low beta?

A) Technology stocks.
B) Aerospace stocks.
C) Software stocks.
D) Public utility stocks.

D) Public utility stocks.

Public utility stocks tend to have low betas as do other defensive stocks. Technology, aerospace, and software stocks tend to have high betas.

117

A company using debt obligations to finance business expansion is indicative of what type of investment risk?

A) Purchasing power risk.
B) Credit or default risk.
C) Market risk.
D) Reinvestment rate risk.

B) Credit or default risk.

A company using borrowed capital to expand is increasing its financial leverage. As such, the possibility of default increases. Investors can reduce their risk either by diversifying into companies using minimal leverage or selecting those issuers with higher credit ratings. The other risks noted are systematic or nondiversifieable risk.

118

If disposable personal income has fallen steadily over the past year, which of the following is most likely to be affected?

A) Firm that produces nondurable consumer goods.
B) Automotive industry.
C) Defense industry.
D) Tobacco industry.

B) Automotive industry.

The automobile industry is cyclical and of the choices, the most likely to be affected by a change in the business cycle as indicated by declining personal income.

119

A stock's beta coefficient is a measure of the stock's:

A) profitability relative to its group.
B) institutional ownership relative to outstanding shares.
C) consistency of its dividend payment.
D) volatility relative to the market.

D) volatility relative to the market.

Beta measures a stock's volatility relative to the overall market. A beta above 1 indicates a more volatile stock, while a beta below 1 describes a stock less volatile than the market.

120

Which of the following would you most likely consider characteristics of a growth stock?

A) Low PE and high dividend yield.
B) Low PE and low dividend yield.
C) High PE and high dividend yield.
D) High PE and low dividend yield.

D) High PE and low dividend yield.

Growth stocks generally have high PE ratios and low (or no) dividends. Value stocks normally have low PE ratios with higher dividend payouts.

121

In a rising market, which of the following is least volatile?

A) A stock with an alpha of 2.0.
B) A stock with an alpha of 0.5.
C) A stock with a beta of 0.5.
D) A stock with a beta of 2.0.

C) A stock with a beta of 0.5.

Beta is a measure of a stock's volatility relative to the overall market, as measured by the S&P 500. A stock with a beta of 2.0 will move twice as fast as the overall market, while a stock with a beta of 0.5 will move half as fast as the overall market.

122

That all market participants have equal access to information is a fundamental premise of:

A) portfolio correlation.
B) asset allocation.
C) the efficient market hypothesis.
D) Monte Carlo simulation.

C) the efficient market hypothesis.

When all market participants have equal access, the theory is that stock prices will reflect that efficiently.

123

Two portfolios have the same expected return of 10%. Portfolio A has a standard deviation of 5% and Portfolio B has a standard deviation of 18%. Under Modern Portfolio Theory (MPT):

A) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk.
B) Portfolio B would be preferred by investors because its standard deviation is more than three times that of Portfolio A.
C) neither portfolio would be preferred because both portfolios have the same 10% expected return.
D) neither portfolio would be acceptable because the risk is too high for the expected return.

A) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk.

Portfolio A would be preferred by investors because it has the same return (10%) as Portfolio B but bears less risk. One of the assumptions of MPT is that investors prefer less risk rather than more risk per unit of return. Because Portfolio A has a smaller standard deviation than that of Portfolio B, it has less risk. Standard deviation measures the volatility of a security. The larger the standard deviation, the larger the security's returns are expected to deviate from its average return and, hence, the greater the risk.

124

Which of the following purchases is most suitable for an investor pursuing an aggressive investment strategy?

A) GHI stock with a beta coefficient of 1.3.
B) AMF stock with a beta coefficient of 1.0.
C) DOH stock with a beta coefficient of .7.
D) LMN stock with a beta of -1.6.

A) GHI stock with a beta coefficient of 1.3.

Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive investment strategies.

125

Of the following stocks, which would be the most suitable for a conservative, risk averse investor?

