CFA Level II Mock Exam 6 - Questions (AM)

CFA Level II Mock Exam 6 – Questions (AM)
FinQuiz.com
CFA Level II Mock Exam 6
June, 2016
Revision 1
Copyright © 2010-2016. FinQuiz.com. All rights reserved. Copying, reproduction or

redistribution of this material is strictly prohibited. info@finquiz.com.
FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com – 6th Mock Exam 2016 (AM Session)
Questions Topic Minutes
1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Economics 18
19-24 Corporate Finance 18

25-36 Financial Reporting and Analysis 36
37-48 Equity Investments 36
49-54 Fixed Income 18
55-60 Derivatives 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
Count Associates (CA) Case Scenario

Count Associates (CA) is an asset management firm that provides portfolio management and
research services. Trisha Boyle is CA’s senior most fixed income manager who overlooks three
fixed income funds offered by the firm. Rita Lucas is CA’s senior equity manager responsible for
overlooking the firm’s equity fund.
CA’s client accounts are divided into two categories, asset-based and performance-fee based.
The compensation of managers responsible for the latter category is based on the returns
generated in excess of a designated benchmark index rate. Performance-fee based accounts pay a
higher portfolio management fee.
CA’s equity fund’s written mandate exclusive requires the selection of stocks of companies with
sound corporate governance practices, a high dividend yield. Any securities selected must have a
low correlation with existing fund assets. Portfolio manager Nigel Hill is evaluating V-Line, a
privately traded concern, which is undertaking an IPO of its stock. Prospects of positive earnings
growth has led the issue to being oversubscribed. Hill submits an order to buy 100,000 shares of
V-Line at a price of $25/share. By the time the order is allocated to suitable client accounts, the
price per share drops to $22. In compliance with the trade allocation policy Hill allocates 60% of
the trading profits to the performance-fee based accounts and the remainder to asset-based
accounts and makes a disclosure of the transaction to Lucas.
Hill employs client funds to invest in the equity of a starter manufacturing concern. Hill has
selected the company for its promising growth prospects, high expected returns and low
correlation with existing fund holdings.
Upon reviewing Hill’s trade, Lucas is alarmed because he has strayed from the fund’s stated
mandate by selecting an investment with a zero dividend yield. She considers the actions Hill
should have taken to avoid making bad judgment.
Lucas instructs her subordinate, Harry Stone, to submit an order for the block purchase of 4,000
shares of Lamda Inc.’s stock. Stone allocates the shares to the portfolio managers responsible for
managing three client accounts on January 30, 2014 at 09:10:00, ten minutes prior to the
execution of the buy order by the dealer. The portfolio managers allocate the shares to their
clients’ accounts after learning of their interest in the stock. Two of the client accounts receive an
allocation price at the average trade price of $45 while one client (Marcus) receives a price of
$50 as the order is relatively larger. All trades are charged a 5% commission.
Boyle collects Information concerning the allocation for presenting to Stone (Exhibit). He asks
Stone what action should be undertaken in the event an order cancellation request is received.

Exhibit:
Allocation of the Lamda Inc. Buy Order to Client Accounts A, B and C
Investible Allocation Price (Prior
Asset Base* Number of Shares to Commission)
Client (Millions) Allocated
Ian Cox $1.0 800 $45
Knowles Smith $1.5 1,200 $45
Grace Marcus $2.5 2,000 $50
*Prior to share allocation
Boyle is considering an investment in the equity tranches of collateralized debt obligations for
the firm’s fixed income fund. He has contacted CA’s research department which will make use
of a commercially developed financial model to forecast the value of the investment if the CDO
manager earns a positive spread. The research analysts evaluate the potential investment by
undertaking an in-depth study of model parameters. The analysts, however, lack technical
knowledge with respect to the model.
1. With respect to allocating the gains generated from V-Line, Hill is most likely in violation
of the CFA Institute Standards of Professional Conduct because:
A. he has violated his duty of loyalty to clients.

B. clients have not given prior consent to the allocation.
C. he has failed to disclose the trade allocation to clients.
2. Which of the following actions should Hill least likely have taken in order to avoid a
violation of the CFA Institute Standards of Professional Conduct with respect to the
startup manufacturing concern?
A. Secure authorization of the change in strategy from clients.

B. Disclose the impact of the change in mandate on portfolios.
C. Allocate trades to the accounts of clients with capital growth preferences.
3. With respect to the Lamda Inc. block trade, Stone is most likely in violation of the CFA
Institute Standards of Professional Conduct with respect to the:
A. price of trade allocated.

B. number of shares allocated.
C. timeliness of order execution.

4. The trade allocation practices adopted for the Lamda Inc. block trade are least likely in
violation of the CFA Institute Standards of Professional Conduct with respect to the:
A. timing of the receipt of client interest.

B. delegation of trade allocation responsibility.
C. receipt of a request for purchase from portfolio managers.
5. CFA Institute Standards of Professional Conduct recommends cancelled orders:
A. to be time stamped.
B. supported with a suitability analysis.
C. documented on a first-in, first-out basis.
6. In order to comply with the CFA Institute Standards of Professional Conduct with respect
to investment analysis, recommendations, and actions, the head of the research
department should:
A. assign analysts who have relevant technical expertise.

B. consider the impact of a decline in spreads on investment performance.
C. disclose to clients that the model is limited in the range of scenarios which are
considered.

