=| Chartered Financial Analyst® CFA’ | LEVELII MOCK TEST FOR 2007 JUNE CFA EXAM For Students in CFA Training Program Only TEST 1-2 ATTENTION: THIS EXAMINATION BOOK 18 USED FOR TRAINING PROGRAM ONLY AND MUST BE RETURNED TO THE PROCTORS AND SECURITY PERSONNEL PRIOR ‘TO LEAVING THE TEST CENTER WITHOUT EXCEPTION.MOCK EXAM 1 MORNING SESSION MORNING SESSION | Topic Question ‘Minutes Ethical and Professional Standards #1--#6 18 Quantitative Methods #7-#12 18 Economics #13-#18, 18 Financial Statement Analysis #19--#24 18 Asset Valuation - Equit (#25—#30. 18 Economics #31--#36 18 Financial Statement Analysis #37--#42 18 Corporate Finance #43--#48 18 Asset Valuation - Equit 49-454 18 ‘Asset Valuation - Derivative #55--#60 1B Total 180 MOCK EXAM 2 AFTERNOON SESSION MORNING SESSION Topic _Question Minutes Ethical and Professional Standards #61--#66 18 Asset Valuation - Eguit; #67--#72 1B Asset Valuation - Debt #73-#78 18 Asset Valuation - Derivative #79--#84 18 Portfolio Management _ 85-490 18 | Bthical and Professional Standards #91496 18 “Financial Statement Analysis #97--#102 18 Corporate Finance _ #103--#108 18 [Asset Valuation - Equity 09-14 | 18 Asset Valuation - Desivative #115--#120 18 Total _ 180Q1-06 Praveen Shankar Case Scenario Praveen Shankar is employed as an analyst for Front Hall Investments (FHI), an asset management firm, Shankar is also a CFA candidate studying for the Level III examination, Based on the past two monthly observations. Shankar observers that auto industry common slocks has strong positive retums when increase in hourly wages were announced, As a result his latest investment strategy report recommends that, in his opinion, adjustments to portfolio holdings of auto industry common stocks should be based on the national labos department's monthly release of ‘hourly wage data, ‘The national labor department was scheduled to release hourly wage data on Thursday, 17 August. However, a clerical error causes the news of a draitatic increase is. hourly wages to be released on the Ishor department’s website on Tuesday, 15 August. Shankar assumes that he is the only analyst who notices the information on the Website, and recommends that FHI’s clients increase their hholdings in auto industry common stocks. in two days, when the wage data was scheduled 10 be released to the public, the prices of auto industry common stocks cise significantly. During the following week, Shankar and FHI receive favorable publicity as a result of ‘his timely recommendation, ‘Norah Pankow, CFA, Shankar’s supervisor, is program director for the local CFA Society. Pankow selects only her own clients as seminar speakers for the society, and she tells Shankar, “ust as I had hoped, the seminars have been very positive for FHI's business.” One of Pankow’s other initiatives for the society is to create a publicly avtilable weblog (blog) on the Internet. The blog’s purpose is to give local society members a forum to discuss matters related in the CFA Program. To help generate discussion among the members, Shankar participates in the blog by listing several of the most recent, unpublished, Level II examination questions nearly word for word. He notes in his blog posting that the questions are from the examination that took place two months earlier. At the end of August, Shankar sits in on a criticized. Shankar states, “ A trustee’s compliance ‘with jions are made.” Pankow the trustee's fiduciary duty is evaluated as of the date the investment de responds, “I believe that a trustee's fiduciary compliance is based on whether the investment tuned out to produce total return that increased the wealth of the trust beneficiaries.” Byrd responds, “I think that both of your view are valid and defensible, and at FHT we have supported either approach depending on the citcunstances.” Impressed with Shankar’s knowledge, Byrd requests that Shankar review FHUs compliance policy ‘and compare it with the CFA Institute Code of Ethics and Standards of Professional Conduct. Two components of FHI’s compliance policy are presented in Exhibit 1. Exhibit 1 Front Hall Investments ‘Two Companents of Compliance Policy1. Employees must not knowing make any misrepresentation related to their investment analyses, recommendations, actions, and other professional activities, 2, Employees must not engage in any dishonest, fraudulent, or deceitful professional professional reputation, conduct, or commit any act that reflects adversely on thei Integrity, or competence. ‘Shankar offers to prepare a list of possible improvements to FHI's compliance policy if he sees that any are needed. As the conversation concludes, Hyrd shows Shankar FHI’s proposed new corporate letterhead, which Byrd says, “will demonstrate our strong commitment to comply with CFA Institute Standards.” Exhibit 2 shows the proposed corporate letterhead. Exhibit 2 Proposed Corporate Letterhead for Front Hall Investments [ Front Hall Investments, committed to the highest standards of practice ‘One month later, Shankar advises Pankow that he will be leaving FHI for a new job. Prior to leaving FHI, at social events during nonworking hours, Shankar approaches two individuals to become clients of his new firm: + Bill Homan oversees the investment of assets for a lange not-for-profit organization. Homan is not a client of FHI, but FHI employees had met with Homan several times over the last three ‘months and were hoping he would hire FHI to manage the large-capitalizatfon value portion of the nonprofit organization’s equity portfolio. "Lin Cheung had recently approached FHI conceming the overall management of an endowment fund. FHI had decided not to accept this fund as a client because of its small size ‘and an investment objective that differed from the expertise and focus of FHI. ‘Question 1 Does Shankat violate any CFAI Standards of Professional Conduct in recommending that clients increase theit holdings of auto industry common stocks? A. No B. Yes, because his recommendation did not have a reasonable basis. C. Yes, because his recommendation did not distinguish between fact and opinion. D. . Yes, because his recommendation was based on material nonpublic information, Question 2 ‘Are Pankow’s selection of seminar speaker and Shankar's blog posting respectively consistent with CPA Institute Standards:Pankow’s selection Shankar's ‘of seminar speakers? blog posting? ANo No B.No ‘Yes C.Yes No D. Yes ‘Yes Question 3 ‘Are Shanikar’s statement and Pankow’s response about fiduciary responsibility consistent with the New Prodent Investor Rule? Shankar's Pankow’s statement response A.No No B.No ‘Yes c. Yes No D. Yes ‘Yes Question 4 ‘Are the two components of FHI’s compliance policy shown in Exhibit 1, consistent with CFA Institute Standards with respect to: cornponent #17 component #2.? A.No No B.No ‘Yes C. Yes No D. Yes Yes Question § Would FHI be in compliance with CFA Institute Standards if it used its proposed new corporate letterhead? A. No, because not all of FHI’s employees are CFA charterholders. B. No, because the CFA logo is not to be used by any firm in its corporate letterhead, CC. Yes, because using the CFA logo in FHI’s proposed new corporate letterhead emphasizes ethical integrity D. Yes, because FHW’s proposed use of the CFA logo meets the standard for using the trademark with dignity and care. Question 6 Did Shankar violate CFA Institute Standards in his discussion with: Homan? Cheung? A. No No B.No ‘Yes C.Yes No D. Yes ‘YesQ7-Q12 Rhonda Hamilton Case Scenario Rhonda Hamilton, CFA, manages the Select Electric Fund, Hamilton is reviewing a research report written by Brian Ender about the U.S. electric utility industry. Ender report includes the regression model and relevant statistics presented in Exhibit 1. The dependent variable for the model is the monthly return for an electric utility equity index for the previous 158 months. The independent variables are the monthly returns for the S&P 500 (S&PSO0) and the difference between the monthly retsras on longterm U.S. government bonds and one-month U.S. Treasury bills (SPREAD). All variables are recorded in percent. Exhibit 1 Ender’s Regression Model Electric Utility Industry variable Coefficient statistic pevalue Constant 0.0069 0018 098 S&PSO0 0.3625 4240 <0.01 SPREAD 10264 «| 7.40 [| <001 R = 0.40 . Durbin-Watson Stati =| 086 Fevalue (2,55) =| 5140 iandard Error of Estimate 450 Ender report concludes that the model is well-specified because its explanatory powe is goad. The report also contains a footnote indicating that confidence intervals for predicted utility equity returns can be easily computed using only the standard error of estimate. Hamilton agiees that S&PS00 and SPREAD are reasonable independent variables, but she is not convinced by Ender conclusions. She computes a X* test statistic of 6.48 (degrees of freedom=2) for «the Breusch-Pagaan test. She then runs a regression similar to that run by Ender and corrects for serial correlation and conditional heteroskedasticity using robust standard errors (ie., Hansen method). Hamilton regression model and relevant statistics are presented in Exhibit 2. Exhibit 2 Hamilton's Regression Model Electric Utility Industry Variable | Coefficient | t-statistic [ p-value Constant | -0.0069 0.013 0.99 S&PS00 0.3625 6.190 | <0.01 READ | 1.0264 4.280 <0 | L__ Rg [= [oao L Durbin.Waison Slatistic [= [ose ~ Comrelaton between SPREAD and S&P500 0.30Hamilton hypothesizes that the returns for the electic ulility equity index have a sensitivity coefficient to bond yields (c., SPREAD) equal to one. She is also interested in the precision of the sensitivity of electric utility equity returns to S&P500. Hamilton wants to use the regression results to address both of these issues. Selected values of the t-distribution, selected X" values, and selected critical values of the Durbin-Watson statistic are shown in Exhibits 3,4, and 5, respectively. Exhibit 3 Selected Values of the t-Distribution ‘(degrees of freedom=df, one-tailed probabilities=p) at P=0.05 100 1.660 110 1.659 120 1.658 200 31.653 +e 1.645 a] Exhibit 4 Selected X? values (degrees of freedom df, evel of significance) I Probability in Right Tail pr | 099 | 09750 | 095 | 09 | 01 | 005 | 0.025 | 0.01 | 0.005 ‘000157 | oonnsee [ 0,003932 | 0.0158 | 2706 [ 3.841 | 5.024 | 6.635 | 7.879 1 2_ | 0.020100 | 0.050636 | 0.102586 | 0.2107 | 4.605 | 59% | 7378 | 9.210 | 10597_ 3_| oatas | 02158 | 03518 | 0.5844 | 6.251 | 7.815 | 9.348 | 11.345 12.838 re 5 0.297 | 0484 | 0071 | 1.064 | 7.779 | 9.488 | 11.143 | 13.277 | 14.860 assa_| 0831 [1145 | 1.610 | 9.236 | 11.070 | 12.832 | 15.086 | 16.750 L_ Exhibit 5 Selected Critical Values of the Durbi 1.05) (aumiber of independent variables=2, sample siz 2 [aw a 80 159) 1.69) 85 1.60) 1.70 0 161 1.70 | 162 ai 100 1.63 i 150 a7 200 IS Question 7 If alpha=0.05, was Hamilton justified in correcting for serial correlation in the regression error terms?A. No, because the calculated value for X”is less than the critical value of 7.378 B. Yes, because the calculated value for X” is greater than the critical value of 5.991 C. No, because the calculated Durbin-Watson statistic is Jess than d), the lower critical D. Yes, because the calculated Durbin-Watson statistic is less than dy, the lower critical value. Question 8 If Hamilton assumes that the monthly values for both SPREAD and S&PS00 are 1 percent, the predicted monthly return for the electric utility equity index is closest to: A. 0.36% B. 1.00% c. 1.03% D. 1.38% Question 9 In assessing how well her regression model explains electric utility equity index returns, Hamilton’s most appropriate conclusion is that: ‘A. 16 percent ofthe Variation in index retoras is explained by the regression model. B. 36 percent