Specially designed as preparation for the Level II 2011 CFA. ®. Exam. The
morning ... SCHWESER 2011 CFA LEVEL II LIVE MOCK EXAM, MORNING
SESSION.
CFA Level II Mock Exam 2011 Morning Session Specially designed as preparation for the Level II 2011 CFA® Exam
The morning session of the Schweser 2011 Level II Mock Exam comprises 10 item sets. Each item set has 6 multiple-choice questions. For grading purposes, each question is worth 3 points, corresponding to the average number of minutes available per question.
Questions 1–6 7–12 13–18 19–24 25–30 31–36 37–42 43–48 49–54 55–60
Topic Ethical and Professional Standards Quantitative Methods Financial Reporting and Analysis Financial Reporting and Analysis Corporate Finance Economics Equity Investments Fixed Income Investments Derivative Investments Portfolio Management
Minutes 18 18 18 18 18 18 18 18 18 18 Total 180
Do not proceed until instructed to do so.
Start Time:_________
©2011 Kaplan, Inc.
SCHWESER 2011 CFA LEVEL II LIVE MOCK EXAM, MORNING SESSION ©2011 Kaplan, Inc. All rights reserved. Published in 2011 by Kaplan, Inc. Printed in the United States of America. ISBN: 978-1-4277-2824-1 / 1-4277-2824-0 PPN: 3200-0260
®
®
®
Required CFA Institute disclaimer: “CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser.” These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated. Disclaimer: Schweser study tools should be used in conjunction with the original readings as set forth by CFA Institute in their 2011 CFA Level II Study Guide. The information contained in Schweser study tools covers topics contained in the readings referenced by CFA Institute and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success. The authors of the referenced readings have not endorsed or sponsored Schweser study tools.
©2011 Kaplan, Inc.
Test Answers 1.
31.
2.
32.
3.
33.
4.
34.
5.
35.
6.
36.
7.
37.
8.
38.
9.
39.
10.
40.
11.
41.
12.
42.
13.
43.
14.
44.
15.
45.
16.
46.
17.
47.
18.
48.
19.
49.
20.
50.
21.
51.
22.
52.
23.
53.
24.
54.
25.
55.
26.
56.
27.
57.
28.
58.
29.
59.
30.
60.
©2011 Kaplan, Inc.
Questions 1 through 6 relate to Ethical and Professional Standards. Antares Investment Management Case Scenario Antares Investment Management is a mid-sized operation based in Boston, Massachusetts. Antares provides investment analysis, advice, and account management services for individuals, investment banking services for corporate clients, and manages assets for several mutual funds. Antares also allocates some client assets among mutual funds of other firms. Antares wants to include CFA Institute’s Research Objectivity Standards as part of the firm’s Policies and Procedures Manual. Antares has a research staff of 30. Antares compensates its research analysts in three ways. They receive a base amount and two bonus amounts. One bonus amount is based on the quality of the research. The quality of an analyst’s research is judged using specific criteria by the head of the research department shortly after it is sent to clients in final form. A second bonus amount depends on the firm’s overall level of revenues and profitability, including the results of the investment banking division. Antares has a written policy on the independence and objectivity of its research and makes this policy available to clients and prospective clients. The policy is disseminated to all employees. Anatares also has supervisory procedures that provide reasonable assurance that both the firm and its employees adhere to the firm’s policy and applicable laws and regulations. Antares’s policies and procedures call for restrictions on personal investing related to the firm’s recommendations. Three policies that Antares enforces, except in cases of extreme financial hardship, are as follows: Policy 1:
“All covered employees and their immediate families are prohibited from taking investment actions contrary to the employee’s or the firm’s current investment recommendations.”
Policy 2:
“Covered employees are prohibited from sharing a proposed change in a security’s recommendation or its price target with the management of the subject company prior to distribution of an updated research report.”
Policy 3:
“The firm’s rating system must provide information that investors can use to assess the suitability of recommended securities for their accounts.”
Antares’s chief financial officer, Dave Haywood, CFA, is considering investing in an IPO which Antares is handling for a major client. Haywood is consulting with Hillary Scott, Antares’s chief compliance officer, in advance of this planned transaction. Scott informs Haywood that the CFA Institute prohibits covered employees and immediate family members from participating in IPOs of subject companies, but she is unsure
whether it is prohibited under the CFA Standards of Practice or the Research Objectivity Standards. Antares has decided to adopt CFA Institute’s Soft Dollar Standards, in addition to CFA Institute’s Research Objectivity Standards. Scott is paying particular attention to the section regarding the selection of brokers. Scott is focused on the need to select a broker that can provide the best trade execution; however, she is also concerned about how much Antares should consider the broker’s financial responsibility and range of services provided. She goes to speak with Haywood regarding what is required under the CFA Institute’s Soft Dollar Standards. Antares has hired a consulting firm to evaluate Antares’s draft policies and procedures and asked the firm to tell them how closely their procedures follow both the CFA Institute Research Objectivity Standards and the CFA Institute Soft Dollar Standards. Three selections from Antares’s Soft Dollar Practices follow: Practice 1:
“Antares must require that brokers with whom they have soft dollar arrangements provide best execution.”
Practice 2:
“Soft dollars from client brokerage will not be used to provide goods and services to the client unless they aid in the investment management process.”
Practice 3:
“For any services that both aid in the investment decision making process and are made available to individual clients, the firm should allocate the cost between soft dollars and the firm.”
