CFA Level II Mock Exam 3 - Solutions (PM)

CFA Level II Mock Exam 3 – Solutions (PM)
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CFA Level II Mock Exam 3
June, 2016
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FinQuiz.com – 3rd Mock Exam 2016 (PM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-18 Corporate Finance 36
19-30 Financial Reporting and Analysis 36
31-42 Equity Investments 36
43-48 Fixed Income 18
49-54 Alternative Investments 18
55-60 Portfolio Management 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
Ken Ortega Case Scenario
Ken Ortega is a senior asset manager at Darryl Associates, an asset management firm in
Belgium. Ortega is undertaking interviews for a research assistant on behalf of his firm.
Ortega comes across two potential candidates, Piet Siemen and Anne Fleur; both are also
CFA Program candidates. The experience section of their resumes reads as follows:
Siemen: “I am a CFA Level III candidate. I have passed the first two levels in
consecutive attempts and will be appearing for the Level III exam in
June.”
Fleur: “I have passed all three levels of the CFA program and will receive my
charter in a year’s time.”
Three weeks after conducting interviews, Ortega hires Fleur as his research assistant.
Fleur’s first task involves analyzing the stock of Eternal, a multi-national semi-precious
jewelry maker.
Prior to conducting her analysis Ortega is invited to attend a dinner where executives of
global multinationals will be present. Due to a busy schedule, Ortega sends Fleur on his
behalf. At the event, Fleur joins a conversation involving Eternal’s CEO and two
company executives. She identifies herself as a middle manager working at the
company’s Dutch branch. The CEO reveals, in a series of private negotiations, Eternal
has received approval from North African authorities to initiate operations involving the
extraction of rare stones.
Upon returning to Darryl, Fleur requests Ortega to reassign her to another stock by
providing a statement in writing, ‘I am no longer able to maintain a neutral view on the
stock’. After being pressed by Ortega to share what her opinion would have been on the
stock, Fleur replies by stating that Eternal’s future outlook is ‘promising’.
Ortega reassigns Fleur to cover the stock of Ricardole, a pharmaceutical firm. Fleur has
little experience with the pharmaceutical sector and so requests her uncle and renowned
industry analyst, Cobus Wouter, for assistance. Wouter uses his personally designed
model to analyze Ricardole and recommends a buy rating. The following day Fleur issues
a report on Ricardole with the same rating. She identifies her relationship with her uncle
and his involvement in small font at the end of the report. In a disclosure she mentions

that an in-house firm model was used to generate the recommendation as well as
describes the model in detail.
After completing her assignment, Fleur decides to apply for an associate position at a
research firm. She attends the interview and is offered the position. She has not yet
accepted the offer as she is negotiating a position in the branch closer to her home. She
has not yet revealed details of the offer to Ortega.
The current year has been fruitful for Ortega who has delivered above-average portfolio
results. His clients are extremely pleased and one of his clients, Richard Hugo, has
mailed him two tickets to a soccer club match and promises to put a word in for Ortega at
the club. Hugo shares with club members and staff, “Ortega is an extraordinary asset
manager. He has the ability to transform an average portfolio into one which generates
assured above-average results.” When disclosing this to Ortega, the manager expresses
his gratitude and requests his client to continue his promotional efforts. Ortega accepts
the match tickets and discloses the offer to his supervisor after attending the match.
During his spare time Ortega volunteers at a charity organization. When performing his
duties he is asked by a volunteer about his duties at Darryl. He replies by stating, “I
manage the accounts of several high-profile clients. Many of these clients are business
entrepreneurs from the local Belgian business community.”
1. Which individual’s resume statement is most likely in violation of the CFA

Institute Standards of Professional Conduct?
A. Fleur
B. Siemen
C. Both Siemen and Fleur.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Fluer’s statement is in violation of Standard VII(B) Reference to the CFA

Institute, CFA Designation, and the CFA Program because the final award of the
charter is subject to meeting the CFA Program requirements and approval by the
CFA Institute Board of Governors. She cannot cite an expected date of receiving
the charter.

2. With respect to the Eternal stock, Fleur is in violation of the CFA Institute
Standards of Professional Conduct relating to:
A. misconduct.
B. material nonpublic information.
C. diligence and reasonable basis.
Correct Answer: A
Reference:
Fleur is in violation of the standard relating to misconduct as she has been

dishonest with Eternal’s CEO and executives regarding her true occupation.
Fleur is not in violation of the standard concerning material nonpublic

information. She has not acted or caused others to act on the material nonpublic
information received (the expansion of Eternal’s extraction operations into
Africa). The standard recommends members and candidates to communicate the
information to their supervisor if public disclosure is not possible. Merely sharing
Eternal’s outlook, who is her supervisor, does not constitute a violation of this
standard.
Fleur is not in violation of the standard relating to diligence and reasonable basis.
She has not made any formal recommendation. Therefore, this standard does not
cover Fleur’s actions.
3. By issuing the research report on Ricardole, Fleur is in violation of the CFA

Institute Standards of Professional Conduct relating to:
A. misrepresentation.
B. disclosure of conflicts.
C. communication with clients and prospects.

Correct Answer: A
Reference:
Fleur is in violation of the standard relating to misrepresentation. This is because

she has incorrectly identified her uncle’s model as the firm’s.
Fleur is not in violation of the disclosure of conflicts standard. This is because she
has attempted to avoid any conflict of interest by disclosing her relationship with
her uncle.
By disclosing the details of the model used, Fleur has complied with the standard
relating to communication with clients and prospects.
4. By applying for the associate position at the research firm, is Fleur in violation of
the CFA Institute Standards of Professional Conduct relating to Duties to
Employer?
A. No.
B. Yes, by not disclosing details of the negotiations.
C. Yes, by not disclosing her attendance at the interview.
Correct Answer: A
Reference:
By not disclosing her attendance at the interview or details of the negotiations,

Fleur is not in violation of any professional conduct standards. Her preparations to
leave work have not interfered with her research assignments.
5. Are Ortega’s actions in violation of any CFA Institute Standards of Professional

Conduct?
A. No.
B. Yes, by accepting the match tickets.
C. Yes, by misrepresenting his performance as asset manager.