of the variation in index returns is explained by the regression model C. 40 percent of the variation in index returns is not explained by the regression model. D. 60 percent of the variation in index returns is not explained by the regression model. Question 10 Based on the results in Exhibit 2, the value of the test statistic relating to Hamilton’s null hypothesis ¥y coefficient to SPREAD is closest to: about the value of the sensi A O11 B. 0.24 C417 D. 4.28 Question 11 Based on the results in Exhibit 2, if degrees of freedom=200, the 95 percent confidence interval for the sensitivity of electric utility equity index returns to S&PSOO is closest to: A. 0.190 0.53 B. 0.22100.50 C. 0.2510 0.48 D. 0.27100.46 Question 12 Because there are only two independent variables in her regression, Hamilton’s most appropriate conclusion fs that multicolineasity is NOT a problem, based on the observation that the: A. mode! R’ is relatively low B. correlation between S&PSO0 and SPREAD is low C. method used for the results in Exhibit 4 also corrects for multicolineartiy D. mocie! F-value is high and the p-values for S&P500 and SPREAD are low.213-018 ‘Renaud Blanc Case Scenario Renaud Blanc is an analyst in the visk management department of De Luca Corporation, a U.S. company that processes fruit and vegetables bought on the world market, Production and sales of packaged fruit juices and condiments occur in the U.S., South America, and Europe. Blane i responsible for making assessments of the relative strength of the U.S. dollar against other relevant currencies, Blanc knows that relative rates of inflation will influence the dollar value of a currency, 0 he forecasts inflation for the U.S. and its trading partners. ‘De Luca buys fruit from Brazil. For the coming year Blanc forecasts annual U.S. inflation of a2 percent and annual Brazilian inflation of 10 percent. The current exchange rate is BRL3/USD (BRL=Brazilian real, USD=U‘S. dollar). The one-year risk-free interest rates in the U.S, and Brazil are 2.25 percent and 18 percent, respectively. One of Blanc colteagues, Paula Smith, makes the following statements: 1. The theory of uncovered interest rate parity allows me to calculate E(S,)/So as being equal to the ratio of the plus the one-year Brazilian interest raté to one plus the one-year U.S. interest rate, when the expected ending exchange rate, E(S:), and the beginning of period exchange rate, Sp are quoted as BRL/USD. NBSP; 2. Exchange rate reduces to inflation uncertainty if all party relationships hold perfectly Smith questions Blanc about whether forward matkets for the Brazilian real give any indication about the expected exchange rate in one year. Blanc responds: Wf the forward rate equals the expected spot rate, then using forward currency contracts to hedge ions) in terms of the expected dollar price that exchange risk would be costless (aside from comm De Luca would pay for fruit Brazil De Luca also purchases finit and packaging materials in Europe. Blanc is considering various ways to hedge against the cost of future material purchases in Europe. For the coming year, he forecasts annual inflation of 4 percent inflation for Europe and 2 percent for the U.S. He believes that uncovered and covered interest parity hold for the U.S. and Europe. Question 13 Based on purchasing power parity, Blanc’s estimate of the exchange rate (BRL/USD) in one year should be closest to: A. 2.60 B. 2.78 C. 324 D. 246 Question 14 Based on interest rate parity, Blanc’s estimate of the one-year forward exchange rate for theBrazilian real (BRL/USD) should be closest to: A. 2.60 B. 2.78 c. 3.47 D. 3.62 Question 15 Is Smith’s statement about the theory of uncovered interest rate parity correct? A. Yes B, No, because the relationship is covered interest parity ‘C. No, because the relationship is relative purchasing power parity. D. No, because the relationship is absolute purchasing power parity, Question 16 Blanc’s best response to Smith's statement about exchange rate risk is that the statement is: A. cottect B. incorrect, because exchange rate risk reduces to real rate uncertainty. C. incorrect, because exchange rate risk reduces to interest rate uncertainty. D. incorrect, because exchange rate tisk is eliminated if all parity relationships hold. Question 17 Is Blanc’s response to Smith about the forward rate and using forward currency contracts correct? AL Yes B. No, because uncovered interest parity must also hold. C. No, because the international fisher effect must also hold D. No, because relative purchasing power parity must also hold. Question 18, If the international Fisher effect holds, based on Blanc’s forecasts, the current one-year risk-free interest rate in Europe should be closest to: A. 0.25% B. 2.25% C. 425% D. 6.25%19-924 Brigitte Langlois Case Scenario Brigitte Langlois, a fixed income securities analyst for Cunard Securities, is responsible for evaluating and monitoring the creditworthiness of companies whose bonds are held in Cunard’s High Yield Intemational Corporate Bond Fund. Langlois bases her buy and sell decisions on a multivariate bankruptcy prediction model that estimates the probability that a company will face insolvency within the next 18 months. As inputs into the model, Langlois uses adjusted, rather than reported, accounting data to calculate a company’s liquidity, solvency, and profitability rai Lanlois and her research assistant, Barclay Kingston, are preparing a research report on Duban Inc., @ U.Sbased company, and Kerwin Corporation, Duban publicly listed Swedish affiliate, to determine whether either company’s intermediate-term bonds would be suitable investments for (Cunard’s bond fund\ Langlois assigns Kington several tasks: Want you to analyze Duban long-term solvency because I an concemed about its obligation to provide pension benefits. Because Duban uses U.S. GAAP while Kerwin uses International Accounting Standards, I want you to prepare an analysis oftheir financial statements Langlois provides Kingston with information about Duban pension plan which is shown below in Exhibit 6 Exhibit 6 Duban Inc Selected Footnote Disclosure Pension Plan Information (U.S. § millions) 2004 2003 ‘Reconciliation of Pension Benefit Oblligation (PBO) Opening Balance $1,606 $1,296 Service cost % a1 Interest Cost 147 131 Plan Amendments 237 Benefits Paid (G48) Gas) Participant Contributions 3 6 7 Closing Balance $1699 | —_—$4,606 2004 2003 Reconciliation of Plan Assets iZ ‘Opening Balance $507 $592, Return on Plan Assets (41) (2) [Employer \contribusions 117 75 Participant Contebutions a | |Benefits Paid (148) (145) Closing Balance $443, $507 Other Information Unrecognized Prior Service Cost 227 250 Expected Return on Plan Assets 46 45 ‘Amortization of Unrecognized Prior Service Cost 3B 2 ‘Amortization of Unrecognized Loss 5 10 Langlois continue to outline Kingston tasks: Daitionslly, J want you to compute the 2004 translation gain or loss on Kerwin assets from the change in exchange rates. Finally, I want you to separate the changed in 2004 operating income into two components: 4: the operational effect, and ‘The exchange3 raté effect due to changes in the Swedish Krona/U‘S. dollar (SEK/USD) exchange rate. Selected information from Duban financial statements, relating to its investment in Kerwin, is shown below in Exhibit 7 Exhibit 7 Selected Information from Duban 2004 Financial Statements Concerning Duban Investment in Kerwin ‘Sweden is an important foreign market for Duban Inc. In-2004, we increased our investment in Kerwin in expectation of strong consumer demand. As indicated below, Kerwin’s 2004 net sales increased by 25% compared with 2003 sales. In addition, Kerwin’s 2004 operating profit increased by 40% compared with 2003 operating profit, as a result of management's tighter control of operating expenses. Kerwin: Selected Financial Data Gn US $ millions) | 2004 2003, Net Sales $5,500 $4,400 Operating profit 3,850 2,750 entifiable assets 3,055 2,350 SKEJUSD Exchange Rate 2004 Year-end rate, 31 December_| 7.2500: ‘Average rate during year 887505: Average of month-end rates Question 19 Based on Exhibit 6, the funded status of Duban persion plan under U.S. GAAP for 2004 ($ 10millions), would be closest to: A. 1,256 liability. B. 681 liability. C. 681 asset. D. 1,256 asset. Question 20 Based on Exhibit 6, the pension expense ($ millions) that would be reported on Duban’s 2004 income staternent under U.S, GAAP would be closest to: A. 187 B. 25 c. 230 D, 317 Question 21 Based on Exhibit 6, Duban's actwal yetura on pension plan assets for 2004 is closest to: A. 9.26% B. 8.09% Cc. 809% D. 9.26% Question 22 Based on Exhibit 7, under US. GAAP Duban’s 2004 translation gain on kerwin's identifiable assets resulting from exchange rate changes (S million) was closest to AnBB2s : B. 980 ©. 1053 D. 7 Question 23 Based on Exhibit 7, the effect of exchange rate changes (exchange rate flow effect) on Kerwin’s 2004 net sales ($ millions) was closest to: A. 141 B. 170 c. 959 BD. 2084 Question 24 Based on Exhibit 7, the operational effect on Kerwin’s 2004 operating income should be computed by multiplying the change in operating income (in SEK) by the: A. 2004 average rate B. 2003 average rate. C. Change in the ending exchange rates. D. Change in the average exchange rates.25.930 Elpo Corporation Case Scenario Stacy Alba and Helen Yang aré analysts in the trust department of a large U.S. bank. They are valuing the common stock of Elpo Corporation, Their valuation process thus far has focused on applying dividend discount and free cash flow models, They have now decided to add the results, given by residual income models including economic value added (EVA) and cash flow return on investment (CFROI) to their reconimendation to the bank Investment Committee. ‘Alba and Yang have spent much time discussing the additional models; considering their advantages, disadvantages, and requirements; and comparing them to the other models they had already used to value Elpo. Early in their discussions, Alba made this statement: ‘VA and return on equity (ROE) are similar in that both measure a firm profitability with reference to ‘the amount and cost of capital ‘Alba later made the following observation: \itially two factors caused concer in selecting a valuation model for Elpo: 1. Elpo pursues a policy of not paying dividends on its common shares. 