Another CFA Level 1 exam is almost here and that means more random web surfers downloading the study materials I made available for free. Before you rush off to download them, here is some text that tries to explain why each question was selected along with some tips on how to solve the questions in my spreadsheet. One of the reasons this spreadsheet is so useful is it contains a random number generator (which requires a VBA macro) which allows you to practice ‘styles’ of questions over and over with different numbers. You will need to do a lot of practice problems to pass the CFA Level 1 Exam.
Before you read further you might want to click “my spreadsheet” in the paragraph above, download the Excel file, open it up and attempt all the questions under simulated exam conditions. The CFA Institute expects you to be able to solve all these questions in under 50 minutes. If you can do that, maybe there is hope for you yet. If not I try to offer additional advice and hints below.
Update May 2016: This appears to be my second most popular CFA exam related post, I’m still in the program, it is becoming more like alcoholics anonymous everyday but lonelier perhaps. I made an even bigger more elaborate spreadsheet than the ones linked to here, but I’m unlikely to ever post it to the Internet for obvious reasons.
Q1 Financial Reporting Analysis: Qualifying Cash Flow
These style of questions may not be en vogue but every CFA Level 1 candidate that wants to pass needs to know how to classify cash flows into CFO, CFI, or CFF. CFI or Cash Flow from Investing is often really easy to calculate so sometimes you just get asked to calculate Cash Flow from Operations and Cash Flow from Financing. There isn’t any easy nemonic to remember what goes where so you need to practice these style of questions, doubly so as you have limited time and they can involve a lot of button pressing on your calculator.
Q2 Financial Reporting Analysis: Weighted Average Shares Outstanding
This is another question that can involve a lot of button pressing depending on how many shares are issued and/or bought back in a single year. The order and timing of share repurchases and issues are important too. Hence why it is necessary to get adept at calculating quickly and accurately with your calculator. Learning how to lay out questions on scrap paper helps.
Q3 Corporate Finance: Cost of Equity Capital
Corporate Finance isn’t considered one of the killer sections but there is some variety to the questions you may have to answer. Calculating the cost of equity capital is a common request and can be made more complicated by including or excluding information. There are at least two formulas you should memorize, one called the Dividend Capitalization Method the other uses CAPM to calculate the cost of equity.
Q4 Corporate Finance: Weighted Cost of Capital
Some questions have a very, very, high likelihood of appearing on the exam. Weighted Cost of Capital or WACC is one of those topics that is likely to be tested. You might not have to calculate WACC during the exam but you sure as hell have to memorize the formula. If you do have to calculate WACC data entry and speed become important and it is wise to write down intermediary numbers.
Q5 Corporate Finance: Valuing a T-Bill
One of my many pet peeves about the CFA curriculum is how US centric it is. There are formulas you must memorize specifically to value US T-Bills. Maybe over time they’ve become less important, but fixed income has a large variety of yield measures and valuation methods. This question asks for the discount yield. You need to memorize several yield formulas, this one is annoying as it uses a 360 day year.
Sometimes you can still end up with the correct answer if you use a 360 versus a 365 day year or vice versa, but sometimes you won’t so you need to pay special attention to formulas that use a 360 day year.
Q6 Equity Investments: Stock Valuation
CFA Candidates will need to know how to value a stock, specifically using the dividend growth rate model. Although the exam questions are multiple choice the CFA Institute has ways of making the questions more confusing so practice makes perfect.
Q7 Fixed Income: Bond Valuation
In my experience CFA Candidates have a better understanding of the stock market than the bond market. They also understand how stocks are valued better than how bonds are valued. Unfortunately you have to do both to pass the CFA Level 1 exam and you have to learn to do both a number of different ways. Although there are special formulae and terminology used to value bonds, sometimes the answer is to think of the problem in terms of Time Value of Money.
Q8 Financial Reporting Analysis: Free Cash Flow
In addition to the CFAI expecting you to know CFO, CFI, and CFF inside out you will also need to know how to calculate the free cash flow to a firm. I made cue cards for both the definition and the formula. This isn’t the trickiest question but it illustrates just how many formulas and definitions you need to memorize.
UPDATE: This question is even trickier than I thought, the presence or absence of a “Net” in front of cash flow from operations makes a big deal. Whether the company uses IFRS or US GAAP can also affect how Free Cash Flow to Firm is calculated. I finally modified the question to state net cash flow from operations which must account for the interest expense * (1 – tax rate) in the original question. I also added two more formulas to my flash card collection as there is more than one way to calculate free cash flow to a firm, it can be done from CFO or Net Income.
