CFA Level 1 - 101 Must Knows 368 Questions with Verified Answers
Addition Rule of Probability - CORRECT ANSWER ADDITION: P(A or B) = P(A) + P(B) -
... [Show More] P(AB)
Roy's Safety First Criterion - CORRECT ANSWER Safety First Ratio = (E(R) - Rₜ) / σ
Larger ratio is better
If (Rₜ) is risk free rate, then it becomes Sharpe Ratio
Sharpe Ratio - CORRECT ANSWER Sharpe Ratio = (E(R) - RFR) / σ
Larger ratio is better
If (Rt) is higher than RFR, then it becomes Safety First Ratio
Central Limit Theorem - CORRECT ANSWER If we take samples of a population, with a large enough sample size, the distribution of all sample means is normal with:
- A mean equal to the population mean
- A variance equal to the population variance divided by sample size (σ² / n)
Standard Error of Sample Mean - CORRECT ANSWER σ / n^½
Binomial Probability - CORRECT ANSWER One of two possible outcomes (i.e. success/failure)
Possible outcomes can be demonstrated in binomial tree
Use "nCr" on calculator to solve:
nCr = P(success)^x * P(failure)^(n-x)
P - Value - CORRECT ANSWER Based on a calculated test statistic, rather than a significance level (which is chosen)
p-value = smallest significance level at which an analyst can reject the null hypothesis
one-tailed test - "less than or equal to"
two-tailed test - "equal to"
Cumulative Distribution Function - CORRECT ANSWER Gives the probability that a random variable will have an outcome less than or equal to a specific value (represented by F(x))
F(x) = probability of an outcome less than or equal to x
Standard normal table (z) shows cumulative probabilities
Effective Annual Yield - CORRECT ANSWER EAY = (1 + (i/n))^n - 1
Stated Rate = (EAY^(1/n) - 1) * n
Continuous Compounding - CORRECT ANSWER ln(EAY) = continuously compounded stated rate
e^(continuously compounded stated rate) = EAY
Type I Error - CORRECT ANSWER Incorrectly rejecting a true null hypothesis
(convicting an innocent person is Type I)
Type II Error - CORRECT ANSWER Failure to reject a false null hypothesis
(failure to convict a guilty person is Type II)
Significance Level / Power of a Test - CORRECT ANSWER Significance Level = Probability of Type I
Power of a Test = (1 - Probability of Type I)
Covariance (Probability Model) - CORRECT ANSWER Covariance of random variables A and B from probability model
On the calculator:
1) Enter returns for set A and joint probabilities for AB; find mean A
2) Enter returns for set B and joint probabilities for AB; find mean B
3) Multiply each joint probability AB by each set's returns minus means
(ex: P(AB1)(A1 - Mean A)(B1 - Mean B) + P(AB2)(A2 - Mean A)(B2 - Mean B) + ... + P(ABn)(An - Mean A)(Bn - Mean B))
4) The summed total is your covariance
Covariance (Sample) - CORRECT ANSWER Covariance of random variables A and B from sample with historical data with n observations
Correlation Coefficient - CORRECT ANSWER COVab / σaσb
Bank Discount Yield (Discount basis) - CORRECT ANSWER (Discount / Face Value) * (360 / Days)
Money Market Yield - CORRECT ANSWER (HPY) * (360 / Days)
Bond Equivalent Yield - CORRECT ANSWER (HPY) * (365 / Days)
Most appropriate for comparing yields!