2, Some changes in Elpo book value have been recorded directly to shareholders? Equity instead of Slowing through the firm income statement. “have concluded that the residual income model readily applies to both circumstances. Therefore, we will not need to make the complicated adjustments that might be required with other valuation models. Yang asked a question After we calculate EVA and CFROT for Elpo, I know we can also calculate the EVA spread and fthe CFRIO spread, But how should we interpret those two measures? ‘Alba and Yang are now valuing the common stock of Elpo, using EVA, CFROI, and other residual income models. Financial information relating to Elpo is given in Exhibit 8i. Exhibit Financial Information Elpo Corporation 7 Total revenue Cost of goods sold 3,710 eneral, and administrative expenses | 5,569 2005 full-year income | _——__—_‘Depreciation expense i statement data US$ Earnings before interest and taxes (EBI) 4178 thousands): [Interest expense 502 |Earnings before axes (EBT) Tax rate Net income 2,426 2005 beginning-of-year Long-term debt $7,282 | financing capital (U.S. $ ‘Shareholders? equity $19,431 thousands): Cost of debt (before tax) 6.90% Cast of equity 9.80% | Capital strneture data: Expected long-term ROE 10.90%, Weight of debt 27.26% ‘Weight of equity 72.14% Question 25 ‘With respect to Alba’s statement about economic value added (EVA) and return on equity (ROE), she is correct in the case of: A. EVA, but not ROE. B. ROE, but not EVA C. Both BVA and ROE D. Neither EVA nor ROE Question 26 ‘With respect to Alba’s observation, is her conclusion about applying the residual income model correct in the case of: Elpo dividend policy? . Changes recorded directly to Elpo shareholders” equity Ae NO No B No ‘Yes c Yes No Ds Yes Yes Question 27 With respect to Yang's question, both of the spread nicasures identified are most accurately interpreted as focusing on the difference between a fiom’s retum on invested capital and that firm's A. cost at equity B. marginal cost of debt. C. expected long-term ROE D, Weighted average cost of capital. Question 28 Elpo’s net operating profit after tax (NOPAT) in thousands for 2005 was closest to: A. $2426 B. $2757 Cc. $2909 D. $3240 BQuestion 29 Elpo’s dollar cost of capital (WACO), in thousands, for 2005 was closest to: A. $1940 B. $2236 ©. $2407 D, $2449 Question 30 Elpo’s residual income, in thousands, for 2005 was closest to: A. $235 B. $522 Cc. $1987 D. $2274 4Case 31-36: Louis Tremblay Case Scenario Louse Tremblay, CFA, is portfolio manager for a global equity fund domiciled in the United States. She wants to add positions in foreign stocks of Canada and Brazil, two countries where there is currently no exposure. Tremblay glaces a call 10 Hall Baroque, the firm’s Economist, to arrange ‘meeting to discuss both his outlook for these economies and some issues related to foreign exchange relationships and intemational asset pricing. During the meeting, During the meeting, Baroque presents the information he gathered in preparation for their discussion, a5 shown below in Exhibit L Exhibit 1 Selected Currency Exchanges and Market Rates Country Currency Spot Exchange Rate* One Risk-free Rate Expected Annual Inflation Rate us. usps NA 4.80% 2.30% Canada. CADS 1.2138-.1.259 4.40% 1.90% Brazil Real 2.3844-2,4082 8.80% 6.30% “Number of foreign currency units per one U.S dollar Baroque begins [his discussion by reviewing some basic relationships that ate useful in understanding the interplay between exchange rates, interest rates, and inflation. He remarks, theoretically, the interest rate differential between two countries should be equal to the expected inflation rate differential over the term of the interest rate. Baroque then discusses the approach he generally uses to model the relationship between seal exchange rate movements and domestic economic activity. He describes how this particalar approach explains bis outlook for the Canadian economy. Baroque states, the traditional trade approach suggests that in the Long-term, a real appreciation in the Canadian dollar relative to other likely to increase Canada’s competitive position and reduce the country’s major world currencies domestic economic activity. His outlook for Brazil’s economy is even less favorable. He explains that in general, the economy of an emerging market tends to have a strongly positive correlation with the value of both their currency and stock markets, Baroque thinks that Brazil’s economic situation will continue to deteriorate along with the value of their currency, which he expects 10 expects ta depreciate by 5% against the U.S. dollar over the coming yeas. Question 31 Given a bid-side quote on the three-month forward contract of CANS1.1986 per U.S. dolla, the three-month forward U.S. dollar is quoted at an annualized: A, 5.00% discount, B, 1.25% discount. C. 1.25% premium. D. 5.00% premium.Question 32 according ton purchasing power parity and based on the spot rate bid quote, the one-year forward exchange rate for the Canadian dollar per U.S. dollar is closest to: A. CADS1.2057. B. CADS$1.2091. C. CADS1.2186. D. CAD$1.2653, ‘Question33 + if a dealer's bid-side quote for the Canadian Dollar/Brazilian Real is CADS0.5250, Tremblay’s profit on 2 USD$4,000,000 initial investment in the triangular arbitrage opportunity is closest to: ‘A. USD$21,135. B. USD$31,315. CC. USD$31,328. D, USD841,609. Question 34 the specific relationship referred to in Mr. Baroque’s remark most accurately describes the: ‘A. international Fisher relation, B. Interest rate party relationship. C. Purchasing power parity relationship D. Foreign exchange expectation relation. Question 35 Regarding Baroque’s description of the traditional trade approach, is he most likely: correct with respect to the suggested effect of an appreciation in the Canadian dollar on the country’s: Competitive position? Domestic economic activity? A No NO B. NO YES c YES No D. ‘YES ‘YES Question 36 -Based on Baroque’s expectations for Brazil's currency, Tremblay’s foreign currency risk premium for the Brazilian Real is closest to: A. 48% 16Case 37-42, Brad Turner Case Scenario Brad Tumer is the Chief Financial Officer of Foster Inc., a non-U.S. based manufacturing ‘corporation that operates internationally and has dual listings on its domestic and a U.S. exchange. Foster has U.$820 billion in fotal assets, with excess cash to invest for a planned acquisition in two years, Information about Foster’s equity portfolio and fixed income portfolio is provided in Exhibits 2 and 3, respectively. All securities were purchased on the first day of the current year, Foster adheres to U.S, GAAP when accounting for its investments in marketable securities. Exhibit 2 Foster Inc. Equity Portfolio (at year end, U.S$ thousands) . Security ee Alton Fac, Barker Ine. Cosmic ine. Darnell Ine. Classification Trading. Available-forsale Available-forsale Equity Method Cost $100,000 $150,000 $250,000 $500,000 beanie? $97,000 $151,000 $257,000 $506,000 end-of-year Dividends received. during $1,000 $2,000 $3,000 $4,000 the yeer Foster's share of investee’s net $5,000 $7,000 $10,000 income ssfor the year arnell Inc. has $2 billion inthe total asses, Foster owns 40 percent of Damell’s equity and hhas representation on Damell’s Board of Directors but dies not have effective control. Note: Exhibits Faster Inc, Fixed Income Portfolio (at year end, U.S $ thousands) " Security Characteristic ygontnc, ‘Fizz ine. GittIne. Harp Tne. Classificaion Trading ‘Available Heldcto-maturity _ Held-o-maturity forsale Cost $20,000 $35,000 $50,000 360,000 Market Value ne "$23,000 $45,000 $45,000 $64,000 end-of year Interest earped for $1 000 2,000 $4,000 $5,000 the year Notes: All fixed income securities were purchased at par value, Turer is interested in understanding the effect of the investment portfolios on Foster’s year-endfinancial statements, Foster is re-evaluating its investment strategy, including whether there has been any change in circumstance that would require a reclassification of certain securities. For turner’s analysis, all ax effects are ignored. Question 37 ‘The contribution of equity portfolio to Foster’s net income for the year is closes to: A. $7,000. 7 B. $10,000 C. $18,000 D. $26,000 Question 38 If all of the equity securities eligible for reclassification had been classified as trading securities, the amount that the entire equity portfolio would contribute to Foster's net income for the year is closest to: A. $8,000 B.. $11,000 CC. $21,000 D. $26,000 Question 39 if Foster accounts for its investment in Darnell by the cost method rather than the equity method, Foster's total assets would most likely decrease by: A. $0 B.. $6,000 . $11,000 D. $15,000 Question 40 If Foster accounts for its investment in Darnell by the proportionate consolidation method rather than the equity method, what are the most likely effects on Foster's: Net income? Retum on assets? A ‘No change Lower B. No change Migher c Higher Lower D. Higher Higher Question 41 ‘At year end, the carrying value of the fixed income portfolio will be closest 10: A. $165,000 B. $168,000 c. $177,000 D. $178,000Question 42 A positive effect om reported net income would most likely occur if Foster had classified: A. both Gilt and Harp as trading securities. B. both Gilt and Harp as available-for-sale securities. C. Gilt as a trading security, and Harp as an available-for sale security D, Gilt as an available-for sale security, and Harp as trading security. 19Cases3-48 Seth Hornsby Case Scenario Seth Homsby, CFA, is an intemal analyst who evaluates proposed capital expansion projects for Huston Oil Delivery, Inc. HOD). HOD is an ollfield-services company with a patented system that has proven successful in bringing oil to the surface more efficiently. Although the system provides excellent results, it requires for the oil delivery system, Hornsby is evaluating two mutually exclusive capital projects. He assumes that either project can be replicated at the end of its expected life, For both projects, all cash flows occurring after the intial project outlay are assumed to be received or paid at the end of each year, HOD uses the same depreciation method for accounting and tax purposes. HOD’s target capital structure is 60 percent ‘equity and 40 percent debt. ‘The first project, detailed in Exhibit 4, would reduce labor requirements by substituting additional machinery for labor in manufacturing the oil delivery system. ‘This project does not increase production capacity, but rather increases HOD’s profit margin. Exhibits Huston Oil Delivery, Inc. Proposed Labor Reduction Project Tnitial project capital outlay $38 million Life of project 3 years Tncrease in net working capital $1 million 50% in year 1 Accelerated depreciation schedule 30% in year 2 20% in year 3 End-of- project salvage value Zero Labor savings, first year $24 million ‘Annual growth rate in labor savings 20% ‘Annual fixed costs $500,000 Tax rate 40% Before-tax cost of debt 12% ‘Company's cost of capital isc nee) Project NPV at 15% saa) $12.25 miliion Project IRR, 33% ‘The second project, detailed in Exhibit 5, would permit HOD to expand productive capacity at its primary manufacturing facility. ixhibit S Huston Oil Deliver, Inc. Proposed Capacity Expansion Project Initial project outlay $60 million 0[tie Project 5S years Expected after-tax cash flows: Year 1 $25 million _ Year? $31 million __| Year 3 3 mil Year 4 $18 million ‘Year S(includes salvage) $13 million ‘Company's cost of capital 15% Project NPV at 15% $17.06 million Project IRR 28% After reviewing Homsby’s analysis, his supervisor, Jon Sanchez, offers the following questions/statements regarding the two projects 1. How would the NPV of the labor reduction project be affected by: 1) an unanticipated increase {n inflation or 2) changing the depreciation method from accelerated to straight-line? 2. I disagree with your assumption that the capacity expansion project is the same level of risk as the company. Expansion projects are generally considered to entail more risk which when reflected in the analysis will increase the NPV. I also have read that Monte Carlo simulation can be used to determine a risk-adjusted discount rate for projects with varying risk relative to the parent company. 3. think we should accept the labor reduction project because it has the higher IRR. Question 43, Regarding the labor reduction project, the total after-tax cash flow for Year 3 § millions) is closest to: A. 15.9 B. 16.9 c. 23.5 D. 24.5 Question 44 Regarding the labor reduction project, increase in accounting income for yeas 1 (S millions) is closest to: A, 101. B. 161. c. 200 D. 270 Question 45 ‘Concermaing Sanchez’s first statement, what is the most likely effect on the project's NPV resulting. from the specitied-changes in: ‘Depreciation method? aA Increase Increase B Increase Decrease c Decrease Increase D. Decrease Decrease Question 46 Concerning his second statement, is Sanchez correct or incorrect regarding: ‘The impact on NPV? ‘Computing a risk-adjusted discount rate? A Conect Conect B Conect Incorrect c Incomect Correct D. Incorrect Incorrect Question 47 Regarding the capacity expansion project, the economic income for year 1 ($ millions) is closest to: A. 206 B. 99 Cc. 116 D. 16.8 Question 48 Concerning Sanchez’s third statement, the most appropsiate decision is to select t ‘A. labor reduction project because its IRR is greater. B. capacity expansion project because its NPV id greater. C. labor reduction project because its equivalent annual annuity is greater. D. capacity expansion project because its equivalent annual annuity is greater. 