2021 CFA LII Mock Exam 2 – PM Session

Victoria Duffy Case Scenario

Victoria Duffy, CFA, recently left her position as a portfolio manager at
DalTex Investment Advisors (DalTex). Her departure was not restricted by a
noncompete agreement, and before leaving, she returned the company-owned
electronic devices she had been issued. Duffy has started her own investment
management firm, Victory Investment Management (Victory). She has talked
with several individuals about joining the firm as part of the management team
and potentially being an equity owner. Duffy has lunch with Linda Kercheval,
CFA, the chief compliance officer at DalTex, as she is interested in offering
Kercheval a position at Victory. During their meeting, Duffy shares with
Kercheval a presentation that includes the proposed management structure,
the investment products to be offered, and a list of potential clients. Kercheval
noted several of the names on the list were clients Duffy had frequent contact
with while at DalTex.

Although Kercheval is excited about the opportunity to join Duffy, she

feels the timing is not quite right so she delays submitting her resignation. A
short time later, she sees one of the clients Duffy had noted in her presentation
in the DalTex office. She stops to talk with the client who mentioned how much
he missed working with Duffy. Kercheval tells the client she had recently seen
Duffy and shares her plans to open her own firm. The client gives Kercheval his
business card and asks her to have Duffy contact him or to give him the name
of her new firm. Kercheval considers what she should do and comes up with
the following options:

Option 1: Call Duffy and recount the conversation.

Option 2: Do nothing until she joins Victory and then pass on the card to
Duffy.
Option 3: Give the client the name of Duffy’s new firm.

While in her home office Duffy prepares for a video call with Lucy Tilton,
CFA. Duffy met Tilton while attending a CFA-sponsored conference. Tilton is a
portfolio manager specializing in alternative investments, specifically the use of
futures and options to mitigate risk for accounts that allow the use of
alternative investments. Duffy is particularly interested in adding someone with
this expertise as it is not her strength. Tilton is very interest in working with
Duffy, but she feels Victory has not reached an asset management level to
support the compensation she requires. They decide on a mutually beneficial
arrangement in which Tilton will create a report for Duffy’s use with daily
commentary about how she is navigating the market for her firm and their
clients. Tilton relishes the idea of working for a smaller firm and hopes to join
Duffy in the near future.

Several months later, Victory has gained enough clients to support

adding Tilton as an employee. Tilton submits her resignation to her current
employer, and although they are disappointed, they are excited for her and her
new opportunity. Because they really like her work they ask if she could
provide them with a daily commentary about her views regarding the market.
Additionally, they are willing to pay her a monthly fee for providing the service.
Because it is basically the same report she is currently providing Duffy, she
agrees, and they negotiate a contract between the two of them with a quarterly
fee paid direct to her. Tilton informs Duffy about the agreement, and Duffy
agrees but is only willing to do this for a period of one year. Duffy makes the
following recommendations regarding the arrangement:

Recommendation 1: You need to draft an agreement outlining what you are

doing and how much they are paying you over the next year.

Recommendation 2: You and your former employer need to sign the

agreement.
Recommendation 3: We also need to send a disclosure to all of our clients and
potential clients.

1.

Based on the information provided, did Duffy most likely violate any CFA
Institute Code of Ethics and Standards of Professional Conduct during
her lunch meeting with Kercheval?

A. No.

B. Yes, with regards to Standard III, Duties to Clients.

C. Yes, with regards to Standard IV, Duties to Employers.

2.

Regarding her conversation with DalTex’s client, which option should Kercheval
most likely choose to prevent violating CFA Institute Code of Ethics and
Standards of Professional Conduct?

A. Option 1

B. Option 2

C. Option 3

3.

Which CFA Institute Code of Ethics and Standards of Professional Conduct has
Tilton most likely violated?

A. Standard IV(A), Loyalty

B. Standard I(B), Independence and Objectivity

C. Both Standard IV(A), Loyalty, and Standard I(B), Independence and

Objectivity
 4.

Which recommendation with regards to Tilton’s agreement is most likely

insufficient to prevent a violation of CFA Institute Code of Ethics and
Standards of Professional Conduct?

A. Recommendation 1

B. Recommendation 2

C. Recommendation 3

Sagara Case Scenario

Sagara, a resource-abundant West African country, has a developing
economy with low capital per worker available. Although the majority of its
population is impoverished, Sagara has a long history of advanced education
and is committed to technological progress. President Benjamin Banantoumou
recently appointed Fatima N’Diarra, PhD, as Economic Development Secretary.
He asks her to help him develop economic policies to promote growth.

Last year, Banantoumou attended a summit of international leaders,

where he learned that developing countries typically face several factors that
affect their growth prospects, such as

1. enforcement of substantive laws,

2. restrictions on imports, and

3. low rates of saving.

