CFA Institute 2008 Mock Exam 01 Q

Q1-6

Sang-Gyung Jun Case Scenario

Sang-Gyung Jun is enrolled in an MBA program and serves as an unpaid intern for Portree Investment Services.

During his internship, Jun's supervisor at Portree, Barbara Fantine, teaches him several stock valuation

techniques. Jun hopes his unpaid internship will eventually result in full-time employment with Portree, and he

enthusiastically recruits a number of wealthy clients, most of whom are family members. Fantine praises his

efforts, remarking that "these clients are the foundation on which you can build your career at Portree."

Despite his success, Jun's internship remains unpaid even after he receives his MBA degree and passes the CFA®

Level III examination. Jun seeks full-time employment with Upsala Financial Corp., which specializes in serving

high-net-worth individuals.

When interviewing for the position at Upsala, Jun informs his interviewer that "I need to obtain only one more

year of work experience before I will receive the CFA charter. I passed all three CFA examinations on the first try."

After the interview, Jun considers contacting the clients he has recruited at Portree to ask if they would become

his clients at Upsala.

When Fantine learns of Jun's plans to leave Portree, she informs Jun, "You are not permitted to use any of the

valuation techniques I have taught you because they belong to me."

Jun subsequently accepts the position at Upsala and informs Fantine. On the same day, Fantine receives news

about the departure of another Portree employee, Jasmine Velez, CFA. Velez is leaving to start an investment

firm that will directly compete with Portree. Velez has not contacted any potential clients, but during non-work

hours she has incorporated the new firm and obtained the necessary licenses.

On Jun's first day of work at Upsala, he receives and reviews a copy of the firm's compliance policy, excerpts of

which appear in Exhibit 1.

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 Exhibit 1
Upsala Financial Corp.
Compliance Policy

Independent Practice

Employees of Upsala may enter into independent practice only in business segments not already targeted by

Upsala, and only in roles clearly leading to improvements in employee skill and expertise that can be used

beneficially by Upsala.

Priority of trades

The interests of outside clients must be given priority over accounts registered in the name of Upsala itself.

Moreover, all personal trades by employees of Upsala firm will be pre-cleared in accordance with the firm's

compliance policies.

Jun also receives new business cards which read "Sang-Gyung Jun, CFA, Investment Consultant." Jun mails

letters of introduction with the business cards to contacts and potential clients.

Jun soon impresses his supervisor at Upsala with his knowledge of stock valuation techniques. He does not inform

his supervisor that he learned the techniques from Fantine at Portree.

Several months later, Jun receives an offer of part-time consulting work from a family friend who needs

assistance marketing investment services to high-net-worth individuals in Korea. Jun reviews the firm's policy on

independent practice and confirms that Upsala does not conduct business in Korea. Jun is convinced that the

consulting work will improve his skills and thus benefit Upsala. He accepts the consulting work, which requires

approximately three hours of late-night work on Mondays and Wednesdays. Jun then sends an email to his

supervisor informing him of the consulting offer, its requirements, duration, compensation, and the skills he

expects to develop from the work.

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Question

According to CFA Institute Standards of Professional Conduct, may Jun solicit clients immediately following his

interview with Upsala?

Select exactly 1 answer(s) from the following:

A. Yes.

B. No, because he owes a duty of loyalty to Portree.

C. No, because he has not yet received an official offer from Upsala.

D. No, because he has not received written permission from either Upsala or Portree.

Question

When preparing to establish an investment firm, does Velez violate the CFA Institute Standard relating to Duty

to Employer?

Select exactly 1 answer(s) from the following:

A. No.

B. Yes, because she plans to compete directly with Portree.

C. Yes, because she incorporated the firm before leaving Portree.

D. Yes, because she uses the knowledge and skills acquired at Portree to develop a competing
business.

P.3 of 46
Question

When using the stock valuation methods at Upsala, does Jun violate any CFA Institute Standards of Professional

Conduct?

Select exactly 1 answer(s) from the following:

A. No.

B. Yes, because he does not have Fantine's permission.

C. Yes, because he does not have Portree's permission.

D. Yes, because he does not inform his supervisor of the source of the methods.

Question

Does Jun violate CFA Institute Standards of Professional Conduct with respect to his:

statement about passing use of the

exams on the first try? business card?

A. No No

B. No Yes

C. Yes No

D. Yes Yes

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

P.4 of 46
Question

To make Upsala's statement on Priority of Trades consistent with CFA Institute Standards, Jun's most

appropriate recommendation is to replace the first sentence with:

Select exactly 1 answer(s) from the following:

A. The interests of clients must be given priority over accounts in which Upsala's employees are

beneficial owners.

B. The interests of outside clients must be given priority over family client accounts and accounts

registered in the name of Upsala itself.

C. The interests of outside clients must be given priority over family client accounts and accounts in

which Upsala's employees are beneficial owners.

D. The interests of outside clients must be given priority over family client accounts, accounts in

which Upsala's employees are beneficial owners, and the accounts registered in the name of Upsala
itself.

Question

When accepting the part-time consulting position, does Jun violate any CFA Institute Standards?

Select exactly 1 answer(s) from the following:

A. No.

B. Yes, because he does not have consent.

C. Yes, because he does not provide adequate disclosure to Upsala.

D. Yes, because the work requirements will interfere with his duties to Upsala.

P.5 of 46
 Q7-12

Jacques Nordique Case Scenario

Jacques Nordique is a quantitative analyst at Brimford Investment Management. One of the firm's managing

partners asks Nordique to collect and analyze data as part of a project to explain and to forecast the behavior of

price/earnings (P/E) ratios. Nordique wants to examine time-series models of P/E behavior and begins by

collecting 15 years of monthly data on market P/E ratios.