A) Large cap cyclical company late in the economic cycle.
B) Large cap consumer goods company.
C) Small cap medical technology company.
D) Mid cap software company.

B) Large cap consumer goods company.

A large-cap consumer goods company is most appropriate for a risk averse investor because of the relative stability of the stock price compared to the other choices, as well as the stability of its earnings.

126

If your customer is pursuing an aggressive stock buying strategy, which of the following is most suitable for him?

A) Convertible bonds of a mid-cap company.
B) GHI stock with a beta coefficient of 1.20.
C) ABC stock with a beta coefficient of 1.0.
D) DEF stock with a beta coefficient of .93.

B) GHI stock with a beta coefficient of 1.20.

Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta is, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive stock-buying strategies and have both the financial ability and the temperament to withstand downturns in the market.

127

A securities analyst reviewing a corporation's financial statements notes that the enterprise has total current assets of $10 million, inventory of $4 million, cash on hand of $2 million, total current liabilities of $8 million and net income of $15 million. The company's acid-test ratio is closest to

A) 1.25 to 1
B) 1.50 to 1
C) .75 to 1
D) 1.00 to 1

C) .75 to 1

The acid-test ratio, also known as the quick asset ratio, is computed by subtracting the inventory from the total current assets and then dividing that remainder by the total current liabilities. In this case, that would be $10 million minus $4 million ($6 million) divided by $8 million, or .75%

128

Each of the following terms is commonly found in modern portfolio theory EXCEPT the

A) efficient set
B) feasible set
C) internal rate of return
D) capital asset pricing model

C) internal rate of return

Internal rate of return (IRR), is not a component of modern portfolio theory as are the other three terms.

129

An analyst viewing a corporate income statement will be able to review all of the following EXCEPT:

A) operating expenses.
B) pre-tax income.
C) current ratio.
D) net sales or net revenues.

C) current ratio.

Current ratio is a balance sheet computation involving current assets and current liabilities. All of the other items relate to income and expenses, items found on an income statement.

130

A client asks her investment adviser representative what footnotes to the financial statements are for. The best reply would be that footnotes:

A) are used to explain how the various ratios are computed because companies recognize that many shareholders do not have a financial background.
B) contain information that doesn’t have a place in the main body of the financial statements.
C) contain a detailed history of the enterprise and its products or services.
D) serve as a bibliography indicating where additional information may be obtained.

B) contain information that doesn’t have a place in the main body of the financial statements.

There are many important financial details that cannot be properly placed in either the balance sheet or the income statement. Examples of these are; method of accounting used, collateral securing debt, pension liabilities and many others. Footnotes are an integral part of the financial statements and are usually found with this notation, “The accompanying footnotes to the financial statements are an integral part of these statements.”

131

A client approaches the IAR handling the advisory account with a request to find a preferred stock that will offer a 6% income return. The IAR suggests a stock paying a $.28 quarterly dividend. That stock will meet the income objective if it has a current market price of

A) $11.91
B) $18.67
C) $4.67
D) $6.72

B) $18.67

The first thing to do is annualize the dividend by multiplying the $.28 by 4. Once we have the annual dividend of $1.12, divide by 6% and the result is $18.6666 or $18.67 properly rounded. If you left your math skills at home, all you have to do is multiply each of the 4 choices by 6% to see which one is closest to $1.12.

132

A fundamental analyst would be interested in funds available for use in the business. Doing which of the following would have the greatest impact on future cash flow?

A) Retaining earnings.
B) Retiring outstanding bonds.
C) Depreciation on assets used in the business.
D) Amortizing goodwill.

B) Retiring outstanding bonds.

The retirement of outstanding bonds means that there will be no future interest payments made. Since a major component of cash flow is a company’s net income, this reduced expense would lead to increased income.

