Chartered Financial Analyst · Level I
CFA L1 Equities: practice questions with answers
6 free exam-style questions on Equities for CFA L1 Level I. Try each one, then open the answer to read the explanation. Fincora has 78 original questions on this syllabus area.
Question 1
Analyst Mateus Rocha observes that many investors in high-growth technology shares believe their earnings forecasts are more accurate than they really are, trade frequently, and give too little weight to evidence that contradicts their views. The behavioural bias most directly described is:
- A overconfidence.
- B loss aversion.
- C herding.
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Answer: A. Overconfidence is the tendency to overestimate one's knowledge, abilities and the precision of one's information. Behavioural finance uses it to explain excessive trading and mispricing, notably overvaluation of high-growth stocks. Loss aversion (losses hurt more than equal gains) and herding (trading in the same direction as others, possibly ignoring private information) describe different behaviour.
Question 2
Marlowe Consumer has a dividend payout ratio of 40%, a sustainable return on equity of 12.5%, and a required return on equity of 10%. Assume the Gordon growth model applies and the dividend growth rate equals the sustainable growth rate. Marlowe's justified forward P/E is closest to:
- A 8.0
- B 16.0
- C 17.2
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Answer: B. Sustainable growth g = retention ratio × ROE = (1 - 0.40) × 12.5% = 7.5%. Justified forward P/E = P0 / E1 = (D1 / E1) / (r - g) = 0.40 / (0.10 - 0.075) = 0.40 / 0.025 = 16.0. The justified trailing P/E would be 16.0 × 1.075 = 17.2.
Question 3
Which of the following practices by an asset manager is most consistent with good stewardship of its clients' equity holdings?
- A Voting with management on every resolution, to maintain good relations with investee companies.
- B Engaging with investee boards on material issues, voting each proxy in clients' best interests under a disclosed policy, and reporting how it voted.
- C Not voting proxies for its passively managed index funds, because index funds cannot sell shares in companies they disagree with.
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Answer: B. Stewardship is the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries. For equity investors it involves:
- monitoring investee companies on financially material matters, including governance and ESG issues;
- engaging with boards and management;
- voting proxies thoughtfully, in the interests of clients, under a documented voting policy;
- reporting on engagement and voting activity.
Passive investors, who must hold every index constituent, rely on engagement and voting ("voice") rather than selling ("exit") to influence companies.
Question 4
Which of the following provides the strongest evidence that a company has pricing power?
- A Its revenue has grown in line with industry sales volumes over the past five years.
- B It has gained market share by cutting prices, while its gross margin has fallen.
- C It has raised prices by more than the increase in its input costs without losing sales volume or market share.
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Answer: C. Pricing power is a company's ability to raise prices (or avoid cutting them) without losing significant sales volume. It usually comes from differentiated products, strong brands, high switching costs, patents or a strong position in a concentrated industry.
Evidence includes: price increases that keep pace with or exceed input cost inflation, stable or rising gross margins, and stable volumes and market share after price rises. Companies with pricing power are better able to protect profitability during inflation.
Question 5
An analyst estimates the beta of Dunsford Mining using the market model. The covariance between Dunsford's returns and the market's returns is 0.0216, and the variance of market returns is 0.0144. The risk-free rate is 3.2% and the expected return on the market is 8.2%. Using the CAPM, Dunsford's cost of equity is closest to:
- A 15.50%
- B 10.70%
- C 6.53%
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Answer: B. In the market model, the slope (beta) of the stock's returns regressed on market returns equals Cov(Ri, Rm) / Var(Rm).
Beta = 0.0216 / 0.0144 = 1.50.
Market risk premium = 8.2% - 3.2% = 5.0%.
CAPM cost of equity = Rf + beta x (E(Rm) - Rf) = 3.2% + 1.50 x 5.0% = 3.2% + 7.5% = 10.70%.
Question 6
Paulo Ferraz buys shares of Kordel Apparel because it has reported strong earnings growth in each of the last three years. He reasons that a company with such a record must be a well-managed growth company whose earnings will keep growing quickly, and he gives little weight to evidence that most companies' high growth rates fall back toward average over time. Ferraz is most likely showing:
- A conservatism bias.
- B mental accounting.
- C representativeness bias.
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Answer: C. Representativeness is the tendency to judge the probability of an outcome by how closely it resembles a familiar category or stereotype, while neglecting base rates. Investors may conclude that a company with a few years of strong growth is a 'growth company' and assume the growth will continue, which can lead to overvaluation. Conservatism is the opposite tendency to underreact by holding on to earlier views. Mental accounting treats money differently depending on its source or intended use.
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