Questions 7 through 12 relate to Quantitative Methods
Ian Walker Case Scenario

Ian Walker is the head of research at Circle Associates, an equity research firm. Walker along
with his two research analysts, Jean Rice and Spencer Dike, are preparing a research report on
the factors influencing emerging stock returns and why they differ from developed market stock
returns.
Walker would like to confirm whether difference in stock returns in the two markets is solely due
to differences in GDP growth forecasts. Walker tests his hypothesis by comparing Indian to U.S.
stocks. Each analyst builds his/her own linear regression model using stock return differences as
the dependent variable and GDP growth differences as the independent variable. The annual
GDP growth data pertains to three time periods in the past; 1990-2005, 2006-2012 and 2013-
2014. Walker has calculated the sum of squared deviations of the independent and dependent
variable in the exhibit below (Exhibit 1) for the purposes of identifying the model which will
generate the most accurate forecast.
Exhibit 1:
Linear Regression Analysis
Model 1 Model 2 Model 3
Sum of squared residuals 0.00015 0.00030 0.00005
Sum of squared deviation of the dependent variable from
mean 0.00018 0.00010 0.00200
Observations 24 24 24
Dike feels that the models are restricted in their comparison of stock returns and that many
important variables have not been considered. He includes three limitations of the assumptions
used to build the linear regression models.
Limitation 1: The error terms are assumed to be normally distributed. This assumption conflicts
with reality and so the existing regression analysis is invalid.
Limitation 2: Differences in GDP growth forecasts are assumed to be nonrandom.
Limitation 3: Error terms are subject to the heteroskedastic assumption when they should reflect
the homoskedastic assumption.

Before exploring the addition of an additional variable, Walker evaluates the three models in
order to determine which model’s fraction of total variation in stock return differences is best
explained by the variation in GDP growth differences.
Next, Walker takes Dike’s consideration into account and, with the help of the two analysts,
redesigns the model by including differences in the pace of technological advancements as the
main variable influencing stock returns over the three time periods as a qualitative variable.
Details relevant to the analysis are summarized in an exhibit (Exhibit 2). A 5% significance level
is being used for the analysis and the formulated null hypothesis is that differences in the pace of
developments do not drive stock return differences.
Exhibit 2:
Qualitative Regression Model
Standard
Coefficient Error t-Statistic
Intercept 0.2507 0.2085 1.2024
1990-2005 0.0480 0.0257 1.8677
2006-2012 - 0.0150 0.0098 - 1.5306
2013-2014 0.0512 0.0319 1.6050
Multiple R2 0.0359
Observations 24
F-statistic 3.8056
Significance F (ANOVA Table) 0.0819
( )
Rice asks Walker why an adjusted R2 R 2 will become more relevant when the model is
redesigned. Walters replies by stating, “ R 2 is more relevant relative to R2 as it indicates that the
model includes the correct set of variables.”
7. Using the data in Exhibit 1, the model which will provide the most accurate forecast for
the difference in stock returns is most likely:
A. 1.
B. 2.
C. 3.

8. In context of the limitations presented by Dike, he is most accurate with respect to:
A. Limitation 1.
B. Limitation 2.
C. Limitation 3.
9. Based on the data collected in Exhibit 1, Walker will most likely that the variation in
stock return differences is best explained by Model:
A. 1 because it has the highest R2.

B. 3 because it has the highest explained variation.
C. 2 because it has the highest coefficient of determination.
10. Using the data in Exhibit 2, the analysts will conclude that the null hypothesis is most
likely:
A. false based on the p-value.

B. true based on the F-statistic.
C. false based on the F-statistic.
11. Walters’ statement concerning R 2 will be inappropriate should the model:
A. have a random walk.

B. have a dummy variable.
C. have a peculiar dataset.
12. Walker decides to expand the multiple regression model by including political risk as a
variable. He predicts that the forecasted R 2 will decrease by 20% but is unsure of how
the R2 measure will respond. Based on his analysis, Walker can reasonably conclude that:
A. R2 is a negative value.
B. R2 has increased a small amount.
C. R2 has declined by more than 20%.

Questions 13 through 18 relate to Economics
Beta Associates Case Scenario

Beta Associates (BA) is a U.S. based asset management firm, which manages the IEF, an
international equity fund. Presently, IEF is allocated to domestic and emerging market equities.
Foreign exchange risks associated with the investments are managed by Ian Johnson, a currency
overlay manager.
IEF’s equity manager is exploring Mexican equities for inclusion in the fund. A portion of the
purchased securities will be allocated to two of BA’s private wealth clients, Paul Singh and
Marie Ferns. To execute the transaction, Johnson will be required to evaluate foreign exchange
uncertainty associated with the transaction and make relevant purchases of the MXN. Johnson
summarizes the details that he feels will be relevant to the transaction and in turn will influence
the USD/MXN bid-ask spread quoted by the dealer.
Detail 1: A total of MXN 0.5 million worth of equities will need to be purchased for the clients’
portfolios of which 20% will be purchased for Singh’s portfolio and the remainder for
Ferns’ portfolio.
Detail 2: The order to buy MXN will be submitted at a time when both the U.S. and Mexican
markets are open for trading.
Detail 3: Mexico is currently in a state of civil unrest.
Detail 4: The inflation rate in Mexico has been steadily increasing over the course of the
previous two years.
Johnson’s colleague, Ryan Ellis, joins him for lunch during which they discuss their latest
assignments. Ellis tells Johnson that his analysis of the USD/MXN spread and currency
markets is incomplete without an evaluation of the impact of the Mexican central bank’s latest
policy announcement to increase domestic money supply on the USD/MXN rate. Ellis adds, “We
cannot assume that the latest policy announcement will have no immediate impact on the current
exchange rate.”
Johnson agrees with Ellis by stating that the best model to use in this scenario is the Dornbusch
Overshooting model. The managers apply the model assuming inflexible output prices in the
short run and evaluate the impact of an increase in nominal money supply on domestic interest
rates as well as the real and nominal values of the USD/MXN rate.

