TOPIC: [2013 CFA Level 1] Quantitative Methods

[Session 2 - Reading 6] Practice Questions, Sample

Questions.
1. The capital budgeting director of Green Manufacturing is evaluating a laser imaging project with the following
characteristics:
Cost: $150,000
Expected life: 3 years
After-tax cash flows: $60,317 per year
Salvage value: $0
If Green Manufacturings cost of capital is 11.5%, what is the projects internal rate of return (IRR)?
A)
13.6%.
B)
$3,875.
C)
10.0%.

-------------------------------------------------------------------------------C

Since we are seeking the IRR, the answer has to be in terms of a rate of return, this eliminates the option not written in a
percentage.
Since they payments (cash flows) are equals, we can calculate the IRR as: N = 3; PV = 150,000; PMT = 60,317; CPT I/Y
= 9.999
2. In order to calculate the net present value (NPV) of a project, an analyst would least likely need to know the:
A)
timing of the expected cash flows from the project.
B)
internal rate of return (IRR) of the project.
C)
opportunity cost of capital for the project.

-------------------------------------------------------------------------------B
The NPV is calculated using the opportunity cost, discount rate, expected cash flows, and timing of the expected cash flows
from the project. The projects IRR is not used to calculate the NPV.

3. An investment with a cost of $5,000 is expected to have cash inflows of $3,000 in year 1, and $4,000 in year 2. The
internal rate of return (IRR) for this investment is closest to:
A)
15%.
B)
25%.
C)
30%.

-------------------------------------------------------------------------------B

The IRR is the discount rate that makes the net present value of the investment equal to 0.
This means -$5,000 + $3,000 / (1 + IRR) + $4,000 / (1 + IRR)2 = 0
One way to compute this problem is to use trial and error with the existing answer choices and choose the discount rate that
makes the PV of the cash flows closest to 5,000.
$3,000 / (1.25) + $4,000 / (1.25)2 = 4,960.
Alternatively: CFO = -5,000; CF1 = 3,000; CF2 = 4,000; CPT IRR = 24.3%.

4. The estimated annual after-tax cash flows of a proposed investment are shown below:
Year 1: $10,000
Year 2: $15,000
Year 3: $18,000
After-tax cash flow from sale of investment at the end of year 3 is $120,000
The initial cost of the investment is $100,000, and the required rate of return is 12%. The net present value (NPV) of the
project is closest to:

A)
$19,113.
B)
$63,000.
C)
-$66,301.

-------------------------------------------------------------------------------A

10,000 / 1.12 = 8,929

15,000 / (1.12)2 = 11,958

138,000 / (1.12)3 = 98,226
NPV = 8,929 + 11,958 + 98,226 100,000 = $19,113
Alternatively: CFO = -100,000; CF1 = 10,000; CF2 = 15,000; CF3 = 138,000; I = 12; CPT NPV = $19,112.

5. Fisher, Inc., is evaluating the benefits of investing in a new industrial printer. The printer will cost $28,000 and increase
after-tax cash flows by $8,000 during each of the next five years. What are the respective internal rate of return (IRR) and
net present value (NPV) of the printer project if Fishers required rate of return is 11%?
A)
13.20%; $1,567.
B)
17.97%; $5,844.
C)
5.56%; $3,180.

-------------------------------------------------------------------------------A

IRR Keystrokes: CF0 = -$28,000; CF1 = $8,000; F1 = 5; CPT IRR = 13.2%.

NPV Keystrokes: CF0 = -$28,000; CF1 = $8,000; F1 = 5; I = 11; CPT NPV = 1,567.
Since cash flows are level, an alternative is:
IRR: N = 5; PMT = 8,000; PV = -28,000; CPT I/Y = 13.2%.
NPV: I/Y = 11; CPT PV = -29,567 + 28,000 = 1,567

6. The financial manager at Genesis Company is looking into the purchase of an apartment complex for $550,000. Net aftertax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years. Genesis
required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the property for
after-tax proceeds of $300,000. What is the respective internal rate of return (IRR) and net present value (NPV) on this
project?
A)
7.01%; $53,765.
B)
13.99%; $166,177.
C)
6.66%; $64,170.

-------------------------------------------------------------------------------A
IRR Keystrokes: CF0 = -$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1.
NPV Keystrokes: CF0 = -$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1.

Compute NPV, I = 9.
Note: Although the rate of return is positive, the IRR is less than the required rate of 9%. Hence, the NPV is negative.
7. Fifty mutual funds are ranked according to performance. The five best performing funds are assigned the number 1, while
the five worst performing funds are assigned the number 10. This is an example of a(n):
A)
ordinal scale.
B)
interval scale.
C)
nominal scale.

