CFA LEVEL 1

MOCK PAPER
Exam Date - 29.09.2019
SOLUTIONS
Working Capital Management

1. A is correct.
Committed lines and revolving lines of credit all contain a commitment by a lender to lend up
to a maximum amount, at the borrower's option for some period of time. A firm with lower
credit quality may have an uncommitted line of credit which offers no guarantee from the
lender to provide any specific amount of funds in the future.

2. B is correct.

3. C is correct.
Short-term funds are a primary source of liquidity.

4. C is correct.

5. C is correct.
Accruals are paid at a later date, and depreciation is a noncash expense.

6. B is correct.
Debt contract system is a secondary source of liquidity.

7. C is correct.
Based on the data provided, the analyst can conclude that Sun Corpo has weaker profitability
than its competitors based on the net profit margin and return on equity. The analyst can also
conclude that the company has less financial leverage (risk) than the industry average based on
the total debt / total capital and the times interest earned ratios. The analyst can conclude that
the company has better short-term liquidity than the industry average (i.e., its competitors)
based on the current ratio.

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8. B is correct.
Primary sources of liquidity include cash resulting from selling goods and services, collecting
receivables, generating cash from other sources and sources of short-term funding such as trade
credit from vendors and lines of credit from banks. Filing for bankruptcy and renegotiating debt
agreements are secondary sources of liquidity.
9. C is correct.
Evaluate the choices of short-term funding available to a company and recommend a financing
method.

10. A is correct.
“A drag on liquidity is when receipts lag, creating pressure from the decreased available funds;
a “pull” on liquidity is when disbursements are paid too quickly, or trade credit availability is
limited, requiring companies to expend funds before they receive funds from sales that could
cover the liability.”
“When economic conditions make capital scarcer, short-term debt becomes more expensive to
arrange and use.” Thus, tight credit conditions are a drag on liquidity.

11. C is correct.

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12. A is correct.
If a firm operates in multiple industries, this would limit the value of financial ratio analysis by
making it difficult to find comparable industry ratios.
13. A is correct.

14. C is correct.

Cost of trade credit =

15. C is correct.
The money market yield is the holding period yield times 360/72 and is always greater than the
discount yield which is the actual discount from face value times 360/72, since the holding
period yield is always greater than the percentage discount from face value. A security's
discount yield and its money market yield are always less than its bond equivalent yield, and its
effective annual yield is always greater than its bond equivalent yield.

16. A is correct.

Therefore, the operating cycle and cash conversion cycle are both longer for the company.

17. B is correct.
While adjustable-rate preferred is an appropriate security for short-term investment of excess
cash balances, other preferred shares are not. Bank certificates of deposit and time deposits can
be for appropriately short periods.

18. A is correct.
Improving a firm's net daily requires more inflows than outflows. Debt proceeds are cash
inflows while funds transferred to a subsidiary, interest and dividend payments, and tax
payments are outflows. The net cash change for the day is $250 - $100 - $125 - $30 = -$5 million.

19. B is correct.
Operating cycle = days of inventory + days of receivables, and is the number of days that it
takes to turn raw materials into cash from sales.

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20. B is correct.
Number of days in period
Number of days of inventory =
Inventory turnover

= 117.73 days

= 54.27 days

Operating cycle = Number of days of inventory + Number of days of receivables

= 117.73 + 54.27 = 172 days
21. C is correct.
No inferences about liquidity are warranted based on this measure. A firm may have higher
credit sales than another simply because it has more sales overall. Cash as a proportion of sales
and inventory turnover are indicators of liquidity.

22. A is correct.
A higher level of uncollectible accounts may occur, but a longer average collection period will
certainly occur.

23. C is correct.

= 28.025%

24. A is correct.

25. A is correct.
“A drag on liquidity is when receipts lag, creating pressure from the decreased available funds;
a “pull” on liquidity is when disbursements are paid too quickly, or trade credit availability is
limited, requiring companies to expend funds before they receive funds from sales that could
cover the liability.”

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 Obsolete inventory takes longer to sell and is often sold at large discounts. Thus, obsolete
inventory represents a drag on liquidity.