133

An investment adviser representative is looking for a suitable investment for a client. The IAR wishes to find something that will offer an attractive return commensurate with its systematic risk. The choices have been narrowed down to Security C and Security L and the selection will be based on alpha. C has a beta of 1.0 and earned 13% while L has a beta of 0.8 and earned 10.1%. The alpha of Security L is:

A) −2.9
B) +2.9
C) −0.3
D) +0.3

C) −0.3

Alpha is obtained by comparing how a security actual performed to the performance one would have expected based upon its beta. A beta of 1.0 is used to indicate the expected volatility of the overall market. Because Security C has a beta of 1.0, its 13% return matches that of the “market”. With a beta of .8, one would expect Security L to produce a lower return, but how much lower? Its return should be 80% of the “market” or, in this case, 80% of 13% which computes to 10.4%. However, its actual return fell short of that by 0.3% giving it a negative alpha of 0.3. Had its actual return been 10.7%, it would have had a 0.3 positive alpha. Although this question doesn’t ask it, based upon the criteria given, the IAR would have selected Security C.

134

A corporation ends its accounting year on September 30th. It would be correct to state that they use a (an):

A) alternative year.
B) fiscal year.
C) accounting year.
D) nine-month year.

B) fiscal year.

Fiscal-year accounting is the term used to describe whenever an entity ends its accounting year on a date other than December 31st.

135

Many businesses choose to use a date other than December 31st to close out their financial year for accounting purposes. When this is done, it is said that the entity is reporting on a:

A) fiscal year basis.
B) non-traditional basis.
C) calendar year basis.
D) alternative year basis.

A) fiscal year basis.

Fiscal year accounting uses a date other than December 31st as its year-end

136

Some risk is involved in almost all investments. In general, the greater the risk, the:

A) smaller the potential return.
B) greater the potential return.
C) more expensive the investment.
D) longer the period until a return will be realized.

B) greater the potential return.

Risk and potential return tend to go together. Low risk investments usually produce low returns. High risk investments offer the hope of high returns.

137

What is the term given to that item, typically found at the bottom of a corporation’s balance sheet, that describes such things as significant accounting policies, commitments made by the company, and potential liabilities and potential losses?

A) contingency statement.
B) resource material.
C) off-line items.
D) footnotes.

D) footnotes.

Footnotes to the balance sheet, describing unusual items, are typically found at the bottom of the statement.

138

Which of the following is used in technical analysis in an attempt to modify fluctuations of stock prices over the long term into a smoothed trend?

A) trend lines.
B) moving averages.
C) consolidation.
D) support and resistance.

B) moving averages.

To avoid the volatility frequently present in stock price trends, analysts will frequently use moving averages. These averages reduce short-term distortions to a minimum.

139

An IAR is viewing the balance sheet of a corporation. Included in the computation of the company's working capital are all of the following EXCEPT:

A) accounts receivable.
B) marketable securities of other companies.
C) cash.
D) convertible bonds it has issued.

D) convertible bonds it has issued.

The working capital of a corporation is equal to its current assets minus its current liabilities (a current liability is payable within 12 months). Because all bonds, convertible or not, issued by the corporation are long-term liabilities, they are not included in the working capital computation. Accounts receivable, marketable securities, and cash are short-term assets included in the calculation of working capital.

140

All of the following ratios are measures of the liquidity of a corporation EXCEPT:

A) debt/equity ratio.
B) acid-test ratio.
C) current ratio.
D) quick ratio.

A) debt/equity ratio.

Liquidity ratios measure a firm's ability to meet its current financial obligations and include the current ratio and acid-test (quick) ratio. However, the debt/equity ratio is a capitalization ratio and measures the amount of leverage compared to equity in a company's overall capital structure.

141

Which of the following would best describe working capital?

A) The amount of money available to the corporation that is currently being held in cash or cash equivalent positions.
B) The amount of money a corporation has available to work with if it liquidates its current assets and pays off all of its current liabilities.
C) A corporation's net worth.
D) The value per share available to shareholders in the event of bankruptcy.