N’Diarra, who has studied the Cobb–Douglas production function,

believes that Sagara’s primary goal should be to raise the growth rate of per
capita GDP. Her two recommendations, therefore, are to

1. increase capital, and

2. invest in technology to raise total factor productivity (TFP).

 N’Diarra adds this conclusion:

“Because the Cobb–Douglas function exhibits constant returns to

scale, as we approach the steady state rate of growth we should
place greater emphasis on continuing to grow TFP in order to avoid
diminishing marginal returns on capital.”

Banantoumou believes that the Sagara economy relies too heavily on the
export of natural rubber. He is convinced that significant industrial capital
investment will persuade foreign direct investors that he is serious about
economic development. He announces that the Sagara government will
construct a large tire factory to take advantage of the country’s rubber
resources. Banantoumou expects that as a result of this investment, per capita
productivity will rise rapidly driving rapid growth in GDP.

N'Diarra is not as optimistic. She warns Banantoumou that Sagara could

fall prey to a resource curse known as the Dutch disease. As demand from the
tire factory drives up the price of rubber, capital flows out of the country and
the local currency could depreciate rapidly. This situation can be prevented if
foreign investors are allowed to own rubber plantations directly rather than
just having access through international markets.

N’Diarra believes that according to the classical growth theory, gains in

per capita GDP are temporary because the resulting population explosion will
lower per capita GDP to subsistence real wage levels. She considers
endogenous growth theory to be more realistic, believing that (1) investments,
such as the new tire factory, will increase the rate of per capita output growth
until the steady state rate of growth is achieved; and (2) investment in research
and development will boost growth even further, thus extending the abnormal
growth period before diminishing marginal returns eventually set in.

In the years after the tire factory begins production, Sagara’s GDP is
expected to grow at a rate exceeding 10% annually, the per capita GDP will
increase commensurately, and the country’s literacy rate will double.
Manufacturing is likely to grow by 15% annually. But this rapid growth will
also bring concerns regarding regulation of the manufacturing sector. The
government has at times struggled to advance the regulatory structure to
address problems associated with the impact of rapid growth on such problems
as pollution, power outages, and water shortages. Banantoumou is worried
that companies have learned to preemptively cooperate with their regulators
with the expectation that the regulators will favor their point of view over a
competitor’s.

As the local financial markets evolve, N’Diarra recommends that she and
Banantoumou study and discuss the legal and regulatory structure of the
United States to generate ideas that they can implement in Sagara. During
their discussion, N’Diarra remarks, “In the United States, self-regulated
organizations can become independent regulators empowered by a government
agency to enforce laws. The US government usually provides this type of
regulator with funding.”

1.

Of the factors cited by Banantoumou after the international leaders summit,

which is least likely to limit sustainable growth?

A. Factor 1

B. Factor 2

C. Factor 3

2.

In reference to the Cobb–Douglas function, N’Diarra’s conclusion is best

described as:

A. incorrect because the Cobb–Douglas function does not exhibit

constant returns to scale.
 B. correct.

C. incorrect because increased TFP is not subject to the law of

diminishing returns.

3.

N’Diarra’s warning regarding the resource curse and its prevention is most
likely incorrect with respect to:

A. her comments about both currency depreciation and direct ownership

of rubber plantations.

B. her comment about owning rubber plantations directly.

C. her comment about currency depreciation.

4.

N’Diarra’s understanding of the two growth theories is most accurate with

regard to:

A. both classical growth theory and endogenous growth theory.

B. endogenous growth theory.

C. classical growth theory.

5.

Banantoumou’s concern regarding the regulatory structure is most likely an

example of regulatory:

A. capture.

B. competition.

C. arbitrage.

6.
N’Diarra’s remark about self-regulated organizations (SROs) is best described
as:

A. correct.

B. incorrect because the US government does not fund independent

regulators.

C. incorrect because SROs do not enforce laws.

Suburban Publishers Case Scenario

Claire Munroe, the senior publishing analyst at North Star Securities,
has begun to review the recent financial performance of Suburban Publishers,
Inc. Suburban, which reports under US GAAP, has a history of purchasing
community news groups from around the country and holding them for several
years even if they are not initially profitable. The growth of online publishing
has been difficult on many major newspapers, but community newspapers
have been particularly resilient.

At the start of 2013, Suburban purchased 24% of the 1 million

outstanding shares of West Reach Community News Group for $12 million.
West Reach’s income and dividends since the purchase to the end of 2016 are
shown in Exhibit 1.