26. B is correct.
Increasing the efficiency of cash flow management falls under primary sources of liquidity.

27. A is correct.
When cash payments are made too quickly, the condition is known as a pull on liquidity. A
drag on liquidity occurs when cash inflows lag.

28. B is correct.
Large, creditworthy firms can get the lowest cost of financing by issuing commercial paper.
Selling receivables to a factor is a higher cost source of funds used by firms with poor credit
quality. A committed line of credit requires payment of a fee and represents bank borrowing,
which would be attractive to a firm that did not have the size or creditworthiness to issue
commercial paper.

29. A is correct.
Short term funds, which include bank lines of credit and short-term investment portfolios, are a
primary source of liquidity.

30. B is correct.

= 188.030 days

= 52.899 days

= 176.207 days

Cash conversion cycle = Number of days of inventory + Number of days of receivables −

Number of days of payables
= 188.030 + 52.899 − 176.207 = 64.722

31. A is correct.

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32. B is correct.

33. C is correct.
“A drag on liquidity is when receipts lag, creating pressure from the decreased available funds;
a pull on liquidity is when disbursements are paid too quickly or trade credit availability is
limited, requiring companies to expend funds before they receive funds from sales that could
cover the liability.”
“If a company’s bank reduces the line of credit it offers the company, a liquidity squeeze may
result." Thus, reduction in the availability of lines of credit is a pull on liquidity.

34. A is correct.
The bond-equivalent yield is calculated as the holding period yield times (365 / number of days
in the holding period). BEY = 1% × (365/30) = 12.17%.

35. C is correct.
When evaluating the performance of its short-term securities investments, a company should
compare them on a bond equivalent yield basis.

36. A is correct.
Note that the face value is greater than the purchase price because the T-bill sells at a discount:

37. C is correct.
Stock splits and reverse stock splits do not affect a firm's future cash flows unless dividend
yields are increased as a result. These transactions change the number of shares outstanding but
they do not raise capital for the firm.

38. C is correct.
Higher receivables turnover is an indicator of better receivables liquidity since receivables are
converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower

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 trade payables could be related to better liquidity, but could also be consistent with very poor
liquidity and a requirement from its suppliers of cash payment.

39. A is correct.

40. A is correct.
The policy statement is inappropriate because it is too restrictive. A policy statement should
focus on meeting the specific safety and liquidity needs of the firm but should also allow the
flexibility to increase yield within these constraints. There are many other securities potentially
suitable for cash management that would provide equivalent or better liquidity and safety of
principal at least equivalent to that of the securities issued by A+ rated banks.

Financial Reporting Quality

41. C is correct.
Management may follow generally accepted accounting principles and still make biased (i.e.,
aggressive or conservative) accounting choices. Biased accounting choices diminish the
decision-usefulness of financial reporting. Aggressive accounting choices are those that increase
earnings, revenues, or operating cash flows in the current period (and likely reduce them in
later periods).

42. B is correct.
Low financial reporting quality is a hindrance in the proper evaluation of a company’s past
performance.

43. B is correct.
If cash flow to net income is consistently less than 1, there may be problems in the company’s
accrual accounting.

44. C is correct.
Financial reporting is most likely to be decision useful when accounting choices are
neutral. Either aggressive or conservative accounting choices by management may be viewed
as biases.

45. A is correct.
A firm can have high financial reporting quality even if its earnings quality is low, such as a
firm that recognizes one-time gains in a period and identifies them clearly. Biased accounting
choices and non-compliance with GAAP represent lower-quality financial reporting.

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46. B is correct.
A high quality financial report increases company value, and contain information that is
relevant and free from error.

47. B is correct.
Management might be motivated to "manage earnings" by making conservative choices and
estimates in periods when earnings are higher than expected, delaying recognition of some of
these earnings to later periods. Meeting debt covenants or improving stock performance in the
near term are more likely to motivate management to make aggressive accounting choices and
estimates.

48. A is correct.
Debt covenants may require a firm to maintain a minimum interest coverage ratio
(EBIT/interest expense). Manipulating the financial statements to increase the interest coverage
ratio would most likely involve overstating earnings, or possibly understating liabilities (for
example by using operating leases instead of capital leases) to decrease interest expense.
Understating or overstating assets would not affect the interest coverage ratio.