B) The amount of money a corporation has available to work with if it liquidates its current assets and pays off all of its current liabilities.

Working capital equals current assets minus current liabilities.

142

Working capital is:

A) only the cash and equivalents.
B) current assets - inventory.
C) current assets - current liabilities.
D) total assets - total liabilities.

C) current assets - current liabilities.

Current means cash or assets that would be exchanged for cash in the ordinary course of business in the current year. In the case of liabilities, current means maturing or falling due within the current year. The net of current assets less the current liabilities implies the company has cash availability of the remainder with which to work.

143

If an analyst wished to determine the degree to which leverage was being employed by a subject company, she would most likely examine that issuer's:

A) current ratio.
B) debt to equity ratio.
C) sales to debt ratio.
D) price to book ratio.

B) debt to equity ratio.

The debt to equity ratio is computed by dividing the issuer's long-term debt by their total capitalization. The higher the ratio, the more leverage being used by the company.

144

An analyst is viewing a subject company's financial statements. She notices that the company has current assets of $20 million, fixed assets of $50 million, and total liabilities of $45 million (of which $10 million is considered long-term). This company's debt to equity ratio is

A) 22.2%
B) 64.3%
C) 28.6%
D) 40%

C) 28.6%

The debt to equity ratio is computed by dividing the issuer's long-term debt by their total capitalization. Total capitalization is the company's net worth (assets minus liabilities) plus the long-term debt. In this example, the net worth is $70 million minus $45 million, or $25 million. Adding the long-term debt of $10 million results in total capital of $35 million. Divide the $10 million by that $35 million to arrive at 28.57%. As we point out in the LEM, this is really a misnomer—it should be called the debt to total capital ratio, but probably will not shown that way on the exam.

145

When a company's debt to equity ratio is higher than typical for that industry, it might be said that the company is:

A) suitable for a conservative investor.
B) highly profitable.
C) highly leveraged.
D) about to increase their dividends.

C) highly leveraged.

The definition of a leverage is the use of borrowed money in the issuer's capital structure. This is seen through the debt to equity ratio. When that ratio is higher than industry standards, it is said that the company is highly leveraged.

146

Issuance of which of the following would most likely increase the leverage in a company's capital structure?

A) bonds.
B) common stock.
C) warrants.
D) preferred stock.

A) bonds.

Leverage is the use of borrowed money. This is reflected in a company's debt to equity ratio. Of these choices, the only one that is borrowed money is the bonds.

147

One measure of a corporation's intrinsic value is its book value per share. When performing this computation, the value of which of the following would normally be subtracted from the corporation's net worth?

1. Cash
2. Wages payable
3. Patents
4. Preferred stock

3. Patents
4. Preferred stock

The computation of book value per share is basically net tangible worth per share of common stock. Therefore, we subtract both the par value of the preferred stock and the value listed on the balance sheet for the intangible assets, such as patents.

148

One measure of a corporation's intrinsic value is its book value per share. When performing this computation, which of the following must be taken into consideration?

1. Goodwill
2. Long-term debt
3. Retained earnings
4. Par value of the preferred stock

1. Goodwill
2. Long-term debt
3. Retained earnings
4. Par value of the preferred stock

The computation of book value per share is basically net tangible worth per share of common stock. Included in the net worth are all assets and liabilities (such as long-term debt) as well as the stockholders equity (par value of the preferred stock and par + paid in surplus of the common stock and retained earnings). Subtracted from this to get tangible book value would be the par value of the preferred stock and the value of intangible assets such as goodwill.

149

Under SEC rules, Form 8-K must be filed:

A) within four business days of the event.
B) within ten business days of the event.
C) promptly.
D) within 15 business days of the event.

A) within four business days of the event.

Form 8-K is used to report newsworthy events to the SEC. The reporting time limit is four business days.

150

Form 8-K must be filed by:

A) registered investment advisers.
B) registered domestic issuers.
C) registered broker/dealers.
D) registered foreign issuers.