Exhibit 1 West Reach Community News Group Income and Dividends,

2013–2016 ($ thousands)

2013 2014 2015 2016

Net income 2,400 1,800 1,950 2,000

Dividends 500 200 50 400

As Munroe reviewed her working papers, she came across a notation that
she had made following the acquisition: “A very strange long-term acquisition
for Suburban. West Reach’s majority holder, William French (who is now 81
years old), holds 72% of the shares and controls the board with an iron hand.
Dividends are paid out according to his needs and preferences. Suburban was
unsuccessful in getting any of its preferred candidates elected to the board or
exerting any influence on West Reach’s dividend policy.” An interesting
development occurred near the end of 2016, when Mr. French sold 100,000 of
his shares to one of Suburban’s competitors for $6.2 million. Just before
Monroe closed her file on this firm, she added, “Mr. French is still firmly in
control but changes may be on the horizon—he is now a few years older”.

At the start of 2014, Suburban purchased 32.5% of the outstanding 2

million shares of Great Lakes Free Press, Inc., for $1,365 thousand. Great
Lakes owned community newspapers in most of the northeastern states.
Although the majority of these papers were provided free of charge, they had
historically maintained strong revenue streams with their focus on personal
interest stories about local individuals and local business advertising. Exhibit 2
provides details of this acquisition (Part A) and subsequent results (Part B).
Great Lakes struggled in 2015 and 2016 with mounting losses and as a
consequence eliminated its dividend.

Exhibit 2 Great Lakes Free Press Values at Acquisition and Subsequent

Performance

Part A: Values at Acquisition, 1 January 2014 ($ thousands)

Book Value Fair Value

Current assets 120 120

Plant and equipment (P&E)* 2,280 2,964

Land 1,440 1,476

3,840 4,560

Liabilities 1,200 1,200

 Net assets 2,640 3,360

Part B: Performance since Acquisition ($ thousands)

2014 2015 2016

Net Income 1,200 –200 –600

Dividends 504 0 0

* Estimated useful life remaining as of the date of acquisition is 10 years, with

straight line depreciation to be used.

Munroe’s calculations for Suburban’s holdings of Great Lakes at the end

of 2016 are summarized in Exhibit 3. She believed that Great Lakes’ share of
local advertising would continue to decline with the growth of regional based
mobile and social media advertising. With little chance of a permanent recovery
in the investment, Munroe believed that Suburban would most likely have to
treat the investment as being impaired.

Exhibit 3 Basis of Munroe’s Opinion of Impairment in Great Lakes, as of

Year-End 2016 ($ thousands)

Book value of Great Lakes 3,256.00

Fair value of Suburban’s investment in Great Lakes 940

Carrying value of Suburban’s investment in Great Lakes 1,264.51

At the start of 2016, Suburban decided to provide its publications with a

new, fresh look and include more high-quality colored images. To meet this
need, Suburban purchased HiQ Printers, which had high speed production
printing presses in all of Suburban’s distribution areas. Suburban purchased
60% of the company’s shares in exchange for its own shares. At the time of the
purchase, there were 8 million shares of HiQ Printers outstanding trading at
$14 per share. The fair value of HiQ Printers’ net identifiable assets at that time
was $99 million. Exhibit 4 shows the shareholders’ equity of both companies
prior to the business combination.

Exhibit 4 Shareholders’ Equity for Suburban Publishers and HiQ Printers

Prior to the Combination in January 2016 ($ thousands)

Suburban Publishers HiQ Printers

Capital stock (no par) 280,000 40,000

Retained earnings 185,000 26,000

Knowing that HiQ’s workforce is unionized, Munroe asked her assistant,

Adeleke Carter, to review HiQ’s labor agreements and report to her anything
that that would impact the value of the acquisition. Carter sent Munroe the
email shown in Exhibit 5.

Exhibit 5 Email from Carter to Monroe

To: Claire Munroe

From: Adeleke Carter

Subject: HiQ Pensions

Hi Claire,

HiQ has two post-retirement plans—here’s a summary of what I found.

Present value of
Defined- Fair value available refunds and
Plan Members and benefit of pension reductions in future
Terms obligation assets contributions

Unionized workforce: $15.500 $16.600 $500,000

60% of the average of million million
their highest five years
of service
Management: matching $8.222 million
contributions by HiQ
and employees of 8% of
salary per annum.

Looks like HiQ was trying to hide some liabilities from Suburban by not
reporting the obligations for management’s plan, but the additional $24.822
million of assets will be a nice boost to reported assets for HiQ and Suburban.

Let me know if you have any questions.

Best, AC

1.

The most appropriate value (in millions) for Suburban’s investment in West
Reach at December 31, 2016, is:

A. $12.00.

B. $13.68.

C. $14.88.

2.