49. B is correct.
Management commentaries in a company’s financial reports are intended to provide a
description of the principle risks.
50. C is correct.
If a company wants to decrease reported earnings, the company’s managers may reduce the
useful life of fixed assets.

51. C is correct.
Under LIFO and with increasing prices, a firm that sells more goods than it purchases or
produces in a period may show an unsustainable increase in gross profit margin because
items recognized in cost of sales are valued older, lower prices, while sales are recorded at
current, higher prices.

52. C is correct.
A significant increase in days payables may indicate that payables have been "stretched" (not
paid or paid more slowly), which increases operating cash flow in an unsustainable manner and
calls the quality of the reported cash flow values into question. Stretching payables does not
affect earnings because the related expenses were recognized in the period incurred. An increase
in days payables will decrease net working capital, other things equal.

53. C is correct.
If a particular accounting choice is considered conservative in nature, then the financial
performance for the current period would exhibit a downward bias.

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54. A is correct.
In the spectrum of financial reporting quality, financial reports that depart from generally
accepted accounting principles are considered to be of lower quality than those that
reflect biased accounting choices. Financial reports that reflect unsustainable earnings, such as
one-time gains, can still be of high quality if they state the situation clearly.

55. C is correct.
Three conditions result in poor financial reporting quality: opportunity, motivation and
rationalization.

56. C is correct.
Reducing tax obligations would be a reason to underreport earnings. The other choices are
motivations to over report earnings.

57. B is correct.
A manager would defer current income to a later period to increase future performance.

58. B is correct.
Decreasing the salvage value will result in higher depreciation expense and lower earnings in
the current period. Recognizing revenue before fulfilling all terms of a sale is an
aggressive revenue recognition method that will increase earnings in the current period. For
firms that use LIFO inventory accounting and in an increasing price environment, selling
more inventory than is purchased or produced will increase earnings unsustainably in the
current period.

59. B is correct.
IFRS require firms that present a non-GAAP (i.e., non-IFRS) measure in their financial reports to
define the measure and explain its relevance, and to reconcile the differences between this
measure and the most comparable IFRS measure.

60. A is correct.
Financial reports that are of low quality make it difficult or impossible for users of the
statements to assess the quality of the firm's earnings, cash flows, and balance sheet values.

Financial Statement Analysis Applications

61. C is correct.
Firms with high dividend payout ratios are typically mature firms with relatively few growth
opportunities.

62. C is correct.
If companies have restated their financial statements, then there is a mismatch between what an
investor would have known at the time of the investment decision and the information used
now in back-testing. This is known as look-ahead bias.

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63. A is correct.
2007 inventory turnover was 5 (365/73 days in inventory). Given inventory turnover and COGS,
2007 average inventory was$20 million ($100 million COGS/5 inventory turnover). 2008
inventory turnover is expected to be 7.3 (365/50 days in inventory). Given expected inventory
turnover, 2008 average inventory is $17 million ($124.1 million COGS/7.3 expected inventory
turnover). To achieve 50 days of inventory on hand, average inventory must decline $3 million
($20 million 2007 average inventory-$17 million 2008 expected inventory). A decrease in
inventory is a source of cash.

64. B is correct.

65. A is correct.
Low leverage implies lower risk.

66. C is correct.
2008 sales are expected to be $600 million ($500 million 2007 sales × 1.2) and 20X8 net income is
expected to be $30 million ($600 million 20X8 sales × 5%). 2008 non-cash operating working
capital is expected to be $120 million ($600 million 20X8 sales × 20%). The change in cash is
expected to be -$5 million ($30 million 20X8 net income + $60 million 20X8 depreciation - $20
million increase in non-cash operating working capital - $75 million 20X8 capital expenditures).
The 20X8 ending balance of cash is expected to be $30 million ($35 million beginning cash
balance - $5 million decrease in cash).

67. A is correct.
Using past trends to project future financial performance would be reliable for a well-diversified
firm operating in a number of mature industries. The diversified firm would likely have
relatively predictable earnings. Using past trends to project future financial performance would
not likely be reliable for the rapidly growing firm involved in numerous acquisitions and
divestitures. Such a firm would likely have high earnings volatility.