B) registered domestic issuers.

Form 8-K filings are required for domestic issuers, registered under the Act of 1933, to report newsworthy events to the SEC. Foreign Issuers, as well as broker/dealers and investment advisers, are exempt from having to file.

151

An issuer of registered securities must file Form 8-K when any of following events occur EXCEPT:

A) when a member of the board of directors resigns due to a disagreement over an operational matter.
B) when an overseas subsidiary issues a news release.
C) when control of the company changes.
D) when a significant amount of assets is disposed.

B) when an overseas subsidiary issues a news release.

An issuer of registered securities must file Form 8-K when control of the company changes, a significant amount of assets is disposed, or when one or more members of the board of directors resigns because of a disagreement over an operational matter. A news release by an overseas subsidiary would not require the filing of Form 8-K because that is a foreign entity and Form 8-K only deals with domestic companies.

152

In order to be in compliance with SEC reporting rules, a company will typically file a Form 10-Q how many times during its fiscal year?

A) One.
B) Two.
C) Four.
D) Three.

D) Three.

The Form 10-Q is used for quarterly financial reporting. However, even though there are four quarters in an accounting year, only three forms are filed. Why? Because the Form 10-K, the annual report, takes the place of the 4th quarterly report.

153

An analyst wishing to check on the most recent financial performance of an SEC registered issuer would probably examine the:

A) Form 13-D.
B) Form 10-K.
C) Form 8-K.
D) Form 10-Q.

D) Form 10-Q.

Financial reporting is done on Forms 10-K and 10-Q; the former on an annual basis, the latter, quarterly. Therefore, the most recent information is going to be on the Form 10-Q.

154

Publicly traded corporations are required to furnish their stockholders with financial information no less frequently than annually. This is usually accomplished by providing an annual report. In lieu of the annual report, this requirement may be met by the furnishing of a:

A) Form 10-Q.
B) Form 10-K.
C) Form 8-K.
D) Form ADV Part 2.

B) Form 10-K.

Form 10-K is the annual audited financial report to the SEC. It may be used in lieu of the annual report to shareholders.

155

Those investors wishing to examine a document that would probably give them the most information about an issuer's current and planned operations would seek out the:

A) Form 10-K.
B) annual report.
C) balance sheet.
D) investor's brochure.

B) annual report.

The annual report to shareholders is going to contain not only a complete financial report of the prior year's operations, but will also include statement from key personnel dealing with the company's future plans.

156

One popular method used to predict the expected return of a stock is the Capital Asset Pricing Model. Analysts using CAPM rely on all of these EXCEPT the:

A) risk-free rate available in the market.
B) standard deviation of the stock.
C) beta coefficient of the stock.
D) expected return on the market.

B) standard deviation of the stock.

Under the CAPM, using the SML, we can determine the expected return of any given stock by taking the risk-free rate and adding to that the product of that stock's beta coefficient and the difference between the expected return on the market and the risk-free rate. Standard deviation is not a factor in this computation.

157

If the expected return on the market is 20% and the risk-free rate is 4%, a stock with a beta coefficient of 0.8 would have an expected rate of return under CAPM of:

A) 16.8%.
B) 16.0%.
C) 12.8%.
D) 19.2%.

A) 16.8%.

The formula is the risk-free rate (.04) plus the product of the stock's beta (.8) and the difference between the expected return on the market and the risk-free rate(.20 - .04). In this case, it would be .04 + .8(.16) or .04 + .128 = .168

158

According to the efficient market hypothesis, information found when reading the Wall Street Journal would be considered

A) semi-strong form market efficiency
B) strong-form market efficiency
C) weak-form market efficiency
D) random walk

C) weak-form market efficiency

The closer to inside information, the stronger the information. Anything published in widely read media would be considered very weak.