2‘Lisa McDonald Case Scenario Lisa McDonald and Basil Moore, her research assistant, are valuing the common stock of Coppa Enterprise wsing a residual income valuation approach. To support the valuation, Moore assembles the basic information shown in Exhibit 6. Exhibit 6 Basic Information for Valuation of Coppa Enterprises ‘current book value per share Is $14.00 Required rate of return for common stock is 10% Forecasted net income pes share for each of the next four years is, respectively, $4.00, $4.00, $3.5, and $3.6 . . © Forecasted residual income per share for each of the next four years is, respectively, $2.60, $2.20, $1.50, and $1.50 © Although the firm will be profitable after year 4, residual income is expected to be zer0, ‘After completing and discussing the valuation, MeDonald decides to modify the approach. To facilitate this second valuation, Moore provides the alternative information shown in Exhibit 7. Exhibit 7 Alternative information for valuation of Coppa Enterprises current book value per share is $14.00. ‘Required tate of return for common stock is 10% Forecasted retumn on equity (ROE) for each of the next four years is, respectively, 40%, 30%, 25%, and 20%. © Annual dividends per share will be $1.00 each year for the next four years. @ Although the firm will be profitable after year 4, residual income is expected to be zero. After completing the second valuation, McDonald and Moore discuss other factors that may affect the valuation of Coppa Enterprise. Specifically, Moore expresses concern about valuing the firm if residual income is positive beyond the four-year time horizon specified in Exhibits 6 and 7. Moore suggests that McDonald dsop the assumption that residual income after year 4 is zero and replace it with an assumption that the terminal stock price (at the end of year 4) is $38. Moore wonders how this would affect the valuation estimate of Coppa Enterprises. McDonald also has other questions. She wants to know the relationship between a firm’s residual income and financial ratios, such as the price/éamings (P/B) ratio or price/book value (P/B) ratio. Finally, she wants to know the effect of several accounting issues on residual income model valuations. ‘Their discussion concludes with a statement by Moore: Fortunately, using a residual income valuation approach requires us 10 identify only a few key determinants. Off-balance sheet items such as pension liabilities, operating leases, and special purpose entities do not enter into the residual income calculation. Similarly, we do not have to adjust book value, one of the key determinants of residual income’s complex items, such as currency translation adjustments that are akeady reflected in comprehensive income. We do need to be 23careful, however, to recognize that the terminal value is very important in determining the result of any residual income model and also that residual income models are not applicable to companies that have negative free cash flow. Question 49 Using Exhibit 6 and the residual income valuation model, the value pet share of Coppa Enterprises ‘common stock is closest to: A. $1891 B. $2033 ©. $21.59 D. $26.03 Question 50 Using Exhibits 7, the residual income for Coppa Enterprises in year 1 is closest to: A, $4.20 B. $4.60 c. $5.20 D. $5.60 Question st Using Exhibits 7 and the residual income valuation model, the value per share of Coppa Enterprises common stock is closest to: A. $22.25 B. $25.42 C. $28.71 D. $31.88 Question 52 If McDonald accepts Moore’s suggestion to change the assumption about residval income after year 4 and uses alternative information set in Exhibit 7, the most likely effect on the estimated value of the stock is a per share increase of: A. $3.71 B. $1639 Cc. $24.00 D. 25.05 Question 53 In the residual income valuation model, if residual income is positive, McDonald should expect that the ratio of the market value of the firm to the book value will most likely be: A. less than zero B. greater than zer0 C. less than 1.0 D. greater than 1.0 PyQuestion 54 With respect to the residual income valuation model, is Moore correct or incorrect in his statements Pension liabilities? Special purpose entities? A. Comect Correct, B. Correct Incorrect c Incorrect Correct D. Incorrect, Incomrect 25Case 55-60 Erica Huang Case Scenario Erica Huang is a derivatives trading advisor for Eastern Funds Company, with expertise in forward and futures markets and contracts. She assists Eastern’s portfolio managers to evaluate forward and futures contracts and to make appropriate decisions when use of these derivatives is warranted. ‘When working with the portfolio managers, who have varying levels of expertise on derivatives, Huang is asked for input on issues of both an analytical and conceptual nature. Managers have also expressed frustration at trying to remember the various day-count conventions used in forward and futures pricing. There managers have approached her with the situations described below. Some of her responses to the portfolio managers rely on the financial market information given in Exhibit 8 below. Exhibit 7 _ Financial Market Information USS. three-month (90-day) annualized Risk-free Rate 6.00%" USS. Continuously Compounded Six-month (180-day) Annualized 5.83% Risk-free Rate Broad Equity Index Level 1,250.00 ‘Broad Equity Index Continuously Compéunded Annualized Dividend 3.00% ‘Japanese Three-month (90-day) Annualized Risk-free Rate 1.00% Japanese Yen Spot Price ¥112.008 -Manager A, an equity manager, has two concerns: 1) Six months ago, to hege against the expected decline in the value of a common stock in which he held 100,000 shares, he entered inte « forward contract to sell the underlying stock at a price of $80. the forward contract has three months to expiration and the stock is trading for $75. he wants to know the value of his current position on a per share basis.2) He expects equity to go up and would like to take a long position in a 180-day forward contract on the Broad Equity Index, which a dealer has priced at 1,285.88. He wants 10 know whether the forward contract is fairly priced. -Manager B runs Easterm’s Global Fund. The fund recently held a special shareholder’s meeting during Which the use of derivatives for hedging purposes was approved. Consequently, knowing that she will receive a yen dividend payment in 90 days, she wants to know at what forward price she can sell yen for dollars. She also wants to test her understanding of the different types of forward contracts and makes the following remark: Telieve that standard forward contracts usually have initial value of zero while off-market forward contracts have a non-zero intial value -Management C is in charge of a fixed income portfolio and asks the following questions: 1. So I understand correctly that, to prevent arbitrage, the futures price must converge to the spot price at expiration and, because marking-to market, the future contract has zero value during its life. 2%2. Am I correct in believing that storage costs and any convenience yield act to increase the future price while any cash flows from the underlying asset act to decrease the price. Question 55 Using a 360-day year, the value of Manager A’s short position in the stock forward contract is closest to: A. $3.84 B. $2.70 Cc. $2.70 D. $3.84 Question 56 Using a 365-day year, Huang’s most appropriate response to Manager A with regard to the Broad Equity Index forward contract is that the contract is: A. fairly priced, B. Not fairy priced, because the no-arbitrage price should be 1,267.57 C. Not fairly priced, because the no-arbitrage price should be 1,268.63. D. Not fairly priced, because the no-arbitrage price should be 1,305.64 Question 57 ‘Using a 365-day year, the 90-day yen/dollar forward price should be closest t A. ¥ 106.728 B. ¥110.67/$ c. ¥1334 D. ¥117S4/$ Question 58 Regarding Manager B’s remarks, is she correct with respect to the initial value of ‘Standard forward contracts? Off-market forward contracts? A. No NO B. NO YES c YES NO D. YES YES Question 59 Is Manager C correct or incorrect with respect to the: Convergence of spot and futures prices at expiration? Zero value of futures contract during it life? A. Conrect correct B. Correct incorrect C. Incorrect correct D. Incorrect incorrect Question 60 ‘Huang's most appropriate response to Manager C’s second question is that storage costs: 2increase the futures price, while a cash flow from the underlying asset and any convenience yield decrease the futures price. increase the futures price, and that a cash flow from the underlying asset and any convenience yield also increase the futures price. decrease the futures price, while ’a cash flow from the underlying asset and any convenience yield decrease the futures price. decrease the futures price, and that a cash flow from the underlying asset and any convenience yield also increase the futures price. 28261-066 CVG Case Scenario CVG is regional investment firm that provides investment banking and brokerage service. The firm hhas a small investment research staff and has recently adapted the CFA Institute Research Objectivity Standards including both the required and recommended policies and procedures. Andrei Kepsh is a junior research analyst at CVG. The director of research has assigned Kepsh to initiate coverage on & local biotechnology company, GeoTech. CVG owns and makes a market in GeoTech shares. CVG recently participated in the selling group, but was not an underwriter, for GeoTech’s inital public offering (IPO). Kepsh was not personally involved in the sale of the IPO. ‘As part of his research, Kepsh meets with GeoTech’s director of investor relations, Nits Olsen. ‘Two weeks later, om 2 May, Kepsh gives Olsen a copy of his completed GeoTech report containing a “buy” recommendation, and asks Olsen to correct any misstatements of fact before the report is « released to CVG’s clients. The next moining, Kepsh sends a copy of the GeoTech report to CVG's investment banking department, and requests @ review of his report for any conflicts of interest ‘before itis released to CVG’s clients on 5 May. On 5 May, Kepsh has lunch with Gentura Hirai, one of CVG’s senior analysts. Hirai explains the CFA Institute Research Objectivity Standards and CVG’s policies and procedures regarding research reports and recommendations. Hirai states that CVG requires that reports be updated annually, or ‘more frequently if there is substantive new information on the subject company. Also, because the research staff is small, CVG initiates coverige based on availability of the analytical staif end is of expected market attraction. Discontinuance of prioritizes companies to be covered on the bi coverage is on the same basis, with a final report sent to clients if staff time permits. After the appropriate waiting period, Kepsh purchases GeoTech shares for his personal account, On 11 May, Kepsh is one of the speakers at a biotechnology investment conference that is open to the public. By the time Kepsh presents his report on GeoTech, the conference program is behind schedule, To save time, Kepsh summarizes his report and