After considering several different time-series models, Nordique estimates a regression equation of the form:

(P/E)t = b0 + b1 (P/E)t-1 + εt

and obtains the results shown in Exhibit 1. Nordique believes the time series is mean reverting and given the

estimated coefficients, he calculates the mean-reverting level of the market P/E ratio to be 13.3.

Exhibit 1

Regression Results

Dependent Variable is the Market Price/Earnings (P/E) Ratio

Regression Statistics

R-squared 0.959

F-statistic 4160.885

Standard Error of Estimate 0.988

Number of Observations 179

Durbin-Watson Statistic 2.115

Coefficients Standard Error

Intercept 0.332 0.189

(P/E)t-1 0.975 0.015

Nordique shares his time-series results with his supervisor, Amy Beloit. She is interested in the implications for

stock-bond allocation, especially given that Brimford's investment strategists are neutral on the future direction

of interest rates. After reviewing the results, Beloit has two concerns about the time series estimated in Exhibit

1: (1) do the error terms exhibit heteroskedasticity; and (2) does the time series exhibit a unit root? Exhibit 2

contains critical values of several test statistics that may be relevant to the results that Nordique and Beloit are

interpreting.

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 Exhibit 2

Critical Values of Selected Test Statistics

t-statistic Durbin-Watson Statistic

One-tailed Probabilities α = 0.05, K = 1

Degrees of freedom p = 0.05 p = 0.025

2 2.92 4.30 dL = 1.65, dU = 1.69

120+ 1.66 1.98

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 Question

Given Nordique is correct about the mean reversion of the time series, his most appropriate action to determine if
the time series equation estimated in Exhibit 1 is correctly specified is to examine the:

Select exactly 1 answer(s) from the following:

A. Durbin-Watson statistic.

B. R-squared value and F-statistic.

C. autocorrelations between the error terms.

D. correlation between the squared error terms and the independent variable.

Question

To determine whether Beloit's first concern is valid, Nordique's most appropriate action would be to:

Select exactly 1 answer(s) from the following:

A. perform the Dickey-Fuller test.

B. re-estimate the model using a moving average.

C. regress the squared residuals from the equation estimated in Exhibit 1 on the squared
residuals lagged one period.

D. test whether the variance of the error in one period depends on the variance of the
error in successive time periods.

Question

Which of the following models is most appropriate to determine if Beloit's second concern is justified?

Select exactly 1 answer(s) from the following:

A. (P/E)t – (P/E)t–1 = b0 + g1 (P/E)t + εt.

B. (P/E)t - (P/E)t-1 = b0 + g1 (P/E)t-1 + εt.

C. (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t - (P/E)t-1] + εt.

D. (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t-1 - (P/E)t-2] + εt.

P.8 of 46
 Question

If Beloit's second concern about the time-series results in Exhibit 1 is correct, Nordique's most appropriate action is to:

Select exactly 1 answer(s) from the following:

A. do nothing, because unit roots can be ignored when the Durbin-Watson statistic exceeds du..

B. do nothing, because unit roots are expected when using time-series data and will not affect the
specification of the equation.

C. re-estimate the regression using the form: (P/E)t = b0 + b1 (P/E)t-1 + b2 (P/E)t-2 + εt.

D. re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 +b1 [(P/E)t-1 - (P/E)t-2 ] +εt.

Question

If Nordique's claim about mean reversion is correct, which of the following recommendations is most appropriate?

Select exactly 1 answer(s) from the following:

A. Overweight stocks if the P/E is above its mean reversion level.

B. Underweight stocks if the P/E is above its mean reversion level.

C. Overweight stocks if the stock market is falling and underweight stocks if the stock market is rising.

D. Overweight stocks if the P/E is below its historical average, underweight stocks if the P/E is above
its historical average.

Question

If the model estimated in Exhibit 1 is correctly specified, and the market P/E ratio is 22.50 in June 2007, the

estimate of the market P/E ratio for August 2007 is closest to:

Select exactly 1 answer(s) from the following:

A. 21.39.

B. 21.91.

C. 22.04.

D. 22.27.

P.9 of 46
 Q13-18

Gregory Fanner (ACI) Case Scenario

Gregory Fanner, CFA, is a financial analyst with Alchemy Consolidated Industries, Inc. (ACI). ACI is a U.S.

corporation involved in several industry sectors and, in addition, has a significant portfolio of intercorporate

investments. Fanner's supervisor, Charles Wilmington, has requested that Fanner provide an update on ACI's

newest equity and debt investments (all purchased 1 January 2007). Wilmington is especially interested in three

of the investments, Marco, Inc., Cortez, Inc., and Da Gama, Inc., because they have declined in value. Fanner

has developed Exhibit 1, containing information about the companies requested by Wilmington.

Exhibit 1
ACI, Inc. Portfolio A
Newest Acquisitions (amounts in millions)

Market Value
Ownership Cost Basis Reported Net Dividends Received by
Investment 31 December
Percentage ($U.S.) Income 2007 ACI in 2007
2007

Columbus, Inc. 60% $200 $200 $65 $6.0

De Soto, Inc. 30% $125 $160 $85 $5.0

Marco, Inc. 25% $75 $65 $60 $3.0

De Vaca, Inc. 10% $25 N.A. $50 $2.0

Viking, Inc. 5% $20 $40 $80 $0.5

In addition to the equity investments in Exhibit 1, Fanner was asked to evaluate two recently acquired debt

holdings, which have been classified as held-to-maturity. Information about these securities is shown in Exhibit

2.