Technical Analysis Indicators - CORRECT ANSWER Continuation:
TRIANGLE (or pennant) = Suggests a pause in the stock price movement that will be followed by a continuation of the previous trend
Reversal:
HEAD AND SHOULDERS = Suggests a future decline in the stock price regardless of prior trend
DOUBLE BOTTOM = Increasing stock price in the future (reversal of a downtrend)
Trendlines:
SUPPORT / RESISTANCE = Range that stock price trades in based on supply/demand. Stock is "supported" from going below a certain low price, and "resists" going above a certain high price
Price Elasticity - CORRECT ANSWER %ΔQuantity / %ΔPrice = (ΔQ / ΔP) * (P₀ / Q₀)
Demand is elastic if less than -1
Demand is inelastic if 0 to -1
Income Elasticity - CORRECT ANSWER %ΔQuantity / %ΔIncome
Positive for normal good
Negative for inferior good
Cross-Price Elasticity - CORRECT ANSWER %ΔQuantity / %ΔPriceʳᵉˡᵃᵗᵉᵈ ᵍᵒᵒᵈ
Positive for substitutes
Negative for complements
Sources of Economic Growth - CORRECT ANSWER Increases in:
- Labor
- Physical Capital
- Technology
- Natural Resources
- Human Capital
(LPT:HN)
"Life Pro Tip: No Hangovers"
Production Function Approach (GDP) - CORRECT ANSWER Potential GDP = A * f(L,K)
L = Labor
K = Capital
A = "total factor productivity" aka increased growth not explained by growth of labor and capital
This is a proxy for growth of technology
Solow (neoclassical) model (GDP) - CORRECT ANSWER Growth in Potential GDP = growth in technology + Wₗ(growth in labor) + Wₖ(growth in capital)
Growth in a country's per capita GDP = growth in technology + Wₖ(growth in K/L ratio)
No Arbitrage Forward Rate - CORRECT ANSWER (1 + price currency int. rate) / (1 + base currency int. rate) = forward exchange rate / spot exchange rate
((1 + price currency int. rate) / (1 + base currency int. rate)) * spot rate = no arbitrage forward rate
Exchange Rate Quotes - CORRECT ANSWER Price Currency / Base Currency
Read as "units of price currency for each unit of base currency"
Business Cycle - Leading Indicators - CORRECT ANSWER Precede:
Weekly Hours Manufacturing
Manufacturing New Orders; Non-defense
Consumer Goods
ISM New Orders Index
Stock Prices
Yield Curve
New Unemployment Ins. Claims
Building Permits
Capital Goods ex. Aircraft
Leading Credit Index
Consumer Expectations
Business Cycle - Coincident Indicators - CORRECT ANSWER Coincide:
Nonfarm payrolls
Personal Income - Transfer Payments
Manufacturing and Trade Sales
Business Cycle - Lagging Indicators - CORRECT ANSWER Follow:
*Unemployment Rate
Duration of Unemployment
Inventory / Sales Ratio
Manufacturing and Trade
Commercial and Individual Loans
Prime Rate
Manufacturing Labor Cost per Unit of Input
Commercial / Personal Credit
Income Ratio
CPI
The Fundamental Relationship (GDP) - CORRECT ANSWER Expenditures: GDP = C + I + G + (X - M)
Income: GDP = (C + S) + T
Fundamental Macro Relationship - CORRECT ANSWER (S-I) = (G-T) + (X-M)
S = Personal Savings
I = Personal Investment
G = Government Spending
T = Tax Revenue
X = Exports
M = Imports
If G > T, government deficit
If X > M, trade surplus
Inflationary Gap - CORRECT ANSWER Real output above full employment (LRAS)
Upward pressure on wages will decrease SRAS, reducing output and increasing prices (SRAS moves up)
Recessionary Gap - CORRECT ANSWER Real output below full employment (LRAS)
Downward pressure on wages should increase SRAS, increasing output to full employment, but recessionary gap may persist if "downward sticky."
Kenesyian theory suggests government spends to step in and increase AD up to equilibrium (stimulus or expansionary monetary policy)
Effects of Trade Restrictions - CORRECT ANSWER Trade restrictions typically increase the welfare of domestic producers, but decrease welfare of domestic consumers and foreign producers.
Overall welfare is decreased by trade restrictions (deadweight loss)
Types of Trade Restrictions - CORRECT ANSWER Tariffs (Oldest) - Taxes on imported goods; benefits government who collects tariff revenue
Quotas - Limits quantity of imports in a time period; benefits government if selling licenses; benefits foreign producers through quota rents
Voluntary Export Restraints - Foreign countries limits on quantity of exports to domestic nation. Effects are similar to quota, but government gets no revenue.
Consumer Price Indexes - CORRECT ANSWER Designed to measure change in cost of basket of goods/services
Weights in CPI reflect purchases of typical urban household
Annual inflation rate is year over year % change in CPI
Laspeyres Index (US CPI) - CORRECT ANSWER (Base year basket at current prices / Base year basket at base prices) * 100
Doesn't account for introduction of new goods, substitutions, or quality improvements (tends to overstate inflation).