Correct Answer: C
Reference:
Ortega is in violation of the standard relating to misrepresentation. This is because

he is fully aware that Hugo is making guarantees with respect to his potential
performance as an asset manager. By allowing and encouraging him to continue
misrepresenting his performance, Ortega is in violation of this standard.
By accepting the match tickets and disclosing details of the offer to his employer,
Ortega has fully complied with the CFA Institute Standards of Professional
Conduct.
6. In context of his conversation with the volunteer, is Ortega’s statement is in

violation of the CFA Institute Standards of Professional Conduct relating to client
confidentiality?
A. Yes, with respect to his complete statement.

B. Only with respect to the portion, “I manage the accounts of several high-
profile clients.”
C. Only with respect to the portion, “Many of these clients are business
entrepreneurs from the local Belgian business community.”
Correct Answer: C
Reference:
Standard III(E) Preservation of Confidentiality requires members and candidates

to keep information about clients confidential (with certain exemptions).
By simply stating that he manages the portfolios of ‘high profile clients’ does not
constitute a violation. This is because the statement does not reveal any specific
client details and is general in nature.
However, he has violated the confidentiality standard by stating that his clients
are Belgian-based and are wealthy entrepreneurs. This is because he is revealing
the identity of his clients by providing specific details.

Questions 7 through 12 relate to Corporate Finance
Locha, Inc. Case Scenario
Locha, Inc. is a pharmaceutical company specializing in cancer-related research and

production of related medications. Last week Locha’s management made a purchase offer
to Trica, a small-scale over-the-counter and prescription drug manufacturer. If the offer is
successful the newly merged company will be identified as Lyre. Presently Trica lacks
quality management. By acquiring Trica Locha’s management wishes to expand its area
of expertise and be in a better position to influence industry product pricing.
Vahan Stepan is a senior manager at Locha. During a senior management meeting Stepan
states,
“One of the benefits of merging with a company with a low EPS measure is that the post-
merger EPS and stock price should increase if Locha’s stock is used as the currency of
purchase.”
Stepan collects pre-merger EPS, price-earnings (P/E), and common stock data with
respect to Locha and Trica to justify his claims (Exhibit 1).
Exhibit 1
Pre-merger Data Concerning Locha, Inc. and Trica
Locha, Inc. Trica
Stock price $65.0 $20.0
EPS 2.5 1.5
P/E 26.0 13.3
Total shares outstanding 4,000,000 650,000
The purchase offer made to Trica is met with stiff resistance from its management.
Trica’s management responds by implementing three measures, either of which will be
implemented if a takeover attempt is made.
Measure 1: Trica’s shareholders have been granted the right to purchase company
shares at a significant discount to market price.
Measure 2: Any shareholder holding more than 16% of Trica’s outstanding stock will
not be allowed to exercise their voting rights.

Measure 3: Invite Fleet Distributors, a distributor of Trica’s products, to submit a

purchase bid for acquiring the pharmaceutical company.
Following the response of Trica’s management, Stepan decides to change Locha’s tactic
by submitting an acquisition offer to the target’s shareholders. Included in this offer is a
proposed list of Locha directors developed by Stepan (Exhibit 2). This list has been put to
shareholder vote. The proposed directors will be members of Lyre’s board if the merger
is successful. Stepan will assume the role of CEO at Lyre.
Stepan feels it is important to ensure that the price paid for Trica’s shares does not
significantly exceed its fair value. As a starting point, he collects the necessary details for
establishing fair value (Exhibit 3). Stepan intends to use the discounted cash flow
technique and a forecast period of four years, 2012 to 2016. At the end of 2016, free cash
flows will grow at a constant rate of 3%.
Exhibit 2
Proposed List of Directors for Lyre
Rodney Clab, a health regulatory consultant to Locha

Virginia Gayle, Stepan’s niece and a pharmacist with an MBA degree
Joseph Icke, the CEO of a former equipment supplier to Trica
Linda Brown, a self-employed pharmaceutical industry analyst
Exhibit 3
Information Concerning Trica, Discounted Cash Flow Technique
(2013-2016)
$’000, where applicable 2013 2014 2015 2016
NOPLAT 10,000 11,500 11,800 12,250
Depreciation 5,000 7,500 7,900 8,350
Net interest income 450 510 620 700
Change in working capital 220 380 470 560
Change in deferred taxes 57 60 82 48
WACC (%) 12.3
Tax rate (%) 30.0

7. Which of the following reasons is most likely a motivation behind Locha’s

decision to purchase Trica?
A. Lock in key suppliers

B. Increase market power
C. Acquire unique capabilities and/or resources
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS b
Locha’s management wishes to increase their ability to influence market pricing.

In this way, they aim to increase market power.
C is incorrect. With Trica lacking a quality management team as well as there

being no identifiable unique capabilities and resources, this factor is not a
motivating force behind Locha’s purchase decision.
A is incorrect. The proposed merger between Locha and Trica is an example of a

horizontal merger. Had the merger been an example of vertical integration,
locking in key suppliers could have been a motivating force behind Trica’s
purchase decision.
8. The proposed offer is most likely an example of a:
A. statutory merger.
B. horizontal merger.
C. conglomerate merger.
Correct Answer: B
Reference:

Apart from the minor differences, Locha and Trica are in the same industry; they
both are pharmaceuticals producing drugs.
A is incorrect. The proposed merger cannot be classified as a statutory merger.