At the end of 2014, the balance in the investment in the associates account for
Great Lakes Free Press (in thousands) was closest to:

A. $1,591.20.

B. $1,567.80.

C. $1,568.97.

3.

With regard to Munroe’s opinion about the possible impairment of the

investment in Great Lakes Free Press, the impairment loss (in
thousands) is closest to:

A. $324.51.
 B. $118.20.

C. $425.00.

4.

Immediately following its business combination with HiQ Printers, the total
shareholders’ equity (in thousands) on Suburban’s consolidated financial
statements is closest to:

A. $532,200.

B. $577,000.

C. $571,800.

5.

Based on Exhibit 5, Carter’s conclusion about the impact of HiQ’s pension

plans is best described as:

A. incorrect, because Suburban will only report the $8.222 million of

management’s plan.

B. correct, because Suburban will report the $24.822 million of pension

assets.

C. incorrect, because there is no defined obligation for management’s

plan.

6.

Based on Exhibit 5, the asset amount reported on HiQ’s balance sheet related
to the unionized workforce pension plan is closest to:

A. $1,100,000.

B. $500,000.
 C. $600,000.

Jason Perry Case Scenario

Jason Perry is an analyst who is researching WIKS General Lighting
(WIKS), a company that has expanded greatly since 2010 (see Exhibit 1).

Exhibit 1: History of WIKS General Lighting

2010 With a cash offering, WIKS Industrial Lighting acquires a residential

lighting company. The residential lighting company retained its
name and became a subsidiary. Both entities manufacture products
for other brands and do not sell directly to the consumer.
2012 WIKS Industrial Lighting acquires a lighting retailer that has its own
stores and multiple contracts supplying larger home goods retailers.
The combined company becomes WIKS General Lighting with its
own brand name and a goal to become publicly traded. The deal is
funded entirely with stock in the new company.
2014 Distribution centers affiliated with the residential lighting subsidiary
are sold. These centers had become redundant given the 2012
transaction.

2016 With a cash offering, WIKS General Lighting purchases a small

research company that develops light-emitting diode (LED)
technology. The acquired company is incorporated into WIKS’s
existing manufacturing operations and development department.
2018 WIKS General Lighting becomes publicly traded through an initial
public offering early in the year.
2019 WIKS General Lighting purchases a foreign lighting manufacturer,
Luminous Integrated Technologies (LIT) with a cash offering of $25 a
share (a 25% premium) for the purchase of all outstanding shares
not already owned by WIKS. As a result, 80% of its domestic
manufacturing unit is now redundant and is sold over the following
six months for $200 million.

Perry discusses WIKS with a fellow analyst, David LeBlanc, who is

familiar with the 2019 transaction. LeBlanc tells Perry that:

Comment 1: WIKS began buying LIT shares in the open market over the
previous year and had accumulated 1 million of LIT’s 20 million
 outstanding shares for $20 million. The belief was that WIKS was
intending to acquire LIT.

Comment 2: LIT’s management became aware of the stock purchasing and

informed WIKS’s management that they objected to the potential
acquisition. This led WIKS to make a stock proposal directly to LIT’s
board of directors instead of starting a discussion with LIT’s management
about an acquisition.

Comment 3: LIT’s board of directors decided to have shareholders vote on the

acquisition, which proved unsuccessful for WIKS. WIKS then made a
cash offer directly to the shareholders, which was successful.

Perry asks why the vote of the shareholders was unsuccessful for WIKS.
LeBlanc responds that a provision allowed existing LIT shareholders other than
WIKS to buy stock at a discount. A number of larger shareholders, who
objected to the deal, proceeded to take advantage of this provision to make the
vote unsuccessful for WIKS. The shares outstanding increased to 25 million
before the vote.

1.

Based on Exhibit 1, the transaction associated with which year is most likely
an example of a consolidation?

A. 2010

B. 2012

C. 2016

2.

Based on Exhibit 1, the transaction associated with which year is most likely
an example of a forward integration?

A. 2010
 B. 2012

C. 2016

3.

The stock proposal attempted by WIKS to acquire LIT described in Comment 2

of LeBlanc’s discussion is best described as a:

A. bear hug.

B. proxy fight.

C. tender offer.

4.

WIKS’s increase in value through the acquisition of LIT is closest to ($ millions):

A. 50.

B. 75.

C. 80.

McLaughlin Corporation Case Scenario

Chan Mei Yee is valuing McLaughlin Corporation common shares using a
free cash flow approach. Yee gathered information about McLaughlin from
several sources. She begins her analysis by determining free cash flow to the
firm (FCFF) and free cash flow to equity (FCFE) for the 2012 fiscal year, using
the financial statements in Exhibits 1 and 2. McLaughlin’s fiscal year ends 31
December.