During their conversation, Ellis shares with Johnson his analysis of Rica, an emerging market
country in South America, facing a surge of foreign capital inflows. His analysis focuses on the
increasing investor interest in Rica and its implication for local currency value, RC, and the
volume of capital inflows. He shares his market observation of Rica with Johnson based on his
study of the country’s economy.
Observation 1: The current account balance has improved as a result of expatriates shifting their
wealth from abroad to invest in local businesses.
Observation 2: The government has announced its intention to liberalize financial markets.
Observation 3: A heightened global investor interest in emerging market (EM) stocks has
attracted more investment to local private businesses. Previously, these investors
preferred developed market (DM) stocks.
Johnson predicts that the surge in capital flows cannot be indefinite and policymakers are bound
to step in should the RC become overvalued. He predicts, “If inflation concerns become
substantial, Rica’s authorities will need to engage in a sterilized operation.” Ellis asks what his
prediction would imply for Rica’s monetary base and domestic short-term interest rates.
The managers conclude their discussion by comparing the effectiveness of central bank
intervention in managing foreign exchange risk in DMs and EMs.
13. In context of the transaction details provided by Johnson, which of the following is least
likely to influence the magnitude of the USD/MXN bid-ask spread?
A. Detail 1
B. Detail 3
C. Detail 4
14. Considering Ellis’s comment concerning the impact of the monetary policy on the
USD/MXN rate, he most likely believes that:
A. real exchange rates are not constant in the short run.

B. purchasing power parity (PPP) holds in the short and long run.
C. changes in the inflation rate and price level do not play a role in exchange rate
determination.

15. Using the Dornbusch Overshooting model, the managers’ analysis will lead them to
conclude that an increase in Mexico’s domestic nominal money supply will be followed
by a:
A. decline in interest rates.

B. relatively lower increase in real money supply.
C. decline in the domestic currency regardless of capital mobility.
16. In context of the observations presented by Ellis, which of the following represents a
push factor?
A. Observation 1
B. Observation 2
C. Observation 3
17. The most likely impact of a sterilized operation in Rica is that:
A. the monetary base will expand.

B. short-term interest rates will decrease.
C. short-term interest rates will remain unchanged.
18. Which of the following conclusions will the two managers least likely reach in their
comparison of the effectiveness of central bank intervention?
A. The effect of EM central bank intervention in their currencies is statistically

insignificant.
B. EM central banks are in a stronger position to influence the path of exchange rates
relative to their DM counterparts.
C. The volume of intervention in DMs is large relative to the daily turnover of DM
currencies in the foreign currency market.

Questions 19 through 24 relate to Corporate Finance
Rockthorn plc Case Scenario

Rockthorn plc is a manufacturer of lead-acid batteries which are purchased by motorboat riders
and camper owners. Rockthorn’s management has redesigned the firm’s production policy and
under the new policy, plastic encasing used to cover batteries will be of lower quality but will be
purchased at a cheaper price. By doing so, management aims to fulfill two objectives:
Objective 1: Lower production costs to improve profitability.
Objective 2: Increase fund availability to finance the revised dividend policy.
Sergius Ivanovich is Rockthorn’s quality control manager. He is evaluating the implications of

the production policy which has been implemented. He has come to determine that while the new
policy has achieved Objective 1, the latest batteries being produced have a shorter average life
and are susceptible to leakages resulting from a deterioration of the outer casing over a period of
time. In addition, the exposure of production employees to sulfuric acid, a substance which is a
vital component to lead acid batteries, and toxic if inhaled has been inadequately dealt with. This
situation will deteriorate with the new policy as the cheaper plastic casing requires a higher
content of sulfuric acid.
In a conversation with Marcus Tyke, Rockthorn’s production manager, regarding the new policy,
Ivanovich states, “I am a proponent of Utilitarian ethics which, when applied to the situation,
would recommend a reversion to higher quality plastic encasing as well as the implementation of
and adherence to a stricter worker safety policy. In this way, even if we compromise on
maximizing stockholder wealth by a small fraction, the rights of customers and employees will
be secured.”
Tyke strongly opposes Ivanovich’s point of view by stating, “While workplace safety must be
addressed, we are not legally obliged to deliver superior quality products. Our responsibility is to
maximize shareholder wealth and this we can only achieve by reducing operating costs in the
long run.”
Upon the conclusion of their discussion, Ivanovich comes to know that the primary motive
behind the policy change was to secure a procurement contract with a plastic casing supplier who
is an acquaintance of Rockthorn’s chief operating officer (COO). The latter will be receiving a
5% commission from the supplier for every dispatched order.