This is because both Locha and Trica will terminate their legal existence and will
be identified as Lyre, a newly formed company. In a statutory merger, one of the
companies ceases to exist as an identifiable entity and its assets and liabilities
become part of the purchasing company.
C is incorrect. Because Locha and Trica are in the same industry, the proposed
merger cannot be classified as consolidation.
9. Using the information in Exhibit 1, if the bootstrapping process works Trica’s

stock price should:
A. rise to $67.86.
B. rise to $153.41.
C. remain the same.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS c.
With its stock price at $65, Locha can issue 200,000 [(650,000 × $20.0)/$65] of
its shares and use the proceeds to purchase the target. Total shares outstanding of
the merged company, including Locha’s initial shares, amount to 4,200,000. The
combined earnings of the merged company will equal $10,975,000 [(2.5 ×
4,000,000) + (1.5 × 650,000)]. Thus, post-merger EPS is 2.61
($10,975,000/4,200,000).
If the bootstrapping process is successful, Locha’s management will be able to

bootstrap earnings to the higher post-merger EPS of $2.61 per share. Applying the
pre-merger P/E ratio, the share price should rise to $67.86 (26.0 × $2.61).
10. Which of the following statements is an accurate description of the measures

listed?
Measure Description
A. 1 dead-hand provision
B. 2 supermajority voting provision
C. 3 white knight defense mechanism

Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS f
Measure 3 is an example of a white knight defense mechanism. Fleet Distributors

is a third party who has been offered to purchase Trica. A white knight defense
mechanism involves the target seeking a third party to purchase the company in
lieu of the acquirer. The target will seek a third party which has a good strategic
fit with it.
Measure 1 is an example of a poison pill (flip-in) defense mechanism. This

provision grants target shareholders the right to purchase its company shares at a
discount.
Measure 2 is an example of a restricted voting rights provision. This provision

restricts stockholders who have recently acquired large blocks of stock from
voting their shares. Usually, there is a triggering stockholding level, such as 15 to
20 percent.
11. How many of the proposed members lack independence?
A. 2
B. 3
C. 4
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 27, LOS e.

Of the four proposed directors three lack independence, Rodney Clab, Virginia
Gayle, and Joseph Icke.
Clab has an important and current business relationship with Locha even if he is
not an employee of the company. Thus his business relationship may compromise
his independence.
Gayle has a personal relationship with Stepan. Given that Stepan will continue to
assume his role at Lyre, the relationship may compromise her independent
judgment.
Icke is a former employee of Trica and his former employment with Trica may
compromise his independence and objectivity. At Lyre, Icke may be inclined to
favor Trica employees over Locha’s employees because of his past relationship.
Brown is an independent individual with no current or past association with the

either of the two companies. Thus she is the only proposed member who does not
lack independence.
12. Basing the terminal value on the discounted cash flow approach, the current
enterprise value of Trica is closest to (in 000s):
A. $141,856.
B. $187,618.
C. $193,655.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS i.

All calculations are in 000s.

$’000, where 2013 2014 2015 2016
applicable
NOPLAT 10,000.00 11,500.00 11,800.00 12,250.00
Plus: Depreciation 5,000.00 7,500.00 7,900.00 8,350.00
Less: Change in working 220.00 380.00 470.00 560.00
capital
Free cash flow 14,780.00 18,620.00 19,230.00 20,040.00
Present value @12.3% 13,161.18 14,764.55 13,578.13 12,600.24
Terminal value, 2016* $221,948.39
Terminal value, 2012** $139,551.00
$"#,#%#×'.#)
*Terminal value, 2016 = = $221,948.39
#.'")*#.#)
$""',2%3.)2
** Terminal value, 2012 = = $139,551.00
'.'")4
Total present value = $(13,161.18 + 14,764.55 + 13,578.13 + 12,600.24 +

139,551.00)
= $193,655.10
$’000, where applicable 2013 2014 2015 2016

NOPLAT 10,000 11,500 11,800 12,250
Depreciation 5,000 7,500 7,900 8,350
Net interest income 450 510 620 700
Change in working capital 220 380 470 560
Change in deferred taxes 57 60 82 48
WACC (%) 12.3
Tax rate (%) 30.0

Questions 13 through 18 relate to Corporate Finance
Robert Somers and John Yildiz Case Scenario
Robert Somers and John Yildiz are developing a dividend policy for their firm, Rocha
Tech. During their initial meeting Somers brings forth the following argument:
Argument 1: “The design of the dividend policy should have no impact on

shareholders’ wealth, particularly those individuals who are able to
customize dividend policy to meet their liquidity needs.”
Yildiz objects to Somers’ argument by presenting the following counter-argument:
Argument 2: “The clientele effect suggests that the design of the dividend policy does
matter. A company’s decision to initiate, increase or cut dividend conveys
credible information concerning management intentions.”
To justify his argument Yildiz goes on to identify two factors, which he believes may
affect dividend policy.
Factor 1: Rapidly developing companies design their dividend policy to provide

them with the flexibility to respond to developments and profitable
investment opportunities.
Factor 2: The dividend policy may be subject to certain limitations, one of them
being impairment of capital rule.
Next, Somers and Yildiz analyze the dividend payment history of Marshal Solutions, a
competitor with an identical operating nature and financing structure to Rocha (Exhibit).

Exhibit
Marshal Solutions’ Dividend
Payment History
Year EPS Dividends
(adjusted) per share
(DPS)
2012 $7.66 $2.45
2011 6.89 2.06
2010 8.20 2.46
2009 7.95 2.39
2008 8.00 2.39
Somers proposes that they should consider a share repurchase program for Rocha. He
justifies his suggestion by claiming that the net impact on shareholders’ wealth will
remain the same under either a repurchase or regular dividend paying program. Rocha
currently carries debt of $30 million and holds equity with a market value of $120
million. He further determines that the company should maintain a repurchase involving
$10 million of the market of value of its common shares. Somers concludes his analysis
by stating,
Statement: “Holding all else equal, compared to issuing new debt for the repurchase
program, the increase in total debt ratio will be greater under a cash
repurchase transaction.”
13. Which of the following assumptions most likely underlie Argument 1?
A. Transaction taxes do not exist

B. Dividends do not influence share value
C. Asymmetric information exists among all investors
Correct Answer: A
Reference:
The dividend irrelevance proposition is based on the assumption that capital

markets are perfect. That is, transaction costs and taxes do not exist and there is
equal (symmetric) information among all investors.

14. Is Yildiz correct with respect to his counter-argument?
A. Yes.
B. No, the clientele effect supports the dividend irrelevance proposition.
C. No, his argument highlights the information content of dividend actions.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS a &b.
Yildiz’s argument highlights the information content of dividend actions

(signaling). This argument rejects the notion that there is symmetric information
among all investors. Also the argument suggests that board of directors and
management, having more information about the company, may use dividends to
signal to investors how the company is doing. This is why a company’s decision
to maintain, initiate or cut dividend conveys credible information regarding
management’s intentions.
15. Factor 1 most likely illustrates:
A. financial flexibility only.

