📘 CFA Level 1 – Equity Investments MCQs (Part 1: Q1–50)
Q1.
Which of the following best describes the primary role of equity securities in an investment portfolio?
A. Provide fixed income and capital preservation
B. Offer ownership and potential for capital appreciation
C. Serve as a hedge against inflation only
D. Reduce portfolio volatility significantly
Correct Answer: B
Explanation: Equity securities represent ownership in a company and give investors the potential for capital appreciation and dividend income. Unlike bonds, they do not guarantee fixed returns but can generate higher long-term returns.
Q2.
Which of the following markets is considered the most liquid for equity securities?
A. Over-the-counter (OTC) markets
B. Private placement markets
C. Organized exchanges (e.g., NYSE, NASDAQ)
D. Dark pools
Correct Answer: C
Explanation: Organized exchanges like NYSE and NASDAQ offer high liquidity, transparency, and price discovery, making them the most efficient markets for equity trading.
Q3.
Which type of equity share typically provides voting rights to shareholders?
A. Preferred shares
B. Common shares
C. Callable bonds
D. Convertible bonds
Correct Answer: B
Explanation: Common shareholders generally have voting rights in corporate governance, unlike preferred shareholders, who usually have priority in dividends but no voting rights.
Q4.
A stock trading below its intrinsic value is considered:
A. Overvalued
B. Undervalued
C. Efficiently priced
D. Illiquid
Correct Answer: B
Explanation: If the intrinsic value is greater than the market price, the stock is undervalued and may represent a good investment opportunity.
Q5.
The dividend discount model (DDM) assumes that:
A. Dividends remain constant indefinitely
B. Stock value is the present value of future expected dividends
C. Dividends are irrelevant in stock valuation
D. Only capital gains determine stock price
Correct Answer: B
Explanation: The DDM values a stock based on the present value of all expected future dividends, making it useful when dividends are a significant part of returns.
Q6.
Which of the following equity indices is market-capitalization weighted?
A. Dow Jones Industrial Average (DJIA)
B. Standard & Poor’s 500 (S&P 500)
C. Nikkei 225
D. Value Line Composite Index
Correct Answer: B
Explanation: The S&P 500 is a market-capitalization-weighted index, meaning larger firms have a greater impact on index movements. DJIA and Nikkei 225 are price-weighted indices.
Q7.
In the Gordon Growth Model, the stock price will increase if:
A. The required rate of return increases
B. The expected dividend growth rate increases
C. Dividend payout decreases
D. Market volatility decreases
Correct Answer: B
Explanation: In the Gordon Growth Model, P0=D1r−gP_0 = \frac{D_1}{r – g}P0=r−gD1. If the growth rate (g) increases, the denominator becomes smaller, leading to a higher stock price.
Q8.
Which of the following is NOT a characteristic of preferred stock?
A. Fixed dividend payments
B. Higher priority than common stock in liquidation
C. Voting rights in company decisions
D. Can be callable or convertible
Correct Answer: C
Explanation: Preferred shareholders usually do not have voting rights. Their main advantages are fixed dividends and liquidation preference over common shareholders.
Q9.
Which market efficiency form suggests that stock prices reflect all public information?
A. Weak-form efficiency
B. Semi-strong form efficiency
C. Strong-form efficiency
D. Behavioral efficiency
Correct Answer: B
Explanation: The semi-strong form of the Efficient Market Hypothesis (EMH) states that all publicly available information is reflected in stock prices, making fundamental analysis less effective.
Q10.
A company’s price-to-earnings (P/E) ratio is most commonly used to measure:
A. Dividend payout stability
B. Market valuation relative to earnings
C. Company’s debt-to-equity structure
D. Short-term liquidity position
Correct Answer: B
Explanation: The P/E ratio compares a company’s stock price to its earnings per share, helping investors assess valuation relative to profitability.
Q11.
Which factor most directly affects a company’s beta in the Capital Asset Pricing Model (CAPM)?
A. Company’s dividend payout ratio
B. Systematic risk relative to the market
C. Unsystematic risk
D. Interest rate risk
Correct Answer: B
Explanation: Beta measures a stock’s sensitivity to overall market (systematic) risk. Unsystematic risk is firm-specific and can be diversified away.
