mock exam level ii 2003 ans

The Association for Investment Management and Research (AIMRsm) does not endorse, promote, review, or warrant the accuracy of the products or services offered by organizations sponsoring or providing CFA® exam preparation materials or programs, nor does AIMR verify pass rates or exam results claimed by such organizations.

DO NOT OPEN THIS EXAM COVER SHEET UNTIL INSTRUCTED TO DO SO BY EXAMINATION SUPERVISOR

2003 CFA® Level II SASF Mock Exam

Instructors:Peter Chau, CFAPatrick Collins, Ph.D., CFAEd Cordisco, CPADon Davis, CFAJivendra Kale, Ph.D.Terry Lloyd, CFAProf. John M. Veitch, Ph.D., CFALoren Walden, CFA, CFP

The Security Analysts of San Francisco

SASF CFA® Level II 2003 Mock Exam

Saturday, May 3, 2003

Questions Topics Time Instructor

Item Set

1 – 10 Ethics SS # 1 & 2 15 minutes Loren Walden

11 – 14 Quantitative Methods SS # 3 6 minutes Jivendra Kale

15 – 27 Debt Instruments SS #13, 14, & 15 20 minutes Peter Chau

28 – 43 Derivatives SS #16 & 17 24 minutes Peter Chau

44 – 49 Portfolio Management 12 minutes Patrick Collins

50 – 55 Financial Statement Analysis SS # 5 9 minutes Ed Cordisco

56 – 63 Economics SS # 4 16 minutes John Veitch

64 – 70 Quant. Methods & Economics SS # 3&4 14 minutes John Veitch

Total 116 minutes

Essay/Item Set

71 – 73 Basic Valuation SS # 8 15 minutes Don Davis

74 – 79 Equity Valuation SS # 9 12 minutes Terry Lloyd

80 – 87 Equity Valuation SS # 10 20 minutes Terry Lloyd

88 – 91 Equity Valuation SS # 11 & 12 8 minutes Terry Lloyd

92 - 96 Financial Statement Analysis SS #7 12 minutes John Veitch

Total 67 minutes

Please note that the distribution of questions on the SASF CFA Level II Practice exam

broadly reflects the weights placed on each subject area by the CFA Level II study guide.

There is no guarantee that the questions on the actual CFA exam will reflect these relative

weights.

The Association for Investment Management and Research (AIMRsm) does not endorse, promote, review, or warrant the accuracy of the products or services offered by organizations sponsoring or providing CFA® exam preparation materials or programs, nor does AIMR verify pass rates or exam results claimed by such organizations.

SASF Level II Mock Exam 2003 Answers of 43

Study Session #1 & 2 – Ethics 2003 Loren Walden, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Each question in this section is 1½ minutes unless noted otherwise

1. Which of the following is an obstacle to and effective proxy voting Policy?

A. Lack of a clear policy and management support;

B. Perception that a policy is a difficult procedure;

C. Voting in the clients best interest;

D. All of the above.

2. Which of the following is not a sanction that AIMR can impose on a covered person?

A. Public censure

B. Private censure

C. Revocation of membership

D. None of the above

3. Which of the following can result in a summary suspension?

A. Felony conviction.

B. Permanent disbarment under securities law

C. Failure to cooperate with and AIMR investigation

D. All of the above

4. Which of the following is a complete description of the principals of the New Prudent Investor Rule?

A. Diversification, Assessment of risk levels, Duty and Authority to Delegate as a prudent investor would, Apply thorough analysis on soft dollar usage;

B. Diversification, Assessment of risk levels, Costs must be justified, Impartiality of balancing income and growth, Apply thorough analysis on soft dollar usage;

C. Diversification, Assessment of risk levels, Duty and Authority to Delegate as a prudent investor would, Impartiality of balancing income and growth, Duty and authority to delegate as a prudent investor would.

D. Duty to front run clients, Duty to use soft dollars to purchase computer software, Duty to favor one client over another, Duty to fail the exam if you choose this as your answer.

5. Which of the following are general fiduciary standards carried over from the Prudent Person Rule to the new Prudent Investor Rule?


A. Care, Skill, Caution, Loyalty

B. Impartiality

C. Diversification

D. A and B only

Fink Quatronion, CFA is the senior portfolio manager at Clink LLC Investment Management, a seven billion dollar firm. Clink focuses upon managing assets for pension funds of technology companies located in the United States. Clink has adopted the AIMR Code and Standards. Fink manages both the many research analysts as well as the portfolio managers at Clink.

One day, Billy Badly, a level II candidate for the Charter Financial Analyst designation, gets called into Finks office. There are several things Fink is concerned about regarding Billy’s conduct and has outlined them on a memo to help keep the meeting on track. The following is the memo:

Memo of conduct problems for Billy Badly.

1. Purchased securities for his personal account that are under review for possible consideration to sell for client accounts

2. Has delegated his research duties required under ERISA buy buying sector funds in some of his client’s portfolios.

3. Has been working on a charity on weekends without disclosing this to his supervisor in writing.

4. Does not review his account’s circumstances at least bi-annually.

5. Did not inform the firm in writing that he was bound by the code.

6. Assuming all of the items did occur, which of the items in the memo are clear violations of AIMR’s Code and Standards?

A. None

B. 1,2,4,5

C. 1

D. 1,2,3,4

7. How could Fink Quatronion, CFA have done a better job and created an affirmative defense?

A. He failed to have systems in place to avoid clear violations of the code. By having check systems in place in writing he could avoid Billy type problems.

B. He could check all new hires for clues about integrity.

C. He should provide all employees a copy of the Code when they are hired and educate them frequently about the code.


D. All of the above.

8. Under ERISA a fiduciary must do which of the following?

1. Have a written investment policy

2. Monitor performance

3. Never use plan assets for their own account

4. Never transact plan assets if a conflict of interest exists

5. Never get kickbacks

6. Never use soft dollars

A. 1,2,3,5 only

B. 1,3,5,6 only

C. l,2,3,4,5 only

D. 1,2,3,4,5,6

9. Under the Prudent Investor Rule each individual security is taken on its own merits.

A. True

B. False

C. Only if ERISA is the operating rule then it is true

D. Only if ERISA and the Prudent Expert rule is enforced

A large group of portfolio managers and analysts meet once a year for an investment conference at a fancy hotel to get educated wined and dined by a brokerage firm. The host firm pays for meals, entertainment, expensive wine, and the hotel suites. At this meeting, breakout sessions are provided for the brokerage firm’s top clients with senior management of publicly traded companies presenting at the conference.

At one of these breakout sessions, an analyst named Tommy Toy, CFA overhears the CEO of Reardon Steel talking into his cell phone before the meeting begins. The CEO said “I can’t say anything right now because I have a room full of Wall Street jerks breathing down my neck. But if they want to buy our firm for that much money, get the board together and we will meet tomorrow morning at corporate headquarters. Send the jet out to get me tonight.”

After hearing this conversation, Tommy gets his own cell phone out and proceeds to call in an order to by several thousand shares of Reardon Steel for his personal account.

10. Which of the following is most true?

A. Tommy can trade all he wants in Reardon Steel for himself but not for his clients.

B. Tommy cannot trade on the overheard information because it came directly from a senior officer who would be considered an insider.