Ivanovich would like to know how the new policy will help increase the availability of funds for
paying dividends and turns to Lydia Cox, a member of the compensation committee. Cox
informs him that the committee aims to distribute an average of 60% of its earnings over the next
ten years.
Cox also shares that the new policy represents a shift from a stable dividend policy but will
continue to focus on the generation of dividends. When asked why dividend income is preferred
to capital gains, Lydia responds, “Many of our investors rely on dividends to sustain lifestyles
and with the lower tax rate on dividends versus capital gains we will be satisfying their
investment objectives.”
19. Will the new production policy give rise to unethical behavior?
A. No.
B. Yes, the policy will lead to substandard working conditions.
C. Yes, the firm intends to increase dividends at the expense of reducing product
quality.
20. Is Ivanonich’s statement with respect to the new production policy consistent with
Utilitarian ethics?
A. Yes.
B. No, the utilitarian philosophy does not support injustice amongst stakeholder
groups.
C. No, the policy will not lead to the best possible balance between good and bad
consequences.
21. Tyke’s response to Ivanovich’s statement is most consistent with:
A. justice theories.
B. utilitarian ethics.
C. the Friedman Doctrine.

22. The responsibility towards stockholders that Tyke is referring to in his statement most
accurately reflects:
A. the agency theory.

B. stakeholder impact analysis.
C. a tradeoff between profitability and revenue growth.
23. By engaging in a procurement contract with an alternative supplier, the COO has least
likely demonstrated his tendency to engage in:
A. self-dealing.
B. a principal-agent conflict.
C. an opportunistic exploitation of value chain participants.
24. Which of the following philosophical approaches to ethics is most likely reflected by
Cox’s statement with respect to the new dividend policy?
A. Kantian ethics
B. Rights theories
C. Utilitarian ethics.

Questions 25 through 30 relate to Financial Reporting and Analysis
Jose Armelo Case Scenario

Jose Armelo, CFA, is a financial statement analyst evaluating the financial reporting quality of
three corporations in the real estate industry in the current year, 2014. Each of the firms being
subject to evaluation constructs real estate properties for commercial and residential purposes.
Armelo will be engaging his recently inducted associate, Gloria Whitman, in the assignment.
Smitax
In the year 2013, a client sued Smitax for the faulty construction of apartment complexes
demanding $1 million in compensation. At the time, the likelihood of Smitax paying the
damages was very low. The dispute has still not been resolved and the company’s legal estate
advisor has advised an out-of-court settlement by paying 50% of the claim in the current year.
The company’s CEO finds the proposal agreeable. Details of the compensation to be paid have
been disclosed in the notes to the financial statements. However, no accounting entry has been
made with respect to the proposed transaction.
V-Line Associates
V-Line Associates is a global real estate developer with divisions operating across the globe. The
management of its Nairobian division has unanimously decided to cease operations following an
unexpected rise in safety concerns. The (translated) costs to shut down the division are $30
million. V-Line has classified these restructuring charges as discontinued operations in the
current year’s income statement.
Bass Inc.
Following a conversation with a senior manager, it has come to Armelo’s knowledge that Bass’s
financial officers are suspected of manipulating the company’s earnings. Armelo decides to
apply the Beneish model to assess the likelihood of these claims and has tasked Whitman with
gathering the necessary data and performing the analysis (Exhibit). A -1.78 M-score is used as
the cutoff value. Whitman summarizes the results of her analysis in a report.

Exhibit:
Beneish Model for Bass Inc.
Value of Coefficient from

Variable Beneish Model
Days Sales Receivables Index 0.560 0.920
Asset Quality Index 0.800 0.404
Accruals 1.500 4.670
Leverage Index 1.210 -0.327
M-score -1.54%
While reading Whitman’s report, Amelio concludes that she may have committed a Type-I error.
Amelio tasks Whitman with exploring why Bass Inc. may have reported an accrual index value
greater than 1.0. Whitman provides her supervisor with two possible justifications:
Justification 1: A large number of non-discretionary accruals have been reported.
Justification 2: Operating cash flows are being manipulated.
Whitman believes that the financial statement analysis of the three companies is incomplete
without an evaluation of bankruptcy probability. She has chosen the Altman model to forecast
bankruptcy risk and intends to undertake the following tasks:
Task 1: Evaluate the risk over multiple time horizons holding the ratios constant.
Task 2: Conduct scenario analysis with different ratios assumed for each scenario across multiple
time horizons.
25. By choosing not to report the claims settlement, is Smitax’s financial reporting quality
undermined?
A. No.
B. Yes, assets are overstated.
C. Yes, total equity is overstated.

26. Has V-Line Associates dealt with the restructuring charges in an appropriate manner?
A. Yes.
B. No, the current year’s earnings will be overstated.
C. No, the previous year’s earnings will be overstated.
27. Based on Amelio’s conclusion, the supervisor has determined that the calculated M-score
in the exhibit should be:
A. lower.
B. higher.
C. based on more variables.
28. Using the data in the Exhibit and considering all indicators except for the accruals index,
Amelo may conclude that Bass Limited (‘s):
A. short-term liquidity risk is high.

B. customer credit quality has improved.
C. has excessively capitalized expenditures.
29. In context of the justifications provided by Whitman, she is most likely correct regarding:
A. Justification 1 only.
B. Justification 2 only.
C. neither of the justifications.
30. Considering both tasks in isolation, Whitman’s will not be able to evaluate bankruptcy
risk by performing:
A. Task 1 only.
B. Task 2 only.
C. both of the set tasks.