Exhibit 2
ACI, Inc. Portfolio B
Newest Acquisitions (amounts in millions)

Interest
Cost Basis
Market Value Received
Investment (Purchased at
31 December 2007 by ACI in
Par Value)
2007

Cortez, Inc. $50 $46 $3

Da Gama, Inc. $35 $30 $2

P.10 of 46
Wilmington has asked for Fanner's opinion about reclassifying the two debt securities to available-for-sale

securities. After investigating, Fanner discovers significant negative changes in the economic circumstances

regarding these securities, and indicates to Wilmington that reclassification should not create a problem. As a

separate issue, Fanner also discovered that the possibility exists for De Soto to be involved in future litigation

such that ACI's influence could be challenged. Currently, ACI's degree of influence over De Soto has not been

compromised.

Fanner has gathered the following additional information:

• ACI controls 7 of 12 seats on the Columbus board of directors, 3 of 10 seats on the De Soto board of directors,
and 3 of 16 seats on the Marco board of directors.

• Marco has a majority holder that exercises control over Marco's operations.
• ACI does not classify equity securities as trading account securities.
• De Vaca is the only security from Exhibits 1 or 2 that is not publicly traded.

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 Question

Based on ACI’s equity investments in Portfolio A, the incremental net income to be included on ACI’s 2007 income
statement was closest to:

Select exactly 1 answer(s) from the following:

A. $16.5 million.

B. $55.0 million.

C. $70.0 million.

D. $96.0 million.

Question

If Fanner reclassifies the debt securities in Portfolio B, the change in ACI's pre-tax income (in millions) for 2007

would be closest to:

Select exactly 1 answer(s) from the following:

A. -$9.

B. -$5.

C. -$4.

D. $0.

Question

For all marketable securities in Portfolios A and B that are classified under SFAS 115, the mark-to-market portfolio
return for 2007 was closest to:

Select exactly 1 answer(s) from the following:

A. $ 8.5 million.

B. $ 9.5 million.

C. $16.5 million.

D. $49.5 million.

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 Question

If, after year end, ACI loses majority control of Columbus through loss of some board seats, the most likely result
is that ACI's:

Select exactly 1 answer(s) from the following:

A. net income will decrease.

B. total revenues will decrease.

C. net working capital will increase.

D. return on common equity will decrease.

Question

If Wilmington announces that the litigation involving De Soto has materialized and that Fanner should make any

necessary reclassifications, the most likely result is that ACI's:

Select exactly 1 answer(s) from the following:

A. debt-to-equity ratio will be lower.

B. book value per share will be lower.

C. income for tax reporting will be greater.

D. cash received from investees will be greater.

Question

The year-end 2007 balance sheet carrying value of De Soto was closest to:

Select exactly 1 answer(s) from the following:

A. $120.0 million.

B. $145.5 million.

C. $150.5 million.

D. $160.0 million.

P.13 of 46
 Q19-24

Erika Wong Case Scenario

Erika Wong, an analyst with Montreal Investments, is forecasting 2008 results for Garrison Inc. Garrison has two

wholly-owned European subsidiaries: Catlette and Heren. Wong has prepared individual forecasts for the parent

company (before consolidating the subsidiaries) in U.S. dollars and for the two subsidiaries in their local currency

(the Euro). She wants to determine how the translation of subsidiary results will affect the consolidated results

of operations, using the following additional information:

• Both Catlette and Heren use the FIFO method for inventory.

• Catlette's results will be translated into dollars using the all-current method.
• Heren's results will be remeasured into dollars using the temporal method.

Wong's forecasted exchange rates for the U.S. dollar and Euro are shown in Exhibit 1 along with historical rates.

Her forecasted financial data for Catlette Company are presented in Exhibits 2 and 3.

Wong is particularly concerned about whether the choice of translation methods will distort Garrison's financial

ratios relative to the ratios in local currencies. She plans to translate the forecasted financial statements for the

subsidiaries into U.S. dollars using the methods which Garrison is expected to use.

Exhibit 1

Exchange Rates

31 December 2007 0.80 Euro = 1.00 US dollar

31 December 2008 0.75 Euro = 1.00 US dollar

2008 average 0.78 Euro = 1.00 US dollar

Rate when Catlette's fixed assets were acquired 0.85 Euro = 1.00 US dollar

Rate when Catlette acquired

Year-end 2007 inventory 0.82 Euro = 1.00 US dollar

Year-end 2008 inventory 0.75 Euro = 1.00 US dollar

P.14 of 46
 Exhibit 2
Catlette Company
Forecasted Balance Sheet
31 December 2008
(in millions of Euro)

Cash and receivables 50

Inventory 200

Fixed Assets 1,000

Total Assets 1,250

Liabilities 350

Capital Stock 650

Retained Earnings 250

Total liabilities and stockholders' equity 1,250

Exhibit 3

Catlette Company

Other Financial Data

(in millions of Euro)

2008 Forecasted Sales 1,000

2008 Forecasted Cost of sales 700

31 December 2007 Inventory 100

P.15 of 46
 Question

Considering the translation method chosen, Garrison most likely designated the Euro as the functional currency for:

Select exactly 1 answer(s) from the following:

A. Heren only.

B. Catlette only.

C. both Heren and Catlette.

D. neither Heren nor Catlette.

Question

When it consolidates Heren's results, Garrison will ignore the exchange rate holding effects of:

Select exactly 1 answer(s) from the following:

A. realized monetary gains.

B. unrealized monetary gains.

C. realized nonmonetary gains.

D. unrealized nonmonetary gains.

Question

The translation method used by Garrison for Catlette is best justified if:

Select exactly 1 answer(s) from the following:

A. Catlette is a sales outlet for the parent's products.

B. Catlette operates in a highly inflationary economy.

C. Catlette is a self-contained independent operating entity.

D. Garrison's reporting currency is used as the functional currency for Catlette.

P.16 of 46
 Question

When Garrison consolidates Catlette's results, unrealized exchange rate holding gains on monetary assets will be:

Select exactly 1 answer(s) from the following:

A. unreported.

B. reported in operating earnings.

C. reported in non-operating earnings.

D. reported in equity as a cumulative translation adjustment.

Question

When Wong converts her forecasted balance sheet for Catlette into U.S. dollars, total assets at 31 December 2008

(in millions) will be closest to:

Select exactly 1 answer(s) from the following:

A. $ 1,038.

B. $ 1,510.

C. $ 1,644.

D. $ 1,667.

Question

When Wong converts her forecasted income statement data for Catlette into U.S. dollars, gross profit margin for
2008 will be closest to:

Select exactly 1 answer(s) from the following:

A. 27.2%.

B. 28.1%.

C. 30.0%.

D. 32.7%.

P.17 of 46
 Q25-30

MFT Plc Case Scenario

MFT Plc is a money management firm based in the U.K. One of MFT's funds invests in companies with effective

corporate governance and conservative capital structures. Rollo Martin, a newly hired analyst, prepares a

presentation for the MFT investment committee.

Before screening potential investment opportunities, Martin asks his supervisor Hugh Crabbin how to identify

effective corporate governance structures/systems. Crabbin states that Martin should look for the following

corporate governance attributes:

• Transparency in disclosures;

• Measurable performance accountabilities;

• Strong directors identification with managers' interest;

• Clearly defined governance responsibilities to stakeholders.

Martin gathers information regarding several enterprises and finds on France-based TML S.A.'s website details on

its corporate governance which are presented in Exhibit 1.

Exhibit 1

Extract from TML S.A.'s Corporate Governance Information

Board Responsibilities

1. Acquire adequate training so that members are able to adequately perform their duties.

2. Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's

performance.

3. Establish corporate values and governance structures for the company to ensure that the business is conducted
in an ethical, competent, fair, and professional manner.

Martin discusses TML S.A.'s corporate governance structure and the valuation implications with his colleague

Buck Dexter. Dexter is concerned about management's ability to receive excessive compensation, to take on

unwarranted off-balance-sheet obligations, and to enter into transactions harming shareholders' long-term

interest.

P.18 of 46
 In addition to TML S.A.'s corporate governance, Martin analyzes the company's capital structure. He observes

that it has a low debt-to-equity ratio relative to its peers. Martin determines the unlevered value for TML S.A. to

be €2,000,000,000. He makes the estimates shown in Exhibit 2 to assess the impact of leverage on TML S.A.'s

capital structure.

Exhibit 2
Selected Leverage Scenarios for TML S.A.

Scenario Low Current Medium High

Present Value of Costs of Financial Distress in € thousand 0 100 1,000 25,000

Weighted Average Cost of Capital 11.00% 10.50% 10.00% 11.00%

Cost of Equity 11.00% 13.00% 16.00% 19.00%

Despite Dexter's concerns with regard to TML S.A.'s corporate governance, Martin includes the company in his

presentation as an investment opportunity. During the investment committee meeting J. G. Carey, one of MFT's

senior members, noted that TML S.A. has a debt-to-equity ratio lower than its peers and has shorter maturity

debt.

Carol Reed, MFT's chief investment officer, is interested in TML S.A.'s dividend policy. TML uses a longer-term

residual dividend approach and currently earnings are near the cyclical high. Martin explains that in the past the

company has kept its cash dividend stable despite rising earnings. Moreover, he believes that the recent increase

in earnings is only temporary. In addition to paying cash dividends, the company has a share repurchase

program.

Reed does not agree that much of the increase in TML S.A.'s earnings is temporary. She wants to know from

Martin what the expected dividend of TML S.A. would be if the company used a 5-year period to adjust the

dividend towards a target payout ratio of 40%. Martin uses TML S.A.'s regular dividend per share of €0.50, last

year's earnings of €2.50 per share, and current year's anticipated earnings of €3.0 per share to calculate the

expected dividend.

P.19 of 46
 Question

Crabbin's list of corporate governance attributes given in response to Martin's question is least appropriate with
regard to:

Select exactly 1 answer(s) from the following:

A. transparency.

B. measurability.

C. identification.

D. defined responsibility.

Question

Is each of the responsibilities of the board of directors listed in Exhibit 1 a component of an effective corporate

governance system?