C. Tommy cannot trade on the overheard conversation because of the subject matter of the information.


D. The only violation that occurred is the brokerage firms offer to pay for the lodging.

Study Session #3 – Quantitative Methods 2003 Jivendra Kale, Ph.D. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Each question in this section is 2 minutes unless noted otherwise

A junior analyst has developed the following regression model to predict tire industry sales at time t based on the variables in Table 1.

t-values: (1.02) (0.67) (1.48) (0.83) (1.76) (1.13)

Number of observations: 36Standard error of estimate: 1637.38Unadjusted R2: 0.955

Table 1. Variable DescriptionsSALES Annual tire industry sales (in millions of dollars)INDRUB Annual demand for replacement tires (Index: year 2000 = 100)CAP Capacity utilization rate (annual percentage) for rubber and plastic

manufacturingINDTR Annual industrial production of tires (Index: year 2000 = 100)MILES Annual all-systems mileage (in billions of miles)PERS Annual personal consumption of tires, tubes, and accessories (in

billions of dollars)

Variable Estimates for 2003INDRUB 144.1CAP 90.7INDTR 143.9MILES 2,359.8PERS 36.6

Critical Values for Student’s t DistributionArea in Upper Tail of Distribution

Degrees of Freedom 10% 5% 2.5%29 1.311 1.699 2.04530 1.310 1.697 2.04231 1.309 1.696 2.04036 1.306 1.688 2.028

11. The goodness of fit, or explanatory power, of a multiple regression equation is given by

A. The standard error of estimate for the regression


B. The F-statistic for the regression

C. The R2 for the regression

D. The t-values for the regression coefficients

12. What is the forecast of tire industry sales for 2003?

A. $19,330.154 million

B. $504.440 million

C. $19.330 million

D. $1,637.38 million

13. What is the 95% confidence interval for the forecast of tire industry sales for 2003?

A. $17,692.774 to 20,967.534 million

B. -$1,637.380 to 1,637.380 million

C. -$2,839.090 to 3,847.970 million

D. $15,986.624 to 22,673.684 million

14. Which is a symptom of multicollinearity?

A. Low R2 but statistically significant coefficients

B. Large R2 but statistically insignificant coefficients

C. Regression coefficients hardly change when independent variables are dropped from the regression equation

D. High standard error of estimate for the regression

Study Session #13 & 14 – Fixed Income – Credit and Valuation 2003 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Alicia Quan is an analyst for a mutual fund that owns some high-yield bonds issued by AQT Corporation. The following table shows AQT’s simplified balance sheet. Amounts are in millions of dollars.

Total assets 1,000 Current liabilities 200Long-term debt 300Equity 500

The long-term debt includes high-yield bonds, some of which are owned by the mutual fund. AQT is planning to embark on a new project that requires additional capitalization of $200 million. It is not clear how AQT plans to fund the new project. It may issue more stocks and possibly more bonds. Alicia is concerned that, if AQT decides to issue additional bonds, the


higher debt ratios would cause the existing high-yield bonds to go down in value. The high-yield bonds include a negative covenant that puts a limit on additional indebtedness unless certain ratios are met. One such ratio is the long-term debt to total capitalization, which must be less than 45%.

15. If AQT were to fund the new project by issuing additional bonds, the long-term debt to total assets ratio would be

A. 16.7%

B. 41.7%

C. 50.0%

D. 58.3%.

16. If AQT were to fund the new project by issuing stocks, the long-term debt to equity ratio would be

A. 30.0%

B. 42.9%

C. 60.0%

D. 71.4%.

17. Alicia is confident that the following cannot happen

A. AQT funds the new project using all stocks

B. AQT funds the new project using all bonds

C. AQT funds the new project using stocks and bonds

D. AQT funds the new project using stocks and syndicated bank loans.

18. Alicia is concerned that the high-yield bonds may drop in value if the new project is capitalized in a way that is detrimental to existing bondholders. She can hedge this risk by

A. shorting Treasury bond futures

B. buying put options on AQT stocks

C. monitoring closely the news from AQT corporate headquarters

D. none of the above.

19. To understand the interest rate risk of the high-yield bonds, Alicia would need

A. the modified duration

B. the effective duration

C. the convexity or effective convexity

D. the nominal spread or zero-volatility spread.


Answers to Item Set B

15. B. Long-term debt = 300 + 200 = 500. Total assets = 1000 + 200 = 1200.

16. B. Long-term debt = 300. Equity = 500 + 200 = 700

17. B. If AQT funds the new project using all bonds, then long-term debt = 300 + 200 = 500, total capitalization = 300 + 200 + 500 = 1000, and long-term debt to total capitalization = 500 / 1000 = 50%. This would violate the negative convenant.

18. D. A is definitely incorrect. Alicia is trying to hedge a credit risk event, not an interest risk event. Therefore Treasury bond futures would not help. B is tempting. Prices of high-yield bonds usually move in the same direction as the same company’s stocks. A put option on the company stock would then move in the opposite direction and provide some hedge. (Of course, finding the proper hedge ratio is still a problem.) In this case, however, the new funding may hurt the bondholders and hence benefit the shareholders. A put option would then lose when the high-yield bonds lose. This is no hedge. C is always a good idea. However, it does not provide a hedge. By the time the news comes out, the market may have reacted.

19. B. C is out since convexity does not help if one does not know the duration. D is out; spreads do not measure interest rate risk. A may be an acceptable answer if the high-yield bond is noncallable. However, since many corporate issues are callable, B is always a safe answer.

Study Session #15 – Fixed Income – Structured Securities 2003 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Abdul Ramaswamy’s department has been analyzing the company’s investments in mortgage-backed securities using nominal spreads and zero-volatility spreads. Some of the elements which may enter the calculations for these spreads are:

(i) yield of a Treasury instrument with maturity equal to the weighted average remaining maturity of the mortgage pool underlying the MBS,

(ii) yield of a Treasury instrument with maturity equal to the average life of the MBS,(iii) spot rates for the entire Treasury yield curve,(iv) expected cash flows for the MBS through its maturity,(v) market price of the MBS.

20. To calculate the zero-volatility spread,

A. (i), (iv), and (v) are needed

B. (ii), (iv), and (v) are needed


C. (iii), (iv), and (v) are needed

D. (v) is not needed.

21. The expected cash flows described in (iv)

A. have already accounted for expected prepayment and therefore accounted for the embedded prepayment option in the MBS

B. have already accounted for expected prepayment but have not accounted for the embedded prepayment option in the MBS

C. have not accounted for prepayment

D. are the same as the cash flows from the MBS with no prepayment.

Abdul wants to use more sophisticated techniques, such as option-adjusted spreads (OAS), to analyze the MBS.

22. OAS is superior to nominal spreads or zero-volatility spreads because

A. it is calculated using a Monte Carlo model

B. it is calculated using a binomial model

C. it properly accounts for the embedded prepayment option in the MBS

D. it makes use of the entire Treasury yield curve and interest rate volatility.

23. The zero-volatility spread may be thought of as

A. a constant spread over the entire yield curve

B. an extreme case of an OAS in which the volatility is assumed to be zero

C. a spread that does not change with volatility

D. both A and B.

Abdul decides to use a Monte Carlo model to analyze the MBS. He uses an interest rate volatility of 10% and obtains an OAS of 50 bp for a FNMA certificate. Later, he realizes that an interest rate volatility of 12% is more appropriate.