Exhibit 1 McLaughlin Corporation Selected Financial Data ($ millions,

except per share amounts)
For Year Ending 31 December 2012

Revenues $6,456
Earnings before interest, taxes, depreciation, 1,349
and amortization (EBITDA)

Depreciation expense 243

Operating income 1,106

Interest expense 186

Pretax income 920

Income tax (32%) 294

Net income $626

Number of outstanding shares (millions) 411

2012 earnings per share $1.52

2012 dividends paid (millions) 148

2012 dividends per share 0.36

2012 fixed capital investment (millions) 535

Cost of equity 12.0%

Weighted average cost of capital (WACC) 9.0%

Exhibit 2 McLaughlin Corporation Consolidated Balance Sheets ($

millions)

as of 31
December

2012 2011

Assets

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

Current liabilities $2,783 $2,678

Long-term debt 2,249 2,449

Common stockholders’ equity 1,072 594

Total liabilities and $6,104 $5,721

stockholders’ equity

Yee plans to perform two different valuations of McLaughlin, which she

calls the “base case” valuation and the “alternative” valuation. Critical
assumptions for each are given in the following lists.

Base case valuation

• 2013 FCFF will be $600 million.

• Beyond 2013, FCFF will grow in perpetuity at 4% annually.

• The market value and book value of McLaughlin’s long-term debt are
approximately equal.

Alternative valuation

• 2013 earnings per share (EPS) will be $1.80.

• EPS will grow forever at 6% annually.

• For 2013 and beyond:

• Net capital expenditures (fixed capital expenditures minus depreciation)

will be 30% of EPS.

• Investments in working capital will be 10% of EPS.

• Of future investments, 60% will be financed with equity and 40% will
be financed with debt.
 Yee is also concerned about the effects on McLaughlin’s 2013 FCFE of
the following three possible financial actions by McLaughlin during the year
2013:

• 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, Yee’s supervisor, reviews McLaughlin’s valuations.

Specifically, Nicosia makes the following three statements:

1. The free cash flow valuation approach is superior to the discounted dividend
valuation approach because the company’s dividends have been
substantially different from its FCFE.

2. Because the company’s capital structure seems unstable, the FCFE

valuation approach is superior to the FCFF valuation approach.

3. If there is a change in control at McLaughlin, the discounted dividend

valuation approach would be superior to a free cash flow valuation
approach.

1.

McLaughlin’s FCFF ($ millions) for 2012 is closest to:

A. $418.

B. $485.

C. $460.

2.

Assuming 2012 FCFF equals $500 million, McLaughlin’s FCFE ($ millions) for
2012 is closest to:
 A. $574.

B. $174.

C. $114.

3.

Using Yee’s base case valuation assumptions and the FCFF valuation
approach, the year-end 2012 value per share of McLaughlin common
stock is closest to:

A. $29.20.

B. $12.78.

C. $23.73.

4.

Using Yee’s alternative valuation assumptions and the FCFE valuation

approach, the year-end 2012 value per share of McLaughlin’s common
stock is closest to:

A. $24.17.

B. $18.00.

C. $22.80.

5.

The most likely combined effect of the three possible financial actions identified
by Yee will reduce McLaughlin’s 2013 FCFE ($ millions) by:

A. $100.

B. $270.

C. $160.
 6.

Which of Nicosia’s three statements pertaining to McLaughlin’s valuation is the

most accurate? Statement:

A. 2

B. 3

C. 1

Tocantins Consultores Case Scenario

Joao Pereira is a fixed-income specialist at Tocantins Consultores, an
investment advisory firm located in São Paulo, Brazil. Paraná Fundação
Educacional, one of Tocantins’s clients, is looking for ways to add equity
exposure to its fixed-income portfolio given that he expects an equity market
rally. Pereira has recommended investments in convertible bonds. He is
meeting with Adriana Silva, chief investment officer for Paraná, to discuss the
recommendation.

At the meeting, Silva asks Pereira, “I understand convertible bonds are

complex securities with multiple features. I am concerned about corporate
actions an issuer might take that would negatively affect the value of any
convertible bonds outstanding. Can you describe some of these actions, their
potential impact, and how, if at all, that impact is mitigated by typical bond
covenants?”

Pereira responds, “Let me review three potential corporate actions.”

Action 1: The issuer could be acquired by another firm; possibly one that is
unattractive to the investor. Covenants typically allow investors to put
the bond back to the issuer, convert at a lower “change of control”
conversion price, or both.
Action 2: The issuer could split the stock or declare a large cash or stock
dividend. This likely would reduce the price per share and, therefore,
reduce the value of the convertible bond. Convertible bonds adjust the
conversion price for stock splits or stock dividends and any cash
dividends.