-------------------------------------------------------------------------------A
The ordinal scale of measurement categorizes and orders data with respect to some characteristic. In this example, the
ordinal scale tells us that a fund ranked 1 performed better than a fund ranked 10, but it does not tell us anything about
the difference in performance.

8. Which measure of scale has a true zero point as the origin?

A)
Nominal scale.
B)
Ordinal scale.
C)
Ratio scale.

-------------------------------------------------------------------------------C
Ratio scales are the strongest level of measurement; they quantify differences in the size of data and have a true zero point
as the origin.

9. Which of the following statements regarding the terms population and sample is least accurate?
A)
A sample includes all members of a specified group.
B)
A sample's characteristics are attributed to the population as a whole.

C)
A descriptive measure of a sample is called a statistic.

-------------------------------------------------------------------------------A
A population includes all members of a specified group. A sample is a portion, or subset of the population of interest.

10. Which of the following statements about statistical concepts is least accurate?
A)
A frequency distribution is a tabular display of data summarized into a relatively small number of intervals.
B)
A sample contains all members of a specified group, but a population contains only a subset.
C)
A parameter is any descriptive measure of a population characteristic.

-------------------------------------------------------------------------------B
A population is defined as all members of a specified group, but a sample is a subset of a population.

11. A summary measure that is computed to describe a population characteristic from a sample is called a:
A)
census.
B)
parameter.
C)
statistic.

-------------------------------------------------------------------------------C
When sampling from a portion of the population, you compute a statistic to make inferences about the population.

12. Which one of the following alternatives best describes the primary use of inferential statistics? Inferential statistics are
used to:

A)
summarize the important characteristics of a large data set based on statistical characteristics of a smaller sample.
B)
make forecasts, estimates or judgments about a large set of data based on statistical characteristics of a smaller sample.
C)
make forecasts based on large data sets.

-------------------------------------------------------------------------------B
Inferential statistics are used mainly to make forecasts, estimates or judgements about a large set of data based on
statistical characteristics of a smaller set of data.

13. There is a 40% chance that the economy will be good next year and a 60% chance that it will be bad. If the economy is
good, there is a 50 percent chance of a bull market, a 30% chance of a normal market, and a 20% chance of a bear market.
If the economy is bad, there is a 20% chance of a bull market, a 30% chance of a normal market, and a 50% chance of a
bear market.What is the joint probability of a good economy and a bull market?
A)
50%.
B)
20%.
C)
12%.

-------------------------------------------------------------------------------B
Joint probability is the probability that both events, in this case the economy being good and the occurrence of a bull market,
happen at the same time. Joint probability is computed by multiplying the individual event probabilities together: (0.40)
(0.50) = 0.20 or 20%.

-------------------------------------------------------------------------------What is the probability of a bull market next year?

A)
20%.
B)
50%.
C)
32%.

-------------------------------------------------------------------------------C
Because a good economy and a bad economy are mutually exclusive, the probability of a bull market is the sum of the joint
probabilities of (good economy and bull market) and (bad economy and bull market): ((0.40) (0.50)) + ((0.60) (0.20)) =
0.32 or 32%.

14. For a stock, which of the following is least likely a random variable? Its:
A)
current ratio.
B)
most recent closing price.
C)
stock symbol.

-------------------------------------------------------------------------------C
A random variable must be a number. Sometimes there is an obvious method for assigning a number, such as when the
random variable is a number itself, like a P/E ratio. A stock symbol of a randomly selected stock could have a number
assigned to it like the number of letters in the symbol. The symbol itself cannot be a random variable.

15. If two events are mutually exclusive, the probability that they both will occur at the same time is:
A)
0.50.
B)
0.00.
C)
Cannot be determined from the information given.

-------------------------------------------------------------------------------B
If two events are mutually exclusive, it is not possible to occur at the same time. Therefore, the P(AB) = 0.

16. Which of the following statements about probability is most accurate?

A)

An outcome is the calculated probability of an event.

B)
A conditional probability is the probability that two or more events will happen concurrently.
C)
An event is a set of one or more possible values of a random variable.

-------------------------------------------------------------------------------C
Conditional probability is the probability of one event happening given that another event has happened. An outcome is the
numerical result associated with a random variable.

17. If event A and event B cannot occur simultaneously, then events A and B are said to be:
A)
mutually exclusive.
B)
statistically independent.
C)
collectively exhaustive.

-------------------------------------------------------------------------------A
If two events cannot occur together, the events are mutually exclusive. A good example is a coin flip: heads AND tails cannot
occur on the same flip.