Questions 31 through 36 relate to Financial Reporting and Analysis
Evan Gill and Rita McGregor Case Scenario

Financial analysts Evan Gill and Rita McGregor are analyzing the financial statements of their
employer, Glace Manufacturing. On January 1, 2014, Glace purchased a five-year, annual
coupon-paying bond issue (Exhibit 1). Glace Manufacturing prepares and presents its financial
statements in accordance with the IFRS. The investment will be accounted for in accordance
with IFRS 9 Financial Instruments. Gill concludes the issue should be held at amortized cost by
providing the following justifications:
Justification 1: “Glace will solely rely on principal repayments and interest payments generated
by the issue.”
Justification 2: “Glace intends to hold the issue for the purpose of collecting contractual cash
flows.”
Justification 3: “The management does not intend to sell the issue in the foreseeable future.”
On January 1, 2015, Glace’s senior investment officer announces the investment committee’s
decision to now rely on the issue as a source of generating arbitrage profits. The market value at
the date of policy change is $325,000.
In response to the announcement, Gill and McGregor proceed to compare how IFRS 9 and IAS
39 differ with respect to the reclassification restrictions and criteria. The two individuals arrive at
the following conclusion:
Conclusion: “The impact of a reclassification of a debt instrument on a company’s financial

statements is prospective under IFRS 9. On the other hand, under IAS 39, any unamortized gains
and losses previously recorded in other comprehensive income are recognized immediately in
profit and loss on the date of reclassification.”
Glace Manufacturing is part of a group of companies with the parent organization, South Sea
Inc. (SSI), operating in the U.S. The parent prepares and presents its financial statements in
accordance with U.S. GAAP. On June 30, 2014 SSI acquired 35% of the common shares of
Holmes Corp, a shipping company, by paying a cash amount of $110,000 on the acquisition date.
McGregor summarized details concerning Holmes’ balance sheet (Exhibit 2). The management
of SSI has elected to use the fair value option to account for the investment. The difference
between book values and fair values is due to a parcel of land.

For the financial year 2014, Holmes Corp generated income of $250,000 and paid dividends of
$60,000.
During 2014, SSI also acquired 20% of the common stock of VR Tech, a software engineering
firm. 35% of VR Tech’s common stock is owned by Frasr Limited, SSI’s competitor. The
transaction will not give SSI’s shareowners any voting privileges. However, 70% of the potential
losses generated by VR will be absorbed by SSI. This contrasts to Frasr Limited’s ownership
rights which permit owners to absorb 80% of VR’s expected residual returns and enjoy voting
rights. The remainder 20% of the expected residual returns will be absorbed by SSI.
The two analysts conclude their discussion by exploring how contingent assets and liabilities are
recognized in business combinations.
Exhibit 1:
Details Concerning Bond Issue on January 1, 2014
Acquisition cost (equal to par value) $250,000
Market value $240,000
Annual coupon rate 10%
Market interest rate 8%
Exhibit 2:
Holmes Corp’s Selective Balance Sheet Information as at June 30, 2014
Book Value Fair Value
Current assets $40,000 $40,000
Property, plant and equipment $158,500 $165,000
Other noncurrent assets $8,200 $8,200
Total liabilities $240,000 $240,000
Net assets $446,700 $453,200
31. Which of the justifications supplied by Gill is least likely mandated by IFRS 9 when
classifying debt instruments?
A. Justification 1.
B. Justification 2.
C. Justification 3.

32. Considering the change in intention, can the debt issue be reclassified under IFRS 9?
A. No, reclassifications are prohibited.

B. Yes, and the issue will be measured at $325,000 on the balance sheet.
C. Yes, and $85,000 will recognized as unrealized gains in other comprehensive
income.
33. The conclusion drawn by the two analysts is most accurate with respect to:
A. IAS 39.
B. IFRS 9.
C. both of the standards.
34. On December 31, 2015 the investment in Holmes Corp will be recorded on South Sea
Inc.’s balance sheet at:
A. $110,000.
B. $113,300.
C. $176,500.
35. The company required to consolidate VR Tech is:
A. SSI.
B. Frasr Limited.
C. both SSI and Fasr Limited.
36. Under IFRS, contractual contingent assets are:
A. not recognized.
B. recognized if they more likely than not meet the definition of an asset on the
acquisition date.
C. subsequently measured at the higher of acquisition date fair value and best
estimate of future settlement amount.

Questions 37 through 42 relate to Equity Investments
Stan-Davis Case Scenario

Stan-Davis is an automobile manufacturer, which is publically listed on the NYSE. The senior
manager at Stan-Davis’s acquisition department, Lisa Gunn, is exploring TS Inc., a supplier of
the rubber used to manufacturer tires as a potential acquisition target. TS is a privately traded
concern. Upon evaluating TS, Gunn opts for the capitalized cash flow method (CCM) to value
the supplier. She justifies her decision based on the following reasons:
Reason 1: “TS’s operating structure and operations will be relatively stable in the foreseeable
future with limited growth potential.”
Reason 2: “Financial projections are difficult to develop due to the lack of adequate financial
statement footnotes.”
Reason 3: “The method is a popular choice for valuing potential acquisition targets.”
Gunn is exploring which definition of value will be most suitable for the acquisition
target given that an arm’s length transaction is unlikely between Stan-Davis and TS.
Many analysts do not share the view that operations will be stable in the future. Thus
a diverse range of projections concerning TS’s potential level of risks, earnings
power, as well as potential synergies arising from the acquisition will exist amongst
potential buyers.
Gunn notes that the valuation process for public and private companies can differ significantly
and is attributed to various factors.
Gunn collects the data necessary to derive the value of Stan-Davis using the CCM (Exhibit). The
data collected reflects projections for the coming fiscal year. The weighted average cost of
capital (WACC) used to discount free cash flows is based on an implicit assumption.