24. As the assumed volatility goes up, the value of the embedded prepayment option in the FNMA certificate

A. goes up

B. goes down

C. may go up or down

D. stays constant if the Monte Carlo model is properly calibrated to the interest rate volatility.


25. If Abdul had used the old OAS of 50 bp but the new 12% volatility to value the FNMA certificate, he would find that the model value of the FNMA

A. is higher than the market price of the FNMA

B. is lower than the market price of the FNMA

C. may be higher or lower than the market price of the FNMA

D. equals the market price of the FNMA if the Monte Carlo model is properly calibrated to the interest rate volatility.

Abdul has some experience with OAS in her work analyzing callable and putable bonds. After analyzing a few MBS, Abdul feels that she understands a lot more about OAS.

26. The OAS of an MBS

A. is always higher than the zero-volatility spread

B. is always lower than the zero-volatility spread

C. may either be larger or lower than the zero-volatility spread

D. may not be compared with the zero-volatility spread because they are calculated using two different methods.

27. The OAS of a callable bond

A. goes up when the assumed volatility goes up

B. goes down when the assumed volatility goes up

C. is always independent of the assumed volatility

D. is independent of the assumed volatility if the binomial model is properly calibrated to the interest rate volatility.

Answers to Item Set D

20. C. Take the expected cash flows and discount them at the appropriate spot rates plus a constant spread. This will result in a certain PV. Using trial and error, change the spread until this PV equals the market price. This spread is the zero-volatility spread.

21. B. The embedded prepayment option manifests itself as different cash flows under different interest rate conditions. One therefore need many cash flow scenarios to fully appreciate the option-like characteristics. A single set of expect cash flows simply will not do.

22. C.


23. D. A is obviously true. B is also true. The subtle point here is that discounting at a long-term spot rate (as in the calculation of a zero-volatility spread) is equivalent to discounting at a series of short-term future rates (as in the calculation of an OAS).

24. A. All options become more valuable with higher volatility.

25. B. When the volatility is increased to 12%, the embedded prepayment option is more valuable. However, the FNMA is short such an option. Therefore the new model value of the FNMA at 12% volatility is lower than the old model value at 10% volatility. The latter must equal the market price, by definition of the OAS.

26. B. Think of the opposite case of 10. When volatility goes down, the OAS of a FNMA goes up. In the extreme case when volatility goes to zero, the new OAS becomes the zero-volatility spread. This must be higher than the old OAS.

27. B. Same reasoning as in an MBS. Like an MBS, a callable bond is short the embedded call option. When volatility goes up, the embedded call option increases in value; hence the model value of the callable bond decreases. To bring the model value back up to the market price, one must decrease the OAS.

Study Session #16 – Derivatives – Futures and Swaps 2003 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Tim Lopez is an analyst at Wo Chong, a major manufacturer and wholesaler of tofu. The sale price of tofu is very stable. However, the cost of production fluctuates with the cost of the ingredients, mainly soybeans.

Tim wants to hedge the cost of production with soybean futures. He wants to run a regression of the cost of production against soybean futures prices:

COSTt = a + b SOYBEANt + et

COSTt = change in cost of production in $ per lb of tofu

SOYBEANt = change in soybean futures price in $ per bushel

Tim understands that the regression results will tell him if hedging will be effective or not.

28. For the hedging to be at least somewhat effective,

A. the coefficient a must not be zero

B. the coefficient b must be positive

C. the coefficient b must be negative

D. the coefficient b must not be zero.


Tim obtains the following regression results:

a = 0.0047, b = 0.0651, R2 = 0.28.

Based on the t statistics, the coefficient a is not significantly different from zero, but the coefficient b is significantly different from zero.

Tim wants to hedge the production cost of 1,000,000 lbs of tofu. Each soybean futures contract is for 5,000 bushels. The July contract is trading at 564.75 ($5.6475 per bushel).

29. Tim should

A. buy soybean futures contracts

B. sell soybean futures contracts

C. hold off because the regression results show hedging will not be effective

D. hold off because the regression results are inconclusive.

30. If Tim decides to hedge, the number of soybean futures contracts to buy or sell is

A. 1

B. 13

C. 325

D. 3,072.

Rightly or wrongly, Tim decides to hedge, and buys or sells the appropriate number of contracts. A month later, he finds that production cost of tofu has gone up from $0.48 per lb to $0.50 per lb. The July soybean futures contract is now trading at 594.75.

31. The cumulative mark-to-market cash flow over the month from the soybean futures contract(s) is

A. negative $1,500

B. negative $19,500

C. positive $19,500

D. positive $921.60.

32. Wo Chong’s net gain or loss is

A. a gain of $19,500

B. a loss of $20,000

C. a gain of $500

D. a loss of $500.


Nisei Bank has a portfolio of floating rate loans indexed to the Prime rate. The Prime rate moves more or less with LIBOR, but changes in jumps and less frequently. The bank’s earnings are directly tied to the amount of interest it receives from its loans. The management of Nisei Bank wants to stabilize its earnings, at least with respect to this portfolio of Prime based loans.

33. To stabilize its earnings, Nisei Bank canA. enter into a swap to receive LIBOR and pay fixed

B. buy a strip of Eurodollar futures

C. sell a strip of Eurodollar futures

D. none of the above.

The portfolio of Prime based loans have a current aggregate balance of $400 million. The balance will decrease over time as borrowers are required to make principal payments every month. The average life of a loan is 10 years.

34. To best stabilize its earnings, Nisei Bank shouldA. enter into a 5-year swap to receive LIBOR and pay fixed on a notional amount of

$400 million

B. enter into a 5-year swap to receive fixed and pay LIBOR on a notional amount of $400 million

C. enter into a 5-year swap to receive LIBOR and pay fixed on a notional amount of $800 million

D. D. enter into a 5-year swap to receive fixed and pay LIBOR on a notional amount of $800 million.

In 2003, Nisei Bank stepped right into the 20th century and discovered a wide variety of swaps besides the plain vanilla swap.

35. To best stabilize its earnings, Nisei Bank should enter intoA. an accreting swap

B. an amortizing swap

C. a basis swap to receive LIBOR and pay Prime

D. a yield curve swap.

Answers to Questions

28. The correct answer is D. Either a positive or a negative b can work. Tim can buy or sell depending on the sign of b. However, if b is zero, then there is no hedge.

29. The correct answer is A. In buying soybean futures, Tim is locking in the price at which Wo Chong can buy soybeans. That is the hedge.

30. The correct answer is B. From the regression, b = 0.0651 bushels of soybeans per lb of tofu. Tim wants to hedge 1,000,000 lbs of tofu, therefore he should hedge with 1,000,000


* 0.0651 or 65,100 bushels of soybeans. Each contract is for 5,000 bushels. Therefore he needs 65,100 / 5,000 or 13.02 contracts. Round that to 13.

31. The correct answer is C. Remember that each contract covers 5,000 bushels. A price change from 564.75 to 594.75 means an increase in price from $5.6475 per bushel to $5.9475 per bushel. Since Tim is long 13 contracts, the cumulative mark-to-market cash flow is positive. The amount is 13 * 5,000 * ($5.9475 $5.6475) or $19,500.

32. The correct answer is D. Loss from increase in production cost of tofu = 1,000,000 * ($0.50 $0.48) = $20,000.

Gain from futures = 13 * 5,000 * ($5.9475 $5.6475) = $19,500.