B. investment opportunities only.
C. both financial flexibility and investment opportunities.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS d.
Factor 1 highlights investment opportunities and financial flexibility. All else

equal, a company with more profitable investment opportunities will pay out less
in dividends than a company with fewer investment opportunities. Since
internally generated cash flow is a cheaper source of capital, companies
undergoing rapid change and/or those with profitable investment opportunities
will modify their dividend policy to meet their needs.
Companies may reduce or omit dividends to obtain the financial flexibility

associated with having cash on hand. All else equal, a company with greater
financial capital is in a stronger position to exploit profitable investment
opportunities with minimum delay.

16. The impairment of capital rule is most likely a component of:
A. tax considerations.
B. future earnings volatility.
C. contractual and legal restrictions.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS d.
The impairment of capital rule may restrict the payment of non-liquidating

dividends.
17. Using the information in the Exhibit, Marshal’s dividend policy can most likely be
characterized as:
A. stable.
B. residual.
C. constant dividend payout ratio.
Correct Answer: C
Reference:
Marshal Solutions’ dividend payout policy is an example of a constant dividend

payout ratio policy. Over the five years presented, the payout ratio is constant is at
around 30%, as shown below:
Year EPS Dividends Payout

(adjusted) per share ratio
(DPS) (DPS/EPS)
2012 $7.66 $2.45 32%
2011 6.89 2.06 30%
2010 8.20 2.46 30%
2009 7.95 2.39 30%
2008 8.00 2.39 30%

18. Is Somers correct with respect to his statement concerning the share repurchase
program?
A. Yes
B. No, the increase in total debt ratio is greater when repurchase is made by
issuing new debt
C. No, the total debt ratio is equal regardless of whether debt or cash is used
for repurchase
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS g
Rocha’s beginning debt ratio is 25% ($30 million/$120 million).
Following a share repurchase using cash on hand, equity should decrease by $10
million to $110 million and the debt amount should not be affected. Thus the total
debt ratio should increase to 27.3% ($30 million/$110 million).
Following a share repurchase by issuing new debt, total debt will increase by $10
million to $40 million and total equity will decrease by $10 million to $110
million. Thus the total debt ratio should increase to 36.4% ($40 million/$110
million).
Thus the increase in total debt ratio is greater when the repurchase is made by
issuing new debt.

Questions 19 through 24 relate to Financial Reporting and Analysis
Bruce Slater, CFA, Case Scenario
Bruce Slater, CFA, is an equity analyst analyzing Howard Corp, a U.S. based
manufacturer of steel pipes. On January 1, 2011 Howard acquired an 80% stake in Flake
Interiors, a U.S. based furniture maker and a 30% stake in Graze, a U.S. farming
equipment maker.
Flake Interiors is operating in a highly competitive environment and has been forced to
reduce inventory levels to cut down production costs. Flake is finding it difficult to cope
in this extreme environment and has determined that it will need to redesign its
production process to keep up with evolving production techniques. Furthermore, input
wood prices are rapidly rising due to environmental regulations limiting deforestation
activities. The applicable tax rate is 30% and is forecasted to rise to 35% next year (in
2013). Selective financial information on the company is presented in Exhibit 1.
Flake Interiors uses the LIFO method of inventory accounting and prepares and presents
its financial statements in accordance with U.S. GAAP. If the FIFO method had been
used inventory would have been higher by $0.9 million, $1.1 million, and $1.2 million
than reported on December 31, 2010, 2011 and 2012, respectively. The breakdown of
Flake’s inventory is presented in Exhibit 2.
Graze capitalized expenditures related to software it developed in early 2008. The

software is used to build custom farming equipment based on specifications made by its
customers. The feasibility of the software was established in 2009 and the company
capitalized development costs of $6.40 million and $8.00 million in 2009 and 2010,
respectively. Amortization expense related to costs capitalized was $0.88 million and
$1.60 million in the two years, respectively. Selective financial information related to the
company is summarized in Exhibit 3. Slater aims to:
Objective 1: compare Graze’s financial results to a competitor which expenses software

development costs and
Objective 2: determine the condition required for reported net income to be higher in
current and future periods for companies which capitalize development
costs.

Slater would like to compare the impact of the pooling of interest to the acquisition
method on the consolidated financial statements of Howard and Graze. Howard’s 80%
equity stake in Graze was purchased by issuing 2,000,000 of its shares at the current
market price of $20. Balance sheet information immediately prior to the acquisition is
presented in Exhibit 4.
Exhibit 1
Selective Financial Information Concerning
Flake, Fiscal Years 2011-2012
In $’000 2012 2011
Sales 3,300 2,250
Cost of sales 990 800
Gross profit 2,310 1,450
Net profit 2,000 1,080
Inventories 3,300 2,150

Total liabilities 5,200 3,000
Total equity 1,220 1,000
Exhibit 2
Flake’s Inventory Breakdown,
Fiscal Years 2011-2012
In $’000 2012 2011

Raw materials 390 500
Work-in-progress 790 880
Finished goods inventory 2,120 770
Total 3,300 2,150

Exhibit 3
Selective Financial Information Concerning
Graze, Fiscal Years 2009-2010
In $’000 2010 2009
Operating income 22,500 18,000
Depreciation and amortization 2,400 1,850
Net income 14,560 12,550
Shares of common stock outstanding 10,000 10,000
Market value of outstanding debt 25,000 22,000
Market price per share 45.60 25.00
Exhibit 4
Balance Sheet Information for Howard Corp and Graze
As at January 1, 2011
Howard Corp, Graze, Book

Book Value ($’000) Value*
($’000)
Shareholder’s equity:
Common stock per $1 100,000 10,000
par value
Additional paid in capital 120,000 8,000
Retained earnings 15,000 7,000
*Fair value of assets and liabilities is equal to their book values
19. Using Exhibit 1 and tax rate information, if the FIFO method had been used, total-
liabilities-to-equity in 2012 would be closest to (ignoring the impact of deferred
taxes):
A. 2.52.
B. 3.64.
C. 3.94.

Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e
Ignoring the impact of deferred taxes, liabilities will be unaffected by the choice
of inventory valuation method. However, the equity balance will be affected
through the retained earnings account as follows:
• Retained earnings will increase by the cumulative increase in operating profit

due to a decrease in cost of goods sold less the taxes on that profit.
Cumulative increase in cost of goods sold less taxes = $1.2 million × 0.7
= $840,000
Liabilities-to-equity = $5,200,000/($1,220,000 + $840,000)
= 2.52
20. Using the information in Exhibits 1 and 2, which of the following statements most
accurately justifies the change in inventory balance between 2011 and 2012?
A. Flake anticipates an increase in future sales

B. Flake anticipates a decline in future demand
C. Higher wood prices have raised inventory unit prices
Correct Answer: B
Reference:

Flake anticipates a decrease in future demand, earnings and sales. This is evident
from the following:
• Raw material and work-in progress are declining while finished goods
inventory has increased significantly, by 175%, signaling a possible decrease
in demand for products and lower future sales and profit.
• Growth rate of sales (47%) is lower than the growth rate of finished goods
inventory (175%); this could indicate a decline in demand and decrease in
future earnings of the company.
A is incorrect (see above).
C is incorrect. The effect of an increase in input prices has been more than offset
by the decline in raw material inventory. This also signals a potential decrease in
demand for the company’s products.
21. Based on objective 1, Graze’s adjusted EV/EBITDA ratio for the year 2010 is
closest to:
A. 14.62.
B. 15.37.
C. 28.46.
Correct Answer: C
Reference:
All calculations are in $’000.

The adjusted EV/EBITDA ratio is calculated by removing the effects of
capitalization from the company’s balance sheet and expensing the costs. While
EV will require no adjustments, EBITDA will need to be adjusted to include the
effects of software development expenditures and remove amortization expense.
EV = Market of equity + Market value of outstanding debt

EBITDA = EBIT or operating income + depreciation + amortization
EV = (10,000 × $45.6) + $25,000 = $481,000
Unadjusted EBITDA = $22,500 + $2,400 = $24,900
Adjusted EBITDA = $24,900 – $8,000 = $16,900
Adjusted EV/EBITDA = $481,000/$16,900 = 28.46

22. Based on objective 1, Graze’s cash flow from operations in 2009 would need to
be:
A. reduced by $5.52million.
B. need to be reduced by $6.40 million.
C. need to be increased by $6.40 million.
Correct Answer: B
Reference:
Since Graze was capitalizing software development costs, all expenditures

incurred would have reduced investing cash flows. However, when expensing
these costs an analyst will need to record the expenditure as an operating cash
outflow and will thus reduce 2009’s operating cash flows by $6.40 million.
23. The condition which Slater is attempting to determine most likely is that:
A. the level of inflation is low.

B. Graze should be a profitable company.
C. Graze’s development costs are increasing.
Correct Answer: C
Reference:
If Graze chooses to capitalize software development costs, it will report higher net
income as long as the expense that would have resulted from amortizing prior
periods capitalized development costs is lower than the amount of current period
development costs; this will occur when the company’s development costs are
increasing.
24. Comparing the impact of the pooling method relative to the acquisition method on
the consolidated financial statements of Howard and Graze, debt-to-equity ratio is
most likely:
A. unaffected by the choice of method.

B. 0.1775 times lower when using the pooling method.
C. 0.079 times higher when using the pooling method.

Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS c
All $ calculations are in thousands.
Under the pooling method, the shares issued by Howard will be measured at par
value and the retained earnings of Graze would be combined with that of Howard
on the consolidated balance sheet.
Under the acquisition method, only Howard’s common stock and paid in capital
will be reported on the consolidated balance sheet and the shares issues by
Howard are measured at fair value. The retained earnings of Graze will be
included in the consolidated balance sheet post-acquisition.
Debt-to-equity ratio (pooling method):
$330,000 + $110,000
$ 100,000 + 10,000 + 2,000 ∗ +120,000 + 8,000 + 15,000 + 7,000
$440,000
= 1.679
$262,000
Debt-to-equity ratio (acquisition method):
$330,000 + $110,000
$ 100,000 + 2,000 ∗ +120,000 + 38,000 ∗∗ +15,000
$440,000
= = 1.600
$275,000
*Par value of shares issued = 2,000 × $1 = $2,000

**Additional paid in capital resulting from shares issued = (2,000 × $20) – $2,000
= $38,000

The debt-to-equity ratio reported under the pooling method is higher by 0.079
times higher.
Howard Corp, Graze,

Book Value Book Value*
($’000) ($’000)
Shareholder’s equity:
Common stock 100,000 10,000
per $1 par value
Additional paid 120,000 8,000
in capital
Retained earnings 15,000 7,000

Questions 25 through 30 relate to Financial Reporting and Analysis
Caroline Forbes Case Scenario
Caroline Forbes is the chief accountant at HuberLow Corp. located in Austin, Texas.
HuberLow Corp. is the global leader in vacuum technology, earning its products the
nickname ‘Dustbusters’. With ever growing international demand, HuberLow is vigilant
in personnel management affairs as it operates on the philosophy of employees being an
entity’s most valuable asset.
The entity currently has a 200,000 workforce spread over 12 countries. The vesting
conditions have already been met by 25,000 employees and 125,000 additional
employees are expected to meet this requirement within the next ten years. Exhibit 1
provides the summarized pension data available on 31st December, 2011.
Exhibit 1
Summarized Pension Data
Available on December 31, 2011
Opening Pension Liability $48,000,000

Interest Rate 9%
Past Service Costs $780,000
Actuarial Gains and Losses $269,000
Closing Pension Liability $53,000,000
A meeting on pension management was setup by the CFO of HuberLow Corp. as the
most recent 5 years of operations have seen a significant drop in turnover rate. During a
meeting, Forbes made the following statements:
Statement 1: Prior to the vesting date, employee service is considered an asset on the
balance sheet.
Statement 2: The return on plan assets decreases the projected benefit obligation.
Statement 3: Curtailment is the reduction in the number of employees currently covered

by the existing plan.