Select exactly 1 answer(s) from the following:

A. Yes.

B. No, because Item 1 is not a component of an effective corporate governance system.

C. No, because Item 2 is not a component of an effective corporate governance system.

D. No, because Item 3 is not a component of an effective corporate governance system.

Question

Dexter's concern regarding TML's management reflects each of the following risk areas except:

Select exactly 1 answer(s) from the following:

A. asset risk.

B. liability risk.

C. accounting risk.

D. strategic policy risk.

P.20 of 46
 Question

Assuming static trade-off theory holds and using the information in Exhibit 2, TML S.A.'s value is:

Select exactly 1 answer(s) from the following:

A. unaffected by capital structure.

B. highest under the low leverage scenario.

C. highest under the high leverage scenario.

D. highest under the medium leverage scenario.

Question

Given TML's dividend policy and Martin's assessment of its earnings, TML's most likely course of action would be to:

Select exactly 1 answer(s) from the following:

A. reduce share repurchases.

B. increase the cash dividend.

C. introduce a stock dividend.

D. maintain the current cash dividend.

Question

If TML S.A. were applying the proposed target payout ratio, its expected dividend would be closest to:

Select exactly 1 answer(s) from the following:

A. €0.54.

B. €0.58.

C. €0.70.

D. €0.74.

P.21 of 46
Q31-36

Faye Kennant Case Scenario

Faye Kennant, an equity analyst, is preparing a research report on Svensoft Oyj, which sells application software

to large financial services firms and is based in Helsinki, Finland. Kennant plans to conduct an industry analysis,

consider several valuation alternatives, and select an appropriate valuation tool.

Her first step is to consider whether Svensoft is in an attractive industry and to gauge whether Svensoft has a

strong position within the industry. She prepares the following industry analysis:

• Industry structure and rivalry: The application software industry is dominated by two companies: Waldoware
and Meteor. The founders of Waldoware and Meteor are long-term rivals and the two firms compete brutally
for every customer. Svensoft has historically avoided competition with the two by focusing on the needs of

large financial services providers. However, Waldoware recently acquired a small financial services software

firm and has provided significant resources for it to compete more effectively. Further, Meteor has developed

its own offering, which many customers consider superior to Svensoft's offering.

• Threat of new entry: The dominant positions enjoyed by existing players have resulted in significant barriers
to entry.

• Threat of substitutes: substitute products are not currently available.

• Customer power: Since most financial services firms already have some sort of application software, the
recent increase in available offerings is allowing them to negotiate much better deals for renewals or new

licenses.

• Supplier power: Labor is the primary input to application software. The increased rivalry has created demand
for programmers and elevated salaries, particularly for experienced programmers.

• Demand: Application software has largely penetrated its target customer base and industry revenue growth
has slowed. Over the business cycle revenues are now expected to rise and fall at approximately 1.25 times

the rate of overall economic growth.

• Supply: There are few limitations to the quantity of application software that can be provided.
• Svensoft has decided to respond to these pressures by further focusing on the reliability of its applications.
Financial services customers have cited reliability as their key consideration in purchase decisions. Svensoft
currently lags Waldoware in this regard but intends to become the most reliable.

Kennant believes in using appropriate valuation models grounded in traditional intrinsic value and discounting

concepts. She believes that modern portfolio theory (MPT) applies to portfolios but it is not useful in valuing an

individual stock.

Given the consolidation that has already taken place in the industry, Kennant believes Svensoft could be acquired.

She considers several potential valuation models to determine Svensoft's potential takeover value.

P.22 of 46
 Question

Does Svensoft appear to be in an attractive industry, and is it well positioned within that industry?

Attractive Well positioned

Industry within Industry

A. No No

B. No Yes

C. Yes No

D. Yes Yes

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

Svensoft's competitive strategy is best described as:

Select exactly 1 answer(s) from the following:

A. focus.

B. cost leadership.

C. differentiation.

D. stuck in the middle.

P.23 of 46
 Question

The industry analysis model for Svensoft pays least attention to:

Select exactly 1 answer(s) from the following:

A. supply.

B. demand.

C. profitability.

D. external factors.

Question

Which life cycle phase and business cycle reaction best describe the application software industry?

Business Cycle
Life Cycle Phase
Reaction

A. Growth Cyclical

B. Mature Cyclical

C. Growth Defensive

D. Mature Defensive

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

P.24 of 46
 Question

With regard to product segmentation and ease of industry entry, the financial service segment of the application
software market is best described as:

Product Ease of
Segmentation Industry Entry

A. rising easy

B. rising difficult

C. falling easy

D. falling difficult

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

Are Kennant's beliefs on valuation models correct with regard to the applicability of:

Modern
discounting?
Portfolio Theory?

A. No No

B. No Yes

C. Yes No

D. Yes Yes

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

P.25 of 46
 Q37-42

Carl Heuser Case Scenario

Carl Heuser is senior equity analyst with Kaleidoscope AG, a specialized Austrian research company. Heuser has

recently assumed responsibility for the global food and beverage industry and is preparing an industry study. A

colleague, Joseph Mayer, who is working on parts of the report, asks why Heuser places so much emphasis on

valuation, given that in efficient markets prices reflect values. Heuser states that valuation models:

• determine objective prices.

• estimate intrinsic stock values.
• help assess the impact of corporate events.
• help infer market expectations reflected in prices.

Mayer still questions the use of relative valuation models. He argues that absolute valuation models specify an

asset's intrinsic value, whereas relative valuation models specify an asset's value only relative to a benchmark

value.

Heuser is focusing his analysis on chilled foods, because he classifies this sub-industry to be in the growth phase

of its life cycle. He investigates French Belle Cuisine S.A. and American Fast Food, Inc. Belle Cuisine makes

branded products served in private hospitals; in this niche market, Belle Cuisine strives to remain the quality

leader at reasonable production costs. In contrast, Fast Food is a mass-market producer. Its success is based on

reasonable quality with highly cost-efficient production. Heuser gathers financial information, shown in Exhibit 1,

about both companies.

