CFA Level 1 - Time Value of Money & Financial Reporting Flashcards

Question 1

What is the Effective Annual Rate (EAR) and why is it important?

Accepted Answer

The EAR is the actual rate of return earned or paid on an investment or loan over a single year, taking into account the effects of compounding. It's important because it allows for a standardized comparison of interest rates from different compounding periods.

Formula: $EAR = (1 + \frac{Nominal Rate}{m})^m - 1$, where $m$ is the number of compounding periods per year.

Question 2

Differentiate between a nominal interest rate and an effective interest rate.

Accepted Answer

1.  **Nominal Rate (Stated Rate):** The annual interest rate quoted without considering the effect of compounding. It's typically the rate per period multiplied by the number of periods in a year.
2.  **Effective Rate (EAR):** The actual annual rate of return or cost of funds, taking into account the effect of compounding over the year. It's always equal to or greater than the nominal rate when compounding occurs more than once a year.

Question 3

State the formula for the Future Value (FV) of a single sum.

Accepted Answer

The future value of a single sum is the value of a present amount at a future date, assuming a certain interest rate.

Formula: $FV = PV 	imes (1 + r)^n$

Where: $PV$ = Present Value, $r$ = interest rate per period, $n$ = number of periods.

Question 4

State the formula for the Present Value (PV) of a single sum.

Accepted Answer

The present value of a single sum is the current value of a future amount, discounted back to the present using a specific discount rate.

Formula: $PV = \frac{FV}{(1 + r)^n}$ or $PV = FV 	imes (1 + r)^{-n}$

Where: $FV$ = Future Value, $r$ = discount rate per period, $n$ = number of periods.

Question 5

Explain the key difference between an ordinary annuity and an annuity due.

Accepted Answer

1.  **Ordinary Annuity:** A series of equal payments made at the *end* of each period.
2.  **Annuity Due:** A series of equal payments made at the *beginning* of each period.

Annuities due will always have a higher future value and present value than ordinary annuities (given the same number of periods and interest rate) because payments earn interest for one additional period.

Question 6

State the formula for the Future Value (FV) of an ordinary annuity.

Accepted Answer

The future value of an ordinary annuity is the sum of the future values of a series of equal payments made at the end of each period.

Formula: $FV_A = PMT 	imes \frac{(1 + r)^n - 1}{r}$

Where: $PMT$ = payment per period, $r$ = interest rate per period, $n$ = number of periods.

Question 7

State the formula for the Present Value (PV) of an ordinary annuity.

Accepted Answer

The present value of an ordinary annuity is the current value of a series of equal payments made at the end of each period, discounted back to the present.

Formula: $PV_A = PMT 	imes \frac{1 - (1 + r)^{-n}}{r}$

Where: $PMT$ = payment per period, $r$ = discount rate per period, $n$ = number of periods.

Question 8

Define Net Present Value (NPV) and its decision rule for capital budgeting.

Accepted Answer

NPV is the sum of the present values of all expected cash inflows and outflows associated with a project, discounted at the project's required rate of return (cost of capital).

**Decision Rule:**
*   If $NPV > 0$: Accept the project (it's expected to increase shareholder wealth).
*   If $NPV < 0$: Reject the project.
*   If $NPV = 0$: Indifferent (project is expected to earn exactly the required rate of return).

Question 9

Define Internal Rate of Return (IRR) and its decision rule.

Accepted Answer

The IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. It represents the project's expected rate of return.

**Decision Rule:**
*   If $IRR > Cost\ of\ Capital$: Accept the project.
*   If $IRR < Cost\ of\ Capital$: Reject the project.

IRR is typically found through trial and error or financial calculator/software.

Question 10

What is the core principle of Discounted Cash Flow (DCF) analysis?

Accepted Answer

DCF analysis is a valuation method used to estimate the attractiveness of an investment opportunity. It uses future free cash flow projections and discounts them to arrive at a present value estimate, which is then used to evaluate the potential for investment. The core principle is that the value of an asset is the present value of its expected future cash flows.

Question 11

Explain the 3-step DuPont analysis for Return on Equity (ROE) and its components.