18. In any given year, the chance of a good year is 40%, an average year is 35%, and the chance of a bad year is 25%.
What is the probability of having two good years in a row?
A)
10.00%.
B)
16.00%.
C)
8.75%.

-------------------------------------------------------------------------------B

The joint probability of independent events is obtained by multiplying the probabilities of the individual events together:
(0.40) (0.40) = 0.16 or 16%.

19. Which of the following statements about the normal probability distribution is most accurate?
A)
Five percent of the normal curve probability is more than two standard deviations from the mean.
B)
Sixty-eight percent of the area under the normal curve falls between the mean and 1 standard deviation above the mean.
C)
The normal curve is asymmetrical about its mean.

-------------------------------------------------------------------------------A

The normal curve is symmetrical about its mean with 34% of the area under the normal curve falling between the mean and
one standard deviation above the mean. Ninety-five percent of the normal curve is within two standard deviations of the
mean, so five percent of the normal curve falls outside two standard deviations from the mean.

20. Which of the following is least likely a probability distribution?

A)
Roll an irregular die: p(1) = p(2) = p(3) = p(4) = 0.2 and p(5) = p(6) = 0.1.
B)
Flip a coin: P(H) = P(T) = 0.5.
C)
Zeta Corp.: P(dividend increases) = 0.60, P(dividend decreases) = 0.30.

-------------------------------------------------------------------------------C
All the probabilities must be listed. In the case of Zeta Corp. the probabilities do not sum to one.

21. Which of the following statements about probability distributions is least accurate?
A)
A discrete random variable is a variable that can assume only certain clearly separated values resulting from a count of
some set of items.
B)

The skewness of a normal distribution is zero.

C)
A binomial probability distribution is an example of a continuous probability distribution.

-------------------------------------------------------------------------------C
The binomial probability distribution is an example of a discrete probability distribution. There are only two possible
outcomes of each trial and the outcomes are mutually exclusive. For example, in a coin toss the outcome is either heads or
tails.
The other responses are both correct definitions.

22. Which of the following statements about probability distributions is least accurate?
A)
In a binomial distribution each observation has only two possible outcomes that are mutually exclusive.
B)
A probability distribution includes a listing of all the possible outcomes of an experiment.
C)
A probability distribution is, by definition, normally distributed.

-------------------------------------------------------------------------------C
Probabilities must be zero or positive, but a probability distribution is not necessarily normally distributed. Binomial
distributions are either successes or failures.

23. A probability distribution is least likely to:

A)
contain all the possible outcomes.
B)
give the probability that the distribution is realistic.
C)
have only non-negative probabilities.

-------------------------------------------------------------------------------B
The probability distribution may or may not reflect reality. But the probability distribution must list all possible outcomes, and
probabilities can only have non-negative values.

24. A dealer in a casino has rolled a five on a single die three times in a row. What is the probability of her rolling another five
on the next roll, assuming it is a fair die?
A)
0.001.
B)
0.167.
C)
0.200.

-------------------------------------------------------------------------------B
The probability of a value being rolled is 1/6 regardless of the previous value rolled.

25. Which of the following statements about testing a hypothesis using a Z-test is least accurate?
A)
If the calculated Z-statistic lies outside the critical Z-statistic range, the null hypothesis can be rejected.
B)
The calculated Z-statistic determines the appropriate significance level to use.
C)
The confidence interval for a two-tailed test of a population mean at the 5% level of significance is that the sample mean
falls between 1.96 /n of the null hypothesis value.

-------------------------------------------------------------------------------B
The significance level is chosen before the test so the calculated Z-statistic can be compared to an appropriate critical value.

26. Susan Bellows is comparing the return on equity for two industries. She is convinced that the return on equity for the
discount retail industry (DR) is greater than that of the luxury retail (LR) industry. What are the hypotheses for a test of her
comparison of return on equity?
A)
H0: DR = LR versus Ha: DR LR.
B)
H0: DR LR versus Ha: DR > LR.
C)
H0: DR = LR versus Ha: DR < LR.

-------------------------------------------------------------------------------B

The alternative hypothesis is determined by the theory or the belief. The researcher specifies the null as the hypothesis that
she wishes to reject (in favor of the alternative). Note that this is a one-sided alternative because of the greater than belief.

27. In the process of hypothesis testing, what is the proper order for these steps?
A)
State the hypotheses. Specify the level of significance. Collect the sample and calculate the test statistics. Make a decision.
B)
Collect the sample and calculate the sample statistics. State the hypotheses. Specify the level of significance. Make a
decision.
C)
Specify the level of significance. State the hypotheses. Make a decision. Collect the sample and calculate the sample
statistics.

-------------------------------------------------------------------------------A

The hypotheses must be established first. Then the test statistic is chosen and the level of significance is determined.
Following these steps, the sample is collected, the test statistic is calculated, and the decision is made.

