CFA Level 1 - Ethics, Corporate Finance & Investment Tools Flashcards

Question 1

What are the six components of the CFA Institute Code of Ethics?

Accepted Answer

1. Act with integrity, competence, diligence, and respect.
2. Place the integrity of the investment profession and client interests first.
3. Use reasonable care and exercise independent professional judgment.
4. Practice and encourage ethical conduct.
5. Promote the integrity and viability of the global capital markets.
6. Maintain and improve professional competence.

Question 2

What is the primary duty of a CFA Institute member regarding client interests?

Accepted Answer

Members and Candidates must act for the benefit of their clients and place their clients' interests before their own and their employer's interests. This is covered under Standard III(A) Loyalty, Prudence, and Care.

Question 3

Under what circumstances can a CFA Institute member use material nonpublic information?

Accepted Answer

Members and Candidates must not act or cause others to act on material nonpublic information. This is a violation of Standard II(A) Material Nonpublic Information.

Question 4

What is "fair dealing" under the CFA Institute Standards of Professional Conduct?

Accepted Answer

Standard III(B) Fair Dealing requires Members and Candidates to deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, or taking investment action. This means treating all clients equitably, though not necessarily identically.

Question 5

What is the requirement for disclosure of conflicts of interest?

Accepted Answer

Standard VI(A) Disclosure of Conflicts requires Members and Candidates to make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to clients, prospective clients, or employers.

Question 6

What is the "diligence and reasonable basis" standard for investment analysis?

Accepted Answer

Standard V(A) Diligence and Reasonable Basis requires Members and Candidates to exercise diligence, independence, and thoroughness in analyzing investments, making recommendations, and taking investment actions, and to have a reasonable and adequate basis, supported by appropriate research and investigation, for any such analysis, recommendation, or action.

Question 7

Define corporate governance.

Accepted Answer

Corporate governance is the system of principles, policies, procedures, and practices by which a company is directed and controlled. It involves the relationship between the company's management, its board of directors, shareholders, and other stakeholders.

Question 8

What is the agency problem in corporate governance?

Accepted Answer

The agency problem arises when there is a conflict of interest between a company's management (the agents) and its shareholders (the principals). Management may act in their own self-interest rather than maximizing shareholder wealth.

Question 9

What are the primary roles of a company's Board of Directors?

Accepted Answer

The Board of Directors oversees management, sets strategic direction, ensures compliance, monitors financial performance, and protects shareholder interests. It typically includes both executive (internal) and non-executive (independent) directors.

Question 10

Define Net Present Value (NPV) and state its decision rule.

Accepted Answer

NPV is the present value of a project's expected cash inflows minus the present value of its expected cash outflows, discounted at the cost of capital.
Decision Rule: Accept projects with $NPV > 0$. If comparing mutually exclusive projects, choose the one with the highest positive NPV.

Question 11

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

Accepted Answer

IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero.
Decision Rule: Accept projects where $IRR >$ cost of capital. If comparing mutually exclusive projects, IRR can lead to conflicting decisions with NPV, in which case NPV is generally preferred.

Question 12

What are some limitations of using IRR for capital budgeting decisions?

Accepted Answer

Limitations include:
1.  **Multiple IRRs:** For projects with non-conventional cash flow patterns (e.g., alternating signs), there can be multiple IRRs.
2.  **Reinvestment Rate Assumption:** IRR implicitly assumes that cash flows are reinvested at the IRR, which may not be realistic. NPV assumes reinvestment at the cost of capital.
3.  **Scale Problem:** IRR does not consider the absolute size of the project, potentially favoring smaller projects with high percentage returns over larger, more valuable projects.

Question 13

How is the Profitability Index (PI) calculated and interpreted?

Accepted Answer

The Profitability Index is the present value of future cash flows divided by the initial investment.
$PI = \frac{	ext{PV of Future Cash Flows}}{	ext{Initial Investment}}$
Decision Rule: Accept projects with $PI > 1$. A PI of 1.25 means that for every dollar invested, the project is expected to generate $1.25 in present value of future cash flows.

Question 14

What is the Weighted Average Cost of Capital (WACC)?