159

An IA explaining modern portfolio theory (MPT) to a client might make all of the following statements EXCEPT

A) if one security has a higher return than another, and, at the same time has a higher risk, choose it
B) if one security has a higher return than another and, at the same time has a lower risk, choose it
C) if two securities offer the same rate of return, choose the one with the lower risk
D) if two securities offer the same risk, choose the one with the higher return

A) if one security has a higher return than another, and, at the same time has a higher risk, choose it

Higher returns are only justified if they bear a relationship to the added risk. The goal of MPT is to maximize the return for any given amount of risk.

160

Which ratio would be looked at to determine the liquidity of a corporation?

A) Debt/equity.
B) Dividend payout.
C) Current.
D) Price/earnings.

C) Current.

A company’s current ratio is their current assets divided by their current liabilities. If their current ratio is strong, they have a highly liquid position.

161

The Capital Asset Pricing Model (CAPM) is most commonly used to determine an investor’s:

A) expected return.
B) required return.
C) time weighted return.
D) holding period return.

A) expected return.

The CAPM suggests that we can determine the expected return of any security (or portfolio) by using the following mathematical formula: Er = Rf + Beta(expected return on the market − Rf). Er stands for expected return, Rf is the risk-free return.

162

One of the goals of Modern Portfolio Theory (MPT) is to construct a portfolio that provides the highest return with the lowest risk. This would be known as the:

A) risk-free portfolio.
B) Sharpe's portfolio.
C) efficient portfolio.
D) managed portfolio.

C) efficient portfolio.

According to Harry Markowitz, the founder of MPT, the goal is to craft an "efficient" portfolio. An efficient portfolio is a portfolio that offers the highest expected return for a given level of risk. The line that connects all these efficient portfolios is the efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk.

163

When an analyst subtracts the inventory from a company’s current assets and divides the remainder by the current liabilities, the result is the:

A) working capital.
B) net worth.
C) quick ratio.
D) current ratio.

C) quick ratio.

The quick ratio, sometimes called the acid-test ratio, is computed by takin

164

An analyst attempting to determine the extent to which financial leverage is being employed by a company would examine the company’s

A) working capital
B) acid-test ratio
C) debt-to-equity ratio
D) book value per share

C) debt-to-equity ratio

Financial leverage is the use of debt capital. The best way to see the extent to which that exists is through the debt-to-equity ratio.

165

When a member of the board of directors of a publicly traded company resigns due to a disagreement over an operational matter,

A) FINRA must be notified promptly
B) Form 8-K must be filed with the SEC within four business days of the event
C) Form 10-K must be filed with the SEC within four business days of the event
D) the Administrator must be notified no later than the close of the business day following the event

B) Form 8-K must be filed with the SEC within four business days of the event

The Form 8-K is used to report significant events of importance to investors. Examples would be the resignation of a member of the board because of an operational dispute, liquidation of a significant asset, filing for bankruptcy, or change in management control. When any of these occur, the Form 8-K must be filed with the SEC no later than four business days after the event. The Form 10-K is the company’s annual filing and that is due, depending on the size of the company, 60 to 90 days after the end of the fiscal year.

166

XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 18.8%. Based on this information ABC had alpha of

A) 18.8%
B) 2%
C) 4.8%
D) 6.8%

B) 2%

Alpha is the extent to which a security’s performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 18.8%, ABC beat the expected by 2% and that is its alpha.

167

XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had alpha of

A) 2.8%
B) 14.8%
C) –2%
D) 2%

C) –2%

Alpha is the extent to which a security’s performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.

168

According to the Efficient Market Hypothesis, one using fundamental analysis would most likely be of the opinion that he could do better than one following

A) weak-form market efficiency
B) semi-strong form market efficiency
C) strong-form market efficiency
D) charts

A) weak-form market efficiency

In weak-form market efficiency, current stock prices fully reflect available security market information such as volume and price movements. Investors cannot achieve excess returns using tech analysis, but may benefit from using fundamental analysis which looks deeper into the company’s potential by examining its financial statements.