25. The number of employees relevant for the calculation of the accumulated benefit
obligation for ten years is closest to:
A. 125,000.
B. 150,000.
C. 200,000.
Correct Answer: B
Reference:
The number of employees relevant for an accumulated benefit obligation

calculation for 10 years = Currently Vested + Expected to meet Vesting
Conditions in the next ten years= 25,000 + 125,000= 150,000.
26. Which measure of pension obligation estimation is based on the going concern
assumption?
A. Vested Benefit Obligation

B. Accumulated Benefit Obligation
C. Projected Benefit Obligation
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 19, Section 2.2
The projected benefit obligation is based on the going concern assumption as it

assumes the business to maintain its operations for the foreseeable futures.
Calculations are made using the assumed turnover rates and salary increases in
future periods.
27. The interest cost for the year ended 31st December, 2011 is closest to:
A. $4,320,000.
B. $4,390,000.
C. $4,770,000.

Correct Answer: A
Reference:
Interest Cost= Discount rate × Beginning pension obligation=9% × $48

million=$4.32 million.
28. The first statement made by Forbes is most likely:
A. correct.
B. incorrect, prior to the vesting date, employee service is considered an
obligation on the balance sheet.
C. incorrect, prior to the vesting date, employee service is considered an
expense on the balance sheet.
Correct Answer: B
Reference:
Until the vesting conditions are met and the retirement plan is exercised, the
company accrues the employees’ services rendered as an obligation to be paid off
in the future.
29. The second statement made by Forbes is most likely:
A. correct.
B. incorrect, the return on plan assets increases the projected benefit
obligation.
C. incorrect, the return on plan assets does not affect the projected benefit
obligation.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 19, LOS d
The return on plan assets does not have any effect on the benefit obligation. The
return increases the fair value of the plan assets.

30. The third statement made by Forbes is most likely:
A. correct.
B. incorrect, curtailment is the change in any of the assumptions in the
existing plan.
C. incorrect, curtailment is the lump-sum payoff to the plan participants.
Correct Answer: A
Reference:
Curtailment occurs when the number of employees covered by the existing plan is
reduced. This reduction may be due to any number of reasons i.e. redundancy,
restructuring etc.

Questions 31 through 36 relate to Equity Investments
Richard Boyle Case Scenario
Rachel Boyle is an equity portfolio manager at Bridge Associates, a U.S. based asset
management firm. Dennis Thorpe is a junior analyst who has been assigned to Boyle. He
will be responsible for valuing two equity stocks, Lighthouse and Wood Deck. Both
stocks are being considered for client portfolios. Thorpe begins his analysis by collecting
information on Lighthouse (Exhibit 1).
Exhibit 1
Information Concerning Lighthouse Stock
Purchase price, paid at the beginning of the year $40.80
Expected dividend per share 1.20
Actual dividend per share 1.50
Expected selling price at the end of the year 42.50
Actual selling price at the end of the year 41.00
Cost of equity* 10.80%
*This is equal to the contemporaneous required return
For the Wood Deck stock, Boyle recommends Thorpe employ two alternative
approaches. Upon Boyle’s recommendation, Thorpe selects the Fama-French model and
the Ibbotson-Chen model to develop a forward looking estimate. He collects the relevant
data in Exhibits 2 and 3, respectively.

Exhibit 2
Data for the Fama-French Model
Return on the S&P 500 index 8.8%

10-year Treasury bond rate 2.5%
1-month Treasury bill rate 1.4%
Average return on 3 small-cap portfolios 12.5%
Average return on 3 large-cap portfolios 9.3%
Average return on 2 high book-to-market portfolios 8.5%
Average return on 2 low book-to-market portfolios 9.8%
Market beta 1.2
Size beta 0.4
Value beta –0.6
Exhibit 3
Data for the Ibbotson-Chen Model
Risk-free rate 2.5%

Real GDP growth rate 5.5%
Expected growth in P/E ratio 2.8%
Forward expected dividend yield 1.1%
Reinvestment return 120 basis points
Inflation forecast 4.5%
Sensitivity to inflation forecast 1.3
Business cycle risk 3.5%
Sensitivity to business cycle risk 2.5
31. Based on the information presented in Exhibit 1, the Lighthouse stock is most
likely:
A. overvalued.
B. fairly valued.
C. undervalued.

Correct Answer: A
Reference:
In order to determine whether the Lighthouse stock is mispriced, it is necessary to

compare the required return (cost of equity, 10.8%) with the expected holding-
period return (calculated below).
;<=>?@>A >CADCE F>GGDCE =HD?>I;<=>?@>A ADJDA>CAF

Expected holding-period return = –1
KLH?MNF> =HD?>
$42.50 + $1.20
− 1 = 0.0711
$40.80
Since the expected return is lower than the required return, the stock is
overvalued. This implies that the price of the stock is above its perceived value.
32. Using Exhibit 1, the ex post alpha on the Lighthouse stock is closest to:
A. –6.63%.
B. –3.69%.
C. –2.96%.
Correct Answer: A
Reference:
Realized alpha = Actual (realized) return – required return
P?@LNG >CADCE F>GGDCE =HD?> I P?@LNG ADJDA>CAF

Actual holding-period return = -1
KLH?MNF> =HD?>
$41.00 + $1.50
− 1 = 0.04167
$40.80
Realized alpha = 0.04167 – 0.108

= – 0.0663 or – 6.63%
33. Using Exhibit 2, the Work Deck stock can most likely be classified as a:
A. small-cap value stock.

B. small-cap growth stock.
C. large-cap growth stock.

Correct Answer: B
Reference:
Given a positive size beta, the Wood Deck stock is classified as a small-cap stock.
Furthermore, a negative value beta suggests that the stock is a growth oriented.
34. Using the information in Exhibit 2, the Fama-French estimate of required return is
closest to:
A. 10.94%.
B. 12.34%.
C. 13.44%.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 10, Reading 30, Los c.
The Fama-French model for calculating required return is presented below:

mkt size value
ri = RF + Bi RMRF + Bi SMB + Bi HML
= 1.4% + 1.2(8.8% – 1.4%) + 0.4(12.5% – 9.3%) + (– 0.6)(8.5% – 9.8%)
= 12.34%
35. Using the information in Exhibit 3, the Ibbotson-Chen model’s estimate of

required return is closest to:
A. 9.7%.
B. 14.6%.
C. 15.6%.