Q12.
The book value of equity is based on:
A. Market valuation of equity
B. Historical cost of assets minus liabilities
C. Replacement cost of assets
D. Fair value accounting
Correct Answer: B
Explanation: Book value reflects accounting values (assets – liabilities) recorded at historical cost, not current market value.
Q13.
Which of the following is a limitation of the Price-to-Book (P/B) ratio?
A. It ignores dividends
B. It is distorted by accounting policies and asset revaluations
C. It is not comparable across firms
D. It ignores market price changes
Correct Answer: B
Explanation: P/B ratios can be distorted by accounting methods (e.g., depreciation, asset write-downs), which affect book value.
Q14.
The dividend payout ratio is defined as:
A. EPS ÷ DPS
B. DPS ÷ EPS
C. Net income ÷ Dividends
D. Retained earnings ÷ Net income
Correct Answer: B
Explanation: Dividend payout ratio = Dividends per share (DPS) ÷ Earnings per share (EPS). It shows the portion of earnings paid out as dividends.
Q15.
Which of the following investors benefits most from cumulative preferred shares?
A. Investors seeking voting rights
B. Investors concerned with missed dividend payments
C. Investors seeking high growth
D. Investors focusing on short-term gains
Correct Answer: B
Explanation: Cumulative preferred shares ensure unpaid dividends accumulate and must be paid before common shareholders receive dividends.
Q16.
Which equity valuation method relies most heavily on projected free cash flows?
A. Dividend discount model (DDM)
B. Residual income model
C. Free cash flow model
D. P/E multiple model
Correct Answer: C
Explanation: Free Cash Flow models value a company based on expected free cash flows discounted at an appropriate rate, useful for firms with low or no dividends.
Q17.
An investor buys stock at $40 and sells it at $48 after receiving a $2 dividend. The holding period return (HPR) is:
A. 10%
B. 15%
C. 20%
D. 25%
Correct Answer: C
Explanation: HPR = (Capital Gain + Dividend) ÷ Purchase Price = (8 + 2) ÷ 40 = 25%.
Q18.
In efficient markets, abnormal returns are:
A. Positive and consistent
B. Random and short-lived
C. Permanent and predictable
D. Independent of new information
Correct Answer: B
Explanation: In efficient markets, new information is quickly reflected in prices, making abnormal returns random and short-lived.
Q19.
Which of the following is NOT a limitation of relative valuation ratios (P/E, P/B, P/S)?
A. Market sentiment can distort ratios
B. They require comparable firms
C. They ignore future growth potential
D. They account for inflation adjustments
Correct Answer: D
Explanation: Valuation multiples generally do not directly account for inflation adjustments.
Q20.
Which type of order ensures a trade is executed immediately at the best available price?
A. Limit order
B. Stop-loss order
C. Market order
D. Good-till-cancelled order
Correct Answer: C
Explanation: Market orders guarantee execution but not price. Limit and stop orders depend on specific price conditions.
Q21.
A stock that provides returns closely correlated with GDP is best described as:
A. Defensive stock
B. Growth stock
C. Cyclical stock
D. Value stock
Correct Answer: C
Explanation: Cyclical stocks move with the economy, rising during expansions and falling during recessions.
Q22.
Which of the following is a benefit of stock buybacks to shareholders?
A. Increases EPS by reducing shares outstanding
B. Guarantees higher dividends
C. Eliminates business risk
D. Reduces systematic risk
Correct Answer: A
Explanation: Stock buybacks reduce outstanding shares, increasing earnings per share (EPS) and potentially raising stock prices.
Q23.
The law of one price suggests that:
A. Identical assets should trade at the same price in efficient markets
B. Stock prices always equal book value
C. Dividends must equal net income
D. Equity markets are always efficient
Correct Answer: A
Explanation: The law of one price means arbitrage opportunities should not exist for identical assets in efficient markets.
Q24.
Which of the following is most associated with value investing?
A. High P/E stocks
B. Low P/B ratio stocks
C. High growth expectation stocks
D. Negative book value stocks
Correct Answer: B
Explanation: Value investors look for undervalued stocks, often characterized by low P/B ratios and low P/E multiples.