Net position = $19,500 $20,000 = $500.

33. B. The bank receives Prime, which fluctuates and causes earnings instability. When Prime goes down, earnings go down, as does LIBOR. If the bank is long Eurodollar futures, the futures position gains when LIBOR goes down, thus providing a hedge.

34. B. Matching the notional balance of the swap with the aggregate balance of the loan portfolio is important. This swap will only hedge the earnings for the first five years. A naïve view of D might lead one to think that 5 years at $800 million is equivalent to 10 years at $400 million. It isn’t.

35. B. The amortizing swap will take care of the declining aggregate balance of the portfolio quite nicely. The basis swap in C merely exchanges the instability from Prime for the instability from LIBOR. However, it is very useful when combined with a fixed for floating swap. See question 5.

Study Session #17 – Derivatives - Options 2002 Peter Chau, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


John Gambol is considering the purchase of JGD stocks and options for his company’s portfolio. JGD stocks are currently trading at $100 per share. JGD options are available in European puts and calls. The times to expiration are three months, six months, and nine months. Strike prices are $90, 95, $100, $105 and $110. All combinations are possible for a total of 2 x 3 x 5 or 30 options.

36. The cheapest call option (lowest call premium) is

A. the three-month call with a strike price of $95

B. the three-month call with a strike price of $105

C. the nine-month call with a strike price of $95

D. the nine-month call with a strike price of $105.


37. If JGD stocks go up, the highest dollar payoff at expiration would come from

A. the call with a strike price of $95

B. the call with a strike price of $100

C. the call with a strike price of $105

D. the put with a strike price of $100.

Of course, it is now prior to expiration. John is interested in doing some day trades to take advantage of short-term stock price movements.

38. If JGD stocks go down, the biggest dollar gain per option would come from

A. buying the six-month put with a strike price of $95

B. buying the six-month put with a strike price of $100

C. buying the six-month put with a strike price of $105

D. buying the six-month call with a strike price of $95.

39. If JGD stocks go up, the biggest return on investment would come from

A. buying the JGD stock

B. buying the three-month call with a strike price of $95

C. buying the three-month call with a strike price of $100

D. buying the three-month call with a strike price of $105.

John soon finds that day trading has its rewards, but comes with risks as well. His next strategy is to buy or write options but hold the position until expiration.

40. If JGD stocks go up, the following option strategy would gain

A. short an JGD three-month put with a strike price of $95

B. long a bull spread

C. short a bear spread

D. all of the above.

41. If JGD stocks go up substantially, the following option strategy would have the most gain

A. long a straddle

B. long a strangle

C. long a butterfly spread

D. long a bull spread


42. If JGD stocks go down substantially, the following option strategy would gain

A. long a straddle, long a strangle, or long a butterfly spread

B. short a straddle, short a strangle, or short a condor spread

C. long a straddle, long a butterfly spread, or long a condor spread

D. long a strangle, short a butterfly spread, or short a condor spread.

43. If JGD stocks stay within a narrow range, the following option strategy would gain

A. long a straddle, short a strangle, or long a bull spread

B. long a straddle, long a butterfly spread, or short a condor spread

C. short a straddle, short a butterfly spread, or short a condor spread

D. short a strangle, long a butterfly spread, or long a condor spread.

Answers

36. B. The cheapest call is the one that is the most out-of-the-money and the closest to expiration.

37. A. Most in-the-money call. The put is out-of-the-money.

38. C. This is another question about the delta of options. The call delta is positive; so D is out since the stock goes down. The put delta always negative; but since the stock goes down, that implies a gain. The magnitude of the put delta increases as the option gets more in-the-money. The deepest in-the-money put is C.

39. D. The return on investment is the increase in option value divided by the option cost. From question 4, we know that the increase in option value is higher for the more in-the-money calls. However, the in-the-money calls cost a lot more. Therefore the return on investment is not as great as that of the out-of-the-money calls. If one were to rank the return on investment from lowest to highest, it would be A, B, C, and D.

40. D. A short put position gains since the put remains unexercised. A long bull spread gains. A short bear spread is identical to a long bull spread.

41. A. C can be eliminated easily since a long butterfly spread loses when stock prices go up at lot. D can be eliminated because a bull spread gives up the extreme upside potential. A straddle gains more than a strangle in extreme price movements. If this were not so, a strangle would dominate a straddle in that it would have a better return at any stock price. Another way of looking at this is the following. A straddle involves buying an at-the-money call and an at-the-money put. A strangle involves buying an out-of-the-money call and an out-of-the-money put. The straddle obviously costs more than the strangle, and therefore should have better upside potential.


42. D. When stocks go down a lot, a long straddle gains, a long strangle gains, a short butterfly spread gains, and a short condor spread gains.

43. D. When stocks trade within a narrow range, a short straddle gains, a short strangle gains, a long butterfly spread gains, and a long condor spread gains.

Study Session #18 – Portfolio Management 2003 Patrick Collins, Ph.D., CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Each question in this section is 2 minutes unless noted otherwise

Consider the following information:

Year Investment X Investment Y

1 4% -6%

2 -10% 8%

3 8% 12%

4 14% -2%

Risk Free Rate: 2%

44. The Covariance of Investment X and Investment Y is:

A. -32.60

B. -21.00

C. +144.82

D. -103.50

Answer: B.Covariance = 1/n(xi – xavg)(yi – yavg), where

Average of x = 4%Average of y = 3%

[(4-4)(-6-3)+(-10-4)(8-3)+(8-4)(12-3)+(14-4)(-2-3)] / 4 =[(0) + (-70) + (36) + (-50)] / 4 = -84 / 4 = -21.00

45. The Standard Deviations of Investments X and Investment Y are:

A. 8.83 and 10.56

B. 6.44 and 4.71

C. 5.52 and 7.28

D. 8.83 and 7.28

Answer: D.


Standard Deviation = [(xi – xavg)2 / n]1/2

Investment X:{[(4-4)2 + (-10-4)2 + (8-4)2 + (14-4)2] / 4}1/2 =

{[(0) + (196) + (16) + (100)] / 4}1/2 = (78)1/2 = 8.83

Investment Y:{[(-6-3)2 + (8-3)2 + (12-3)2 + (-2-3)2] / 4}1/2 =

{[(81) + (25) + (81) + (25)] / 4}1/2 = (53)1/2 = 7.28

46. The correlation of Investment X and Investment Y is:

A. -0.3267

B. -0.8144

C. +0.0161

D. -0.6599

Answer: A.r = Covxy / (SDx)(SDy)r = -21.00 / (8.83)( 7.28) = -21.00 / 64.28 = -0.3267

47. The expected rate of return of a portfolio consisting of 40% Investment X and 60% Investment Y is:

A. 3.3%

B. 3.8%

C. Cannot be answered with data provided

D. 3.4%

Answer: D.E(Rp) = E(Rx)(%x) + E(Ry)(%y) =(.04)(.4) + (.03)(.6) = (.016) + (.018) = .034 = 3.4%

48. The standard deviation of a portfolio consisting of 40% Investment X and 60% Investment Y is:

A. 21.44

B. 13.89

C. 3.88

D. 4.63

Answer: D.SDp = [(%x)2(SDx)2 + (%y)2(SDy)2 + 2(%x)(%y)(COVxy)]1/2

SDp = [(.4)2(8.83)2 + (.6)2(7.28)2 + 2(.4)(.6)(-21.00)]1/2


SDp = [(.16)(77.97) + (.36)(52.99) + (-10.08)]1/2

SDp = [12.48 + 19.08 – 10.08]1/2 = 4.63

Consider the Following Information:

Beta Estimated Return Estimated Standard Deviation

Investment A .9 8.5% 16%

Investment B 1.1 10.5% 24%

Variance of the Market: .0289Return of the Market: 11%Risk Free Rate: 3%

49. The Alpha of Investment B is:

A. +.02%

B. -.02%

C. +1.8%

D. +4.02%

Answer: B.Alpha is the difference between Estimated Return and Required Return (as determined by the Security Market Line under the Capital Asset Pricing Model)Required return of Investment B = Risk Free Rate + Beta(Return of the Market – Risk Free Rate).Required Return of B = .03 + 1.1(.11 - .04)Required Return of B = .03 + .077 = 10.7%

Alpha = 10.5% - 10.7% = -.02% Investment B’s Alpha is negative.