Accepted Answer

WACC is the average rate of return a company expects to pay to all its security holders (debt, preferred stock, common equity) to finance its assets. It represents the minimum return a company must earn on an existing asset base to satisfy its creditors and owners.
$WACC = (W_d 	imes K_d(1-t)) + (W_p 	imes K_p) + (W_e 	imes K_e)$
Where $W$ = weight, $K$ = cost, $d$ = debt, $p$ = preferred stock, $e$ = equity, $t$ = corporate tax rate.

Question 15

How is the cost of equity ($K_e$) typically estimated using the Capital Asset Pricing Model (CAPM)?

Accepted Answer

The CAPM estimates the required rate of return for equity based on its systematic risk (beta).
$K_e = R_f + \beta_e (R_m - R_f)$
Where $R_f$ = risk-free rate, $\beta_e$ = equity beta, $(R_m - R_f)$ = market risk premium.

Question 16

How is the cost of debt ($K_d$) determined for WACC calculation?

Accepted Answer

The cost of debt is the yield to maturity (YTM) on the company's existing long-term debt or the rate at which the company could issue new debt. Since interest payments are tax-deductible, the after-tax cost of debt is used in WACC: $K_d(1-t)$, where $t$ is the corporate tax rate.

Question 17

What is the dividend discount model (DDM) approach to estimating the cost of equity?

Accepted Answer

The DDM (specifically the Gordon Growth Model) estimates the cost of equity by rearranging the formula for the present value of a growing perpetuity of dividends.
$K_e = \frac{D_1}{P_0} + g$
Where $D_1$ = next year's expected dividend, $P_0$ = current stock price, and $g$ = constant dividend growth rate.

Question 18

Differentiate between the null hypothesis ($H_0$) and the alternative hypothesis ($H_a$) in hypothesis testing.

Accepted Answer

**Null Hypothesis ($H_0$):** A statement of no effect or no difference. It is the hypothesis that the researcher tries to disprove or reject.
**Alternative Hypothesis ($H_a$):** A statement that contradicts the null hypothesis. It is what the researcher is trying to prove.

Question 19

Explain Type I and Type II errors in hypothesis testing.

Accepted Answer

**Type I Error ($\alpha$):** Rejecting a true null hypothesis (false positive). The probability of a Type I error is the significance level.
**Type II Error ($\beta$):** Failing to reject a false null hypothesis (false negative). The probability of a Type II error is related to the power of the test.

Question 20

What does the correlation coefficient ($\rho$) measure, and what are its possible values?

Accepted Answer

The correlation coefficient measures the strength and direction of a linear relationship between two variables. Its value ranges from -1 to +1.
*   $+1$: Perfect positive linear relationship.
*   $-1$: Perfect negative linear relationship.
*   $0$: No linear relationship.

Question 21

What is the general form of a simple linear regression equation, and what do its components represent?

Accepted Answer

The general form is $Y_i = b_0 + b_1X_i + \epsilon_i$.
*   $Y_i$: Dependent variable (the variable being predicted).
*   $X_i$: Independent variable (the predictor variable).
*   $b_0$: Y-intercept (the expected value of Y when X is 0).
*   $b_1$: Slope coefficient (the expected change in Y for a one-unit change in X).
*   $\epsilon_i$: Error term (the residual difference between the actual and predicted Y values).

Question 22

What does the R-squared ($R^2$) value represent in a regression analysis?

Accepted Answer

R-squared, or the coefficient of determination, measures the proportion of the variance in the dependent variable that is predictable from the independent variable(s). It ranges from 0 to 1. An $R^2$ of 0.75 means that 75% of the variation in the dependent variable can be explained by the independent variable(s) in the model.

Question 23

What are the key assumptions of a simple linear regression model?

Accepted Answer

Key assumptions (often remembered by LINE or similar acronyms):
1.  **Linearity:** The relationship between X and Y is linear.
2.  **Independence:** The error terms are independent of each other.
3.  **Normality:** The error terms are normally distributed.
4.  **Homoscedasticity:** The variance of the error terms is constant across all levels of X.
5.  **No perfect multicollinearity:** (For multiple regression) Independent variables are not perfectly correlated.

CFA Level 1 - Ethics, Corporate Finance & Investment Tools

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