Action 3: Convertible bonds often contain an embedded call option feature

allowing the issuer to repurchase the bond. An issuer will call the bond
only when it can replace it with one that has a lower interest rate —
either because market interest rates have dropped or because the
issuer’s credit rating has improved. It might also call the bond to use
excess cash to retire debt.

Silva asks Pereira for investment recommendations. Pereira responds by

describing a 10-year bond issued three years ago by Juruá Automotivo (JA).
The bond has a par value of BRL R$100,000 and annual interest payments
based on an 8.0% coupon rate. It became convertible one month after issue
and remains convertible until one month before maturity. At issuance, JA’s
share price was BRL R$41.50 and its conversion price was BRL R$50.00. It will
become callable on the interest payment date at 106% of par in years 5 and 6,
104% of par in years 7 and 8, and 102% of par in year 9.

The bond’s third interest payment was just paid. It is trading at BRL
R$127,000, its current conversion price is BRL R$25.00, and JA’s share price
is BRL R$30.20. Market interest rates have not changed substantially since the
bond was issued, and JA’s credit rating remains unchanged since the bond
was issued.

Silva tells Pereira, “The many types of embedded options found in

different convertible bonds makes their valuation difficult. Despite that, it is my
understanding that the most common approach to valuation in practice
involves using the current yield curve with a set of assumptions of future
interest rate volatility to build a binomial interest rate tree. The cash flows are
determined for each node of the tree, based on whether any of the embedded
options are expected to be exercised. The resulting cash flows are valued on the
tree using the same process as for an option-free bond. Conceptually, this
means the value of the convertible is equal to the value of the option-free bond
minus the value of any embedded options that can be exercised by the investor
plus the value of any embedded options that can be exercised by the issuer.”

1.

With respect to corporate actions, Pereira is most likely correct regarding:

A. Action 1.

B. Action 2.

C. Action 3.

2.

Based on the information provided about the convertible bond issued by Juruá
Automotivo, the bond’s market conversion premium ratio is closet to:

A. 4.88%.

B. 5.13%.

C. 6.20%.

3.

The current risk-return profile of the Juruá Automotivo bond most closely
resembles that of a:

A. hybrid.

B. bond equivalent.

C. stock equivalent.
 4.

Is Silva’s understanding of the valuation of convertible bonds most likely

correct?

A. Yes.

B. No, she is incorrect regarding the common approach to valuation.

C. No, she is incorrect regarding the conceptual valuation of a convertible

bond.

Meredith Whitney Case Scenario

Meredith Whitney is a senior consultant in the Swaps Advisory Group of
DCM Capital, an independent advisory firm. Whitney will be preparing to meet
with three clients who need advice on structuring and implementing a swap
program to manage their interest rate exposures. She is assisted by a junior
analyst from the fixed income group, Toni Yang.

For her meetings, Whitney plans to use the data presented in Exhibit 1
below.

Exhibit 1 Current Term Structure of Rates (%)

Days Libor Euribor Hibor

90 1.42 1.86 1.22

180 1.84 2.11 1.53

270 2.12 2.24 1.7

360 3.42 2.34 1.87

Note: Libor is the London Interbank Offered Rate. Euribor is the Euro
Interbank Offered Rate. Hibor is the Hong Kong Interbank Offered Rate. All
rates shown are annualized.

Whitney’s first meeting is with Novatel, a US based company that

currently has an outstanding loan of $250,000,000 that carries a 5.15% fixed
interest rate. Novatel’s managers feel that the current interest rate on the loan
is high and they also believe that interest rates are poised to decline. Whitney
advises Novatel to enter into a one-year pay-floating Libor receive-fixed interest
rate swap with quarterly payments. The notional principal on the swap will be
$250,000,000. Whitney’s first task is to determine the appropriate swap rate.

Yang asks Whitney to explain the calculation of the fixed swap rate in a
floating-for-fixed interest rate swap. Whitney outlines three possible methods
for Yang to consider:

Method 1: The swap rate is the difference between Libor and the fixed interest
rate on the bond.

Method 2: The swap rate is the rate that sets the value of the fixed-rate bond
equal to the notional principal of the swap.

Method 3: The swap rate is the rate that sets the initial value of the swap
equal to zero.

Next, Whitney meets with Grand Manufacturing. This client is based in

Hong Kong but requires a €25,000,000 one-year bridge loan to fund operations
in Germany. Grand Manufacturing is currently able to borrow euros at an
interest rate of 3.75% but wonders if there is a less expensive alternative.
Whitney advises Grand to borrow in HK$ and enter into a one-year foreign
currency swap with quarterly payments to pay euros at a fixed rate and receive
HK$ at a fixed rate. The current exchange rate is HK$11.42 per €1, and the
notional amounts will be exchanged at initiation and at maturity.