Study Session #5 – Accounting – Mergers 2002 Ed Cordisco, CPA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Below is selected data from String Corporation’s acquisition of Cord Corporation on January 1, 2001. On that date, String acquired, for cash, all of the outstanding $5 par value voting stock of Cord for $100,000. Cord’s Property Plant & Equipment has a fair market value of $50,000 in excess of cost. Both companies continue to operate separately. Listed below are selectedseparate and consolidated Balance Sheet and Income Statement accounts.

Balance Sheet Account String Cord Consolidated


Cash $ 20,000 $ 10,000 $ 30,000Accounts Receivable 27,000 24,000 45,000Investment in Cord 100,000 - -0-Property & Equip 120,000 100,000 270,000

Accounts Payable 18,000 16,000 28,000Stockholders’ Equity 249,000 118,000 317,000

Income Statement Account

Revenues $350,000 $250,000 $560,000Cost of goods sold 252,000 195,000 420,000Gross Profit 98,000 55,000 140,000

50. Which one of the following accounting methods would be appropriate to account for this business combinations?

A. Pooling Method

B. Purchase Method

C. Cost Method

D. Equity Method

51. What is the primary difference between the Pooling Method and the Purchase Method accounting for a business combination?

A. The Pooling Method values the assets and liabilities at Fair Market Value.

B. The Purchase Method combines net income for the entire year.

C. The Purchase Method values the assets and liabilities at Fair Market Value.

D. Goodwill is only created using the Pooling Method.

52. Assume both companies are located in a foreign country where the International Accounting Board Standards (IASB) apply for the purchase method.

A. In-process Research & Developments costs are treated as an asset.

B. Amortization of goodwill, if any, is not amortized.

C. Assets and liabilities are recorded at net book value.

D. Goodwill is not created.

53. The financial ratios under the purchase method and pooling method will be affected in the following way.

A. The fixed asset turnover ratio will increase under the pooling method.

B. The fixed asset turnover ratio will decrease under the pooling method.


C. The use of pooling method, under IASB, will result in a more consistency of financial ratios.

D. The use of the purchase method under USGAAP and IASBGAAP will result in a more consistency of financial ratios.

54. At year end December 31, 2001 what was the amount of inter-company sales from String to Cord?

A. 27,000

B. 6,000

C. 12,000

D. 40,000

55. At year end December 31, 2001, what was the amount of inter-company Cord’s payable to String for inter-company purchases?

A. 27,000

B. 6,000

C. 12,000

D. 40,000

Study Session #4 – Economics 2003 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Each question is 2 minutes unless noted otherwise.

You are given the following information about the Turkey and the U.S.:

Spot Rate in 1995

Turkish lira per US$ e1995 = l 59,650/US$

Price Level Index in 2000 (Base Year 1995 = 100)

PTurkey2000 = 1521.6

PUS2000 = 112.7

56. Using the above information, the PPP spot exchange rate for the US$ in terms of Turkish lira in 2000 was closest to:

A. l 90,763,440/US$

B. l 907,634/US$

C. l 805,354/US$

D. l 6,722,555/US$


PP Rate2000 = e1995 x [PTurkey2000 / PUS

2000] = l 59,650/US$[1521.6/ 112.7]

= l 805,354.39/US$

Use the following information in the next four questions

Junior Johnson, an international fixed income analyst, is given the following information regarding the current spot rate and interest rates for the U.S. and Australia:

Table I

Current Spot Rate

Australian$/US$ AU$ 1.620/US$

Annual Interest Rate 3-month Gov’t 2-Year Gov’t

Australia 4.80% 4.68%

U.S. 1.22% 1.65%

57. The 3-month forward exchange rate between the Aussie dollar and the US dollar implied by the information in Table I is closest to:

A. AU$ 1.565/US$

B. AU$ 1.677/US$

C. US$ 1.645/AU$

D. AU$ 1.634/US$

Take Australia as home country given the way the exchange rate is quoted.

Covered Interest Parity Condition requires:

AU 3-month return = Hedged 3-month US Return

[1+rAU/4) = 1/e0 x (1+rUS/4) x f3-month

(1 + .0480/4) = (1/1.620) x (1.0122/4) x f3-month

Solving for the 3-month forward from above yields f3-month = 1.620 x (1.0120/1.0031) = 1.634

58. Using the information in Table I above, Junior Johnson’s expected future spot exchange rate for the US$ in terms of AU$ for two years in the future is closest to:

A. AU$ 1.668/US$

B. AU$ 1.677/US$

C. AU$ 1.718/US$

D. AU$ 1.737/US$


Australia is the Home Country and the EXR given is in Direct terms so that formula can be applied in straightforward way. To construct a two-year in the future forecast you must adjust the annualized interest rates to take into account the two-year forecast horizon.

Forecast Rate2005 = EXR2003 x [1+rAU]2/[1+rUS]2

Forecast Rate2005 = AU$1.62/US$ x [1.0468/1.0165]2 = AU$ 1.7180/US$

According to a poll of forecasters by The Economist magazine the expected inflation rate for the U.S. is 1.8% this year and 1.5% next year, while the expected inflation rate for Australia is 2.7% this year and 2.5% next year.

59. Using this information instead, Johnson’s expected future spot exchange rate for the US$ in terms of AU$ for two years in the future is closest to:

A. AU$ 1.635/US$

B. AU$ 1.650/US$

C. AU$ 1.689/US$

D. AU$ 1.718/US$

Using inflation differentials leads to a forecast for a smaller depreciation in the AU$ than does using the interest rate differentials

Forecast Rate2005 = EXR2003 x {[1+AU]2003 [1+AU]2004}/{[1+US]2003 [1+US]2004}

Forecast Rate2005 = AU$ 1.620/US$ x {(1.027)(1.025)} /{(1.018)(1.015)}= US$ 1.650/AU

60. Johnson’s supervisor decides that the best forecast for the Aussie dollar/US$ exchange at the end of two years is AU$ 1.635/US$. Using this forecast and the information from Table I, the expected US$ total return from a two-year investment in Australia government bonds is closest to:

A. 3.72%

B. 8.57%C. 7.44%

D. 5.04%

Expected Return calculated as

Expected US return = e2003 x (1 + AU return)2 x (1/E[e2005])

Expected US return = AU$1.62/US$ x (1.0468)2 x (1/(AU$1.635/US$) = 1.0857

i.e. 8.57% total return over two years


61. It is two years later. The actual exchange rate runs out to be AU$1.69/US$. The actual total return from a two-year investment in Australia government bonds is closest to:

A. 3.72%

B. 8.57%

C. 7.44%

D. 5.04%

Actual Return calculated as

Actual US return = e2003 x (1 + AU return)2 x (1/e2005)

Actual US return = AU$1.62/US$ x (1.0468)2 x (1/(AU$1.69/US$) = 1.0504

i.e. 5.04% total return over two years

Use the following table in answering the next two questions.