1. In regard to the CFA Institute Research Objectivity Standards, the compensation system for Antares’s research analysts is: A. not acceptable because there is a link between research analyst compensation and investment banking activities. B. not acceptable because it does not use analyst accuracy in determining compensation. C. acceptable because there is no direct link between investment banking income and compensation, and because compensation is partially based on research quality. 2. With regard to Antares’s written research objectivity policy statement and its distribution and implementation, the CFA Institute Research Objectivity Standards require: A. no further actions. B. that each covered employee sign a statement of compliance at least annually. C. that a senior officer of the firm attests annually to the firm’s clients that the firm adheres to the policy.
3. Which of the following statements about whether the three excerpts from Anatares’ policies and procedures are all required by the Research Objectivity Standards is most accurate? A. All three policies are required by the CFA Institute Research Objectivity Standards. B. Policy statement #2 is not a requirement as feedback from the corporation can be helpful in identifying any analytical errors that underlie the analysis, but the other two are required. C. Only policy statement #3 is not required, as suitability is determined by the account manager, not at the firm level. 4. The CFA Institute’s Research Objectivity Standards prohibit covered employees and members of their immediate families from: A. participating in any subject company’s IPO. B. participating in a subject company’s IPO only when the subject company new issue is a “hot issue” (i.e., one that is oversubscribed). C. purchasing shares of subject companies in advance of an IPO only for firms in the industry assigned to the employee. 5. In selecting a broker for client trades where soft dollars are involved, CFA Institute members are: A. required to consider trade execution capabilities well as an evaluation of the broker’s financial responsibility and the range of services provided. B. prohibited from using soft dollars from client brokerage to purchase goods and services that do not benefit the client. C. required to disclose soft dollar arrangements to the client prior to entering into any such arrangements. 6. Regarding Antares’s practices with respect to soft dollars, compliance with the CFA Institute Soft Dollar Standards least likely requires: A. Practice 1. B. Practice 2. C. Practice 3.
Questions 7 through 12 relate to Quantitative Methods. Winterville Investment Managers Case Scenario Mary Gran and Tracy Joyner are analysts for Winterville Investment Managers. Gran is analyzing monthly returns for a U.S. small-cap equity index and a European Union smallcap equity index. The information below provides the results of her analysis. n = 72 n ∑ Xi = 0.7831 i=1 n ∑ Yi = −0.0747 i=1 n ∑ Xi − X Yi − Y = 0.00159 i=1 n 2 ∑ Xi − X = 0.00239 i=1 n 2 ∑ Yi − Y = 0.026445 i=1
( ) ( ) (
)(
(
)
(
)
)
For a different project, Gran has been analyzing the regression results for financial data of Canadian firms but she suspects there is a problem with the analysis. She describes the problem, its detection, and its solution as follows: •
• •
The problem with the analysis is that the estimated standard errors are too small, leading to calculated t-statistics that are too large. This would lead the unaware researcher to believe that the regression coefficients are statistically significant, when in fact they are not. The Durbin-Watson test would be used to detect this problem. A Durbin-Watson statistic lower than the Durbin-Watson critical value would suggest that the problem exists. One solution to the problem would be to adjust the standard errors using the Hansen method.
Joyner is interested in the relationship between U.S. stock returns and the day of the week. Specifically she believes that the returns on Monday may be lower than returns during the rest of the week. Her regression equation is: St = α + βD t + ε t
where S t is the U.S. stock return and Dt is a dummy variable equal to one if the return falls on a Monday and zero if it occurs during the rest of the week. The daily data
examined is for the last 30 years of returns. The intercept is 0.1428 and the slope coefficient is –0.1194. The standard error for the slope coefficient is 0.0391. Gran is interested in how the returns for multinational corporations are related to the returns of individual country markets. As a start, she regresses the returns for a large consumer products firm based in the U.S. against the returns for the Standard and Poor’s 500 index. There were 1190 weekly returns used in the regression. The analysis of variance results are presented in the following table. ANOVA Regression Residual Total
Sum of Squares 0.2688 1.0839 1.3527
Joyner evaluates Gran’s regression and states that because the U.S. firm is a multinational, the returns for other country stock indexes should be included as independent variables in a single regression. Joyner makes the following comments: Statement 1: We should include the returns for these other indexes as explanatory variables as long as adding them increases the R2 for the regression because this shows that the explanatory power of the regression is improved. Statement 2: I believe that there may be a problem with Gran’s original regression. Suppose the returns for other country stock indexes such as the Nikkei 225 are highly correlated with the returns for the U.S. multinational and the S&P 500. If Gran uses the S&P 500 returns as the sole independent variable, the regression coefficients are biased and inconsistent.
Joyner has also been evaluating the relationship between U.S. stock returns and the commercial paper premium (CPP6), which is the six-month commercial paper rate minus the Treasury bill rate, and the Federal Funds rate (FEDFUND). She uses monthly data and has 294 observations in the regression. The results of the regression of U.S. returns on CPP6 and FEDFUND are below.