Exhibit 1

Belle Cuisine and Fast Food

Selected Financial Information, Year End, in Million Euros

Belle Cuisine Fast Food

Sales 120.0 200.0

Earnings before interest and taxes 17.0 30.0

Earnings before taxes 9.0 14.0

Net income 6.0 9.3

Assets 200.0 225.0

Equity 40.0 50.0

P.26 of 46
Analyzing the competitive forces within the chilled food sub-industry, Heuser finds that Belle Cuisine, Fast Food,

and their various competitors buy ingredients from a large number of suppliers. Although both companies

currently experience above industry average operating returns, Heuser is concerned about Belle Cuisine's

dependence on five private hospital groups, where more than 75% of its sales are concentrated.

In his study Heuser rates the chilled food sub-industry to be attractive for investors because, as a result of the

industry structure, companies can capture a high proportion of the product value created. He states that the:

• industry growth is an element in determining rivalry.

• high capital requirements serve as a barrier to entry.

• absence of supplier concentration keeps input factor costs low.
• buyer propensity to substitute reduces intensity of rivalry.

Finally, Mayer argues that the chilled foods sub-industry is in the pioneering stage of the industry life cycle

because:

• it is still at risk for many business failures.

• product acceptance is established.

• companies are competing for market share.

• shifting consumer tastes drive the sub-industry.

P.27 of 46
 Question

Is Mayer correct or incorrect in his statement about:

absolute valuation relative valuation

models? models?

A. Correct Correct

B. Correct Incorrect

C. Incorrect Correct

D. Incorrect Incorrect

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

Based on DuPont analysis, the primary determinant of Fast Food's higher return on equity, compared with Belle
Cuisine, is Fast Food's:

Select exactly 1 answer(s) from the following:

A. lower tax burden.

B. higher asset turnover.

C. lower interest burden.

D. higher net profit margin.

P.28 of 46
 Question

With respect to Belle Cuisine's prospects for profitability, which of the following best describes the effect of the
bargaining power of Belle Cuisine's:

suppliers? buyers?

A. Low Low

B. Low High

C. High Low

D. High High

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

With respect to capturing product value created as a result of industry structure, Heuser's least correct statement

relates to:

Select exactly 1 answer(s) from the following:

A. industry growth.

B. capital requirements.

C. supplier concentration.

D. buyer propensity to substitute.

P.29 of 46
 Question

Belle Cuisine's generic competitive strategy is best described as:

Select exactly 1 answer(s) from the following:

A. cost focus.

B. differentiation.

C. cost leadership.

D. differentiation focus.

Question

In the context of the industry life cycle, Mayer's classification of the chilled food sub-industry is best supported by

his argument relating to:

Select exactly 1 answer(s) from the following:

A. business failures.

B. product acceptance.

C. competition for market share.

D. shifting tastes driving the sub-industry.

P.30 of 46
 Q43-48

Jan Katz Case Scenario

Jan Katz, an analyst for Western Advisors, has been asked by the fixed-income portfolio management team to

review two investment-grade bonds and two high-yield bonds.

The investment-grade bonds, issued by Barr Manufacturing and Park Retailers, carry the same credit ratings.

However, Moody's and Standard & Poor's have placed the debt of Barr Manufacturing, a major producer of

consumer products, on downgrade watch. It is widely expected that Barr's debt will be downgraded by both credit

rating agencies, but Katz believes a major risk is that the downgrade is not fully reflected in the price of the bonds.

Park Retailers, a general merchandise retailer, has just announced major expansion plans which will be funded

internally, and the management team asks Katz to determine Park's financial capacity to do so. Katz states: "The

best measure to use in making this determination is the current level of the company's operating cash flow."

Recent financial data for both Barr and Park are shown in Exhibit 1.

Exhibit 1

Selected Financial Data

(in U.S. $ millions except ratio)

Barr Manufacturing Park Retailers

Acid Test Ratio 0.70% 0.65%

Current Assets $5,953 $12,928

Current Liabilities $5,199 $8,314

Long-term Debt $7,436 $12,013

Shareholder's Equity $2,449 $11,065

Net Income $1,221 $1,841

Interest Expense $580 $894

Income Tax Expense $263 $1,119

Depreciation & Amortization Expense $674 $1,320

Capital Expenditures $225 $410

Cash Dividend Payments $497 $237

In preparation for her review of the high-yield bonds issued by Arc Holdings and Tadd Group, Katz gathers the

information shown in Exhibit 2.

P.31 of 46
 Exhibit 2
Debt Structure

Percentage of Total Debt Arc Holdings Tadd Group

Bank Debt 10% 40%

Unsecured Reset Notes 20% 0%

Senior Debt 15% 20%

Senior Zero Coupon Bonds 15% 0%

Subordinated Debt 40% 40%

Finally, Katz concludes her evaluation with an analysis of the corporate structures of these holding companies,

both of which have three operating subsidiaries. In her report to the portfolio management team, Katz makes the

following statements.

Statement 1: If short-term interest rates rise, Arc Holdings is more likely to experience cash flow problems

because they have a higher percentage of reset notes.

Statement 2: In the event of liquidation, the bank debt of both these companies would have a higher priority of
claims status than the senior debt.

Statement 3: The presence of zero coupon bonds in the debt structure of Arc Holdings impairs the company's
ability to improve its credit quality in future periods.