28. The first step in the process of hypothesis testing is:

A)
to state the hypotheses.
B)
selecting the test statistic.
C)
the collection of the sample.

-------------------------------------------------------------------------------A

The researcher must state the hypotheses prior to the collection and analysis of the data. More importantly, it is necessary to
know the hypotheses before selecting the appropriate test statistic.

29. Which of the following statements least describes the procedure for testing a hypothesis?
A)
Compute the sample value of the test statistic, set up a rejection (critical) region, and make a decision.
B)
Develop a hypothesis, compute the test statistic, and make a decision.
C)
Select the level of significance, formulate the decision rule, and make a decision.

-------------------------------------------------------------------------------A

Depending upon the author there can be as many as seven steps in hypothesis testing which are:
Stating the hypotheses.
Identifying the test statistic and its probability distribution.
Specifying the significance level.
Stating the decision rule.
Collecting the data and performing the calculations.
Making the statistical decision.
Making the economic or investment decision.

30. Which of the following is the correct sequence of events for testing a hypothesis?

A)
State the hypothesis, select the level of significance, formulate the decision rule, compute the test statistic, and make a
decision.
B)
State the hypothesis, select the level of significance, compute the test statistic, formulate the decision rule, and make a
decision.
C)
State the hypothesis, formulate the decision rule, select the level of significance, compute the test statistic, and make a
decision.

-------------------------------------------------------------------------------A

Depending upon the author there can be as many as seven steps in hypothesis testing which are:
Stating the hypotheses.
Identifying the test statistic and its probability distribution.
Specifying the significance level.
Stating the decision rule.

Collecting the data and performing the calculations.

Making the statistical decision.
Making the economic or investment decision.

31. One of the underlying assumptions of technical analysis is that supply and demand is driven by:
A)
rational behavior during calm markets and irrational behavior during volatile markets.
B)
rational behavior only.
C)
both rational and irrational behavior.

-------------------------------------------------------------------------------C

Successful technical analysis assumes both rational and irrational behavior during all market conditions.

32. One of the assumptions of technical analysis is:

A)
all analysts have all current information.
B)
the market is efficient.
C)
supply and demand are driven by rational and irrational behavior.

-------------------------------------------------------------------------------C

The market is driven by rational and irrational behavior.

33. A technical analyst believes stock prices are primarily driven by:
A)
specialist trading.
B)
market supply and demand forces.

C)
the random walk hypothesis.

-------------------------------------------------------------------------------B
Other assumptions of technical analysis include:
Supply and demand is driven by both rational and irrational behavior, security prices move in trends that persist for long
periods of time, and while the cause for changes in supply and demand are difficult to determine, the actual shifts in supply
and demand can be observed in market price behavior.

34. Which of the following is least likely an underlying assumption of technical analysis?
A)
Prices are determined by supply and demand.
B)
Markets are efficient and all known information is reflected in prices.
C)
Supply and demand for a stock is driven by rational and irrational behavior.

-------------------------------------------------------------------------------B
For technical analysis to succeed, markets must have some inefficiency in order for trends to develop.

35. The advantages of using technical analysis include:

A)
the incorporation of psychological reasons behind price changes.
B)
ease in interpreting reasons behind stock price trends.
C)
complete objectivity.

-------------------------------------------------------------------------------A

Technical analysis avoids having to use fundamental data and adjusting for accounting problems, incorporates psychological
as well as economic reasons behind price changes, and tells WHEN to buy; not WHY investors are buying. Drawbacks
include subjective interpretation of charts and graphs.

36. The advantages of using technical analysis include:

A)
the incorporation of psychological reasons behind price changes.
B)
ease in interpreting reasons behind stock price trends.
C)
complete objectivity.

-------------------------------------------------------------------------------A

Technical analysis avoids having to use fundamental data and adjusting for accounting problems, incorporates psychological
as well as economic reasons behind price changes, and tells WHEN to buy; not WHY investors are buying. Drawbacks
include subjective interpretation of charts and graphs.

37. When a relative strength ratio (stock price over market price) is increasing, the stock is:
A)
tracking the index.
B)
underperforming the index.
C)
outperforming the index.

-------------------------------------------------------------------------------C
Relative strength: When prices of an individual stock or industry change, it is difficult to tell if the change is stock specific or
caused by market movements. If two variables are changing at the same rate, the ratio created by dividing one of the
variables by the other will remain constant. This is called the relative strength ratio.
Relative Strength = Stock Price / Market Price
If the ratio increases over time the stock is out-performing the market (a + trend)
If the ratio declines over time the stock is under-performing the market (a trend).