Intercept CPP6 FEDFUND
Coefficients 1.9172 –3.1000 –0.0109
Standard Error 0.6499 0.6400 0.0943
t-Statistic 2.9498 –4.8438 –0.1159
7. The correlation between the returns on the U.S. small-cap equity index and the returns on the European Union small-cap equity index is closest to: A. 0.20. B. 0.30. C. 0.40. 8. Which of the following is the most likely problem in Gran’s regression analysis of the Canadian firm data? A. Multicollinearity. B. Positive serial correlation. C. Negative serial correlation. 9. How should the results from Joyner’s regression concerning stock returns on Monday be interpreted? A. The predicted value for Monday’s stock return is –0.1194 and Monday’s stock returns are significantly different from those during the rest of the week. B. The predicted value for Monday’s stock return is 0.0234 and Monday’s stock returns are significantly different from those during the rest of the week. C. The predicted value for Monday’s stock return is –0.1194 and Monday’s stock returns are not significantly different from those during the rest of the week. 10. Given the ANOVA results for Gran’s regression of the U.S. multinational returns on the S&P 500 returns, the best interpretation is that the coefficient on the S&P 500 variable is: A. equal to zero. B. greater than zero. C. not equal to zero. 11. Regarding the statements made by Joyner on Gran’s regression, are both statements correct? A. Yes. B. No, both statements are incorrect. C. No, one of the statements is correct but the other statement is incorrect. 12. A 95% confidence interval for the CPP6 regression coefficient in Joyner’s regression is closest to: A. 0.00 to –6.20. B. –1.85 to –4.35. C. –2.46 to –3.47.
Questions 13 through 18 relate to Financial Reporting and Analysis. Garden Supply Case Scenario Garden Supply Company has a wholly owned foreign subsidiary, Lantana Inc., located in the island nation of Zinnia. The majority of Lantana’s operating and financing decisions are made locally by Lantana’s management, although Lantana relies on Garden Supply for some administrative expertise. The local currency in Zinnia is the zin and Garden Supply reports its financial results in U.S. dollars. The country of Zinnia has experienced significant inflation and currency depreciation over the years. Over the past three years, the annual inflation rate has averaged 20%. Exhibit 1 contains the recent exchange rates. Exhibit 1: Exchange Rates
Average for 2008 December 31, 2008 Average for 2009 December 31, 2009
$ / Zin 0.97 0.90 0.84 0.78
Exhibit 2 contains selected items from Lantana’s most recent balance sheets. Exhibit 2: Balance Sheets—Lantana Inc. zin, in millions Monetary Assets Nonmonetary Assets
Monetary Liabilities Nonmonetary Liabilities Capital Stock Retained Earnings
2009 130 700 830
2008 110 695 805
360 125 50 295 830
330 190 50 235 805
Both Garden Supply and Lantana maintain their inventories using the first-in, first-out (FIFO) method. Lantana’s beginning inventory was purchased when the zin exchange rate was $1.04 and its capital stock was issued when the zin exchange rate was $1.10. Purchases were made evenly throughout the year.
13. Under U.S. generally accepted accounting principles, Lantana’s functional currency is most likely: A. the U.S. dollar. B. the zin. C. some other currency. 14. As a result of using the appropriate translation method, Garden Supply’s other comprehensive income (as opposed to its net income), for the year ended 2009, will most likely include: A. a gain. B. a loss. C. no gain or loss. 15. If the current rate method is used to translate Lantana’s financial statements at the end of 2009, stockholders’ equity, stated in U.S. dollars, would be closest to: A. $249.8 million. B. $269.1 million. C. $379.5 million. 16. As compared to the temporal method, Lantana’s gross profit margin ratio, when translated into U.S. dollars using the current rate method, would be: A. higher. B. lower. C. unchanged. 17. As compared to the temporal method, Lantana’s total asset turnover ratio at the end of 2009, when translated into U.S. dollars using the current rate method, would be: A. higher. B. lower. C. unchanged. 18. Assume, for this question only, that the country of Zinnia is experiencing hyperinflation. If Garden Supply follows International Financial Reporting Standards, it will most likely recognize: A. a purchasing power loss. B. a purchasing power gain. C. no purchasing power gain or loss.
Questions 19 through 24 relate to Financial Reporting and Analysis. Jacobs Advisors Group Case Scenario James Reed, CFA, is a health care analyst for the Jacobs Advisors Group. Reed conducts a review of Beverly Pharmaceutical, Inc.’s financial statements in order to prepare a report on the firm. Reed reviews his initial report on Beverly Pharmaceutical with Krista Reynolds, a Level I CFA candidate. During their discussion, Reynolds tells Reed that she is unclear about how management assumptions affect the financial statements of a corporation with a defined benefit, versus a defined contribution, retirement plan. Reed explains using the disclosures about Beverly’s defined-benefit pension plan presented below in Exhibit 1. They review Beverly’s selection of a discount rate, rate of compensation growth, and expected return on plan assets. Reed explains to Reynolds that changes in these assumptions can have a sizeable impact on reported financial results. Exhibit 1 Data in $000s Beginning Pension Obligation Beginning Fair Value Plan Assets For the period: Service Costs Interest Costs Actuarial Loss Benefits Paid Expected Return on Plan Assets Actual Return on Plan Assets Contributions to Plan
4,545
Income Statement Items Operating Profit Interest Expense
$25,000 ($1,300)
Other Income Income Before Taxes
$350 $24,050
Assumptions Return on plan assets Discount rate Compensation growth
7.5% 9% 3%
4,327
404 409 42 560 324.5 412 895
Reynolds asks Reed about the differences between the calculation of pension expense on the income statement under IFRS and U.S. GAAP, and about the differences between IFRS and U.S. GAAP methods of calculating the funded status of the plan reported on the balance sheet. To see if Reynolds has grasped these differences, Reed asks her to calculate the plan’s beginning funded status, ending funded status, and the change in funded status of the plan, all under U.S. GAAP. Reed also explains to Reynolds that some of the figures in Exhibit 1 are footnote disclosures that provide important information about the plan’s performance over the period. Further, he explains that pension expense on the income statement is not necessarily equal to true economic cost of the plan for the period, and that whether the
plan’s funded status shown on the balance sheet is equal to true economic asset or liability of the plan to Beverly depends on the accounting method used. While reading the annual reports for Beverly, Reynolds notes that Beverly has an incentive stock option plan in place for key employees. She is unsure of how to account for these options and how compensation expense is affected by the issuance of the incentive options. For the most recent period, Beverly granted some incentive stock options that were out of the money and exercisable four years after the grant date. She wonders if how the compensation expense associated with these options is recognized under IFRS and under U.S. GAAP depends on whether the options are in the money or not. 19. In responding to Reynolds’s question about the effects of management assumptions about a defined benefit pension plan, Reed would most accurately tell her that an increase in the assumed rate of compensation growth would likely increase: A. both the projected and accumulated benefit obligation. B. the projected, but not the accumulated, benefit obligation. C. neither the projected nor the accumulated benefit obligation. 20. The true economic status of a defined benefit pension plan is always equal to the funded status reported on the balance sheet for: A. both U.S. GAAP and IFRS reporting firms. B. IFRS reporting firms but not U.S. GAAP reporting firms. C. U.S. GAAP reporting firms but not for IFRS reporting firms. 21. Reynolds should calculate the change in the funded status of the Beverly plan under U.S. GAAP, based on the items reported in Exhibit 1, as: A. –$108,000. B. $234,000. C. $452,000. 22. To calculate the economic expense of a defined benefit pension plan for the period, an analyst would most likely refer to the footnotes and: A. simply use the change in net funded position over the year. B. subtract the change in net funded position from the company contribution. C. subtract the benefits paid to plan beneficiaries from the change in net funded position.