SPOT 3-MONTH FORWARD 1-YEAR FORWARD

PHILLIPINE PESO P 54.700-54.850/US$ P 54.9625-55.1625/US$ P 55.4990-55.7990/US$

JAPANESE YEN ¥ 117.130-117.180/US$ ¥ 116.975-117.075/US$ ¥ 116.690-116.840/US$

62. The exchange rate at which a Japanese bank will buy Phillipine pesos spot is closest to:

A. ¥ 2.1355/peso

B. ¥ 2.1413/peso

C. ¥ 0.4683/peso

D. ¥ 2.1422/peso

63. The value of the rate at which a Japanese bank will sell Phillipine pesos on the three-month-forward is closest to:

A. ¥ 2.1301/peso

B. ¥ 0.4716/peso

C. ¥ 2.1224/peso

D. ¥ 2.1206/peso


Study Session #3 & 4 – Quantitative Methods & Economics 2003 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Each question is 2 minutes unless noted otherwise.

The next two questions use the following table

Firm A Firm B Firm C

Revenues Euros US$ Euros

Costs Yen Euros US$

Assets Euros Euros US$

Liabilities Yen US$ Euros

Assume all three firms report their financial statements in US$.

64. An appreciation of the Euro against the US$ is likely to result in the greatest increase in the Return on Assets of which of the above three firms?

A. Firm A

B. Firm B

C. Firm C

D. All the firms are equally sensitive.

65. An appreciation of the Euro against the US$ is likely to result in the greatest decrease in the Debt/Equity ratio of which of the above three firms?

A. Firm A

B. Firm B

C. Firm C

D. All the firms are equally sensitive.

Questions 66. – 70. use the following regression results.


You are given the following International CAPM regression results for the U.S.$-denominated returns of a German multinational, SOP.

E(RSOP) = 0.032 + 1.245 RPW + 1.367 SRP¥ + 0.89 SRP€ + 0.45 SRP£

(0.015) (0.056) (0.987) (0.097) (0.109)

R2= 0.346 N = 120

66. Which is the least significant currency exposure that this firm faces based on the results of the above regression?

A. Japanese Yen exposure

B. Eurozone (Germany) Euro exposure

C. British Pound exposure

D. U.S. $ exposure.

67. Based on the results of the ICAPM regression, which of statement is correct?

A. A 1% appreciation of the Euro has no significant effect on the German firm’s value denominated in Euros.

B. A 1% appreciation of the Euro has no significant effect on the German firm’s value denominated in US$.

C. A 1% appreciation of the Euro has a +1% effect on the German firm’s value denominated in Euros.

D. A 1% appreciation of the Euro has a -1% effect on the German firm’s value denominated in Euros.

68 Which is the most valid interpretation of the R2 of this ICAPM regression?

A. R2 is low indicating the model does not explain the firm’s returns adequately.

B. R2 is high indicating the model explains the majority of the firm’s returns.

C. R2 indicates the systematic risk in the firm’s returns.

D. R2 indicates the idiosyncratic or diversifiable risk in the firm’s returns.

69. Under ICAPM’s assumption regarding the behavior of international capital markets, what is the least likely source of problems in the residuals of the regression?

A. Problems arising from omitting an important currency risk premium in the regression.

B. Heteroscedasticity due to changing volatility in foreign exchange markets.

C. Serial correlation arising from market inefficiency.

D. Multicollinearity due to the correlation between the world risk premium and the currency risk premiums.


A U.S. Investor evaluating the German multinational SOP using its estimated ICAPM regression and the following information.

– Currency risk premiums (SRP) are relative to the US$.– Expected return on World market is 8.2%.

Japan Germany U.K. U.S.

Risk-free Rate 0.02% 2.55% 3.59% 1.22%

Stock Market Return

-5.8% +2.8% +1.5% +9.2%

SRP$,i -1.50% 3.34% 1.43%

70. SOP’s expected US$ return based on the ICAPM regression and the information given above is closest to

A. 12.17%

B. 13.04%

C. 13.82%

D. 14.70%


Study Session #8 – Basic Valuation 2003 Don Davis, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Time allocated is given in each question.

THE QUESTIONS IN THIS SECTION ARE BASED ON THE FOLLOWING DATA:

Sample Company Financial StatementsYearly Data ($000 except per share data)

Income Statement December December2000 2001

Revenue $3,480 $5,400Cost of goods sold 2,700 4,270Selling, general, and admin. expense 478 665Depreciation and amortization 30 40

Operating income (EBIT) $272 $425

Interest expense 22 25Income before taxes $250 $400

Income taxes 60 110Income after taxes $190 $290

Diluted EPS $0.60 $0.84Shares outstanding (000)

Average 317 346 Year End 320 360

Balance Sheet December December2000 2001

Cash and cash equivalents $460 $ 50Accounts receivable 540 720Inventories 300 430Net Goodwill 50 43Net property, plant, and equipment 710 1,787

Total assets $2,060 $3,030

Current liabilities $760 $860Long Term Debt: 300 350Deferred Taxes 60 80Stockholders' equity 940 740

Total liabilities and equity $2,060 $3,030

LIFO Reserve 10 15Accumulated Goodwill Amort 10 17Year End Market price per share $21.00 $23.00Annual dividend per share $0.20 $0.40


Other Assumptions to use:

Use Book Values to determine the cost of capital. Assume no short term debt Assume no operating leases or non-operating income Assume a 4% risk-free rate Assume an equity market risk premium of 6%. Assume that Sample’s beta is 1.1 Assume that Sample’s marginal pre-tax cost of long term debt is 6% Assume that the marginal tax rate is 35%

First two questions are based on the “Economic Value Added” methodology.

(Total 15 minutes)

USE THE FOLLOWING TEMPLATE IN ANSWERING THIS QUESTION

Thing to calculate Calculation

71. Calculate 2001 Net Operating Profit After Tax, the intermediate step used to determine EVA.

(3 minutes)

Cash Operating Taxes: Tax expense: $ 110Adj: (a) (Incr) in Deferred Taxes ( 20)Add: (b) Tax benefit of Int Exp 9Total $ 99(a) Since deferred taxes went up, it means cash taxes paid was lower than tax expense.(b) = ($25 * 35%)

NOPAT: EBIT (Oper. Profit): $ 425 Add back Goodwill Amort. 7 Add: Incr. in LIFO reserve 5Adjusted EBIT (Adjusted Oper Profit) $ 437

Less: Cash Operating Taxes 99NOPAT: $ 338


USE THE FOLLOWING TEMPLATE IN ANSWERING THIS QUESTION

72. Calculate the adjustment for capital that must be made to Net Operating Profit to arrive at EVA.

(6 minutes)

Cost of Debt: 6% (1-.35) = 3.90%Cost of Equity: 4% + ( 1.1 (6%) ) = 10.60%

Equity Capital: 2000: 2001:Book Value of Equity $ 940 $1,740Deferred Taxes 60 80LIFO Reserve 10 15Accum Goodwill Amort 10 17Total Equity Capital $1,202 $1,852

Concept of EVA is based on INVESTED capital, and so includes add-backs to book value of equity.