Paasche Index - CORRECT ANSWER (Current year basket at current prices / Current year basket at base prices) * 100
Does allow for substitution
Fischer Index - CORRECT ANSWER Chain weighted: Geometric mean of Paasche & Laspeyres Indexes
Market Stuctures - CORRECT ANSWER Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
Perfect Competition - CORRECT ANSWER Many Firms
"Commodity" Products
No pricing power (price taker)
Compete only on price
Monopolistic Competition - CORRECT ANSWER Many Firms
Differentiated Products
Slight pricing power
Compete on price, features, advertising
Oligopoly - CORRECT ANSWER Few Firms
May be differentiated
May be significant pricing power
Compete on price, features, advertising
Monopoly - CORRECT ANSWER One Firm
No Good Substitutes
Significant pricing power
No need to compete; only advertise
Expansionary Fiscal Policy - CORRECT ANSWER Fiscal policy is expansionary if deficit increases or surplus decreases (G > T)
policy rate < neutral interest rate
Contractionary Fiscal Policy - CORRECT ANSWER Fiscal policy is contractionary if deficit decreases or surplus increases (G < T)
policy rate > neutral interest rate
Neutral Interest Rate - CORRECT ANSWER Long Term Trend of GDP Growth + Target Inflation Rate
Cash Flow from Operations (CFO) - CORRECT ANSWER Transactions that affect Net Income
CFO = Net income + noncash - WC investments
Typically, cash flows are operating if they affect current assets/liabilities
IFRS:
Interest or dividends received CFO or CFI
Interest or dividends paid CFO or CFF
US GAAP:
Interest or dividends received CFO
Cash Flow from Investing (CFI) - CORRECT ANSWER Purchases and sales of assets, some financial investments
Typically, cash flows are investing if they affect long-lived assets
IFRS:
Interest or dividends received CFO or CFI
Cash Flow from Financing (CFF) - CORRECT ANSWER Transactions that affect firm's capital structure (equity; long-term debt)
Typically, cash flows are financing if they affect long-lived liabilities and equity
IFRS:
Interest or dividends paid CFO or CFF
US GAAP:
Dividends paid are CFF
Non-Cash Transactions - CORRECT ANSWER Disclosed in footnotes of cash flow statement
Operating Cycle - CORRECT ANSWER Days inventory on hand + Days Sales Outstanding (DSO)
Cash Conversion Cycle (Net Operating Cycle) - CORRECT ANSWER Days inventory on hand + Days Sales Outstanding (DSO) - Days payables
Days Inventory on Hand - CORRECT ANSWER 365 / Inventory Turnover
Days Sales Outstanding (DSO) - CORRECT ANSWER 365 / Receivables Turnover
Days of Payables - CORRECT ANSWER 365 / Payables Turnover
Net Profit Margin - CORRECT ANSWER Net Income / Revenue
Asset Turnover - CORRECT ANSWER Revenue / Assets
Leverage Ratio - CORRECT ANSWER Avg. Total Assets / Avg. Total Equity
DuPont Decomposition of ROE (1-3 Stage) - CORRECT ANSWER ROE (1 Stage)
= (Net Income / Equity)
ROE (2 Stage)
= (Net Income / Revenue)
* (Revenue / Equity)
= Net Profit Margin
* Equity Turnover
ROE (3 Stage)
= (Net Income / Revenue)
* (Revenue / Assets)
* (Assets / Equity)
= Net Profit Margin
* Asset Turnover
* Financial Leverage (or Equity Multiplier)
DuPont Decomposition of ROE (5 Stage) - CORRECT ANSWER ROE
= (Net Income / EBT)
* (EBT / EBIT)
* (EBIT / Revenue)
* (Revenue / Assets)
* (Assets / Equity)
= tax burden
* interest burden
* EBIT margin
* asset turnover
* Financial Leverage (or Equity Multiplier)
Free Cash Flow to Firm (FCFF) - CORRECT ANSWER Cash flow available to debt and equity holders
FCFF = Net income + noncash charges + after-tax interest - FC (fixed) investment - WC (working) investment
FCFF = CFO + after-tax interest - FC investment
Free Cash Flow to Equity (FCFE) - CORRECT ANSWER Cash flow available to equity holders after meeting obligations of debt holders
Can sometimes be used in lieu of dividends to evaluate value of firm
FCFE = CFO - FC Investment + net borrowing
Impairment of Long-Lived Assets - CORRECT ANSWER Asset is impaired if market value falls below B/S carrying value
IFRS: check for impairment annually
US GAAP: Assess when circumstances dictate; apply recoverability test
Recoverable Amount - CORRECT ANSWER Greater of fair value less selling costs (what you can net for it if you sell it) or value in use (PV of future cash flows)
Recoverability Test - CORRECT ANSWER Asset is impaired if sum of undiscounted cash flows is less than carrying value
Recovery of Impairment - CORRECT ANSWER May be recognized under IFRS; not allowed under US GAAP
Financial Statement effect of Impairment - CORRECT ANSWER - Long-lived asset decreases by impairment amount
- Income decreases by impairment amount when recognized