23. When calculating periodic pension expense under U.S. GAAP, prior service costs resulting from an amendment to the plan that improves benefits should be: A. recognized as pension expense in the current period. B. recognized in comprehensive income but amortized over a period of years to pension expense. C. recognized as pension expense in the current period only to the extent that the improved benefits are vested. 24. With respect to the stock options granted by Beverly in the most recent period, Reynolds would most correctly state that: A. compensation expense should be recognized over 4 years. B. no compensation expense should be recognized in the current period because the options have no intrinsic value. C. compensation expense in the current period should be the fair value of the options as of the grant date.
Questions 25 through 30 relate to Corporate Finance. Jupiter Fuels Case Scenario Rupert Porter, CFA, is the Chief Financial Officer for Jupiter Fuels, a small petroleum refinery and chemical manufacturing company. The company is profitable, but Porter and his assistant, John Rogers, are always looking for new ways to increase the company’s value. Porter and Rogers are considering altering the company’s capital structure, but want to begin by determining the company’s current WACC as a baseline. Exhibit 1: Selected Items from Jupiter Fuels’ Financial Statements Book Value of Debt Book Value of Equity Market Value of Debt Market Value of Equity Shares Outstanding Dividends/Share Expected Growth Rate in Dividends Expected Growth Rate in EPS Effective Tax Rate Interest Rate on Debt
$45 million $85 million $50 million $120 million 11 million shares $1.27 (most recent) 3.0% 3.0% 40% 8.0%
Roger recommends that Jupiter consider issuing new debt to repurchase company stock in the market. Roger mentioned a recent meeting with Jupiter’s investment bankers who were keen on underwriting any new debt offering. During that meeting, the consensus was that the market liquidity conditions were very good. Their discussion then moves on to investment decisions that are pending on Porter’s desk. Jupiter Fuels’ chemical division is considering replacing one of its fractionating columns to reduce manufacturing costs, but Porter is not convinced the replacement is justified from an economic perspective especially given that the company would eventually move to different technology and not replace any of the columns being considered beyond their useful lives. Two new models are being considered. Porter has estimated a projectspecific WACC of 11.0%. Based on estimates provided by various departments at Jupiter Fuels, Rogers has created the following cash flow estimates for the Alpha-9 and the Beta-T models:
Alpha-9 –300 Beta-T –800
1 100 200
2 200 200
3 300 300
4 0 200
5 0 200
6 0 350
Porter is also evaluating another capital project involving mining in Australia. Porter looks at Exhibit 2, provided to him by the vice president of Capital Investments. Exhibit 2: Project: Multi-Chemical Resource Mining in Australia Initial outlay: $10 million Project life: Three years Annual after-tax cashflows (high estimate): $5 million (low estimate): $2 million Tax rate: 30% Probability of high estimate: 60%. Probability of low estimate: 40%. Note: Project can be abandoned at our discretion after one year. At that time, salvage value is estimated to be $6 million. After three years, no salvage value is expected. Porter evaluates the Australian market for sourcing debt capital. He observes that Australian legal system is based on common law and is very efficient. Finally, Porter and Rogers discuss economic profit and residual income and their impact on Jupiter Fuels’ market value. Rogers makes the following statements: Statement 1: The economic profit method, based on a project’s annual economic profit and the project’s WACC, will produce an NPV equal to the project’s market value added (MVA). Statement 2: The residual income model can be used to calculate a project’s NPV using Jupiter Fuels’ WACC if the equity charge is correctly calculated and deducted from the annual net income amounts. 25. The WACC for Jupiter Fuels is closest to: A. 9.9%. B. 12.0%. C. 14.7%. 26. Assuming it makes economic sense to replace Jupiter Fuels’ existing fractionating column, which model should Porter select and why? A. The Beta-T model because it has a greater NPV. B. The Alpha-9 model because it has an equivalent annual annuity of $70.29. C. The Beta-T model because it has a replacement chain NPV of $199.42.
