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Free CFA Equity Practice Questions & Answers
385 exam-style Equity questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 1
Residual income is best described as:
Select an option first.
Correct answer: B — Net income minus the required return on equity capital
Explanation: Why: Residual income measures profit after covering the cost of equity. A: Dividends are irrelevant to residual income. C: That’s closer to net income, not residual income. D: That resembles free cash flow, not residual income.
Question 2
A firm has beginning equity of $200 million, earns $30 million, and its required return on equity is 12%. What is residual income?
Select an option first.
Correct answer: A — $6 million
Explanation: Equity charge = 0.12 × 200 = 24 Residual income = 30 – 24 = 6 B: Ignores equity charge. C: Equity charge itself. D: Subtracts incorrectly.
Question 3
Residual income models are most useful when:
Select an option first.
Correct answer: A — The company pays no dividends and has unpredictable cash flows
Explanation: Residual income works well when dividends or cash flows are unreliable. B: Negative book value breaks the model. C: Stable dividends favor DDM. D: No equity means no residual income.
Question 4
A company’s ROE equals its required return. What is the long‑term residual income?
Select an option first.
Correct answer: B — Zero
Explanation: If ROE = required return, residual income = 0. A/C: Only true if ROE differs from required return. D: Sufficient information is provided.
Question 5
Which input is not required for a residual income valuation?
Select an option first.
Correct answer: C — Forecasted dividends
Explanation: Dividends are irrelevant to residual income. A/B/D: All essential for RI valuation.
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Question 6
A firm has beginning equity of $50 per share, ROE of 14%, and required return of 10%. What is residual income per share?
Select an option first.
Correct answer: A — $2
Explanation: Residual income = (ROE – required return) × beginning equity = (0.14 – 0.10) × 50 = 0.04 × 50 = 2 B/C/D: Incorrect calculations.
Question 7
Residual income valuation is most sensitive to errors in:
Select an option first.
Correct answer: C — Required return on equity
Explanation: The discount rate heavily affects the equity charge and valuation. A: Dividends irrelevant. B: Book value matters but is usually stable. D: More relevant to FCFF/FCFE.
Question 8
A company has ROE of 8% and required return of 12%. Residual income will be:
Select an option first.
Correct answer: C — Negative
Explanation: ROE < required return → value destruction → negative RI. A: Only if ROE > required return. B: Only if equal. D: It will be negative, not increasing.
Question 9
Which situation makes residual income valuation less appropriate?
Select an option first.
Correct answer: B — Large non‑recurring charges
Explanation: Large one‑offs distort earnings → distort RI. A/C/D: All support RI modeling.
Question 10
A firm has beginning equity of $120, required return of 9%, and residual income of $6. What is net income?
Select an option first.
Correct answer: C — $16.8
Explanation: Equity charge = 0.09 × 120 = 10.8 Net income = RI + equity charge = 6 + 10.8 = 16.8 A: RI only. B: Equity charge only. D: Incorrect sum.
Question 11
The terminal value in a residual income model is typically based on:
Select an option first.
Correct answer: B — A constant residual income growth assumption
Explanation: Terminal RI often assumes stable long‑run RI growth. A: DDM assumption. C: Only used in distress. D: Not part of RI framework.
Question 12
Residual income equals abnormal earnings. “Abnormal” refers to earnings:
Select an option first.
Correct answer: B — Above the cost of equity
Explanation: Residual income = earnings above required return. A/C/D: Not the definition of abnormal earnings.
Question 13
A firm’s book value per share is $40. ROE is expected to be 15% for one year, then equal the required return of 10% thereafter. Residual income in Year 2 will be:
Select an option first.
Correct answer: B — Zero
Explanation: Once ROE = required return → RI = 0. A/C: Only true if ROE differs. D: Sufficient info is given.
Question 14
Which statement best describes the advantage of residual income models?
Select an option first.
Correct answer: B — They work even when cash flows are negative
Explanation: Residual income can still be positive even if cash flows are weak. A: They absolutely require a discount rate. C: They are sensitive to accounting quality. D: Book value is essential.
Question 15
A company has beginning equity of $300 million, earns $45 million, and its required return is 14%. What is residual income?
Select an option first.
Correct answer: A — $3 million
Explanation: Equity charge = 0.14 × 300 = 42 Residual income = 45 – 42 = 3 B: Ignores equity charge. C: Incorrect math. D: RI is positive, not negative.