P.32 of 46
 Question

The major risk that Katz believes to be associated with Barr Manufacturing's debt is best described as:

Select exactly 1 answer(s) from the following:

A. price risk.

B. default risk.

C. downgrade risk.

D. credit spread risk.

Question

Which of the following statements best describes a comparison of working capital between Barr and Park?

Select exactly 1 answer(s) from the following:

A. Park's working capital is more adequate based on the current ratio.

B. Barr's working capital is more adequate based on the acid-test ratio.

C. It is inappropriate to make direct comparisons because the issuers are in different

industries.

D. It is inappropriate to make direct comparisons because these ratios fail to take into
consideration any off-balance sheet assets and liabilities.

P.33 of 46
 Question

For Barr Manufacturing, the total debt to capitalization ratio and the EBIT (earnings before interest and taxes)
interest coverage ratio, respectively, are closest to:

Total debt to EBIT interest

capitalization ratio coverage ratio

A. 49.3% 2.1

B. 49.3% 3.6

C. 83.8% 2.1

D. 83.8% 3.6

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

For Park Retailers, the funds from operations/total debt ratio is closest to:

Select exactly 1 answer(s) from the following:

A. 9.1%.

B. 15.6%.

C. 25.5%.

D. 26.3%.

P.34 of 46
 Question

Are Statement 1 and Statement 2, respectively, most likely correct or incorrect?

Statement 1 Statement 2

A. Correct Correct

B. Correct Incorrect

C. Incorrect Correct

D. Incorrect Incorrect

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

Is Statement 3 regarding zero coupon bonds most likely correct?

Select exactly 1 answer(s) from the following:

A. Yes.

B. No, because the present interest expense savings will allow the company to improve
its credit quality in the future.

C. No, because the senior bonds will be more adversely affected as the amount of senior
bonds grows over time.

D. No, because the present interest expense savings will allow the company to improve
its credit quality in the future and the senior bonds will be more adversely affected as
the amount of senior bonds grows over time.

P.35 of 46
 Q49-54

Ravi Baloo Case Scenario

Ravi Baloo is a portfolio manager with Springtree Investments, a U.S.-based asset management firm. Baloo is

considering using derivatives to enhance returns and manage risk. He asks his junior analyst, Thomas Monk, to

help him.

In Exhibit 1, Monk summarizes the relationship between an increase in the value of each of the listed inputs and

the value of a European-style call option, holding all else constant.

Exhibit 1
Effect of Increasing Input Values on European-style Call Option Values

Effect on
Input
Call Option Value

Exercise price Decrease

Risk-free rate Increase

Time to expiration Decrease

Volatility of the underlying Increase

Baloo wonders how gamma would impact a delta hedging program. He makes the following statements regarding

the gamma of a long call option position:

1. "Gamma is larger when there is less uncertainty about whether the option will expire in- or

out-of-the-money."

2. "A delta hedge of the risk in an option's position is likely to be more effective the smaller the gamma of the
option's position."

Baloo asks Monk to assist him in analyzing the valuation of options and swaps. Monk considers the following

strategies:

• Arbitrage based on put-call parity for options on Acuriva Ltd. (ACT) equity.
• Purchase of a European put option on Tekvonix (TVX) equity, a large holding in the portfolio.
• An equity swap to gain exposure to the Russell 2000 Index.

P.36 of 46
 Put-call Parity with ACT Equity

Exhibit 2 provides market prices of selected instruments related to ACT equity as of 30 March 2008.

Exhibit 2
Market Prices of Selected Instruments
as of 30 March 2008

Security Price

European call option on ACT equity $2.25

European put option on ACT equity $3.40

ACT equity price $33.66

Time to expiration of options 3 months

Exercise price of options $35.00

Annualized risk-free rate 6.00%

Using put-call parity, Monk determines that the price of a synthetic call option on ACT equity expiring in 3 months

with an exercise price of $35.00 is $2.58.

Put Option on TVX Equity

Monk uses a one-period binomial model to calculate the value of a one-year put option on TVX equity. Details of

the put option are given in Exhibit 3.

Exhibit 3

European Put Option on TVX Equity

as of 30 March 2008

Time to expiration 1 year

TVX equity price $52

Exercise price $45

Model predicted up move 15%

Model predicted down move 20%

Annualized risk-free rate 6.00%

P.37 of 46
 Equity Swap on Russell 2000 Index

Monk suggests entering into a two-year equity swap in which Springtree will receive the rate of return on the

Russell 2000 Index and will pay a fixed interest rate. The swap has annual payments. The fixed rate of the swap

to be initiated on 30 March 2008 is 4.99%. The Russell 2000 Index is at 757.09 at the beginning of the swap, and

the notional principal of the swap is $100 million.

One hundred days later, the Russell 2000 Index is at 723.86, and the term structure of interest rates is as

presented in Exhibit 4.

Exhibit 4
Term Structure of LIBOR Interest Rates 100 Days Later

Days (T) L0(T) B0(T)

260 0.0442 0.9691

620 0.0499 0.9209

Note: Calculations are on a 360-day basis. T = Time to expiration; L0(T) = LIBOR rate to time T; B0(T) = Discount
factor of $1 from time T to the present.

Monk states, "The value of this equity swap is the amount of money that is exchanged on the annual payment

date."

P.38 of 46
 Question

Which of the relationships summarized by Monk in Exhibit 1 is incorrect?

Select exactly 1 answer(s) from the following:

A. Exercise price

B. Risk-free rate

C. Time to expiration

D. Volatility of the underlying

Question

Are Baloo's statements regarding gamma correct?