Q25.
The Efficient Market Hypothesis (EMH) is least consistent with:
A. Technical analysis being useful
B. Prices reflecting available information
C. Randomness of abnormal returns
D. Fundamental analysis being limited
Correct Answer: A
Explanation: EMH rejects the effectiveness of technical analysis, as price trends are assumed to already reflect all available information.
Q26.
An ADR (American Depositary Receipt) allows investors to:
A. Buy foreign stocks on U.S. exchanges in U.S. dollars
B. Invest in foreign bonds without currency risk
C. Access private equity investments
D. Avoid foreign market risk completely
Correct Answer: A
Explanation: ADRs let investors trade foreign company shares in U.S. markets using U.S. dollars, simplifying access to global equities.
Q27.
Which of the following is an advantage of equity financing for a company?
A. No obligation to pay dividends
B. Reduces dilution of ownership
C. Guarantees fixed cost of capital
D. Lowers weighted average cost of capital (WACC)
Correct Answer: A
Explanation: Unlike debt, equity financing does not require fixed payments, though it dilutes ownership.
Q28.
Which equity index is price-weighted?
A. S&P 500
B. Dow Jones Industrial Average (DJIA)
C. FTSE 100
D. MSCI World Index
Correct Answer: B
Explanation: DJIA is a price-weighted index, meaning higher-priced stocks have greater influence, regardless of company size.
Q29.
The residual income model is most useful when:
A. Companies do not pay dividends
B. Free cash flows are stable
C. Companies have negative book values
D. Growth rates are constant
Correct Answer: A
Explanation: The residual income model values companies that may not pay dividends but still generate returns above their cost of equity.
Q30.
Which of the following investors would prefer growth stocks?
A. Those seeking stable income
B. Those preferring undervalued low P/E stocks
C. Those focused on capital appreciation
D. Those avoiding volatility
Correct Answer: C
Explanation: Growth investors target companies with high earnings growth potential, often reinvesting profits rather than paying dividends.
Q31.
The primary market is where:
A. Investors trade previously issued securities
B. Companies issue new securities to raise capital
C. Mutual funds and ETFs are traded
D. Derivative contracts are traded
Correct Answer: B
Explanation: The primary market is for new security issuance (IPOs, bond offerings), while secondary markets handle existing securities.
Q32.
Which of the following is an example of unsystematic risk?
A. Changes in interest rates
B. A company’s CEO resigning suddenly
C. Inflation rising across the economy
D. A global recession
Correct Answer: B
Explanation: Unsystematic (firm-specific) risk relates to events affecting only one company or industry, and can be diversified away.
Q33.
The earnings yield is the inverse of which ratio?
A. Dividend yield
B. Price-to-Book ratio
C. Price-to-Earnings ratio (P/E)
D. Price-to-Sales ratio
Correct Answer: C
Explanation: Earnings yield = Earnings ÷ Price = 1 ÷ P/E. It is often used for cross-market comparisons.
Q34.
Which of the following would decrease a company’s return on equity (ROE), all else equal?
A. Higher net income
B. Lower financial leverage
C. Lower total equity
D. Stock buybacks
Correct Answer: B
Explanation: Reducing financial leverage (less debt, more equity) lowers ROE since equity base increases relative to net income.
Q35.
A limit order ensures that:
A. The trade will always be executed immediately
B. The trade executes only at a specified or better price
C. The trade avoids all transaction costs
D. The trade guarantees highest return
Correct Answer: B
Explanation: Limit orders give price control but may not guarantee execution if the market does not reach the specified price.
Q36.
If a firm’s intrinsic value is greater than its market price, the stock is considered:
A. Overvalued
B. Fairly valued
C. Undervalued
D. Risk-free
Correct Answer: C
Explanation: Undervalued stocks are trading below their estimated intrinsic value, making them attractive for investors.
Q37.
Which of the following is a leading indicator of equity market performance?
A. GDP growth rate
B. Unemployment rate
C. Stock market index movements
D. Corporate tax collections
Correct Answer: C
Explanation: Stock market performance often predicts future economic conditions, making it a leading indicator.