- Taxes due not affected because tax deductions are not recognized until asset is sold/disposed (unrealized loss)
- If DTL for asset exists, reduces DTL to narrow gap between carrying and tax base
- cash flows not affected (non-cash)
- Depreciation expense in future periods will decrease (reduces depreciable value)
Revaluation of Long-Lived Assets - CORRECT ANSWER US GAAP: prohibited
IFRS: allowed if fair market value can be determined reliably
Revaluation Up - CORRECT ANSWER Revaluation up to fair value
Goes directly to S/E as revaluation surplus unless they reverse a previous loss on I/S
Revaluation Down - CORRECT ANSWER Revaluation down to fair value
Reduces any previous reevaluation surplus first; if no previous surplus exists, go to I/S and recognize as loss
Fair Value Model for Investment Property - CORRECT ANSWER IFRS only; long-lived assets held for rental income or price appreciation
FVM is similar to trading securities
Carry asset at fair value; recognize gains/losses on I/S
Revaluation vs. Fair Value Models - CORRECT ANSWER If no losses have been recognized, Fair Value model will value asset higher because any gains will be sent to S/E as revaluation surplus under revaluation model
Types of Leases - CORRECT ANSWER Operating Lease
Finance Lease (IFRS) / Capital Lease (US GAAP)
Finance Leases - CORRECT ANSWER Treat as if borrowing to purchase asset
Treat liability as if amortizing loan
IFRS: Finance Lease if rights/risks of ownership transferred to lessee
US GAAP: Finance Lease if any of these are met:
- Title Transfers at end of lease
- Bargain purchase option at end of lease
- Lease period is 75% or more of useful life
- PV of lease payments if 90% or more of value
Operating Leases - CORRECT ANSWER Treat as if renting the asset
Payments are rental expense on I/S
Payments are CFO outflows on C/F
Finance Lease (B/S) - CORRECT ANSWER Recognize long-lived asset equal to lower of fair value or PV of lease payments, and recognize a liability equal in value to the long-lived asset
Long-term liability has a current portion, same as LT debt
Finance Lease (I/S) - CORRECT ANSWER Depreciation expense on asset and interest expense on liability
- greater than lease payments in early years of lease; less than payments in later years
Finance Lease (C/F) - CORRECT ANSWER Payments are part interest (CFO outflow) and part principal (CFF outflow)
Interest portion can be classified as CFF under IFRS
Cash Flow from Operations (CFO) - CORRECT ANSWER Transactions from firm's regular business activities
CFO (Direct Method) - CORRECT ANSWER Direct Method: Start with cash from customers; add all other CFO receipts; subtract all CFO payments
CFO (Indirect Method) - CORRECT ANSWER Indirect Method: Start with net income and undo anything that isn't CFO
Requires adjusting accruals to a cash basis
Sources of Cash - CORRECT ANSWER Increase in a liability; decrease in an asset
Uses of Cash - CORRECT ANSWER Decrease in a liability; increase in an asset
Expensing Asset - CORRECT ANSWER Cost is an expense on I/S
Classified as operating cash outflow
Capitalizing Asset - CORRECT ANSWER Cost is recorded as asset on B/S
Classified as an investing cash outflow
Expense (depreciation or amortization) on I/S, cost spread over asset's life
Effects of Capitalizing vs. Expensing - CORRECT ANSWER Capitalization:
- smooths earnings
- Higher NI in current period, lower in later periods
- Higher assets and S/E
- Increase CFO, decrease CFI
Total Debt Ratio - CORRECT ANSWER Debt / Assets
Fixed Asset Turnover Ratio - CORRECT ANSWER Sales / Fixed Assets
Deferred Taxes - CORRECT ANSWER Result from different accounting rules for financial reporting and tax reporting
Income tax expense (fin. reporting) might not always equal taxes payable (tax reporting)
If differences are temporary, B/S will reflect DTA or DTL
Deferred Tax Examples - CORRECT ANSWER Accelerated depreciation
warranty expense
Warranty Expense - CORRECT ANSWER Recognized over warranty period for fin. reporting, but not actually paid for tax reporting
Tax Loss Carryforward - CORRECT ANSWER Taxable losses from earlier period can be carried forward. Losses can be used to reduce taxable income in subsequent periods.
Reduction in future taxes payable is DTA
Valuation Allowance - CORRECT ANSWER DTA reduced for probability that it won't be realized; contra account under US GAAP
(DTAs are directly reduced under IFRS; no such thing as valuation allowance)
Revenue Recognition LT Projects (Reliable) - CORRECT ANSWER Firms may recognize revenue and profit for LT projects if outcome can be reliably estimated.