Exhibit:
TS Valuation Data for the CCM
Free cash flows to equity* $45,000
Working capital investment $8,500
Fixed capital investment $10,400
Non-cash charges $1,200
Required return on equity 10%
Capitalization rate 8%
*Cash flows at T =1. Thereafter cash flows will
grow at a long-term sustainable rate.
Gunn would like to determine the role of business valuation standards and practices in private
equity valuation and decides to engage in a discussion with Raul Martinez, a private equity
specialist. Martinez makes the following comments:
Comment 1: “The objective behind valuation standards is to impose a framework which legally
binds valuators to a set of standards.”
Comment 2: “Business valuations vary according to companies and across time. Therefore,
valuation standards cannot be relied on to provide technical guidance.”
37. Which of the following reasons presented by Gunn negates the use of the CCM to value
TS?
A. Reason 1.
B. Reason 2.
C. Reason 3.
38. The definition of value which is most suitable for TS is:
A. market value.
B. intrinsic value.
C. investment value.
39. Gunn will conclude that, in contrast to Stan-Davis, TS will have:
A. have more management depth.

B. a greater preference for tax-exempt municipals.
C. have greater pressure from long-term investors.

40. The implicit assumption being used by Gunn to value TS is that the:
A. debt and equity are being held at their optimal weights.

B. debt and equity weights are quoted based on their book values.
C. size of the capital structure will decline in the foreseeable future.
41. Using the information in the exhibit, the value of the invested capital in TS is equal to:
A. $273,000.
B. $341,250.
C. $562,500.
42. Martinez is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. both of his comments.

Questions 43 through 48 relate to Equity Investments
Maxim Inc. Case Scenario

Maxim Inc. is a privately traded manufacturing concern operating in the timber industry. Mark
Jamestown, Maxim’s CEO, has organized a meeting with Ian Knight and Linda Scholes, two
private equity specialists. Jamestown aims to address the following objectives in the meeting:
Objective 1: Value Maxim Inc. using a fundamental factor model.
Objective 2: Forecast Maxim Inc.’s future free cash flows.
At the commencement of the meeting, Jamestown poses the following question to the analysts:
“What are the typical reasons for performing valuation of private equity businesses and
interests?” The analysts respond as follows:
Statement 1: “Valuation is necessary when a company undertakes transactions that have both
accounting and tax implications such as those involving an employee stock
ownership plan (ESOP).”
Statement 2: “An acquisition of one company by the other may call for valuation.”
Statement 3: “Corporate activities such as transfer pricing often have tax implications calling for
valuation.”
The two analysts are divided in their opinion regarding which model to use to achieve the first
objective. Knight proposes the residual income model for the sole reason that it captures the
shortcomings of traditional accounting.
To demonstrate the application of the residual income technique, Knight collects relevant details
(Exhibit 1). Using the single-stage residual model, he arrives at an intrinsic per share value of
$60.00.
Scholes joins the conversation by pointing out that residual income, which is based on a
company’s earnings, is inappropriate for comparing Maxim to the average industry. Instead, she
advocates for the free cash flow valuation approaches to achieve the first objective.

To achieve Objective 2, Scholes collects the necessary data (Exhibit 2). Her analysis is based on
historical data and the current and expected economic environment. She expects the proportions
of incremental fixed capital and working capital to maintain their historical relations with sales.
Exhibit 1:
Residual Income Model Details
Current market price per share $55
Sustainable growth rate 4%
Cost of equity 6%
Retention rate 40%
Exhibit 2:
FCFF Forecast Data
Forecasted EBIT margin 15%
Tax rate 30%
Current capital expenditures $50,000
Current depreciation expenses $45,500
Current sales $800,000
Forecasted sales $1,000,000
Increase in working capital $30,000
Target debt ratio 0.40
43. The most appropriate classification of the reasons for performing private equity
valuations provided by the analysts is:
Statement 1: Statement 2: Statement 3:

A. transaction-related transaction-related compliance-related.
B. transaction-related compliance-related transaction-related.
C. compliance-related transaction-related transaction-related.
44. The ‘shortcomings’ of traditional accounting overcome by residual income referred to by

Knight is that the measure:
A. recognizes the opportunity cost of generating capital.

B. is based on economic profitability and not subject to manipulation.
C. does not assume that interest expense is a representative cost of debt financing.

45. Using the data in Exhibit 1, Knight will conclude that the:
A. justified price-to-book ratio is greater than 1.

B. intrinsic value is equivalent to the book value per share.
C. present value of expected future residual earnings is negative.
46. Which of the following arguments least likely supports Scholes’ argument in favor of free
cash flow valuation approaches?
A. Differences in capital structure between companies are accounted for.

B. Terminal values can be forecasted with a reasonable degree of certainty.
C. The reinvestment of cash flows made in capital assets to maximize firm value in
the long-run is considered.
47. Using the data in Exhibit 2, the forecasted free cash flows to the firm (FCFF) is closest
to:
A. $70,500.
B. $71,000.
C. $115,500.
48. The target debt ratio in Exhibit 2:
A. assumes there are no noncash charges.