27. Based on the information provided in the case and Exhibit 2, with respect to the mining project in Australia, Porter should: A. reject the project as NPV = –$714,000. B. accept the project as NPV = +$214,000. C. reject the project as NPV = –$500,000. 28. Based on Porter’s evaluation of Australian legal system, he would most likely find more of: A. long-maturity debt issued by low D/E issuers. B. short-maturity debt issued by high D/E issuers. C. long-maturity debt issued by high D/E issuers. 29. Regarding Roger’s statement about repurchasing company stock, which of the following is least valid reason for share repurchases? A. Increase EPS. B. Increase managerial flexibility. C. Increase financial leverage. 30. Regarding Rogers’ statements about the economic profit and residual income methods: A. both statements are accurate. B. neither statement is accurate. C. only one statement is accurate.
Questions 31 through 36 relate to Economics. Coley Consulting Case Scenario Greg Joyner and Terry Luc are economists for Coley Consulting. Coley provides economic analysis and advice to portfolio managers, institutional investors, investment banks, and other organizations throughout North America. One of Coley’s clients is Preserve the Bay, a national environmental group. The group’s president, John Powell, has asked Joyner and Luc to determine the potential impact of an environmental regulation he favors. The position of the association which represents the interests of companies in the affected industry has been that the regulation will not only hurt their shareholders, but will also reduce employment and wages in the industry, suppliers revenues and profits, and municipal tax revenues from companies in the industry. Powell’s position is that the regulation is long overdue and that the only reason it has not passed is that government regulatory bodies are dominated by former industry executives. Although Powell acknowledges that the regulation will have some negative impact on stakeholders, it is his contention that industry groups are overestimating the cost of the regulation and the magnitude of its negative impact. Joyner is examining the attractiveness of the Japanese yen, relative to that of the U.S. dollar, for an institutional client. Joyner has examined the historical dollar-yen exchange rate extensively and has found that interest rate parity and the foreign exchange expectation relation both tend to hold for the two currencies. The following table provides the quotes for the spot and forward exchange rates over a one-week period. USD:JPY spot January 2 January 9
Bid 90.90 90.63
Ask 90.96 90.75
USD:JPY one year forward January 2 January 9
Bid 90.50 90.21
Ask 90.62 90.39
Luc is focusing on the currencies of the U.S., Mexico, and Australia. Although he believes that it is unlikely that dealers misprice currencies, he decides to check the Australian dollar-Mexican peso rate to determine if there is any potential for arbitrage profits. Luc has access to 1,000,000 MXN to use if he identifies an attractive trade.
The table below provides some current spot rate quotes.
AUD:USD rate USD:MXN rate AUD:MXN rate
Bid 0.8000 12.800 10.1000
Ask 0.8012 12.818 10.1020
Joyner is examining the prospects for emerging markets and frontier markets, at the request of a client. One of the countries he is investigating is Dhana, which has experienced rapid growth in its economic output. Its most recent economic activity and some related measures are presented below in rables, the local currency. GDP (rables) Depreciation Net property income from abroad
2,640,000 210,000 140,000
31. The argument made by John Powell concerning industry regulation is most consistent with the: A. capture hypothesis. B. industry insider hypothesis. C. share-the-gains, share-the-pains theory. 32. The changes in the dollar-yen spot and forward exchange rate quotes over the dates reported are most consistent with a: A. decrease in liquidity in the dollar-yen market. B. decrease in the expected volatility of the dollar-yen exchange rate. C. desire by currency dealers to decrease their yen holdings. 33. Assuming Joyner’s research and conclusions regarding the relations between yen and dollar interest rates and currency movements are correct, and that real interest rates have tended to be equal for U.S. dollars and Japanese yen, the dollar-yen spot and forward exchange rates on January 9 are most consistent with an expectation that: A. the yen will depreciate relative to the dollar over the next year. B. inflation in the U.S. will be higher than in Japan over the next year. C. the nominal risk-free interest rate in Japan will fall relative to the nominal riskfree rate in the U.S. over the next year.
34. Assume that Joyner’s finding that interest rate parity holds is correct and that the JPY is expected to appreciate over the coming year. If U.S. monetary authorities then change their policy unexpectedly to stimulate the U.S. economy over the coming year, what will be the most likely impact on the current spot exchange rate (JPY:USD) and on the expected appreciation of the JPY? Spot rate A. Decrease B. Increase C. Increase
Expected appreciation Decrease Increase Decrease
35. If Luc employs the capital he has available to take advantage of any arbitrage opportunity presented by the current quotes for the MXN, USD, and AUD exchange rates, his profit will be closest to: A. 13,661 MXN. B. 16,810 MXN. C. no profits. 36. If Joyner were called on to explain the terms in his table of Dhana’s economic activity, he would most correctly state that gross national income is the total income earned by the: A. citizens of a country including returns on their foreign assets. B. residents of a country regardless of their citizenship and where their assets are located. C. citizens of a country but does not include the returns on any assets located outside the country.
Questions 37 through 42 relate to Equity Investments. Castlebridge Investors Case Scenario Mary Hudson and Jill Craig are analysts for Castlebridge Investors. Castlebridge manages the portfolios of high net worth investors and institutions. They also provide investment banking advice to corporations and private equity firms. Hudson and Craig are considering the appropriate valuation model for each of two firms. The firms under consideration are Kirkham Gas and Light (Kirkham) and Banstead Goods (Banstead). Selected firm characteristics are described below. •
Kirkham pays a dividend that has grown steadily over the past twenty years. The firm has a dividend payout ratio of 27%. Castlebridge is valuing Kirkham as a potential acquisition by a larger utility company. Hudson and Craig believe that Kirkham currently has too little financial leverage and expect that the firm’s leverage will be significantly increased if it is acquired by their client.