Q9 Financial Reporting Analysis: Interest Expense and Amortization
It isn’t enough just to know what Interest Expense and Amortization means you have to be able to calculate it for a bond issued by a firm. This is a multiple step process that I had to practice over and over to try and get it to sink into my head. Maybe this questions isn’t that likely to appear on an actual exam, but there is no point in collecting and practicing only the easy questions.
Q10 Financial Reporting Analysis: Other Comprehensive Income
CFO, CFI, CFF, and Free Cash Flow are perhaps more likely to be tested but Other Comprehensive Income seems to have become en vogue. I made more than one cue card trying to understand how to calculate Other Comprehensive Income.
Q11 Financial Reporting Analysis: Accounting for Leases
FRA as the section is called now is one of the biggest and hardest sections of the CFA Level 1 Exam. One of my least favourite topics is leases specifically accounting for leases. Calculating the Interest Expense isn’t that hard, but calculation the Amortization Expense and doing both in under 1.5 minutes that can be a challenge.
Q12 Quantitative: Standard Deviation
I’ve had to take more statistics classes than I would have liked to, the more I study statistics the less I enjoy it. You might figure you got Standard Deviation down cold, you know what buttons to push on a calculator. But the CFA Institute has many ways to test your knowledge of statistics, one is giving you a covariance matrix.
Q13 Equity Investments: Stock Valuation
The likelihood of being asked to value a stock during the Equity portion of the exam is very high. Unfortunately there is more than one way to do this, there is also more than one way to test that you know how to estimate a stock price. This question illustrates one of many, but one that just might catch up a few candidates. Don’t be that examinee.
Q14 Accounting: Trade Credit
You might think you’re an expert in accounting. You’re the CFO of a Web 2.0 startup, it says so on your business card. Unfortunately not every industry uses trade credit. Web 2.0 startups in particular don’t do a lot of shipping and receiving to lot of accounts and/or suppliers. Trade Credit is just the kind of question the CFA Institute can ask that could mean the difference between mid band and top band on the exam. I spent a lot of time learning how to calculate the cost of borrowing when using trade credit, just in case.
Q15 Equity Valuation: P/E Ratio
In addition to expecting Candidates to know how to value stocks they expect them to know how to calculate the P/E or Price to Earnings Ratio. This is one of many ways to test your knowledge of the P/E Ratio.
Q16 Accounting: Inventory
Inventory questions I think used to be more common. You need to know how to convert between FIFO and LIFO and vice versa. This question tests the effect such an accounting change has on net income.
Q17 Portfolio Theory: Standard Deviation
Portfolio Theory is a small section, you’re an expert on Standard Deviation right? Then you’ll have no problem solving this question likely because you memorized this formula. Memorizing formulae isn’t enough, you can save yourself time on the exam if you practice problems you’re likely to encounter. This question isn’t that likely but if it comes up you’ll be glad you practiced as knowing how much variance there is in the return of the risk free asset can save you time. You also have to learn to read the questions carefully as they may not be asking you to calculate standard deviation, but they are testing your knowledge of the formula and portfolio theory.
Q18 Derivatives: Forward Rate Agreement
There are worse questions the CFAI can ask besides “What is the payment amount due to the FRA buyer?” But derivatives including more exotic ones like Forward Rate Agreements are part of the curriculum. Maybe you hope to only get option and swap questions, but maybe you should practice this question just in case. My cue card for the FRA Payoff Formula may also be useful. I think I included a Forward Rate Agreement question as I found it the most difficult. There can be some tricky questions involving currency exchange rates but I might not have been able to ‘cook’ them up.
Q19 Quantitative: EPS
Perhaps this question could also appear in the Equity portion of the exam. Besides stock price and P/E Ratio, EPS or Earnings Per Share is highly likely to be tested. The CFA Institute has lots of ways to test key concepts. You’ll need a good understanding of Time Value of Money to pass the CFA Level 1 exam.
Q20 Financial Reporting Analysis: Earnings Per Share
Remember how I said EPS will definitely be tested, they also could test it during the Accounting portion of the exam. This is by far the nastiest question so far in my spreadsheet. It not only asks for earnings per share, it also asks for diluted earnings per share as well. You have three whole minutes to calculate both, go!
I eventually got adapt at solving these style of questions. The actual exam question could be easier. There is more than one way to answer this question, apparently the “If-Converted” method is what most people recommend.
Q21 Quantitative: Confidence Interval
Remember what I said about not enjoying statistics anymore. It is a large body of knowledge though only a few concepts will actually be tested on the exam. In order to be prepared you need to memorize a lot of stuff, including various values of Z for different confidence intervals. This is yet another way to test your knowledge of our old friend Standard Deviation.