Question 16
Residual income becomes negative when:
Select an option first.
Correct answer: C — ROE is below the required return
Explanation: Why correct: Residual income = (ROE − required return) × beginning book value. If ROE < required return, the difference is negative. A. ROE > required return → RI positive B. ROE = required return → RI zero D. Book value zero → RI mechanically zero, not negative
Question 17
A company with stable ROE and stable payout ratio will most likely have:
Select an option first.
Correct answer: B — Constant residual income
Explanation: Why correct: If ROE and book value growth are stable, residual income tends to stabilize. A. Decline only if ROE falls C. Increase only if ROE or book value rises D. RI is directly tied to ROE
Question 18
Residual income valuation is most useful when:
Select an option first.
Correct answer: A — The firm pays no dividends
Explanation: Why correct: RI models work well when dividends are not meaningful or not paid. B. Unpredictable earnings reduce RI reliability C. Negative book value breaks the model D. No equity capital → no book value → cannot compute RI
Question 19
The clean surplus relation requires that:
Select an option first.
Correct answer: B — All changes in equity except owner transactions pass through income
Explanation: Why correct: Clean surplus: Ending BV = Beginning BV + Net income − Dividends. A. Not all gains bypass income C. Dividends ≠ earnings D. Book value changes with earnings and dividends
Question 20
A firm with high ROE but also high required return will have:
Select an option first.
Correct answer: B — Low or negative residual income
Explanation: Why correct: If required return is extremely high, ROE may not exceed it. A. Only true if ROE > required return C. RI is directly tied to ROE D. RI is not equal to dividends
Question 21
Residual income is best interpreted as:
Select an option first.
Correct answer: B — Earnings after covering the cost of equity
Explanation: Why correct: RI measures economic profit after charging equity capital. A. That describes FCFE C. Not related to RI D. Interest expense is already in net income
Question 22
A firm’s residual income will increase if:
Select an option first.
Correct answer: C — ROE increases
Explanation: Why correct: Higher ROE → higher (ROE − required return). A. Higher required return reduces RI B. Lower book value reduces RI D. Dividends do not directly affect RI
Question 23
The terminal value in a residual income model is usually based on:
Select an option first.
Correct answer: A — A constant ROE assumption
Explanation: Why correct: Terminal RI is typically modeled using stable ROE and stable growth. B. Dividends not central to RI C. FCFE is a different model D. Sales growth does not directly determine RI
Question 24
Residual income valuation is least appropriate when:
Select an option first.
Correct answer: A — Accounting distortions are large
Explanation: Why correct: RI relies heavily on clean accounting; distortions reduce reliability. B. RI is good when dividends are irregular C. RI works even with negative FCFE D. Stable ROE is ideal
Question 25
If a firm’s ROE equals its required return, the justified P/B ratio is:
Select an option first.
Correct answer: B — Equal to 1
Explanation: Why correct: If ROE = required return → no value added → P/B = 1. A. Only if ROE < required return C. Only if ROE > required return D. It is determinable
Question 26
A firm with rising book value but constant ROE will have residual income that:
Select an option first.
Correct answer: B — Rises
Explanation: Why correct: RI = (ROE − r) × BV. If BV rises, RI rises (assuming ROE > r). A. Only if ROE < r C. Only if BV is constant D. Not implied
Question 27
The main advantage of RI over dividend models is that RI:
Select an option first.
Correct answer: B — Does not require dividends
Explanation: Why correct: RI works even when dividends are not meaningful. A. RI still requires many assumptions C. RI depends heavily on book value D. RI uses earnings, not cash flows
Question 28
A company with volatile ROE will likely have:
Select an option first.
Correct answer: B — Unreliable residual income forecasts
Explanation: Why correct: Volatile ROE → volatile RI. A. Opposite C. RI depends directly on ROE D. RI ≠ net income
Question 29
The equity charge in RI valuation represents:
Select an option first.
Correct answer: B — Required return on equity capital
Explanation: Why correct: Equity charge = required return × beginning book value. A. Dividends irrelevant C. Interest is debt cost D. Taxes not part of equity charge
Question 30
A firm with high leverage but stable ROE will have RI that is:
Select an option first.
Correct answer: A — Higher risk
Explanation: Why correct: High leverage increases volatility of ROE → RI becomes riskier. B. Leverage increases risk, not decreases C. Leverage affects ROE volatility D. Not necessarily negative
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