•
Banstead is a consumer goods firm that has recently returned to profitability after five years of financial difficulty. The firm instituted a small dividend this year after 4 years of no dividends. However, the firm’s free cash flow to equity is negative and the dividend is greater than Banstead’s net income. Hudson and Craig have doubts as to the sustainability of the dividend without a significant improvement in operating results.
After her initial examination of the financial statements for both Kirkham and Banstead, Hudson makes the following remarks concerning dividends, earnings, and free cash flows: Statement 1: If Kirkham were to substitute a stock repurchase program for the dividends, free cash flow to equity would increase for the selling shareholders, but decrease for the long-term shareholders. Free cash flow to the firm, however, would be unaffected. Statement 2: Given Banstead’s recent return to profitability and an increase in its EBIT, both free cash flow to equity and free cash flow to the firm will increase. The magnitude of the increase will be higher for free cash flow to equity, compared to free cash flow to the firm, because of the institution of the dividend payment.
Craig is investigating the valuation of Tarrington Enterprises, a small biotechnology firm. She has decided to value the firm using a FCFE approach, using the firm’s financial statements which have been prepared according to International Financial Reporting
Standards (IFRS). The figures for Tarrington Enterprises are provided below. The firm sold no long-term assets in 20X1.
Revenues Cost of goods sold Gross profit SG&A expense Depreciation expense EBIT Interest expense EBT Taxes @ 40% Net Income
20X1 $400 $140 $260 $45 $60 $155 $20 $135 $54 $81
20X0 $300 $120 $180 $40 $50 $90 $15 $75 $30 $45
Cash Accounts receivable Inventory Current assets Gross property plant equipment Accumulated depreciation Total assets
$15 $30 $55 $100 $500 $220 $380
$10 $20 $30 $60 $350 $160 $250
Accounts payable Short-term debt Current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity
$30 $59 $89 $120 $60 $111 $380
$30 $20 $50 $110 $60 $30 $250
At the request of a client, Hudson is examining the prospects of Wickham Materials, a thinly traded, regional firm. The firm’s FCFF has grown at a fairly constant rate of 4%. She uses the following figures to value the firm and to calculate its per share equity value. FCFF Target debt-to-equity ratio
$8,000,000 0.30
Par value of debt
$13,000,000
Market value of debt
$12,000,000
Shares outstanding
2,500,000
Required return on equity
18%
Cost of debt
10%
Long-term growth in FCFF Tax rate
4% 30%
Craig is valuing an equity interest in Royal Homes, a builder of residential housing. Royal Homes has experienced healthy growth in free cash flow to equity over the recent past and this is expected to continue for the next three years. Craig, however, projects that FCFE growth will slow after that. After a transitional period, FCFE will stabilize. Given the firm’s most recent free cash flow to equity of $1.00 per share, Craig will value the firm assuming a 13% shareholder's required return. The growth rate for FCFE is 20% for the first three years, 15% in the fourth year, and 10% in the fifth year. The FCFE growth rate is expected to be 5% from year 6 onward. Hudson states that one method of estimating FCFF would be to start with EBITDA × (1 – tax rate) and then subtract out additional investment in working capital and fixed assets. Craig states that Hudson has omitted an adjustment for depreciation in her estimation of FCFF. 37. Which of the following best describes the valuation models that Hudson and Craig would most appropriately apply to Kirkham Gas and Light and Banstead Goods? A. Apply a dividend discount model for both Kirkham Gas and Light and for Banstead Goods. B. Apply a dividend discount model for Kirkham Gas and Light and a free cash flow to equity model for Banstead Goods. C. Apply a free cash flow to the firm model for both Kirkham Gas and Light and Banstead Goods.
38. Regarding the statements made by Hudson about free cash flow to equity and free cash flow to the firm for Kirkham Gas and Light and Banstead Goods, are both statements correct? A. Yes. B. No, both statements are incorrect. C. No, one of the statements is correct but the other statement is incorrect. 39. Which of the following is closest to the Tarrington Enterprises’ FCFE for 20X1? A. –$55. B. –$32. C. $5. 40. Which of the following is closest to the per share equity value that Hudson should estimate for Wickham Materials? A. $24.24. B. $26.30. C. $29.04. 41. For Royal Homes, which of the following is closest to the present value of the expected FCFE for years 6 onward (terminal value)? A. $12.98. B. $13.78. C. $15.57. 42. Regarding Hudson’s estimate of FCFF based on EBITDA × (1 – tax rate), what is the adjustment she should make for depreciation? A. Depreciation expense should be subtracted out. B. After-tax depreciation expense should be subtracted out. C. The depreciation expense times the tax rate should be added in.