recommendation and does not make any disclosure statements. ARer the presentation, a conference participant requests a copy of his report. Kepsh responds that the report is available to any member of the audience for @ nominal fee. (On 25 May, Kepsh sells shares of GeoTech 10 pay for a wedding anniversary gift for his wife. In the future., Kepsh expects that, based on CVG’s bonus policy, he will receive large bonuses’ from increased investment banking fees and brokerage commissions attributable to his recommendations. Question 61, 61: In giving his report to Olsen, does Kepsh comply with CFA institute Research objectivity ‘standards? A; No, because the report contained his recommendation. B: No, because no part of a research report can be shared with the subject company prior to »publication, C: Yes, because he submitted copy to the director of research. Ds Yes, because he asked Olsen to correct any misstatements of facts. Question 62 62: Does Kepsh's interaction with the investment banking department comply with CFA. Institute Research Objectivity Standards? A: Yes. : No, because he is prohibited from any contact with the investment banking department. : No, only because the investment banking department has been provided with the report containing the recommendation. D: No, both because the investment banking department has been provided with the report containing the recommendation, and because he does not direct the report through the compliance department, Question 63 63: Do CVG’s policies regarding the updating of reports and discontinuance of coverage; respectively, conform with CFA Institute Research Objectivity Standards? Updating of reports Discontinuance of coverage A No No B: No Yes G Yes No G Yes ‘Yes Question 64 64: Tobe in compliance with CFA Institute Research Objectivity Standards, Kepsh must inform. the conference audience about all ofthe following, except. A: CVG’s ownership of GeoTech shares. ‘B: Kepsh’s ownership of GeoTech shares. C: CVG's making a market in GeoTech shares. D: CVG's participation in the selling group for the initial public offering of GeoTech. Question 65 65: Does Kepsh’s response to the conference participant’s request for a copy of the GeoTech -eport conform to CFA Institute Research Objectivity Standards? Ar Yes B: No, because CVG should provide its research reports only to its clients. : No, because CVG should provide research reports at no charge to all members of the audience. D: No, because CVG should provide research reports at no charge to those members of the 0audience requesting a copy. Question 66 66: Are Kepsh’s sale of shares and CVG’s bonus policy, respectively, in conformity with CRA Institute Research Objectivity Standards? Sale of shares Bonus policy A No No B: No Yes G Yes No D: ‘Yes Yes at67-972 ‘Chan Mei Yee Case Scenario Chan Mei Yee is valuing Mclaughin Corporation common shares using a free cash flow approach. She assembled information about McLaughlin from several sources. She begins her analysis by estimating free cash flow to the firm (FCFF) and ire cash flow to equity (FCFE) for the 2006 fiscal : ‘year, using the financial statements in Exhibits 1 and 2 and other financial information contained in Exhi 3. McLaughlin fiscal year ends 31 December. ‘MILaughlin Corporation Selected Financial Data (ailtions, except per share amounts) For Year Ending 31 December 2006 Revenues $6,456 Cost of goods sold 3368 Selling, gencral, and administrative expense 4744 Easnings before interest, taxes, depreciation, and amortization(EBUTDA) 1,349 Depreciation expense 243 ‘Operating income 1,106 Interest expense 186 Pretax income 920 Income tax 294 Net income $626 Number of outstanding shares (mi au 2006 Earnings per share $1.52 2006 Dividends paid (millions) suas 2006 Dividends per share $0.36 2006 Fixed capital expenditures (millions) $535 Exhibit 2 // McLaughlin Corporation Consolidated Balance Sheets Gaillions) At31 December 2006 2005 Cash and cash equivalents $32 $21 Accounts receivable 413 417 Inventories 709 638 Other current assets 136 123 Total current assets 1,290 1,199 Long-term assets, net 4817 4522 Total assets $6,104 $5,721(Current liabilities $2,783 $2,678 Long-term debt 2,249 2,449 ‘Common stockholders? equity 1072 594 ‘Total liabilities and stockholders’ Equity $6,104 $5,721 Chan plans to perform two different valuations of McLaug! Valuation and the alternative Valuation. Critical assumptions for each are given in Exhibit 3 and the information below. 1, which she callg the base case Exhibit 3 Other Currént Financial Information for McLaughlin Corp. Effective tax rte 32.0% Cost of equity 12.0% Weighted average cost of capital 9.0% Non-operating assets $0 ¢ case valuation © 2007 FCFF will be $600 million © FCEF will grow forever at 4 percent annually © The market value and book value of McLaughlin long-term debt are approximately equal Alternative valuation © 2007 eamings per share (EPS) WILL BE $1.80 © EPS will grow forever at 6 percent annually. © For 2007 and beyond © Net capital expenditures (fixed capital expenditures minus depreciation) will be 30 percent of EPS, © - Investments in working capital will be 10 percent of EPS © 60 percent of future investments will be financed with debt. Chan is also concemed about the effects on McLaughlin 2007 FCFF of three possible financial actions by McLaughlin: © Increasing common stock cash dividends by $110 million, © Repurchasing $60 million of common shares. © Reducing its outstanding long-term debt by $100 million, ‘Melissa Nicosia, Chan supervisor, reviews the McLaughlin valuations. Nicosia states that the free cash flow valuation approach is superior to the discounted dividend valuation approach because the company dividends have been substantially different form its FCFE. Nicosia also slates that because the company capital structure seems unstable, the FCFE valuation approach is superior to the FCFF valuation approach, Question 67 3‘McLaughlin's FCFF for 2006 was closest to: A. $460 million B. $474 million C. $485 million D. $545 million Question 68 ‘McLaughlin's 2006 FCFE was less than its 2006 FCEF by an amount closest to: A. $74 million B. $126 million C. $326 million D. $386 million Question 69 Using Chan’s base case valuation assumptions and the FCFF valuation approach, the year-end 2006 value per share of McLaughlin common stock should be closest to: A. $18.25 B. $23.73 Cc. $24.89 D. $29,20 Question 70 Using Chan’s alternative valuation assumptions and the FCFE valuation approach, the year-end 2006 value per share of McLaughlin common stock should be closest to: A. $18.00 B. $22.80 ©. $24.17 D. $25.20 Question 71 The combined effect of the three possible financial actions is most likely to result in a decrease in ‘McLaughlin’s 2005 FCFE OF A. $100 million B. $160 million . $170 million D. $270 million Question 72 Are Nicosia’ explanations correct with respect othe: | Free cash flo w valuation approach being FCFE valuation approach | supetir to the discounted dividend valuation | being superior to the | approach? FCF valuation approach? A No No = (s No Yes — 34No fe073-078 Arnold Barker Case Scenario ‘Amold Barker is an analysis at BAYCON Investments. He has been asked to revise BAYCON’s credit analysis process for corporate fixed income securities. This credit analysis process is the basis, for the selection of individual bonds for BAYCON Investments fixed-income portfolios. Hank Su, Barker’s Supervisor, comments that one limitation of the current credit analysis process at BAYCON is that it only provides an estimate of a bond's default risk, He asks Barker to expand the spread ‘credit analysis process to provide an estimate of a bond's Credit spread risk. Su defines cre tisk as follows: Credit spread risk is the risk that the issuer will fail to satisfy the terms of the bond with respect to payments. In addition, Su believes that the current credit analysis process focuses too much on character, collateral, and covenants, and not enough on capacity. In response to Su's Observation, Barker develops @ quantitative debt-capacity model to assess the capacity of an issuer to meet its obligations, His debi-capacity model is based on the issuer's profitability, debt coverage, and cash flow analysis. Barker decides to use the model to evaluate Haynes Industries, a recent javestment-grade bond issuer. To calculate the inputs to the debt-capacity model, Barker gathered selected financial data, displayed in Exhibit 4, on Haynes Industries. Barker also decides to look at several key ratios used by Standard & Poor’s and other credit analysts, including coverage ratios, solvency ratios, and funds form operations/totai debt. Exhibit 4 Selected Financial Data for Haynes Industries (in millions) [Income Staterment Items 2004 2003 EBIT $18,100_|, $16,600 ‘etincome ftom continuing operations | 5,186 4352 Depreciation & amortization 1,703 1,693, [Other non-cash charges | 783 | 290. Tnterest expense 1,740 4,850 Income tax rate 31% 31% Balance Sheet Items Current assets ‘Accounts payable | 5512 (Current maturities of long-term debt 2172 Long-term debt 11,475 Lease debt equivalent __|__500 Shareholders’ Equity 16,646 Working capital 984 36‘Other Items Dividends paid 2,246 2,095 {Capital expenditures 1,482 1,679 Ed Dawson, a fixed-income reseasch manager at BAYCON, has reviewed Barker's debt-capacity ‘model and makes the following statements about the model’ applicability to high-yield bonds, asset backed securities, and municipal bonds: 1. For the model to be useful for high-yield issues, it must consider the entire debt structure of the issuer. For example, high-yield issuers rely to a greater extent on bank debt than investment-grade issuers, 2. While the model has limited applicability in the assessment of the credit of asset backed securities, it can be used to evaluate the quality of the servicer. However, it cannot be used. to assess the underlying collaterals ability to generate cash flows. 3. the credit analysis of municipal tax-backed bonds should involve assessing the issuer's: © debt structure, © ability and political discipline to maintain sound budgetary policy, © Socal tax base and intergoveramental revenues available, and © flow of funds structure. Question 73 Su’s definition of credit spread risk is most appropriately characterized as: AL correct B. incorrect, because credit spread risk isthe risk that a bond's price will fall when the bond’s risk premium increases while the yield on a similar maturity Treasury bond falls. C. incorrect, because credit spread risk isthe risk that a bond's price will fall when the bond’s risk premium decreases while the yield on a “Treasury bond rises. D. incorrect, because credit spread risk isthe risk that a bond’s price will fall when the bond’s risk premium remains constant while the yield on a simular maturity Treasury bond. Question 74 the funds from operations/total debt” ratio for Haynes Industries for 2004 was closest ta: A. 50.5% B. 52.4% C. 54.2% D. 63.5% Question 75 For 2004, compared with 2003, did Haynes Industries have an increase or decrease in: Interest coverage? Short-term solvency? A. Increase Increase B. Increase, Decrease 3C. Decrease Increase D. Decrease Decrease ‘Question 76 Given the debt structure described in Dawson's first statement, the factor that is least likely to affect the creditworthiness of the high-yield issuer isthe : A. ability to refinance, B, Impact of sale of assets. C. Presence senior bonds in the debt structure. ‘D. Impact of changes in short-term interest rates. Question 77 Regarding Dawson's second statement that refers to asset-backed securities, is he correct or incorrect in describing the model's ability Evaiuate the quality of the servicer? Determine the ability of the ability of the underlying collateral to generate cash flows? A Conrect Comrect B. Conreet Anconrect c Incorrect correct D. Incorrect Incorrect ‘Question 78 Dawson’s third statement is least accurate with respect to the issuer’s: A. debt structure, B. Flow of funds structure. C. Local tax base and intergovernmental revenues available D. Ability and political discipline to maintain sound budgetary policy. 