Q38.
The price-to-sales (P/S) ratio is useful when:
A. Earnings are negative
B. Companies have no sales
C. Dividend payout is high
D. Companies are capital intensive
Correct Answer: A
Explanation: P/S ratios are useful when EPS is negative (no meaningful P/E), since sales figures are typically positive.
Q39.
Which of the following corporate actions reduces the number of outstanding shares without affecting ownership proportion?
A. Dividend reinvestment plan
B. Stock split
C. Reverse stock split
D. Rights issue
Correct Answer: C
Explanation: A reverse stock split consolidates shares (e.g., 2-for-1 becomes 1-for-2), reducing outstanding shares but keeping proportional ownership.
Q40.
A company with stable dividends is best valued using:
A. Price-to-sales ratio
B. Gordon growth model (DDM)
C. Residual income model
D. Free cash flow model
Correct Answer: B
Explanation: The Gordon Growth (constant growth DDM) is most applicable to mature companies with stable dividend growth.
Q41.
Which of the following indices is market-cap weighted?
A. Dow Jones Industrial Average (DJIA)
B. Nikkei 225
C. S&P 500
D. Value Line Index
Correct Answer: C
Explanation: The S&P 500 is weighted by market capitalization, giving larger firms greater influence.
Q42.
Which type of stock is most likely to perform better in an economic downturn?
A. Growth stock
B. Cyclical stock
C. Defensive stock
D. Penny stock
Correct Answer: C
Explanation: Defensive stocks (utilities, healthcare, consumer staples) maintain stable demand even during recessions.
Q43.
Which of the following best describes an efficient frontier in portfolio theory?
A. A set of portfolios with minimum risk
B. A set of portfolios that maximize return for given risk
C. A set of portfolios with equal returns
D. A set of portfolios with maximum beta
Correct Answer: B
Explanation: The efficient frontier represents portfolios offering the best possible expected return for each level of risk.
Q44.
What is the primary advantage of ETFs over mutual funds?
A. Higher management fees
B. Ability to trade intraday like stocks
C. Guaranteed higher returns
D. Fixed dividend yield
Correct Answer: B
Explanation: ETFs can be traded intraday like stocks, unlike mutual funds, which are priced once daily.
Q45.
A stock’s intrinsic value is most sensitive to:
A. Changes in P/B ratio
B. Changes in discount rate and growth rate
C. Book value fluctuations
D. Market sentiment
Correct Answer: B
Explanation: In valuation models, intrinsic value is highly sensitive to changes in discount rate and expected growth.
Q46.
Which of the following is a feature of preferred stock?
A. Voting rights
B. Priority over common stock in dividends
C. Guaranteed capital gains
D. Unlimited upside potential
Correct Answer: B
Explanation: Preferred stockholders receive dividends before common stockholders but usually lack voting rights.
Q47.
The Sharpe ratio measures:
A. Risk-adjusted return using standard deviation
B. Market risk premium
C. Systematic risk using beta
D. Return correlation with market
Correct Answer: A
Explanation: Sharpe ratio = (Portfolio return – Risk-free rate) ÷ Standard deviation of portfolio returns.
Q48.
The random walk hypothesis implies:
A. Prices follow predictable patterns
B. Stock prices move independently and unpredictably
C. Technical analysis is highly effective
D. Abnormal returns can be earned consistently
Correct Answer: B
Explanation: Random walk theory suggests stock prices move randomly and are unpredictable, consistent with EMH.
Q49.
Which of the following investors is most likely a contrarian investor?
A. Buys when others are pessimistic and sells when others are optimistic
B. Follows market momentum and trends
C. Focuses on defensive stocks during downturns
D. Diversifies across asset classes
Correct Answer: A
Explanation: Contrarian investors go against market sentiment, buying undervalued assets when pessimism is high.
Q50.
Which of the following best explains why arbitrage opportunities rarely exist in efficient markets?
A. Investors are irrational
B. Regulators prohibit arbitrage
C. Prices quickly adjust to eliminate mispricing
D. Arbitrage requires insider trading
Correct Answer: C
Explanation: In efficient markets, competition among traders quickly eliminates arbitrage opportunities.