Correct Answer: C
Reference:
The Ibbotson-Chen model for deriving the required return estimate is as follows:
Required rate of return = {[[1 + EINFL](1 + EGREPS*)(1 + EGPE) – 1.0] +
EINC}
= {[1 + 4.5%][1 + 5.5%][1 + 2.8%] – 1.0 + [1.1% + 1.2%]
= 15.63%
*This quantity should approximately track the real GDP growth rate.
36. A limitation of using a model which generates forward-looking estimates is that:
A. it may suffer from data mining bias.

B. it is subject to behavioral biases in forecasting.
C. nonstationarity may render the estimates less useful.
Correct Answer: B
Reference:
The Ibbotson-Chen model is an example of a macroeconomic model. Forward-

looking estimates generated by such a model are subject to behavioral biases in
forecasting.
A and C are incorrect. Models which generate forward-looking estimates are less
subject to nonstationarity or data biases (such as data mining) than historical
estimates.

Questions 37 through 42 relate to Equity Investments
Guinness Associates Case Scenario
Guinness Associates is an equity research firm providing stock valuation among other
services. Yuzuki Iwate is the chief valuator at Guinness. She is valuing the stock of two
manufacturing concerns, Cable and Rightmore; both corporations operate in different
industries.
Cable installs electric cables in homes and offices. The company is currently undergoing
a rough period which has put its survival in jeopardy. Although the company has
managed to generate positive EPS to present date, predictability of future earnings has
become highly uncertain. Iwate determines that the price-to-book-value (P/BV) ratio is
most appropriate for valuing Cable by providing the following justifications:
Justification 1: Book value is a useful valuation measure for companies which are not
expected to continue as a going concern.
Justification 2: Book value is an appropriate measure for companies which are primarily
composed of liquid assets.
Justification 3: Book value is less subject to manipulation than earnings.
Iwate summarizes selective financial information for valuing Cable (Exhibit 1).
Exhibit 1: Selective Financial Information Concerning Cable

Current market price $42.92
EPS over most recent four quarters 14.70
Current dividend per share $5.00
Growth rate 3%
Required rate of return 15%
Total shareholder’s equity $1,200,000
Preference shares $250,000
Number of common shares outstanding 800,000
Number of preference shares outstanding 125,000
Industry median P/BV 40.80

Rightmore is a chip manufacturer which has been in operation for almost six years. Iwate
will be valuing Rightmore using the P/CF multiple. Using this technique she is
attempting to ascertain the relative valuation of the Rightmore stock. Iwate will conduct
her analysis by comparing the manufacturer to a competitor, Gadget, Inc. The necessary
information for performing P/CF analysis is summarized in Exhibit 2. Furthermore, Iwate
will also determine Gadget, Inc.’s P/S ratio and has collected the necessary information
in Exhibit 3.
Iwate concludes her analysis by determining that the most ideal cash flow measure is one
which is closely related to valuation theory and reflects the amount of required capital
expenditures.
Exhibit 2
Information Concerning Rightmore and
Gadget, Inc. – P/CF Analysis
P/CF 5-Year Consensus
Growth Rate (%)
Rightmore 12.5 6.7
Gadget, Inc. 16.5 5.2
Exhibit 3
Information Concerning
Gadget, Inc. – P/S Calculation
$’000
Sales 550
Total assets 1,295
Total liabilities 360
Net profit 100
Dividend payout ratio (%) 35
Required rate of return (%) 12.5
37. The most appropriate justified P/E ratio for Cable is closest to:
A. 2.83.
B. 2.92.
C. 3.01.

Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS b & c
The most appropriate P/E multiple is the trailing P/E multiple. This is because
future earnings cannot be predicted with certainty. In this scenario, it will be
necessary for Iwate to rely on past earnings.
KQ $%".2"
Justified trailing P/E = = = 2.92
;Q $'%.R#
38. Based on the P/BV approach and the information in Exhibit 1, Cable is:
A. overvalued.
B. fairly valued.
C. undervalued.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS r.
Cable stock’s book value per share = Common shareholders’ equity/number of

common shares outstanding.
Common shareholders’ equity = Shareholders’ equity – total value of equity

claims that are senior to common stock
Common shareholders’ equity = $1,200,000 – $250,000

= $950,000
Book value per share = $950,000/800,000 = 1.1875

Cable stock’s price-to-book value = 42.92/1.1875 = 36.14
Compared to the industry median P/BV ratio (40.80), Cable appears to be

relatively undervalued.

39. Which of Iwate’s justifications support the use of the P/BV approach for valuing
the Cable stock?
A. Justification 1
B. Justification 2
C. Justification 3
Correct Answer: A
Reference:
Justification 1 most appropriately supports the use of the P/BV multiple for
valuing Cable. Cable’s going concern status is highly uncertain and thus book
value is appropriate for companies that are not expected to continue in this
manner in the foreseeable future.
Justification 2 does not support the use of the P/BV multiple for valuing Cable.
Cable is a manufacturing concern. Companies chiefly comprising of liquid assets
include finance, investment, insurance and banking institutions.
Justification 3 does not support the use of the P/BV multiple for valuing Cable.
With respect to manipulation book value and earnings are almost equal; that is,
both are subject to manipulation.
40. Based on the information in Exhibit 2, Rightmore is most likely:
A. overvalued.
B. fairly valued.
C. undervalued.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS r

Rightmore’s P/CF ratio is lower than Gadget, Inc.’s ratio (12.5 vs. 16.5,
respectively). This suggests that Rightmore is undervalued based on the P/CF
ratio. All else equal, it is expected that investors would expect a higher growth
rate for Gadget, Inc. However, based on the consensus 5-year growth rate,
Rightmore’s growth rate is 1.5% higher.
In conclusion, Rightmore is relatively undervalued based on the P/CF ratio and

expected growth rate.
41. Using the information in Exhibit 3, the justified P/S multiple based on the Gordon
growth model for the Gadget, Inc. stock is closest to:
A. 1.23.
B. 2.28.
C. 6.95.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS h
Based on the Gordon growth model, P/S is stated as:
P0 (E0 S 0 )(1 − b)(1 + g )

=
S0 r−g
g =𝑏×𝑅𝑂𝐸
= (1 – 0.35) × $100,000/($1,295,000 – $360,000)
= 6.95%
P0 ($100,000 $550,000)(0.35)(1 + 0.0695)

= = 1.2263 or 1.23
S0 0.125 − 0.0695
42. The cash flow measure which Iwate is referring to is most likely known as:
A. CFO.
B. FCFF.
C. EBITDA.
Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS m
Iwate is referring to the FCFF measure. FCFF directly reflects the amount of a
company’s required capital expenditures and has a stronger link to valuation
theory than EBITDA.