B. represents the debt capital necessary for growth.
C. represents the cost of maintaining existing capital stock.

Questions 49 through 54 relate to Fixed Income
Gus Weaver Case Scenario

Gus Weaver is a fixed income analyst a Caramel Alliance (CA), an asset management firm. CA
maintains a fixed income fund, which is currently invested in option-free fixed rate corporate and
Treasury bonds. He is seeking to expand the fund holdings and is evaluating two potential
investments, a putableand convertible issue.
Investment A: Three-Year Putable Bond Issued by Samson Corp.

To exploit yield curve movements, Weaver decides to invest in a 2-year bond issue. The
embedded option is currently exercisable at 100. Weaver projects the full price and effective
duration of the issue when the yield curve is flat at 2% and moves down by 100 basis points
(Exhibit 1). Using this information, he aims to determine how these two variables will respond to
an upward parallel shift of 100 basis points.
Exhibit 1:
Effective Duration and Full Price of Putable Bond Issue
Interest Rate
At a 2% Flat Interest Rate Up Down by 100
Yield Curve by 100 Basis Basis Points
Points
Full Price $101.25 ? $102.50

Effective Duration 4.52 ? 5.60
Investment B: Ten-Year Westham Interiors (WI) Convertible Bond Issue

Weaver is primarily interested in the potential equity exposure associated with the WI
convertible. The prospectus of the convertible includes a provision whereby investors may forgo
lending to WI if the latter is merged or acquired by another company during the life of the issue.
Selective details concerning the issue are summarized in an exhibit (Exhibit 2).

Exhibit 2:
Convertible Bond Issue Prospectus
Issue date January 1, 2014
100% of par denominated into bonds of
Issue price $1,000 each
Conversion period January 31, 2015 to December 22, 2024
Initial conversion price $8.00 per share
Each bond is convertible into 14,000 shares
Conversion ratio of WI common stock
110%; starting two years after issue date up
Issuer call price to one year before maturity
The exercise of the embedded put option
following a change in control event will
entitle investors to receive compensation in
the form of cash and/or subordinated notes.
Change of control provision
Market Information:
Share price on January 1, 2015 $7.23

Share price on February 25, 2015 $8.15
Convertible bond price on February 25, 2015 $110,850
Straight bond value on February 25, 2015 $110,850
Joanne Buck is a junior fixed-income analyst at CA. Buck has recently been tasked with
preparing a report on the WI convertible. By using the data in Exhibit 2, Buck aims to address
the following questions in her report:
Question 1: When should we expect a forced conversion to occur and will the occurrence of such
an event strengthen or weaken WI’s capital structure?
Question 2: How will WI’s debt-to-equity ratio be affected when the embedded conversion
option is exercised?
Question 3: Which factors will significantly influence the risk-return characteristics of the WI
issue?

49. Using the information in Exhibit 1, the effective duration of the putable issue if rates rise
by 100 basis points is:
A. less than 4.52.

B. less than 5.60.
C. greater than 5.60.
50. The change in control provision described in Exhibit 2 is an example of a:
A. soft put.
B. hard put.
C. threshold put.
51. Using the information in Exhibit 2, does an arbitrage opportunity exist on February 25,
2015 with respect to the WI convertible?
A. No.
B. Yes; there is an opportunity to earn $3,250 in profit.
C. Yes; there is an opportunity to earn in $9,630 in profit.
52. The most appropriate response to Question 1 is when:
A. credit spreads have widened and the capital structure will strengthen.
B. interest rates have declined and the capital structure will not be unaffected.
C. interest rates are constant but the current share price exceeds conversion price and
the capital structure will strengthen.
53. The most appropriate response to Question 2 is that WI’s debt-to-equity ratio will:
A. improve.
B. deteriorate.
C. not be affected.
54. On February 25, 2015 the Westham issue will resemble a (n):
A. hybrid instrument.
B. busted convertible.
C. common share issued by the company.

Questions 55 through 60 relate to Derivatives
Alpha Associates Case Scenario

Alpha Associates is a derivatives dealer firm and a member of the CDS industry. AA provides
credit solutions to lenders across the globe. Sean Vaughn is AA’s senior most derivatives trader.
Vaughn is examining the current credit exposures of some of his clients. As part of his survey,
Vaughn has collected details concerning three independent events affecting protection buyers.
Event 1: Buyer A lives in a country where the economy has entered into a recession.
Event 2: Buyer B originates from a country where the monetary authorities have announced a
policy to increase interest rates. This announcement will increase borrowing costs.
Event 3: Buyer C resides in a country in which the municipal government authorities and bond
issuers are observing a moratorium in order to deal with the existing economic crisis.
Vaughn moves on to evaluate a three-year CDS issued by AA (Exhibit 1). The reference
obligation is a three-year, $10 million bond issued by Tike Limited with an annual coupon rate
of 4.2%. Vaughn projects the hazard rates as 3%, 5% and 7%, respectively, for the three years of
the issue. In addition, Tike Limited has two other issues trading at 30% and 40% of par
respectively.
Exhibit 1:
Details Concerning CDS
Coupon rate 4%
Coupon payment frequency Quarterly
Original credit spread 520 basis points
Duration Two years
Notional principal $100 million
Recovery rate 40%
Vaughn notes that the original credit spread is highly unlikely to remain constant given that the
credit curve is sloping steeply upwards and the credit spread on the CDS under evaluation is
expected to widen by 150 basis points.