The final meeting is with KPS Financial Services, a US based asset

manager. KPS wants to increase the equity exposure to the US market in one of
its portfolios by $100,000,000. Whitney advises KPS to enter into a one-year
equity swap with quarterly payments to receive the return on a US stock index
and pay a floating Libor interest rate. The current value of the US stock index
is 925.
 Each client follows Whitney’s advice and immediately implements the
recommended position.

Ninety days have passed since Whitney’s initial meetings, and in the
interim interest rates have increased dramatically. Whitney’s clients have
asked to meet with her to review their positions.

In order to prepare for the meeting, Whitney has obtained updated

interest rate data that is presented in Exhibit 2. In addition, she determines
that the exchange rate for the Hong Kong dollar is HK$9.96 per €1, and the US
stock index is at 905.

Exhibit 2 Term Structure of Rates 90 Days Later (%)

Days Libor Euribor Hibor

90 2.21 2.94 1.95

180 2.62 3.03 2.45

270 3.73 3.08 2.7

Note: Libor is the London Interbank Offered Rate. Euribor is Euro Interbank
Offered Rate. Hibor is the Hong Kong Interbank Offered Rate. All rates shown
are annualized.

1.

Using data in Exhibit 1 and a 30/360 day count, the annualized fixed rate of
the swap recommended by Whitney for Novatel is closest to:

A. 2.22%.

B. 3.36%.

C. 5.15%.

2.

Which method described by Whitney is most likely correct?

A. Method 3
 B. Method 2

C. Method 1

3.

Based on the information in Exhibit 1 and using a 30/360 day count, the
annualized fixed rates on the currency swap suggested by Whitney for
Grand for euros and Hong Kong dollars, respectively, will be closest to:

A. 2.34% and 1.87%.

B. 2.13% and 1.58%.

C. 2.32% and 1.85%.

4.

Using data in Exhibit 2 and a 30/360 day count, the market value of Novatel’s
swap after 90 days is closest to:

A. –$602,250.

B. –$2,875,000.

C. –$2,408,880.

5.

Using the data in Exhibit 2, the market value of Grand Manufacturing’s swap
after 90 days is closest to:

A. –€4,103,142

B. €2,701,178

C. –€3,625,900

6.

The equity swap cash flow for KPS Financial Services’ at 90 days is closest to:
 A. –$1,807,200

B. –$2,232,400

C. –$2,517,200

Borah Culebra Case Study

Borah Culebra is an appraiser at Crestone Advisors, a firm that provides
valuations and appraisals of commercial real estate properties. She recently
completed appraisals on two properties and is briefing her supervisor, Elias
Sneffels.

Property 1 is an office building located in the downtown business district

of a midsize city in the United States. Culebra tells Sneffels, “I evaluated
Property 1 using three separate approaches, generally referred to as the
income, cost, and sales comparison approaches. Each approach requires the
appraiser’s individual judgment on inputs used. However, the greatest degree
of confidence is placed on estimates produced by the sales comparison
approach, because it is based on market pricing.”

She continues, “Property 1 has 180,000 square feet of office space plus
15,000 square feet of retail space on the ground floor. The average office space
rent is $23 per square foot per year, whereas the retail space rents for twice as
much. Vacancy rates over the past few years have averaged 15% for both types
of space, and I expect this to remain stable into the future. Tenants only pay
for utilities, janitorial, and security guard services, which cost $320,000 per
year. The property manager charges 8% of effective gross rent. Other operating
expenses average $1,250,000 per year. I used this information when estimating
Property 1’s value using the direct capitalization method.”

After Culebra’s brief of the Property 1 appraisal, Sneffels responds,

“Three factors cannot be modeled using the direct capitalization method.”
Factor 1: There is an increasing risk of a recession that could lead to tenants
defaulting on their leases.

Factor 2: 40% of the office space in the building is rented to a single tenant
whose 10-year lease ends in 15 months.

Factor 3: Rental rates in the city have been rising and are expected to continue
to rise at a steady rate of 4% per year.

When discussing her appraisal of Property 2, an apartment complex in a

southwestern US suburb, Culebra provides the data on recent sales of similar
properties that she used in her analysis. The data are shown in Exhibit 1.