Statement #1 Statement #2

A. No No

B. No Yes

C. Yes No

D. Yes Yes

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

P.39 of 46
 Question

Based on the data in Exhibit 2 and Monk's determination of the synthetic call option price, Baloo's strategy should
include:

Select exactly 1 answer(s) from the following:

A. selling the put option in the market and buying the equity.

B. buying the put option in the market and buying the equity.

C. selling the put option in the market and shorting the equity.

D. buying the put option in the market and shorting the equity.

Question

Based on the data in Exhibit 3 and the one-period binomial model, the value of the one-year put option is closest to:

Select exactly 1 answer(s) from the following:

A. $0.32.

B. $0.83.

C. $1.70.

D. $2.38.

P.40 of 46
 Question

Given the data in Exhibit 4, the market value of Springtree's position in the swap 100 days after the initiation of the
swap is closest to:

Select exactly 1 answer(s) from the following:

A. -$5,910,000.

B. -$3,070,000.

C. $3,070,000.

D. $5,910,000.

Question

Is Monk's statement regarding the value of the equity swap correct?

Select exactly 1 answer(s) from the following:

A. Yes.

B. No, because the value of the swap is the sum of the annual payments.

C. No, because the value of the swap is the amount of money that is exchanged on the
final payment date.

D. No, because the value of the swap is determined by the combination of stock and
bond transactions that replicate the cash flows on the swap.

P.41 of 46
 Q55-60

Maria Mendez Case Scenario

Maria Mendez, CFA, is a research analyst at Three-Star Investment Management. Mendez is collecting and

analyzing data as part of a project to explain and to forecast Three-Star's portfolio returns using arbitrage pricing

theory (APT). Mendez begins by collecting five years of monthly data including: 1) surprise in GDP growth (GDP)

and 2) surprise in inflation (INF) to use in explaining portfolio returns.

Mendez estimates a two-factor APT model of the form:

E(Rp) = RF + λ1βp,GDP + λ2βp,INF

and obtains the results shown in Exhibit 1.

Exhibit 1

Results - Two-factor APT Model

Dependent Variable is the Portfolio Return

Portfolio Sensitivity to GDP Factor Sensitivity to Inflation Factor

P 1.0 0.8

Q 0.7 -0.4

R 1.2 1.6

Mendez shares her results with Andy Benoit, her supervisor and a portfolio manager. He is interested in

computing forecasted portfolio returns given his expectations for factor prices and the risk-free rate shown in

Exhibit 2. He also wants to know the expected return for a portfolio comprised of equal parts of Portfolios Q and

R.

Exhibit 2

Expected Risk-free Rate and Factor Prices

Risk-free Rate of Return 4.5%

Factor Factor Price

Surprise in GDP Growth 3.0%

Surprise in Inflation -2.5%

P.42 of 46
Benoit is also interested in comparing active risk between two of his other portfolios. He asks Mendez to estimate

the BARRA US-E3 factor model, which incorporates industry categories and risk indexes. The results of the active

risk analysis are presented in Exhibit 3. Based on her results, Mendez computes information ratios for Portfolios

S and T equal to 0.25 and 0.55, respectively.

Exhibit 3
Results - Active Risk Squared Decomposition
Percent of Total Active Risk in Parenthesis

Active Factor

Portfolio Industry Risk Indexes Total Factor Active Specific Active Risk Squared

S 10.0 (28%) 12.0 (33%) 22.0 (61%) 14 (39%) 36

T 2.0 (5%) 26.0 (65%) 28.0 (70%) 12 (30%) 40

P.43 of 46
 Question

The model estimated in Exhibit 1 is most accurately described as a:

Select exactly 1 answer(s) from the following:

A. statistical factor model.

B. factor sensitivity model.

C. fundamental factor model.

D. macroeconomic factor model.

Question

Given the model estimated in Exhibit 1, the expected return on Portfolio P is closest to:

Select exactly 1 answer(s) from the following:

A. 4.40%.

B. 5.00%.

C. 5.50%.

D. 9.50%.

Question

Given the model estimated in Exhibit 1, the expected return on Benoit's new portfolio combining Portfolios Q and R

is closest to:

Select exactly 1 answer(s) from the following:

A. 5.85%.

B. 7.20%.

C. 7.70%.

D. 8.85%.

P.44 of 46
 Question

Based on the results reported in Exhibit 3, the tracking risks for Portfolios S and T, respectively, are closest to:

Portfolio S Portfolio T

Tracking Risk Tracking Risk

A. 4.7% 5.3%

B. 4.7% 6.3%

C. 6.0% 5.3%

D. 6.0% 6.3%

Select exactly 1 answer(s) from the following:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

Question

Based on the analysis reported in Exhibit 3, the most appropriate conclusion regarding the active risk analysis of the

two portfolios is that:

Select exactly 1 answer(s) from the following:

A. Portfolio S assumed more active factor risk than Portfolio T.

B. Portfolio S earned a higher return from active asset selection.

C. Portfolio T earned a higher return from active factor selection.

D. Portfolio T was industry neutral compared to the benchmark portfolio.

P.45 of 46
 Question

Given the information ratios computed by Mendez, the most appropriate conclusion regarding the relative
performance of the two portfolios is that:

Select exactly 1 answer(s) from the following:

A. Portfolio S experienced greater active risk.

B. Portfolio T experienced more risk per unit of return.

C. Portfolio S earned a mean return below the benchmark.

D. Portfolio T experienced superior risk-adjusted performance.

P.46 of 46