Weighting: 2000: 2001: Average:Debt: $ 300 = 20.0% $ 350 = 15.9% 18.0%Equity: 1,202 = 80.0% 1,852 = 84.1% 82.0%Total Invested Capital $1,502 = 100.0% $2,202 = 100.0% 100.0%

Weighted Average Cost of Capital: 9.39%

Adjustment: subtract Wtg Avg Cost of Capital *Year End Capital= (9.39%) ($2,202) = ( 207)

Result: EVA (not asked for) $ 131

73. Calculate the Market Value Added in 2001.(Assume that book value of debt equals market value of debt.)

(6 minutes)

2000: 2001Yr End Shares 320 360

x Yr End Stock Price $21 $23Market Value of Equity $6,270 $8,280

Book Value of Debt: 300 350Total Market Value: $6,570 $8,630

Difference $2,060

Invested Capital(From Question 2. Above) 1,502 2,202

Difference $ 700

Market Value Added: $1,360


Scoring:

The entire question has a value of 21, proportion it as follows:

Question 71:

Correct Cash Operating Taxes 1Correct Adjusted EBIT 1Correct Final Result (NOPAT) 1

Question 72:

Correct Cost of Equity 2Correct Weighted Avg Cost of Capital 2Correct Adjustment for Capital 2

Question 73:

Correct Market Value 2Correct Invested Capital 2Correct Final Result (MVA) 2

Note: no points deducted if answer is off by 1 due to rounding.

Reference: Peterson & Peterson, Pages 12-24


Study Session #9 – Industry & Company Analysis 2003 Terry Lloyd, CPA, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Competitive Strategies -Above average industry performance is in many ways determined by a firm’s ability to employ a competitive advantage.

74. List and describe three types of competitive strategies that allow a firm to obtain a competitive advantage.

(1½ minutes)

Cost leadership. The firm seeks to be the low cost provider in the industry and seeks to achieve lower operating costs across all product lines. Prices are set at or jut below the industry average. The product should be homogeneous.

Differentiation . The firm focuses on product attributes that are important to buyers. The firm can charge a premium price for these benefits.

Focus . A focuser attempts to achieve cost leadership or product differentiation within a product niche.

75. Discuss the risks associated with each of the three generic strategies.

( 1½ minutes)

Cost leadership. The firm will not achieve cost leadership if several firms are trying to be the cost leader, including foreign firms.

Differentiation. A change in customer preferences, or imitation by competitors, whose benefits are perceived to be greater than the benefits offered by the subject firm.

Focus. The target segment ceases to be profitable.

76. List three ways that a producer can achieve cost leadership

( 1½ minutes)

(1) economies of scale,

(2) proprietary technology,

(3) preferential access to raw materials/inputs (such as lower rents paid for occupied space).

77. List three ways that a producer can differentiate its product.

( 1½ minutes)

Differentiation: (1) product differentiation, (2) unique marketing strategies, (3) unique delivery methods


Industry Analysis

78. Discuss three factors that should be included in an industry analysis model.

( 3 minutes)

Any Three of the following

Industry classification by life cycle phase or by response to the various stages in the business cycle.

External factor review of the issues that influence the fortunes of a given industry.

Demand analysis of the prospective market demand based on macroeconomic factors, industry classifications, and external factors.

Supply analysis, which evaluates prospective aggregate supply, based on current capacity and planned capacity additions.

Profitability analysis, looking to prospective industry profitability, using the factors listed above.

International competition and markets review, looking to potential competition from offshore sources.

79. Illustrate the life cycle of a typical industry.

( 3 minutes)

At the inception phase and new product or service is created. During this phase, the product/service is being tested and marketed to buyers.

During the pioneer phase sales and profits are low (or even negative) and the level of risk is high.

Next is the growth phase, when the product/service gains wider acceptance and sales and margins increase as some firms begin to dominate. During the later stages of the growth phase new firms enter (through expiring protections such as patents).

In the maturity phase, the firms collectively push the industry performance to average.

The industry eventually moves to decline, where firms have diminishing profit margins, consolidation and overall downsizing.segment ceases to be structurally attractive.


Study Session #10 – Equity – Valuation Models 2002 Terry Lloyd, CPA, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Discounted Dividend Valuation

80. An analyst has determined that the required rate of return for an equity investment in shares of XYZ is 10.5%. If the risk free rate is 6% and XYZ’s beta is 1.2, calculate the current equity premium.

This is a derivation of the risk premium from the CAPM and is solved algebraically:

R = Rfree + [β(Rmarket –Rfree)]

0.105 = 0.06 + [ 1.2(equity premium)] ; the equity premium = 0.0375

(2 minutes)

81. XYZ is not expected to pay a dividend until 10 years from now, at which time it is expected to pay a dividend of $1.25 and to increase the dividend at a rate of 6% thereafter. If the required rate of return is 7%, calculate the current value of XYZ.

V0 = = $67.99

It is discounted back for nine years since it is next year’s dividend that is discounted back.

(2 minutes)

82. XYZ is a stable firm with earnings and dividends expected to grow at 4% indefinitely. If the current dividend is $1.23 and the current value of XYZ is $17.00, calculate the required return.


This is a variation Gordon Growth:

r = + g = +.04 = $11.52%

(2 minutes)

83. A firm has a net income of $1.8 million on sales of $40 million, average assets of $40 million, and stockholders’ equity of $25 million. If the firm distributes 30 percent of its profits as dividends, calculate the Sustainable Growth Rate.

Sustainable growth = ROE x b [the retention rate]

g = ROE x b = x (1 - 0.30) =5.04%

(2 minutes)

84. If the required rate of return is 7%, calculate the value of a $100 par 5.5% fixed-rate perpetual preferred share.

The formula for fixed rate preferred is the same as that of a stock with no expected increase in dividends:

Vperpetual = = = = $78.57

(2 minutes)

Free Cash Flow Valuation

The Gray furniture company earned $3.50 per share last year. Investment in fixed capital was $2.00 per share, depreciation was $1.60, and the investment in working capital was $0.50 per share. Gray is currently operating at their target debt ratio of 40 percent, meaning 40 percent of new working capital and fixed capital will be financed with new borrowings.

85. Calculate the value of Gray’s stock if the shareholders require a return of 14 percent on their investment and the expected rate of growth in free cash flow to the equity is 4 percent per annum.


FCFEquity0 = NI – (1-DR)(FCInv – dep) – (1-DR)(WCInv) = $3.50 – (1 - .4)($2.00 - $1.60) – (1 - .4)($0.50) = $2.96

Equity value per share = = $30.78

(4 minutes)

The Anderson Door Co. earned $30 million before interest and taxes on revenues of $80 million last year. Capital expenditures were $20 million, and depreciation was $15 million. The additions to working capital were $6 million. Anderson is currently operating at their target debt ratio of 25 percent, and their tax rate is 40 percent. The shareholders require return of 15 percent on their investment, the firm’s cost of debt is 8 percent, and the expected growth rate in firm cash flows is 5 percent. The market value of debt is $25 million.