169

One of the offshoots of the capital asset pricing model (CAPM) is the Capital Market Line (CML). The equation for the CML uses which one of the following?

A) Beta
B) Correlation coefficient
C) Standard deviation
D) Alpha

C) Standard deviation

The CML provides an expected return for a portfolio based on the expected return of the market, the risk-free rate of return, and the standard deviation of the portfolio in relation to the standard deviation of the market. The equation for the CML uses the: expected return of the portfolio; risk-free rate; return on the market; standard deviation of the market; and standard deviation of the portfolio.

170

LMN Manufacturing Company, listed on the NYSE, is an SEC reporting company. Each of the following would require the filing of a Form 8-K EXCEPT

A) acquisition of a major asset
B) a change in top management
C) a change in external CPA firm engaged to perform the annual audit
D) relocation of wholly owned subsidiary

D) relocation of wholly owned subsidiary

The Form 8-K is used to report significant events that could affect the price of the company’s stock. The SEC does not consider a relocation of a subsidiary to be of significant magnitude.

171

Which of the following would appear as assets on a corporation’s balance sheet?

1. Prepaid expenses
2. Deferred tax credits
3. Notes payable
4. Notes receivable

1. Prepaid expenses
4. Notes receivable

Prepaid expenses, such as advertising, rent, or insurance, are listed as assets on the balance sheet. All receivables are assets, while payables are liabilities. Under current accounting practice, deferred tax credits are treated as a liability.

172

When analyzing a company’s financial statements, gross margin is computed by subtracting from revenues

A) the cost of goods sold plus interest expense
B) all expenses, including income tax
C) all expenses, including income tax plus preferred dividends
D) the cost of goods sold

D) the cost of goods sold

A company’s gross margin is the profit from operations remaining after subtracting the cost of goods sold from the revenues (sales). It is frequently shown as a percentage derived from dividing the gross margin by the sales or revenues of the enterprise. Because interest is a fixed rather than operating expense, it is not included in the computation. You might also see this referred to as pre-tax margin.

173

A review of a corporation’s financial statements reveals the following information:

-Net assets - $50 million
-Net revenues - $20 million
-Cost of goods sold - $14 million
-Depreciation - $1 million
-Interest - $1 million
-Long-term debt - $20 million

Using the information, the gross margin for the year was

A) 53%
B) 30%
C) 25%
D) 20%

B) 30%

The gross margin, or margin of profit, is usually expressed as a percentage. It is the operating profit remaining after subtracting the cost of goods sold from the revenues (sales), divided by those revenues. In this question, the cost of goods sold is $14 million, and that number includes the depreciation. Subtracting $14 million from $20 million results in an operating profit of $6 million, which is 30% of the $20 million in revenues. You might also see this referred to as pre-tax margin. Please note that, as with so many questions on the exam, there are extra numbers that have no relevance to the question.

174

Which of the following are key assumptions of the Capital Asset Pricing Model (CAPM)?

1. Investors hold diversified portfolios
2. Income tax rates are stable
3. Investors can borrow and lend at the risk-free rate
4. There is a perfect capital market

Which of the following are key assumptions of the Capital Asset Pricing Model (CAPM)?

1. Investors hold diversified portfolios
3. Investors can borrow and lend at the risk-free rate
4. There is a perfect capital market

CAPM assumes that investors will be looking at a return for taking systematic risk, hence holding diversified portfolios. One of the most important assumptions is that investors will be able to borrow/lend at the risk-free rate. Finally, CAPM assumes a perfect capital market, meaning that all securities are valued properly (their returns will plot to the [SML] security market line, and there are no tax or transaction costs). Income taxes are not a consideration, because not all investors are going to be in the same tax bracket.

175

Two of the major factors involved in the Capital Asset Pricing Model (CAPM) are

1. interest rates
2. risk
3. tax rates
4. time

2. risk
4. time

CAPM is built on the theory that investors must receive a return commensurate with the amount of risk taken over a specified period of time.

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