389-084 ‘Walter Speckley Case Scenario ‘Walter Speckley isa high net worth individual who has recently relocated permanently from Europe to the United States. Speckley has sold his European properties and will receive €10 million proceeds 180 days from now. the terms of the sale require him to keep the funds in escrow for an additional 180 days after receipt. He intends to invest the escrowed funds in a 180-day euro-denominated money market instrument, When the escrow period ends 360 days from now, Speckley intends to convert these funds to U.S. dollars and buy stock in the first Bank of Kanata (FBK), @ small regional U.S. bank that he has identified as an attractive investment opportunity. (FBK stock is priced in U,S. dollars, and the company will pay a dividend of $ 5.00 per share 180 days from now). 1. yield he will receive on his euro-denominated money market investment 180 days from ‘exchange rate he will receive 360 days from now when he converts his funds from euros to US. dillars. 3. purchases price of FBK stock now, because he expects the stock price to increase in the future, To accomplish these objectives, Sprckley plans to use forward contracts. Exhibit 5 describes the transactions proposed by Speckley. Exhibit 5 Time-line of Events Now 180 Days from Now 360 Days from Now Cash Transactions Property sale proceeds received £€10,000,000received Euro-denominated money market investment €10,000,000 invested investment matures Euros converted into U.S, dollars dollars reoelved FBK stock purchase (in U.S. dallars) stock purchased Dividend paid on FBK STOCK $5.00per share Derivatives transactions Euribor forward rate agreement contract entered contract matures Forward currency contract contract entered contract matures Forward contract on FBK stock contract entered contract matures Speckley approaches Wing & Partners, a private investment bank, to obtain price quotes on the 9various forword contracts needed. Iling & Partners bases the price quotes on the information in Exhibit 6 Exhibit 6 Current Forward Contract Pricing Information 180-day Buribor 2.50% 360-day Euribor 3.50% 180-day U.S. yield 3.00% 360-day U.S. yield 3.00% Dollars per one Euro $1.25 Price per share of FBK stock $100.00 Howard DUNN, an analyst at Iling & Partners, tells Speckley that using currency futures contracts, ‘will be more profitable than using forward currency contracts. Dunn notes that Speckley’s Investment objectives requite converting euros ‘© dollars, and tells Speckley that the current exchange rate on the 360-day forward currency contract will buy fewer dollars per Euro than could be bought at the current spot exchange rate, When Speckley asks why, Dunn replies: The exchange rate is quoted as the price of one exo in U.S. dollars. The 360 day forward exchange rate is lower than the current spot exchange rate because the price of the forward currency contracts will need to reflect the fact that 360-day U.S. interest rates are lower than 360-day European interest rates, Question 79 Based on the information in Exhibits 5 and 6, the price of a 6*6 Euribor forward rate agreement (FRA) should be closest to: A. 0.0222. B. 0.0300. c. 0.0444 D. 0.0600. Question 80 ‘Based on the information in Exhibits 5 and 6, the price of a 360-day euro forward contract should be closest to A, $1.238 B. $1.244 c, 81.250 D. $1.256 Question 81 ‘Bosed on the information in Exhibits 5 and 6, the price of a 360-day forward contract on FBK stock should be closest A. $97.93 0B. $98.07 ©. $103.00 D. $108.07 Question 82 Dunn’s suggested strategy for using currency futures contracts is unlikely to have any advantage over using a forward currency contract because the currency futures contract wi A. reflect normal contango B. reflect normal backwardation . buy am equal number of dollars D. indicate the presence of risk premia Question 83 Dunn’s explanation of the difference between the 360-day forward exchange rate and the current spot exchange rate is : A. correct B. incorrect, because it ignores future movements in the spot exchange rate, C. Incorrect, because it ignores the fact that 180-day U.S. yield is higher than the comparable Euribor. BD. Incortect, because the forward exchange rate will be higher when U.S. interest rates are lower «than European interest rates. Question 84 In 360 days when the forward contracts matuie, the market value of the euro forward contract is ‘$149,000 and the market value of the forward contract on FBK. IS $263,000. the credit risk from Speckley’s perspective is: Euro Forward FBK Forward AL 80. $0 B 30. $263,000 c $149,000 $0 D. $149,000 $263,000 on985.90 Karl Schmit Case Scenario Karl Schrnit, an investment advisor with CHT Advisors, is meeting with a new client, Dr. Albert Amin, an orthopedic surgeon. They are discussing the imminent transfer of Amin’s account to CHT. ‘Amin expects to retire one year from ow at age 62. his investment portfolio is currently valued at $5 million and is divided equally among publicly-traded equities, private equity, and real estate partnerships. For his lifetime, Amin will receive inflation-adjusted payments, currently $100,000 per ‘year, of royalties from the sale of a patent on medical devices that he invested. Upon retirement, Amin intends to establish a $1 million trust fund for the education of his grandchildren. Within the first year of his retirement, Amin and his wife expect to purchase for cash ‘a second home in a resort area at an estimated cost of $5000,000 and to pay off the $300,000 ‘mortgage on their principal residence. Their annual living expenses in retirement are estintated to be {$250,000 in 2007 dollars. Schmit has estimated that Amin will be subject to a 35 percent tax rate on all income and capital gains once he retires. Schmit has prepared Exhibit 7 to summarize Amin’s Retirement funding requirements. Exhibit 7 Dr. Amin’s Retirement Funding Requirements ‘At reticement: Trust fund for grandehisdren $1,000,000 Within first year of retirement: Purchase of second home $500,000 Pay off mortgage $300,000 Annual living expenses in 2007 dollars $250,000 Schmit has also calculated an annual spending rate for Amin of 5.78 percent, He defines the spending rate as Amin’s annual living expenses minus the after-tax royalty income that he will receive divided by the net assets available for investment after establishing the trust fund and completing the purchase of the second ome and paying off the mortgage [8250,000-100,000"(1.00-0.35)}/($5,000,000-1, 800,000), Amini tells Schmit that in retirement, he does not want to be exposed to wide variations in the market value of his portfolio. He is especially concemed about minimizing the damage form negative returns in any annual period. He also does not want fo worry about not having enough money for living expenses after paying taxes and adjusting for inflation. Amin asks Schmit about CHT’s forecast of the investment return for various asset clases, the rate of inflation, and tax rates. Schmit has summarized that in Exhibit 8 Exhibits CHT Projected Investment, Inflation, and Tax Enviroment Asset Classes Expected Average Annual Returns ‘Treasury Bills 3.5% 2Bonds (Investment Grade) 50 Equities-Public 90 Equities-Private 160 Real Estate 10 Expected Annual Rate of Inflation=3,0% Expected Tax Rate Range=40 - 15%, depending on tax bracket CHT does not prepare investment policy statements but instead offers clients four different portfolios. Each client is asked to select the portfolio that best reflects her/his risk tolerance and return objectives. Amin intially selects the portfolio that contains a conservative mix of bonds and stocks, because it will provide the most current income, Schmit suggests that Amin consider a slightly more aggressive portfolio in view of his age and life expectancy, which is at least 20 years based on his health and family history. Schmit has calculated an annual total required retum objective of more than 13 percent for Amin based on his cash flow consideration in his caleulations. ‘The next day Amin tells a colleague, John Duncan, about his meeting with Schmit, During the course of the discussion, Duncan makes the following statement to Amin: ‘You should insist that Schmit prepare an investment Policy statement that will document your particular objectives and constraints. You should also insist Amin makes a note to discuss an investment policy statement and asset allocation with Schmit st their next meeting, (Question 85 At the of his retirement, which of the following best characterizes Amin’s: “Tex concerns? Liquidity requirements? ‘A. Significant Significant B. Significant Insignificant Insignificant Significant Insignificant ‘Qne year after etitement, which of the following best characterizes Amin’s liquidity risk on the: Asset side? Liability side? A Significant Significant B Significant Insignificant c Insignificant Significant D. Insignificant Insignificant ‘Question 87 With respect to risk tolerance at the time of his retirement, which of the following best charactetizes Amin’s: Ability to take risk? ‘Willingness to take tisk? A. Below average Below average B. Below average Aboye average aC. Above average Below average D, Above average Above average Question 88 Given Amin’s concems regarding negative returns, the most appropriate measure of sisk for his portfolio is: A. value at risk B. tracking risk CC. standard deviation D. economic factor risk Question 89 Which of the following best characterizes Amin's: Return objective? Overall risk tolerance? A. Below average Below average B. Below average Above average C. Above average Below average D. Above average Above average Question 90 If Schmit follows Duncan's advice regarding an appropriate: strategic asset allocation, the most appropriate factor to combine with Amin’s investment policy statement is the : A. investment strategy B. investment specifications C. capital market expectations D, maximal and minimal permissible asset class valuesCase 91-96 Maria Santoyo Case Scenrio Maria Santoya, CFA is a portfolio manager for Superior Investment Management(SIM). SIM currently claims compliance with CBA Institute Soft Dollar Standards, Santoya receives a call ‘from Juan Garza, a new client of SIM. He asks about letter he reccived from SIM stating, with respect to the Juan Garza Personal Account, any soft dollar arcangements. comply with the mandatory provisions of the CFA Institute Soft Dollar Standards. He wants to know how these Standards affect SIM’s decisions regarding what products and services they include in any soft-dollar arrangements, Santiya explains to Garza that in determining whether to use client brokerage to pay for research, the Standards require that the investment manager use certain criteria, including: Criteria 1: the primary use of the product or service must directly assist the investment manager in the decision-making process; Criteria 2: the manager must be able to atribute the benefit af the product of service to each client whose brokerage is used to pay for that befit. Garza wants to request that all trades for his personal account be directed to his sister, who is a ‘broker, incorder to take advantage of her firm's commission recapture program which would provide cash benefits payable directly to Garza. Santoya remarks, the Standards do not prohibit this practice