Loss (if any), must all be recognized in current period
Percentage of Completion (Method) - CORRECT ANSWER Revenue each period = Total project revenue * percentage of completion - revenue recognized to date
Revenue Recognition LT Projects (unreliable) - CORRECT ANSWER IFRS: Expense costs when incurred, recognize revenue up to costs, no profit until completion
US GAAP: Completed contract method; all revenue, expense, and profit at completion
Percentage of Completion (Formula) - CORRECT ANSWER Costs incurred to date / total estimated costs
Ending Inventory - CORRECT ANSWER Beg. Inventory + Purchases - COGS
LIFO - CORRECT ANSWER Last In First Out
Is not allowed under IFRS!
Choosing an Inventory Costing Method - CORRECT ANSWER Choose the one that matches flow of physical goods most appropriately
LIFO Layer - CORRECT ANSWER Layer of goods at certain LIFO price
FIFO Inventory (calculation) - CORRECT ANSWER LIFO Inventory + LIFO reserve
FIFO Retained Earnings - CORRECT ANSWER LIFO Retained Earnings + LIFO reserve * (1 - tax rate)
FIFO COGS - CORRECT ANSWER LIFO COGS + Change in LIFO reserve
Inventory Preferences for Analysis - CORRECT ANSWER FIFO values for Inventory
LIFO values for COGS
These valuations are closer to true replacement cost
Accounting for Investment in Securities - CORRECT ANSWER Trading Securities:
- Intended to sell in short term; marked to market each period; unrealized gains/losses reported on I/S
Available for Sale:
- May sell prior to maturity; marked to market each period; unrealized gains/losses reported on S/E (OCI)
Held to Maturity:
- Not to be sold; B/S value is amortized cost (unless impaired, then market value)
Change in Security Value (Accounting) - CORRECT ANSWER Realized Gains/Losses, Interest, dividend income
always to I/S
Accounting for fixed-coupon bond liabilities - CORRECT ANSWER IFRS: Proceeds - Issuance Costs
US GAAP: Proceeds (issuance costs amortized on B/S as asset)
YTM when issued will determine interest expense for each period
Effective Interest Method - CORRECT ANSWER Discount or Premium amortized over life of bond, so that at maturity B/S liability will equal face value
Follows Constant Yield Price Trajectory
Straight Line Method (EIM) - CORRECT ANSWER Total discount (premium) / #periods
Permitted under US GAAP
Fair Value Alternative (EIM) - CORRECT ANSWER IFRS and US GAAP allow reporting liability at fair value; cannot change to another method once selecting (changes I/S value)
Effects of Leasing vs. buying Long-Lived Asset - CORRECT ANSWER Purchase Long Lived Asset:
Recognize asset on B/S at original cost
Recognize depreciation each period on I/S
Cash paid for asset is CFI in purchase period
Lease long lived asset (finance lease):
Recognize asset & liability on B/S
Lower of: PV of payments, fair value
Each period: recognize expenses on I/S
Depreciation expense on asset; Int. exp on liability
Cash paid for lease payments is part CFF (principal repaid) and CFO (interest paid)
Finance Lease Liability - CORRECT ANSWER Treated as an amortizing loan
(lease liability and loan liability are the same)
Temporary and Permanent Tax Differences - CORRECT ANSWER Difference between income tax expense and taxes payable
DTAs and DTLs are temporary differences and will eventually be reversed
Tax-exempt interest income is permanent and will not be reversed
Permanent Tax Difference Formula - CORRECT ANSWER Tax Rate = Income Tax Expense / Pre-Tax Income
Aggressive Accounting Decisions - CORRECT ANSWER Increase current income or improve reported financial position
Conservative Accounting Decisions - CORRECT ANSWER Decrease current income or worsen reported financial position
Basic EPS Calculation - CORRECT ANSWER (Net Income - Preferred Dividends) / Weighted avg. common shares
Weighted avg. common shares includes share issuance, share repurchases, stock splits / dividends
Diluted EPS Calculation - CORRECT ANSWER Company must report diluted EPS if they have them
Potentially Dilutive Securities - CORRECT ANSWER Stock Options or Warrants
Convertible Bonds
Convertible Preferreds
Stocks & Warrants (Dilutive EPS) - CORRECT ANSWER Exercise does not affect earnings to common, but does increase common shares
Use Treasury Stock Method:
Assume company purchases shares w/ proceeds of options / warrants, and issues new share for the rest, all at average price for the year
Convertible Preferred Shares (Dilutive EPS) - CORRECT ANSWER Conversion affects earnings to common, and increases common shares
Test for dilution:
Convertible Preferred Dividends / #New Shares if converted
Convertible Bonds (Dilutive EPS) - CORRECT ANSWER Conversion affects earnings to common, and increases common shares [Show Less]