Accepted Answer

DuPont analysis decomposes ROE into three key components to understand its drivers:

$ROE = Net\ Profit\ Margin 	imes Asset\ Turnover 	imes Financial\ Leverage$

$ROE = (\frac{Net\ Income}{Sales}) 	imes (\frac{Sales}{Average\ Total\ Assets}) 	imes (\frac{Average\ Total\ Assets}{Average\ Shareholder\ Equity})$

*   **Net Profit Margin:** Measures operating efficiency (how much profit per dollar of sales).
*   **Asset Turnover:** Measures asset use efficiency (how much sales per dollar of assets).
*   **Financial Leverage (Equity Multiplier):** Measures the extent to which a company uses debt to finance assets.

Question 12

Briefly describe the additional components in the 5-step (extended) DuPont analysis.

Accepted Answer

The 5-step DuPont analysis further breaks down the Net Profit Margin into:

$ROE = Tax\ Burden 	imes Interest\ Burden 	imes EBIT\ Margin 	imes Asset\ Turnover 	imes Financial\ Leverage$

$ROE = (\frac{Net\ Income}{EBT}) 	imes (\frac{EBT}{EBIT}) 	imes (\frac{EBIT}{Sales}) 	imes (\frac{Sales}{Average\ Total\ Assets}) 	imes (\frac{Average\ Total\ Assets}{Average\ Shareholder\ Equity})$

*   **Tax Burden:** Impact of taxes on profitability.
*   **Interest Burden:** Impact of interest expense on profitability.
*   **EBIT Margin:** Operating profitability before interest and taxes.

Question 13

Explain the FIFO (First-In, First-Out) inventory method and its impact during periods of rising prices.

Accepted Answer

FIFO assumes that the first units purchased or produced are the first ones sold.

**Impact in Rising Prices:**
*   **COGS:** Lower (older, cheaper costs are expensed).
*   **Ending Inventory:** Higher (newer, more expensive items remain).
*   **Net Income:** Higher (lower COGS leads to higher gross profit).
*   **Taxes:** Higher (higher net income).

FIFO generally results in inventory and COGS values that more closely reflect the actual physical flow of goods for most businesses.

Question 14

Explain the LIFO (Last-In, First-Out) inventory method and its impact during periods of rising prices.

Accepted Answer

LIFO assumes that the last units purchased or produced are the first ones sold.

**Impact in Rising Prices:**
*   **COGS:** Higher (newer, more expensive costs are expensed).
*   **Ending Inventory:** Lower (older, cheaper items remain).
*   **Net Income:** Lower (higher COGS leads to lower gross profit).
*   **Taxes:** Lower (lower net income, providing a tax advantage).

LIFO is generally prohibited under IFRS.

Question 15

How do US GAAP and IFRS differ regarding the use of LIFO and FIFO?

Accepted Answer

*   **US GAAP:** Permits the use of both FIFO and LIFO (as well as weighted-average cost).
*   **IFRS:** Prohibits the use of LIFO. Only permits FIFO and weighted-average cost.

This is a significant difference that can impact comparability between companies reporting under different standards.

Question 16

What do liquidity ratios measure, and provide two examples.

Accepted Answer

Liquidity ratios measure a company's ability to meet its short-term obligations (those due within one year). They indicate how easily assets can be converted to cash.

**Examples:**
*   **Current Ratio:** $\frac{Current\ Assets}{Current\ Liabilities}$ (measures ability to cover current liabilities with current assets).
*   **Quick Ratio (Acid-Test Ratio):** $\frac{Cash + Marketable\ Securities + Accounts\ Receivable}{Current\ Liabilities}$ (a more conservative measure, excluding inventory).

Question 17

What do solvency ratios measure, and provide two examples.

Accepted Answer

Solvency ratios measure a company's ability to meet its long-term obligations and its overall financial viability. They indicate the extent to which a company relies on debt financing.

**Examples:**
*   **Debt-to-Equity Ratio:** $\frac{Total\ Debt}{Shareholder\ Equity}$ (measures the proportion of debt financing relative to equity financing).
*   **Debt-to-Assets Ratio:** $\frac{Total\ Debt}{Total\ Assets}$ (measures the proportion of assets financed by debt).

Question 18

What is the fundamental difference between liquidity and solvency?