Exhibit 1: Property 2 Sales Comparison Data

Comparables

Subject
Variable Property 1 2 3

Number of units 372 490 280 415

Avg size per unit (sq.
ft.) 1,100 950 1,300 1,150

Age (years) 6 11 3 7

Condition good fair excellent good

Location good good prime prime

Date of sale (months
ago) 2 10 5

Sales price ($millions) 45.40 51.75 54.80

Sales price per unit ($) 92,653 184,821 132,048

Adjustments

Size per unit (average) 12% -14% -5%

Age (years) 14% -10% 3%

Condition 10% -10% 0%

 Location 7% -7% 0%
Date of sale (months
ago) 0% 5% 3%

1.

Is Culebra most likely correct in her comments regarding the three approaches
to real estate valuation?

A. Yes.

B. No, she is incorrect regarding the approach with the greatest degree of
confidence.

C. No, she is incorrect regarding the need for appraisers to use judgment
in each approach.

2.

Using the information provided for Property 1, the estimated net operating
income for the first year is closest to:

A. $2,207,060.

B. $2,469,100.

C. $2,527,060.

3.

For the valuation of Property 1, which of the factors Sneffels describes most
likely indicates a need to use the discounted cash flow method rather
than the direct capitalization method?

A. Factor 1

B. Factor 2

C. Factor 3
 4.

Using the information in Exhibit 1 and the sales comparison approach, the
estimated value of Property 2 is closest to:

A. $47.63 million.

B. $50.78 million.

C. $53.93 million.

Nebbiolo Case Scenario

Francesca Barolo is an equity portfolio manager at Gruppo Nebbiolo,
Spa, an investment management firm located in Turin, Italy. She is meeting
with Diego Moscato, the equity research manager at Dolcetto Partners, with the
objective of receiving a buy rating on her funds from this key institutional
investment consulting firm.

Barolo and Moscato meet to discuss the firm’s investment philosophy,

team, and process, as well as her performance track record. Barolo tells
Moscato that she firmly believes in active management and her ability to add
value relative to a benchmark because markets are inefficient.

Barolo starts the meeting by stating that the criteria for benchmark
selection is as follows: “It should be market capitalization weighted and should
reflect the opportunity set available. The positions can be replicated at a low
cost, weights are known ex ante, and return data are timely on an ex post
basis. Value added is calculated as the sum of the active asset allocation
decisions and the weighted sum of the value added from security selection. The
firm conducts performance attribution based on a decomposition of value
added into several sources, which include asset allocation, sector selection,
and security selection.”
 The meeting then progresses to a discussion of the risk and return
measures presented in Exhibit 1. Barolo notes that during this period, the risk-
free rate was 1.75%, and the benchmark return was 9.00%.

Exhibit 1: Data for the Nebbiolo Funds

Portfolio Return Active Risk

Fund A 10.10% 4.00%

Fund B 10.50% 6.25%

Fund C 11.85% 7.30%

Moscato tells Barolo that he likes to measure the consistency of active

returns when reviewing and comparing managers. Because Barolo manages
three funds, he was going to rank them in his analysis.

Moscato asks Barolo, “As an active manager, what is your approach to

generating excess returns?”

Barolo responds, “I am a firm believer in the fundamental law of active

management” and makes the following three points to support her view:

Point 1: The productivity of an active portfolio manager depends on both the

skill level and how many opportunities are identified and put to use in
the funds. The information ratio measures how much active return has
been earned for the level of active risk taken.

Point 2: The information coefficient is the correlation between forecasted active

returns and realized active returns. The transfer coefficient measures the
degree to which a fund manager’s forecast is translated into active
weights.

Point 3: Breadth is important and represents the number of independent

decisions a fund manager makes in constructing the portfolio.
Mathematically, breadth can be expressed as the number of independent
investment opportunities squared.
 Barolo’s and Moscato’s discussion evolves into a debate about the
strengths and limitations of the fundamental law of active management. Barolo
provides her perspective, “The strength of the fundamental law of active
management is that it provides a framework for evaluating and comparing
managers based on skill. It can even produce operational measurements of the
essential elements of an active management strategy. However, it also has
some limitations. First, it does not consider covariances in calculating breadth.
Second, it cannot measure ex ante value added.”

1.

Are the criteria that Barolo describes to Moscato at the start of the meeting
most likely correct?

A. Yes.

B. No, she is incorrect regarding benchmark selection.

C. No, she is incorrect regarding performance attribution.

2.

Given Moscato’s preference for risk and return measurement and based on the
data in Exhibit 1, how does he most likely rank the funds?

A. Fund A, Fund B, Fund C

B. Fund B, Fund C, Fund A

C. Fund C, Fund A, Fund B

3.

Which of Barolo’s points regarding the fundamental law of active management

is least likely accurate?

A. Point 1
 B. Point 2

C. Point 3

4.

Barolo is least likely correct with regard to which aspect of the strength and
limitations of the fundamental law of active management?

A. The strength

B. First limitation

C. Second limitation