and we will certainly honot your request, however, I should inform you of two important facts: Fact one, as your investment manager, tis my duty to continue to seek to obtain best execution, Fact two, arrangements that require me to commit a certain percentage of any client’s brokerage -ay aifect my ability to seek to obtain best execution and adequate research, ‘Later that week, Santoya meets with Max Baza, who has been a client of SIM for more than twenty years. When Baza initially signed up with SIM, Santoya structured his portfolio with mostly equities in order to meet his portfolio with mostly equities in order to meet his high-growth investment objective, This investment objective was initially agreed upon and outlined in a letter to Baza at the beginning of his relationship with SIM and has aot changed over the years. ‘During the meeting, Baza mentions that he retires from his job last year and is concemed about the recent low returns in his portfolio. Santoya explained that early last year, she decided to reallocate a large portion of his account out of equities and into bonds because she suspected he was approaching retirement age and wanted to increase the amount of income generated in his account in anticipation of his needs for additional cash flow. Baza was satisfied with her explanation and impressed that she would consider this since they hada’t Spoken in the last several years. Baza also asked about a small-position of a technology stock that showed up on his statement not Jong ago and had almost doubled in price, Santoya stated, that investment was part of an oversubscribed issue in which performance-based fee accounts received first priority. The trade was 45in accordance with SIM’s trade allocation procedures, which are disclosed to our clients in advance of any trading activity. Baza responds that he is happy with the asset-based fee arrangement he has ‘with SIM and will be content to receive any allocation of these types of securities in the future. Question 91 ‘According to the CFA Institute Soft Dollar Standards, the statement that Garza received in his letter from SIM: A. is recommended, but not required. B. Is required because SIM claims compliance. C. Is requited only if itis specifically requested by the client, D. Isneither required nor recommended because compliance With the Standards are voluntary. Question 92, Regarding her explanation (o Garza about the criteria used to determine whether to use client brokerage to pay for research, is Santoya correct with respect to: Criteria 22 no yes yes ‘Question 93 In honoring Garza’s request, is Stantoya violating any CRA institute Soft Dollar Standard? A. no BB. yes, because itis her duty to seek to obtain the best execution C. yes, because client brokerage must be used for research services D. yes, because it may affect her ability to obtain best execution and adequate research Question 94 regarding the facts relation to the practice of clientdirected brokerage, according to the CFA Institute Soft Dollar Standards, which of the following most appropriately describes Santoya’s responsibility to disclose: Fact one? Fact two? A. required required B. required recommended . recommended required D. recommended recommended Question 95 In reallocating Baza’s portfolio, did Santoya violate any CFA Institute Standards? AL yes B. no, because she had a reasonable and adequate basis forthe reallocation C. no, because she made full disclosure ofthe change to Baza during their meeting D. no, because the change in allocation is more suitable to Baza’s current objectives. 46Question 96 Is Santoya’s method of allocating oversubscribed issues consistent with CFA Institute Standards? ‘A. no, because she did not obtain Baza’s approval in writing BB. no, because the trade allocation procedures were not equitable C. yes, because firms may offer different levels of service for different levels D. yes, because she made full and fair disclosure and is in compliance with her employer's policy and procedures. aCase 97-102 ‘Merick Manufacturing Case Scenario Merick Manufacturing is a U.S.-based textile manufacturer whose equity securities are listed on the New York Stock Exchange and the London Stock Exchange. Merick prepares financial statements under both U.S. Generally Accounting Principles (U.S. GAAP) and Jntermational Accounting ‘Standards (IAS). On 1 January 2004, Merick acquired 50 percent of the equity of Lisam, Inc., a smail international textile manufacturer. The purchase price was $500 million in cash. The remaining 50 percent equity in Lisam is owned by a governmental entity outside of the U.s. Kim King, CFA, has been assigned the task of determining the potential effect of the acquisition on Merick’s reported financial results using both U.S. GAAP and IAS. She is particularly concerned about the distortion of finencial ratios (profitability, liquidity, solvency, and efficiency) that might occur if the equity method is used. King is unsure at this point whether Merick will account for the acquisition using the equity method, proportionate consolidation method, or consolidation method, She has tentatively concluded, however, that under U.S. GAAP Merick is unlikely to have control ‘over Lisam, but that under IAS Merick is likely to be deemed to have methods to improve financial {information for users. Kings uses historical 31 December 2003 balance sheets(Exhibit 1) and projected income statements for the year ending 31 December 2004 (Exhibit2) for Merick and Lisam to determine how the financial cesults and ratios may differ under each of the three acquisition accounting methods. The fivancial statements do not reflect the acquisition, and there are no inter-company transactions ing-of-year balance between Metick and Lisam. For ratio computation purposes, King uses begint sheet values rather than average balance sheet values. She considers this appropriate because year-end projected balance sheets are expected to remiain essentially unchanged for both firms other than the direct effects of the acquisition. Also, she uses projected income statement data for 2004, adjusted for the impact of the acquisition method. "The fair values of Lisam’s assets and liabilities at 31 December 2003 are equal to their historical reported amounts, Exhibit 1 _Balance Sheets on 31 December 2003 immediately Prior to Acquisition) Merick Manufacturing Lisam, Ine uss | comme" uss | commen Mitions | S®* miltons | Si Percentage(%) Percentage(%) Cash $900 36.00 $100 (cores Inventory | 500 20.00 300 20.00 Other Current | 100 4.00 200 13.33 1 Assets [otal current ) $1,500 60.00 $600 40.00 Asset 4 Plant and | 1,400 56.00 800 93.33 Equipment _ : |‘Accumulated | (600) (20.00) (200) (3.33) Depreciation Other 100 4.00 300 20.00 Non-current Assets | Total Assets | $2,500 100.00 $1,500 100.00 Short-term | $200 [8.00 $100 [697 Debt Other Current | 300 12.00 200 1333 Liabilities “Total Current | $500 20.00 $300 20.00 Liabilities L Long-term | 700 8.00 200 1333 Debt ‘Common | 200 8.00 100 667 Stock Retained | 1,100 44.00 900 60.00 Eamings ‘Shareholders? [ 1,300 52.00 3,000 6.67 Equity Tal $2,500 700.00 $1,500 100.00 Liabilities and Shasehoiders? A a Exhibit 2 Projected Income Statements for the Year Ending 31 December 2004 Meriek Manufacturing T Lisam, Inc. USS Common uss ‘Common Millions Size Millions Size = a Percentage(se) | _ Percentage(%) NetSales | $3,750 300.00 |_| $2,500 100.00 Cost of | (2,250) (€0.00) (4,600) (64.00) | Goods Sold} _ _ | Gross profit | 1,500___| 40.00 900 36.00 | Depreciation | (140) (3-73) (60) (2.40) Expense [ Other “| (085) (26.27) (600) (24.00) | Expense Operating 375 10.00 | 240 9.60 Income te| interest (75) (2.00) (30) (1.20) Expense | Pretax 300 8.00 210 840 Income _ | Income Taxes | (120) G20) @ (36) NetIncome | $180 4.80 3126 S04 Operating | 375 10.00 240 9.60 Income Interest 5) (@.00) 60) (120) Expense | Pretax (120) 0.20) @ 3.36) 1 Income Netincome _| $180 480 [$126 5.08 | Question 97 the Jeast appropriate conclusion for king to make with respect to the effect of the equity method of accounting is that: ‘A. Merick’s retum on sales will be overstated. B, Merick’s return on equity will be overstated. C. There is loss of fitnote information related to lisam. D. Liabilities will be excluded Som Merick’s balance sheet. Question 98 if King’s tentative conclusions about Merick’s contral are correct, would the equity method of accounting for the acquisition be acceptable under: U.S. GAAP? IAs? A NO No B. No YES c ‘YES No D. NO NO. Question 99 Immediately after the. acquisition, Merick’s ratio of longterm debt to total assets using the consolidation method and equity method, respectively, would be close to: Consolidation method Equity method A 250% B.00% B. 22.50% 29.09% © 25.11% 28.00% D. 25.1% 29.09% ‘Question 100 immediately after the acquisition, Merick’s current ratio using the proportionate consolidation 50‘method and equity method, respectively, would be close to: Proportionate consolidation method Equity method A 2.00 2.00 B. 2.00 3.00 c 27 2.00 D. 277 3.00 Question 101, incorporating Lisam’s projected resulls and considering the three acqu ‘Merick’s gross profit margin for the year ending 31 December 2003 will be: A. highest under the equity method. B. Highest under the consolidation method. C, Highest under the proportionate consolidation method. D. The same under all three methods (equity, consolidation, and proportionate consolidation). tion accounting methods, Question 102 incorporating Lisam’s projected results and considering the three acquisition accounting methods, Merick’s total asset turnover for year ending 31 December 2003 will be : ‘A. lowest under the equity method. 'B, lowest under the consolidation method. C. lowest under the proportionate consolidation method, D. The same under all three methods (equity, consolidation, and proportionate consolidation). stCasei03-108 Roaming Systems Case Scenario Roaming Systems Inc. is a publicly traded company that develops software for mobile workforce applications. The company has profitable since its second year in operation, but after five years of rapid growth the forecast for the next five years (Exhibit 3, below) indicates that growth (sa ‘measured by capital spending) will slow from that experienced in previous years. Exhibit3 Roaming Systems Inc. Forecasted Net Income and Capital Spending (USS millions) Fiscal year 2007-2008 2009-2010 2011 Netincome 10 12_—s13.2._—«1S2_—«ATS Capital spending 6 = 7027 SS Unless Roaming Systems adopts a plan to distribute excess cash to shareholders, it will soon accumulate a large cash position. The company’s target capital structure is 3- percent debt and 70 percent equity. The fonder and president, Paul Mackenzie, and the company’s tseasurer, France Leblanc CFA, are having a conversation about initiating a dividend. Mackenzie: I am excited that we will finally be paying a cash dividend. I think that in 2007 we should pay out everything that we don’t plan to spend on capital projects. That should make our stockholders very happy and help keep our share price up? Leblan determine the excess cash we will have available to distribute to shareholders. 