Q22 Portfolio Theory: Covariance of Returns
Another practice question from the minuscule portion of the exam devoted to portfolio theory. Not only is this a portfolio theory question, it is also a covariance question and you can’t calculate covariance without Standard Deviation. During my undergrad degree I would have had to calculate this out longhand, possibly without a calculator as that is how some of my professors rolled. The CFA Institute allows the use of a more powerful calculator than even my MBA allowed, knowing how to use some of the worksheets on the BA II Plus can save you valuable time on the exam. This question illustrates how important it is to learn the STAT and DATA worksheets in particular. Add this cue card to your collection as well.
Q23 Corporate Finance: Beta
Beta will be tested. The question is will they ask you to calculate a stock’s beta say using the pure-play method? Better practice just in case.
Q24 Corporate Finance: Operating Cycle
Corporate Finance isn’t among the most feared sections of the CFA Level 1 exam but it can contain some tough questions. You will need to learn the difference between the Operating Cycle and the Cash Conversion Cycle. It doesn’t help that the Cash Conversion Cycle is also known as the Net Operating Cycle. While rushing through 240 multiple choice questions, it is easy to forget the difference one word can make, one little three letter word like “Net”.
Q25 Fixed Income: Bond Duration
There are other fixed income instruments besides bonds and t-bills, but bonds and t-bills are by far the most likely to be tested. It isn’t enough to memorize all the valuation formulae you also need to learn a lot of jargon/terminology and you damn sure need to learn what duration means and how to calculate it for a given bond.
Q26 Fixed Income: Dirty Price of a Bond
Remember all that bond valuation jargon you had to learn, you definitely need to learn the difference between the ‘clean’ and ‘dirty price’. Question 20 is difficult and time consuming, this question is worse. It took me a long time to understand that the dirty price is part of the next coupon, plus the percentage of par times the par value. Even if you remember that key insight, you still only have 90 seconds to solve this problem.
The dirty price is also known as the full price and here is a cue card I made, but mainly you just need to practice valuing bonds until you can do it in your sleep or at least first thing in the morning.
Q27 Financial Reporting Analysis: Cash flow
Remember how I pretty much guaranteed CFO, CFI, CFF, or some subset of the three would need to be calculated during the exam. Here is a question that asks for all three. If you get a question like this you have 4.5 minutes. The CFA Institute doesn’t care if you do the question the direct or indirect way, but sometimes then again they just might, so you’ll have to learn both even if you strongly prefer one over the other.
Q28 Fixed Income: Bond Equivalent Yield
Here is another T-Bill question which requires yet another formula you need to memorize just on the off chance there is a question about T-Bills on the exam. There are quite a number of ‘yields‘ you can be asked to calculate, keeping the definitions and formulae straight isn’t easy, which is why special formulas for US T-bills is an annoyance, but one you have to live with if you want to master the CFA Curriculum, particularly the fixed income portion.
Q29 Alternate Investments: Real Estate
The Alternate Investments section is a bit of a crap shoot, there are very few questions so it is possible that material you know well may be tested, it is also possible the section includes a difficult question for which you are unprepared. For Real Estate you need to know NOI particularly how to value real estate using NOI, but you also may need to know how to solve a question like this about after-tax cash flow.
Tax avoidance and reduction strategies are a big part of some people’s investment and overall business strategies. I’m no accountant but the difference between IFRS and US GAAP will be tested somehow, this question isn’t however an example of that.
Q30 Free Cash Flow to Firm from CFO: Financial Reporting & Analysis
Due to debate in forums and the possible ‘trick’ nature of the FCFF question I included as question 8, I searched through a bunch more old practice exams for another question asking Candidates to calculate Free Cash Flow to Firm. It makes a difference whether you are given CFO or Net Income as a starting point. This question gives you CFO along with a bunch more data. Maybe this isn’t the most difficult FR&A question but I added it in for completeness.
Why are these 30 Questions Important?
I’ve done a lot of CFA Level 1 Practice Problems, probably more than anyone else blogging on a Friday night just before an exam that they’ve already passed. Of all the practice problems I ever did, exactly 29 were collected and hooked up to a random number generator. No one can say for sure what will be tested on the next CFA Level 1 exam, certainly not me, I have no insider knowledge. I’m not even allowed to say whether questions like these appeared on past CFA Level 1 exams, but of all the practice questions I ever did these 29 are the ones that I felt necessary to practice over and over and over.
I also spent a lot of time memorizing cue cards aka flash cards. Here are more general tips and exam writing advice for the CFA Level 1 test.
Don’t leave spammy comments directing people to your company’s CFA study materials, I will delete them.