Accepted Answer

*   **Liquidity** refers to a company's ability to meet its *short-term* financial obligations (e.g., pay suppliers, employees) as they come due. It's about having enough cash or easily convertible assets.
*   **Solvency** refers to a company's ability to meet its *long-term* financial obligations (e.g., repay long-term debt, interest payments) and remain financially viable over the long run. It's about the overall structure of debt and equity. A company can be liquid but not solvent, or vice versa.

Question 19

Define Deferred Tax Assets (DTA) and provide common causes.

Accepted Answer

A Deferred Tax Asset (DTA) arises when a company has paid more tax than it owes, or when it has overpaid tax in the current period but expects to recover it in future periods. It represents a future tax saving.

**Common Causes:**
*   **Warranty Expenses:** Expensed for accounting purposes when incurred, but deductible for tax purposes only when paid.
*   **Tax Loss Carryforwards:** Current period tax losses that can be used to offset future taxable income.
*   **Revenue Recognized for Tax *After* Accounting:** e.g., installment sales.

Question 20

Define Deferred Tax Liabilities (DTL) and provide common causes.

Accepted Answer

A Deferred Tax Liability (DTL) arises when a company has paid less tax than it owes in the current period, but expects to pay the difference in future periods. It represents a future tax obligation.

**Common Causes:**
*   **Accelerated Depreciation for Tax Purposes:** Companies often use accelerated depreciation for tax (to reduce current taxable income) and straight-line depreciation for financial reporting. This creates a temporary difference where taxable income is lower than accounting income initially.
*   **Revenue Recognized for Tax *Before* Accounting:** e.g., subscription revenue received in advance.

Question 21

How do Deferred Tax Assets (DTA) and Deferred Tax Liabilities (DTL) impact the balance sheet and income statement?

Accepted Answer

**Balance Sheet:**
*   **DTA:** Reported as a non-current asset (or current if expected to reverse within one year).
*   **DTL:** Reported as a non-current liability (or current if expected to reverse within one year).

**Income Statement:** The change in DTA/DTL from one period to the next affects the **Income Tax Expense**.
*   An increase in DTL or a decrease in DTA increases income tax expense.
*   A decrease in DTL or an increase in DTA decreases income tax expense.
*   The income tax expense reported on the income statement is the sum of current tax expense and deferred tax expense/benefit.

Question 22

What do activity ratios measure, and provide two examples.

Accepted Answer

Activity ratios (or efficiency ratios) measure how efficiently a company is using its assets to generate sales.

**Examples:**
*   **Inventory Turnover:** $\frac{Cost\ of\ Goods\ Sold}{Average\ Inventory}$ (measures how many times inventory is sold and replaced).
*   **Receivables Turnover:** $\frac{Sales}{Average\ Accounts\ Receivable}$ (measures how efficiently a company collects its receivables).
*   **Total Asset Turnover:** $\frac{Sales}{Average\ Total\ Assets}$ (measures overall asset utilization).

Question 23

What do profitability ratios measure, and provide two examples.

Accepted Answer

Profitability ratios measure a company's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity.

**Examples:**
*   **Gross Profit Margin:** $\frac{Gross\ Profit}{Sales}$ (measures profit after COGS).
*   **Net Profit Margin:** $\frac{Net\ Income}{Sales}$ (measures profit after all expenses, including taxes).
*   **Return on Assets (ROA):** $\frac{Net\ Income}{Average\ Total\ Assets}$ (measures profit generated per dollar of assets).

Question 24

What do valuation ratios measure, and provide two examples.

Accepted Answer

Valuation ratios are used to compare the relative value of different companies or to assess whether a company's stock is undervalued or overvalued. They relate a company's market value to some measure of fundamental value.

**Examples:**
*   **Price-to-Earnings (P/E) Ratio:** $\frac{Market\ Price\ Per\ Share}{Earnings\ Per\ Share}$ (measures how much investors are willing to pay for each dollar of earnings).
*   **Price-to-Book (P/B) Ratio:** $\frac{Market\ Price\ Per\ Share}{Book\ Value\ Per\ Share}$ (compares a company's market value to its book value of equity).

CFA Level 1 - Time Value of Money & Financial Reporting

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