86. Calculate the value of the firm and the value of the firm’s equity.

FCFFirm0 =EBIT(1 – tax rate) + dep –FCInv – WCInv=

$30,000,000(1 – 0.40) + $15,000,000 - $20,000,000 - $6,000,000 =$7,000,000

After tax cost of debt = 0.08(1- 0.40) = 0.048 = 4.8%

WACC = (0.75 x 0.15) + (0.25 x 0.048) = 0.1245 =12.45%

Value of the firm = = $98,657,718

Given that the firm has $25 million in outstanding debt, the aggregate value of equity is $98,657,718 - $25,000,000 = $73, 657,718.

(4 minutes)


87. Describe how to use free cash flow to the firm (FCFFirm) models to value a firm’s equity, and discuss when it is appropriate to use an FCFFirm model instead of an FCFEquity model to value a firm’s equity.

FCFFirm models can be used to value a firm’s equity by first valuing the entire firm and then subtracting the value of the debt. This approach should yield the same estimate of equity value as an FCFEquity model if (1) consistent assumptions are made about growth in the two approaches, and (2) the firm’s debt is correctly valued.

It is more appropriate to use an FCFFirm model to value a firm’s equity if the firm has significant financial leverage or it is making substantial changes to its capital structure.

(2 minutes)

Study Session #11 & 12 – Equity – Applications & Special Issues 2003 Terry Lloyd, CPA, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.


Market-Based Valuation Price Multiples

The stock of Western Graphics Co. paid a dividend of $0.40 per share last year on earnings of $1.00 per share. The firm’s earnings and dividends are expected to grow at 5% per year forever.

88. Calculate the justified trailing price to earnings multiple based on these forecasted fundamentals for Western’s stock if shareholders require a return of 12% on their investment.

Trailing P/E

= = = 6.0

(2 minutes)

An analyst is valuing an electric utility with a dividend payout ratio of 0.65, a beta of 0.56, and an expected earnings growth rate of 0.032. A regression on other electric utilities produces the following equation:

Predicted P/E = $8.57 + (5.38 x dividend payout) + (15.53 x growth) - (0.61 x beta).


89. Calculate the predicted P/E on the basis of the values of the explanatory variables for the company.

Predicted P/E = 8.57 + (5.38 x 0.65) + (15.53 x 0.032) – (0.61 x 0.56) = 12.2

(2 minutes)

A junior portfolio manager has been asked to consider price-to-cash flow for the analysis in making a recommendation for an addition to the portfolio. She has gathered the following information:

Recent Price

Trailing CF per Share

P/CF Trailing FCFEquity per Share

P/FCFEquity Consensus Year

Growth Forecast

Beta

ABC $47.48 $2.00 23.90 $0.36 132.78 17.5% 1.22XYZ $28.40 $1.36 20.88 $0.99 28.69 22.2% 1.36

90. Compare the valuation of XYZ with ABC and make a recommendation for an addition to the portfolio.

XYZ appears to be undervalued relative to ABC. This conclusion is based on (1) XYZ is selling at a P/CF of 20.88, which is 88% of the P/CF for ABC (23.9), and (2) the P/FCFEquity for XYZ (28.69) is 22% of the P/FCFEquity for ABC (132.78). An investor can buy XYZ’s cash flow for a lower multiple and gets higher expected growth, based on consensus growth forecast of 22.2% for XYZ relative to 17.5% for ABC.

(2 minutes)

Residual Income Valuation

91. Explain the relationship between the residual income (RI) approach to valuation and dividend discount model (DDM) and free cash flow to equity (FCFEquity) alternatives.


In theory, the same value, or total present value, should be derived using expected dividends, expected FCFEquity, or book value plus expected RI if the underlying assumption are the same.

However, the recognition of value is different because FCFEquity and DDM models forecast future cash flows while RIMs start with a balance sheet measure of equity and the present value of expected future RI. An RIM can be used along with other models to assess the consistency of results.

(2 minutes)

Study Session #6 & 7 – Financial Statement Analysis 2003 Prof. John M. Veitch, CFA. All rights reserved. Reproduction in any form, in whole or in part, is prohibited without permission.

Use the following Footnote for the questions in this section

Pension Plan Footnote

The company has noncontributory defined benefit plans covering substantially all U.S. employees. The benefits for these plans are based primarily on years of service and employees' pay near retirement. The company's funding policy is consistent with the funding requirements of federal law and regulations.

The projected benefit obligation was determined using a discount rate of 9 percent at December 31, 2002 and 7.25 percent at December 31, 2001, and an assumed long-term rate of compensation increase of 5 percent. All quantities are in millions of $.

The Plan assets consist principally of common stocks and U.S. government obligations. The expected rate of return on plan assets is 9.25%

( As of December 31, ) 2002 2001

Actuarial PV of:

Vested Benefit Obligation $5,743 $5,567

Accumulated Benefit Obligation 6,256 6,024

Projected Benefit Obligation 7,820 7,169

Fair Market Value of Plan Assets 5,788 6,197

Book Value of Plan Assets 5,678

( for the year of ) 2002 2001

Service Cost $389

Interest Cost 477

Benefits Paid 493 457


Employer Contributions 84 78

Actual Return on Plan Assets (89) (126)

92. Which one of the following quantities is the most appropriate measure of the firm’s pension obligation in the event of the firm’s liquidation – VBO, ABO, PBO or Fair Market Value of the Plan Assets? Provide a brief justification for your choice.

PBO takes into account expected future increases in worker salaries. If the firm is expected to be liquidated this clearly overstates the pension obligation of the firm.

FMV of Plan Assets measures the ability to meet the pension obligation.

VBO measures the obligation that the firm has towards workers even if they leave the firm.

The most appropriate measure is the ABO as it captures the obligation to existing workers based on their existing salary structure.

(1 minute)

93. Calculate the value of the Interest Cost for the firm’s pension plan during the year 2002.

Interest Cost = PBOBeginning x Discount Rate = $7,169 x .09 = $645

(1 minutes)

94. Calculate the value of the Service Cost for the firm’s pension plan during the year 2002.

PBOYear-end = PBOBeginning + Service Cost + Interest Cost – Benefits Paid

$7,820 = $7,169 + Service Cost + $645 - $493

Service Cost = 7820 – 7169 – 645 + 493 = $499

(2 minutes)

95. Calculate the value of the Reported Pension Expense for the firm’s pension plan during the year 2002.


Pension Expense = Service Cost + Interest Cost – Expected Return on Plan Assets

= $499 + $645 – 6,197 x .0925 = $571

(2 minutes)

96. Calculate the value of the Actual Economic Pension Expense for the firm’s pension plan during the year 2002.

Pension Expense = Service Cost + Interest Cost – Actual Return on Plan Assets = $499 + $645 – (–89) = $1,233

(2 minutes)

95. Calculate the Book Value of Pension Assets for the firm’s pension plan on December 31, 2002.

BVend

= BVBegin + Expected Return on Plan Assets + Employer Contributions – Benefits Paid

= $5678 + $6,197 x .0925 + $84 – $493 = $5,842

(2 minutes)

96. Calculate the Minimum Liability Adjustment for the firm’s pension plan on December 31, 2002.


As ABO > FMVend of Plan Assets

MLA = ABO – FMVend of Plan Assets = $6,256 - $5,788 = $468

(2 minutes)


mock exam level ii 2003 ans

Documents