1 suggest we cor long-run sustainable earnings in order to set to payout policy that sends a signal to shareholders that, {future dividends will be stable. think we should look at the capital spending budget for the next five years and then ler Mackenzie: however we decide to do it, we should distribute the cash to shareholders because 1 believe they would rather have the dividends than for us to reinvest the earnings. As a matter of fact, jon a cash dividend will likely boost our P/E ratio by increasing the expected growth rate in dividends. Leblanc: we must also temember that other companies in the tech sector tend to keep their dividend payout ratios around 25 percent of earnings, well below the U.S. corporate average of 40 percent. Furthermore, I think our objectives should be to stabilize the stock price as growth slows and to distribute to shareholders the cash we cannot effectively reinvest; ‘Mackenzie: ok, you have the financial background. Draw-up some proposals of our options and we will discuss them before the next board meeting, Question 103 concerning his first statement, what approach to dividend policy is Meckenzie proposing and what‘will be the most likely effect of that approach on Roaming System’s share value? Approach to Dividend Policy Effect on Share Value ‘A. Residual approach Increase B. Residual approach Decrease C. Long-term residual approach Increase D. Long-term residual approach Decrease Question 104 ‘Based on Mackenzie's first statement, the cash dividend for 2007 would be closest to: A. $28 million. B. $4.0 million, C, $5.8 million. D. $8.2 million. Question 105 Concerning her first statement, the approach to dividend payout policy Leblanc is proposing is best described as the: ‘A. target payout ratio. B. Stable dividend policy. €. Residual dividend approach, D, Long-term residual dividend approach. Question 106 ‘Which dividend preference theory is most consistent with Mackenzie's second statement, and is his comment regarding the P/E ratio most likely correct or incorrect according to that theory?“ Dividend Preference Theory ‘Change in the P/E Ratio A. third-in —the-hand? Correct BR, third-in-the-hand? Incorrect C. dividend imelevance Correct, D. dividend inetevance Incomrect (Question 107 Given Roaming System’s net income in 2006 of $8.0 million, if Roaming Systems adopts the industry's target payout ratio and uses a four-year adjustment period, their 2007 annual cash dividend, based on the target payout approzch, will be closest to: A. $125,000. B. $200,000 . $625,000 D. $1,000,000 Question 108 Given Roaming System's current outlook, which of the following will most likely meet the objectives in Leblane’s second statement and send the appropriate aignal to shareholders? A. a share repurchase 33B. distribution of a large cash dividend . initiation of a small cash dividend only. D. initiation of a small cash dividend accompanied by a share repurchase 34case109-114 Scotia West Case Scenario Scotia West, CFA, has identified HealthPlus Inc. (HPS), a company in the Canadian retail health industry that she is interested in adding to her client’s portfolios. ‘West has gathered the following information about the retail pharmacy industry in general, the typical retail pharmacy, and some specific information about HPS. Retail Pharmacy Industry Trends and Challenges: @ «sales and earnings growth trend line corresponds to the general economy; © sales and earings exhibit strong growth during economic upturns, and slight dips in profitability during recession years; @ consensus expected annual compound growth rate is 89% per year over the next 5 years based on the following factors; © aging baby-boomers are providing an increasing demand for health care products, to preserve their youths @ increasing demand for drugs with an aging population and the development of new drugs: © increasing demand for information about medical conditions such as high blood pressure or diabetes and how to manage these diseases © increasing life expectancy; © eazy into the market of large rétalers such as mass merchandisers and larger grocery stores; . © development of mail-order and on-line pharmaci © Canadien market consists of two national chains competing for market share with a few smaller regional chains and scattered independent stores. Atypical retail pharmacy is divided into two sections: 1 the pharmacy area, normally located at the back of the store, along with the ‘over-the-counter(OTC) drugs and other medical aids; 2. the front-end of the store which traditionally sells health and beauty products, convenience items, stationary or gifts cards, and may offer photo-finishing, photocopying or similar services. Women ‘make 80% of front-end purchases. HPS: HPS is the number one Canadian chain of retail pharmacies, operating over 900 states (about one-sixth of the national retail market) across the country. The company is currently experiencing @ higher growth rate than the average of the industry through strategic initiatives. Their current strategic initiative, involves an aggressive remodeling program of their stores, increasing the size of their average store from 9,000 to 4,000 square feet. The focus of the remodeling is to expand the front-end of the store and turn it into an upscale beauty boutique that sells higher margin cosmetics and skin care products. Personne! trained in skin care and cosmetics application will staff these areas.Traditionally, retail pharmacies have cartied lower-end lines of cosmetics and beauty products in a self-serve section while the more expensive, higher-margin lines were carried in mid-to-upper scale department stores. The mass merchandisers entering the market have been encroaching on the low-end lines. HPS hopes to combat this competition in low-end lines by moving to higher-end products. Management believes altracting customers with their more convenient locations in residential areas, and extended store hours. In addition, they believe that higher end products will provide increased profit margins and lower sales volatility during periods of slower economic growth. The target of this redesign is working women with more money to spend and tess time to stop. HPS is also focused on providing the best service in the pharmacy area with on-line refills, e-reminders and by reducing the time to fill 2 prescription. They believe that providing superior service and advice in both sections of the store will improve their competitive position, the superior service combined with cost control will allow them t6 increase margins, ‘West estimates that HealthPlus’s shares will appreciate $4,00 over the coming twelve months and the estimated rate of return on the stock is 10%. During the past year, the stock has traded between $28.00 and $38.00, with a most recent price of $37.50, earnings per share for the year were $1.50: while the announced a special dividend of $1.00 to be paid in the first quarter of the upcoming year. Question 109 Based on the information gathered by West, which of the following best describes the retail pharmacy industry in terms of the: Industrial life cycle? Business cycle? AL Mature Cyclical B. Mature Defensive C Growth Cyclical D. Growth Defensive Question 110 Based on the information gathered by west, which of the following external factors is most likely having the biggest impact on the retail pharmacy industry? A. technology. B. Government C. Demographics D. Social changes Question 111 Based on the information gathered by west, which of the following competitive forces is most likely the biggest threat for the retail pharmacy industry? A. threat of new entrants B. bargaining power of buyers C. bargaining power of suppliers D. threat of substitute products of servicesQuestion 112 ‘The competitive strategy of Healthplus can best be described as, A. acostveas strategy B. acosteadership strategy C. being stuck-in-the middle. D. a differentiation-focus strategy. Question 113 Healthplus’ alpha is closet to: A. 0.7% B. 33% C. 4.7% D. 73% Question 114 the most appropriate model to use ia estimating the intrinsic value of Healthplus isthe ‘A. dividend discount model B, discounted cash-flow model C. asset-based valuation model D. price-earnings valuation model.Casel15-120 ‘Mary Fuentes ease scenario Mary Fuentes, CFA, is @ portfolio manager for a group of mortgage-backed mutual funds. Ske is training, frank person, a corporate bond analyst that was recently asked to extend his responsibilities to mortgage-backed securities. Fuentes begins with a discussion about the basic cash flow characteristics of mortgage passthrough securities. Using the data shown below in exhibit 4 Exhibit 4 , Selected cash flow data for fnma passthrough security as of may 1,2005 Outstanding Joan balance [ Scheduled monthly ] Scheduled monthly] Net monthly interest. to | payment principal payment__| bondholders. | $364,808,000 $2,766,500 $296,446 $2,280,050 Fuentes goes on to explain how the cash flows of these pass through securities can be redistributed to different bond classes to create collateralized mortgage obligations (CMOs), She illustrates this with @ CMO deal thet was created from an almost identical pass through security as that shown above. Selected data for a portion of this sample CMO deal is shown below in exhibit 5. Exhibits Selected data for sample CMO Security ‘Coupon Effective Option-adjusted duration spread Collateral 7.50% 6.9 years 75 ‘Pac tranches : Pa (PAC i) 15% 25 years 30 50 Pb (PAC) 75%. 5.0 years 40 60 _| ‘Support tranches | 7.5% 2Syears 20 100 Sa(paciiscH) | 7.5% 68 years 90 160 Sb —_(suppost > bond) (@ FNMA pass through securities with an 8.125% WAC and 325-month WAM Fuentes. discusses the use of the Monte Carlo simulation model for valuing mortgage-backed securities. Pearson has done some preliminary research and makes the following two comments about this model: 1. The imerest rate paths generated by the simulation must be adjusted to produce arbitrage-free values for the benchmark interest rates used, 2. If on-the-run treasury rates aré the benchmark interest rates used, the option-adjusted measure the average spread over the treasury yield curve? Fuentes cautions pearson about the significant variations that can occur in the effective duration measure of a mortgage-backed security that is computed with the use of the Monte Carlo simulation model. Fuentes continues, there is another commonly-cited duration measure that is a form of effective duration, but is based on 2 single prepayment rate over the life of the mortgage-backed security for any given interest rate shock. 38The discussion tams towards commercial mortgage-backed securities (CMBS), IN WHICH Fuentes makes her final remark, he senior tranche in a DMBS, deal has the Ieast protection against prepayment risk and the greatest protection against principal losses due to defaults. Question 115 Given a single monthly mortality rate of 0.514% for may 2005, the monthly prepayment amount for the pass through security shown in exhibit 4 will be closest to: A. $1,578,667 B. $1,860,893 C. $1,873,589 D. $1,875,113 Question 116 Which of the following securities shown in exhibit 5 has the greatest prepayment risk and the highest priority of principal payments, respectively? ‘greatest prepayment risk highest priority of payments A tranche sb tranche pa B. ‘ranche sb tranche sa c the collateral tranche pa Dv. she collateral tranche sa ‘Question 117 From a tolal retum perspective, which of the following securities is priced relatively rich when compared tothe other tranches shown in exhibit 5? A. Tranche pa 3 B. Tranche pl C. Tranche sa 1D. Tranche sb Question 118 Regarding his comments about the Monte Carlo simulation model, is Pearson correct or incorrect with respect to his: First comment? Second comment? A. comect correct B. comect incorrect C. incorrect correct D. incorrect incorrect Question 119 ‘The other commonly citied duration measure that Fuentes describes is most likely: A. implied duration B. empirical duration + cash flow duration soD, coupon curve duration Question 120 ‘Regasding bec final remark about the senior tranche in a CMBS deal, is Fuentes correct with respect, to the amount of protection against Prepayment risk? ipal losses due to defaults? A. NO NO B. NO YES Cc. YES NO D. YES YES 60