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68. C is correct.
“Credit analysis has a special concern with the sensitivity of debt-paying ability to adverse
events and economic conditions—cases in which the creditor’s promised returns may be most at
risk. Because those returns are generally paid in cash, credit analysis usually focuses on cash
flow rather than accrual income. Typically, credit analysts use return measures related to
operating cash flow because it represents cash generated internally, which is available to pay
creditors.”

69. C is correct.
Gamma offers standardized products and the demand for its product is stable i.e. no
seasonality. It enjoys backward integration which somewhat guaranty stable cost structures and
supply of materials. Therefore, the forecast of gross profit for Gamma should be the most stable
and reliable.

70. A is correct.
Credit analysts consider both business risk and financial risk.

71. B is correct.
Analyst #1’s statement is inaccurate: The depreciation expense for 2019 is the change in
accumulated depreciation.
Depreciation expense = 300 - 225 = 75
The expected remaining useful life of the assets at the end of 2019 is 16 years.

= 16 years

Analyst #2’s statement is inaccurate: The average age of the assets at the end of 2019 is 4 years.

= 4 years

72. A is correct.
If the criteria are independent of one another, the probability that all will occur is the product
of the individual probabilities (Multiplication Rule for Independent Events), i.e. 0.28 x
0.585 x 0.62 x 0.523 = 0.053, or 5.3%, which would produce 106 meeting the criteria, i.e.,
5.3% x 2,000.

73. B is correct.
Growth investors are interested in firms having low dividend yields, high P/B ratios and high
P/E ratios. These firms have minimal payout ratios due to the number of investment
opportunities available. Thus, the investor has a growth tilt.

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74. C is correct.
Requiring that net income be positive would eliminate companies that report a positive return
on equity only because both net income and shareholders’ equity are negative.

75. C is correct.
Using the EBITDA coverage ratio (EBITDA / Interest expense), Omega's EBITDA coverage is 1.4
($79,300 EBITDA / $58,100 interest expense) and Alpha's EBITDA coverage is 1.6 ($69,400
EBITDA / $44,000 interest expense). Using EBITDA to measure operating profit, Alpha has a
lower operating profit margin than Omega. Alpha's EBITDA margin is 4.2% ($69,400 EBITDA /
$1,650,000 revenue) and Omega's EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000
revenue). Using fixed asset turnover to measure the efficiency of fixed assets, Omega uses its
fixed assets less efficiently than Alpha. Alpha's fixed asset turnover is 5.5 ($1,650,000 revenue /
$300,000 average fixed assets) and Omega's fixed asset turnover is 4.5 ($1,452,000 revenue /
$323,000 average fixed assets).

76. A is correct.
Shareholders' equity = $35 million / 0.5 = $70 million. The most appropriate analyst adjustment
for an operating lease is to add the present value of lease payments to the firm's assets and long-
term debt (leaving equity unchanged). This will result in a debt-to-equity ratio of ($35 million +
$12 million) / $70 million = 0.6714.

77. B is correct.
In the case of start-ups, past performance may be irrelevant to predict future performance.

78. C is correct.
Credit analysts consider both financial and business risk while making a rating
recommendation.

79. C is correct.
When comparing ratios of companies using different accounting standards, adjustments
may be required. Adjustments made to one financial statement often affect other financial
statements as they are linked.

80. B is correct.
2008 sales are expected to be $30 million ($20 million 2007 sales × 1.5) and 2008 net income is
expected to be $4.5 million ($30 million 2008 sales × 15%). 2007 non-cash operating working
capital was $4 million ($20 million 2007 sales × 20%) and 2008 non-cash operating working
capital is expected to be $7.5 million ($30 million 2008 sales × 25%). 2008 operating cash flow is
expected to be $4 million ($4.5 million 2008 net income + $3 million 2008 depreciation - $3.5
million increase in non-cash operating working capital). Forecasts for small firms, start-ups, or
firms operating in volatile industries may be less reliable than a forecast for a large, well
diversified, firm operating in mature industries.

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