Questions 43 through 48 relate to Fixed Income Investments. Western Teachers Retirement Fund Case Scenario Sharon Summers, CFA, serves as Chief Financial Officer for the Western Teachers Retirement Fund (WTRF), a large pension fund with assets in excess of $5 billion. Summers is responsible for the asset management group, which includes fixed income analysts Ben Sabage and Tonya Williams. Recently, WTRF’s board revised the fund’s target asset allocation, increasing its targeted fixed income allocation range from 15–20% of total assets to 25–30% of total assets. Historically, WTRF has not invested in mortgage-backed securities (MBS). With the newly increased fixed income target allocation, the board has become more interested in MBS because of their higher yields. At its next meeting, the asset management group discusses several possibilities. Williams proposes that the fund purchase a planned amortization class (PAC) CMO. She argues that a PAC has a more predictable cash flow stream than an otherwise similar sequential CMO tranche. Sabage recommends newly issued interest-only (IO) strips from FNMA-backed issues. The proposals regarding these two securities lead Summers to recognize that she, as well as the asset management group, needs to review the characteristics of MBS. Sabage states, “The prepayment rates of the underlying mortgages will significantly affect returns on MBS. The conditional prepayment rate (CPR) and the Public Securities Association (PSA) benchmark rate are considered to be the industry standards for the analysis of MBS. Further, the PSA prepayment rate assumes that the monthly prepayment rate for a mortgage increases over the first few years after an MBS is issued.” Williams adds that “the PSA benchmark is usually the best model for predicting prepayment speeds under various interest rate scenarios.” Summers raises her concerns to Williams about increasing WTRF’s investments in MBS because they have risks that are not present in option-free fixed income securities. Williams responds that the prices of mortgage securities tend to increase less when mortgage interest rates fall than they decrease when mortgage rates rise. Summers is interested in monthly cash flows, prepayment speeds, and the durations of mortgage-backed securities. She realizes that there are additional complexities for PAC and IO CMOs with respect to these issues. Understanding these issues will help her evaluate the purchase of these securities based on her forecast for rising interest rates. Summers must make a decision about adding commercial mortgage-backed securities (CMBS) to the portfolio. She is also investigating the differences between residential MBS and CMBS. Sabage tells her that the primary differences between CMBS and residential MBS have to do with their prepayment risks and in the recourse of the lender in the event of borrower default. Summers asks him to explain how these differences in prepayment risks and lender recourse affect the relative yields of MBS and CMBS.
43. The primary reason that Williams’ claim about PAC cash flows compared to those of a similar sequential CMO tranche is correct is that a PAC tranche: A. benefits from a support tranche created from the same original mortgage pool. B. is a shorter term security and benefits from the prepayment protection period. C. receives all the principal payments up to its face value. 44. Regarding Sabage’s and Williams’ statements about PSA benchmark prepayment rates: A. both analysts are correct. B. both analysts are incorrect. C. only one analyst is correct. 45. Which of the following factors is least likely to influence prepayments? A. Housing turnover. B. Income tax rates. C. Characteristics of the underlying mortgages. 46. In response to Summers’ concerns about risks not present in option-free debt securities, Williams describes which characteristic of mortgage-backed securities? A. Interest rate risk. B. Negative convexity. C. Reinvestment rate risk. 47. Regarding the possible investment in IO strips, it is most likely that Summers would: A. favor them for their negative convexity. B. not favor them because she thinks prepayments will decrease. C. favor them because rising rates will lead to greater total interest rate payments. 48. In response to Summers’ question about CMBS and MBS yields, Sabage should explain to her that the typical differences between them in prepayment risk and in lender recourse will each most likely lead to CMBS yields that, relative to MBS yields, are relatively: Difference in prepayment risk A. higher B. lower C. higher
Difference in lender recourse lower higher higher
Questions 49 through 54 relate to Derivative Investments. Mulroney Case Scenario Tess Mulroney has some experience with options and uses them for both speculation and hedging. As she often uses over-the-counter options, Mulroney typically calculates option values herself before taking any positions at dealer prices. Mulroney owns a $4,000,000 floating rate, annual-pay, 5-year note that pays LIBOR plus a 1.5% spread, and wants to hedge her interest rate risk. She anticipates a fall in interest rates and would like to establish a minimum of 6% on her interest payments. Current 1-year dollar LIBOR is 5%. Mulroney believes that 1-year LIBOR one year from now will fall, with a 40% probability of being 4.5% and a 60% probability of being 4%. Mulroney is also considering a purchase of one-year European style put options with an exercise price of 35 on her Merrill Materials stock, which is currently trading at 38. To check her dealer’s price on these puts, she uses a binomial model with a semi-annual probability of an up move equal to 60% and an up-factor of 1.2. She uses the yield on a 6-month T-bill as the risk-free rate for her binomial model. Mulroney is interested in 1-year calls at 40 on Tyrex Mining shares and compiles the following information: Stock price: $43 Calls@40: $6.15 Puts@40: $2.31 1-year risk-free rate: 3.5% She wonders whether purchasing synthetic calls would be less expensive than purchasing the listed calls. Despite her experience, Mulroney knows she always has more to learn. She reviews some technical material on options that she found on the Internet. Mulroney spends the next hour reading up on sensitivity factors related to option pricing (the so-called Greeks). She finds the relations for exercise prices and asset prices quite intuitive but is not as comfortable with theta, vega, and rho. Mulroney has heard about “dynamic hedging” with options and knows that it has to do with the sensitivity of the option price to changes in the value of the underlying asset. She calls her financial advisor, Ben Glanda, CFA, and asks how a dynamic hedge differs from simply buying puts on her shares if she anticipates extra volatility or believes the probability of share price declines has increased. Glanda tells her that what she is asking about is also called delta hedging and that she can sell calls or buy puts to create a delta hedge. He explains that the deltas are the sensitivities of option prices to changes in the asset value and the “dynamic” part means
that the position must be adjusted over time. He also tells her that delta hedges work better when the gamma of the option used is low. Glanda suggests that for Mulroney’s speculative trades she might consider options on futures or options on forwards to get more leverage and limit her downside compared to direct investment in futures or forward contracts. He is unable to explain the difference between European and American options on futures and forwards but tells Mulroney he will get back to her. 49. If Mulroney wants to earn a minimum of 6% on her 5-year note using interest rate options based on 1-year LIBOR she will: A. sell a series of interest rate puts at 4.5%. B. buy a series of interest rate puts at 4.5%. C. sell a series of interest rate calls at 6%. 50. Assuming the risk-free interest rate for a 6-month holding period is constant at 1.2%, the value of the 1-year put options on Merrill Materials is closest to: A. $3.33. B. $1.38. C. $1.35. 51. Regarding the calls on Tyrex Mining, in order to gain the exposure she wants at the lowest cost, Mulroney should buy: A. the listed calls. B. synthetic calls and save $0.18 on each option. C. synthetic calls and save $0.51 on each option. 52. According to the Black-Scholes-Merton option pricing model, if Mulroney buys calls on Ampex, an increase in the risk-free rate will change the value of the calls in the: A. same direction as an increase in volatility. B. opposite direction to an increase in the price of Ampex. C. same direction as a decrease in the time to expiration. 53. With respect to the role of gamma in dynamic hedging, Glanda should tell Mulroney that: A. at-the-money options work better compared to out-of the-money options. B. longer-term options work better because they have lower gammas. C. out-of-the money options work better because they have higher gammas.