Once Vaughn has completed his evaluation of the CDS, he undertakes a study of how the pricing
and compensation of credit risk in bond and CDS markets can give rise to arbitrage
opportunities. He evaluates whether a similar opportunity exists with respect to a potential long
position in the credit risk of Yalt Inc., a lender of credit. The position is currently under
evaluation. Details concerning the potential CDS to be issued and the underlying obligation have
been summarized for the purpose of analysis (Exhibit 2).
Exhibit 2:
Analysis of CDS Issued to Yalt Inc.
Underlying annual yield-to-maturity 5%
Underlying term to maturity 3 years
CDS credit spread 350 basis points
CDS term to maturity 4 years
Yalt Inc’s funding cost 275 basis points
55. In context of the events being analyzed by Vaughn, which of the following represents a
potential credit event, which is likely to trigger a CDS payment from AA?
A. Event 1.
B. Event 2.
C. Event 3.
56. Using the information provided in Exhibit 1, the price of the CDS per 100 par amounts
to:
A. $98.4.
B. $100.8.
C. $101.6.
57. Using the information provided in Exhibit 1 and the vignette concerning the Tike Limited
reference obligation, the expected loss for the first two years of the issue is closest to (in
millions):
A. $0.26.
B. $0.35.
C. $0.50.

58. If the forecast for credit spreads does materialize and AA elects to unwind the CDS
contract by buying a new contract, it will:
A. monetize a loss.
B. face a decline in the market value of the original CDS.
C. need to pay a lower upfront premium on the new CDS.
59. With respect to the CDS issued to Yalt Inc., the trade being explored by Vaughn is most
likely classified as:
A. basis.
B. curve.
C. long/short.
60. To exploit arbitrage opportunities with respect to the CDS issued to Yalt Inc., AA should:
A. sell protection in the CDS market and go long the bond.

B. buy protection in the CDS market and go long the bond.
C. sell protection in the CDS market and go short the bond.

CFA Level II Mock Exam 6 - Questions (AM)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA Level II Mock Exam 6 - Questions (AM)

Uploaded by

Copyright:

Available Formats

CFA Level II Mock Exam 6 – Questions (AM)

Copyright © 2010-2016. FinQuiz.com. All rights reserved. Copying, reproduction or

FinQuiz.com © 2016 -­ All rights reserved.

FinQuiz.com – 6th Mock Exam 2016 (AM Session)

Questions Topic Minutes

1-6 Ethical and Professional Standards 18

7-12 Quantitative Methods 18

19-24 Corporate Finance 18

49-54 Fixed Income 18

FinQuiz.com © 2016 -­ All rights reserved.

Questions 1 through 6 relate to Ethical and Professional Standards

Count Associates (CA) Case Scenario

FinQuiz.com © 2016 -­ All rights reserved.

A. he has violated his duty of loyalty to clients.

A. Secure authorization of the change in strategy from clients.

A. price of trade allocated.

FinQuiz.com © 2016 -­ All rights reserved.

A. timing of the receipt of client interest.

5. CFA Institute Standards of Professional Conduct recommends cancelled orders:

A. assign analysts who have relevant technical expertise.

FinQuiz.com © 2016 -­ All rights reserved.

Questions 7 through 12 relate to Quantitative Methods

Ian Walker Case Scenario

Limitation 2: Differences in GDP growth forecasts are assumed to be nonrandom.

FinQuiz.com © 2016 -­ All rights reserved.

FinQuiz.com © 2016 -­ All rights reserved.

A. 1 because it has the highest R2.

A. false based on the p-value.

11. Walters’ statement concerning R 2 will be inappropriate should the model:

A. have a random walk.

FinQuiz.com © 2016 -­ All rights reserved.

Questions 13 through 18 relate to Economics

Beta Associates Case Scenario

Detail 3: Mexico is currently in a state of civil unrest.

FinQuiz.com © 2016 -­ All rights reserved.

A. real exchange rates are not constant in the short run.

FinQuiz.com © 2016 -­ All rights reserved.

A. decline in interest rates.

17. The most likely impact of a sterilized operation in Rica is that:

A. the monetary base will expand.

A. The effect of EM central bank intervention in their currencies is statistically

FinQuiz.com © 2016 -­ All rights reserved.

Questions 19 through 24 relate to Corporate Finance

Rockthorn plc Case Scenario

Objective 1: Lower production costs to improve profitability.

Objective 2: Increase fund availability to finance the revised dividend policy.

Sergius Ivanovich is Rockthorn’s quality control manager. He is evaluating the implications of

FinQuiz.com © 2016 -­ All rights reserved.

21. Tyke’s response to Ivanovich’s statement is most consistent with:

FinQuiz.com © 2016 -­ All rights reserved.

A. the agency theory.

FinQuiz.com © 2016 -­ All rights reserved.

Questions 25 through 30 relate to Financial Reporting and Analysis

Jose Armelo Case Scenario

FinQuiz.com © 2016 -­ All rights reserved.

Value of Coefficient from

Justification 1: A large number of non-discretionary accruals have been reported.

Justification 2: Operating cash flows are being manipulated.

FinQuiz.com © 2016 -­ All rights reserved.

A. short-term liquidity risk is high.

FinQuiz.com © 2016 -­ All rights reserved.

Questions 31 through 36 relate to Financial Reporting and Analysis

Evan Gill and Rita McGregor Case Scenario

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.

FinQuiz.com © 2016 - All rights reserved.