54. With respect to options on futures and options on forwards, Mulroney should be aware that American options are more valuable than European options most likely for options on: A. futures but not for options on forwards. B. forwards but not for options on futures. C. neither forwards nor futures.
Questions 55 through 60 relate to Portfolio Management. Smart Ideas Investments Case Scenario Joyce Calhoun manages stock funds for Smart Ideas Investments, a large money manager in California. She was recently asked to take over the management of three foreign stock funds. Calhoun wants to select some international stocks with growth potential for a new technology mutual fund. She ordinarily uses the standard capital asset pricing model as the starting point in her valuation, but is concerned that the standard model may not be suitable for comparing foreign companies to U.S. companies. Therefore, Calhoun intends to use the international capital asset pricing model (ICAPM), although she is unclear whether additional assumptions beyond those supporting the standard CAPM are necessary to derive it. She is currently considering two U.S. stocks, Clamshell Mining and Monaco Materials. The companies do business only in the United States and Mexico, and Calhoun has determined that the only currencies that matter to these companies are the U.S. dollar and the Mexican peso. The risk-free rate is 5% in Mexico and 3% in the United States. The market risk premium is 9% in Mexico and 4% in the United States. The world market risk premium is 8%. The current spot rate is six pesos per U.S. dollar. A year from now, the U.S. dollar is expected to be worth 5.5 pesos. Below are some data about the stocks. Company Clamshell Monaco
World Beta 0.8 1.6
Currency Exposure (peso) 0.7 1.7
An investment club asks Calhoun to speak on worldwide integration of capital markets. At the meeting, Calhoun makes the following statements about the international flow of capital: “Many people find foreign investing too risky. There are few private investors who operate internationally.” “Many foreign governments do not want U.S. investment, so they make it expensive and complicated for U.S. investors to purchase their securities.” “Sometimes the value of funds invested in foreign countries will decline because of changes in currency rates, even if the local currency value of the investment does not fall.” Calhoun recalls there is likely a model that explains the tendency of a country’s equities to rise in value at the same time its currency is appreciating, but she can’t remember the details.
Calhoun is considering an investment in one of three laboratory equipment makers. Fletcher Scientific, a firm located in Thailand and owned by a British holding company, sells its products throughout Europe and the British Isles. Neuerungen of Germany manufactures in Italy, and its sales are mainly in Britain and Malaysia. Duke of Cornwall produces its own goods in England, and its sales are mainly in Continental Europe, Thailand, and Taiwan. Before selecting one of the stocks for her mutual fund, Calhoun does some research on currency exchange rates, and concludes that: • • •
The Thailand baht and other Southeast Asian currencies are likely to depreciate in real terms relative to the British pound and the euro over the next year. The British pound should appreciate relative to the euro over the next year. Changes in the pound-euro exchange rate should reflect the difference between the inflation rates in the two countries.
55. In order to use the extended CAPM to compare U.S. and foreign stocks, analysts must add to the assumptions of the standard CAPM an assumption that: A. purchasing power parity always holds. B. investors have the same return expectations. C. all investors can borrow and lend at the same risk-free rate. 56. Using the international CAPM (ICAPM), the foreign currency risk premium for a Mexican investor is closest to: A. –10.3%. B. 7.1%. C. 11.1%. 57. Assume the foreign currency risk premium for the Mexican peso is 3%. Based on the ICAPM, the expected one-year return on a U.S. dollar portfolio consisting of 70% Clamshell and 30% Monaco is closest to: A. 14.3%. B. 16.3%. C. 18.2%.
58. Which of the following statements made by Calhoun is least accurate with respect to the international flow of investment funds? A. “Many people find foreign investing too risky. There are few private investors who operate internationally.” B. “Many foreign governments do not want U.S. investment, so they make it expensive and complicated for U.S. investors to purchase their securities.” C. “Sometimes the value of funds invested in foreign countries will decline because of changes in currency rates, even if the local currency value of the investment does not fall.” 59. With regard to the model that Calhoun believes explains the positive correlation between equity returns and currency appreciation, it is most likely that she is referring to the: A. traditional model. B. free markets theory. C. money demand model. 60. If Calhoun’s exchange rate predictions are correct, all else equal, the company values will most likely change in which of the following ways? A. Fletcher Scientific will rise in value, while Neuerungen and Duke of Cornwall will lose value. B. Fletcher Scientific will rise in value, Neuerungen will maintain its value, and Duke of Cornwall will lose value. C. Duke of Cornwall will rise in value, Neuerungen will maintain its value, and Fletcher Scientific will lose value.