Questions 43 through 48 relate to Fixed Income
East Side Analytics Case Scenario
East Side Analytics (EA) is a market research firm based in the U.S. Sergio Marcus is
one of the firm’s research analysts and specializes in fixed income securities. Marcus is
preparing a research report on how credit risk in the fixed income market has evolved
calling for credit analysis models which explore correlated default risk based on
macroeconomic factors.
Marcus begins his study by attempting to address the following question, “Why are
traditional approaches limited in their ability to manage credit risk?”
To answer this question, Marcus draws three limitations of traditional credit analysis
techniques.
Limitation 1: Credit scores are insensitive to economic conditions; a deteriorating

economy will have little to no effect on a borrower’s credit riskiness.
Limitation 2: Credit ratings represent a complex statistical technique for analyzing the
credit risk of a borrower.
Limitation 3: Credit ratings and credit scores tend to be highly volatile over the business
cycle.
Following his analysis of traditional credit risk measures, Marcus proceeds to explore
structural and reduced form models. For this task he pairs with Lisa Fernandez, his
subordinate. During a meeting between the two Fernandez states, “The structural model
makes an assumption regarding the distribution of asset prices which has implications for
a company’s loss distribution.”
With respect to the reduced form model, Fernandez and Marcus arrive at the following
conclusions which will be included in the report:
Conclusion 1: The estimation procedure used by the reduced form model is flexible
allowing for default probabilities to vary with the state of the economy.
Conclusion 2: The parameters, default probabilities and loss given default, used to value
debt are subject to model assumptions.

Conclusion 3: The decomposition of credit spread in the reduced form model reveals an
absence of liquidity risk.
Marcus believes that their analysis is incomplete without an illustration of how credit risk
measures are derived using the reduced form model. He collects data with respect to a
two-year zero-coupon bond issue (Exhibit). He has assumed a constant default
probability and loss given default for his analysis.
Exhibit: Data Concerning a Two-

Year Zero-Coupon Bond Issue
Face value $895
Time to maturity 1.5 years
Default intensity 0.03
Loss given default 0.55
43. With regards to the limitations of traditional credit measures, Marcus is most
accurate with respect to Limitation:
A. 1.
B. 2.
C. 3.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 15, Reading 46, LOS b & c

Marcus is accurate with respect to Limitation 1 only. Credit scores do not

explicitly depend on the external business cycle or macroeconomic conditions.
These credit measures are subject to adjustment if the borrower’s behavioral or
financial circumstances change.
Marcus is inaccurate with respect to Limitation 2. Credit ratings represent a

simple statistic that summarizes a complex credit analysis of a potential borrower.
Marcus is inaccurate with respect to Limitation 3. Credit rating agencies aim to
keep ratings stable over time in order to reduce unnecessary volatility of debt
prices. In addition, many lenders prefers stability in credit scores over accuracy
and so there may be pressure on credit rating agencies when generating credit
scores.
44. The implication of the return distribution which Fernandez is referring to in her
statement is that the loss distribution will becharacterized by:
A. fat tails.
B. thin tails.
C. symmetry.
Correct Answer: B
Reference:
The structural model assumes that the return distribution of asset prices is
lognormal; this assumption implies a thin tail for the company’s loss distribution.
However, there is evidence that the loss distribution is in fact characterized by
tails which are fatter than those implied by a lognormal distribution.
45. The estimation procedure discussed in Conclusion 1 is most likely known as:
A. implicit.
B. lognormal.
C. hazard rate.
Correct Answer: C
Reference:

C is correct. The reduced form model uses historical estimation for estimating the
parameters. This approach is an application of hazard rate estimation.
A is incorrect. Implicit estimation is not typically used because the technique

unrealistically assumes that default probability and loss given default do not
depend on the macroeconomic state of the economy. An unrealistic model
produces biased estimates which are inconsistent with the market structure.
46. In context of Conclusion 2, default probabilities in a reduced form model are least
likely subject to the assumption of:
A. systemic risk.
B. going concern.
C. idiosnycratic risk.
Correct Answer: B
Reference:
Based on model assumptions, default probabilities depend on the business cycle

through macroeconomic state variables. This allows for the probability of default
to increase during a recession and decline during expansions. This leads to
probabilities being subject to the assumption of systemic risk.
In addition, whether a particular company defaults will depend on company-

specific considerations. This assumption will result in default probabilities being
subject to company-specific factors which are unrelated to the economy.
47. Conclusion 3 is accurately stated because the reduced form model assumes that:
A. assets trade in frictionless markets.

B. the riskless rate of interest is stochastic.
C. a company’s zero-coupon bond trades in frictionless markets.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 15, Reading 46, LOS f & g

The assumption that a company’s zero-coupon bond trades in frictionless markets

implies that there is no quantity impact of a sale or purchase transaction on the
price of a security. The presence of such a quantity impact introduces liquidity
risk. Therefore, the assumption of frictionless markets is equivalent to that of an
absence of liquidity risk. Therefore, the credit spread in reduced form models is
entirely due to credit risk.
A is incorrect. The reduced form model does make assumptions about the assets
of a company as the only security required to be traded is the zero-coupon bond.
C is incorrect. The interest rate pattern does not have any implications for market
liquidity.
48. Using the data in the Exhibit, the maximum amount a bondholder would be
willing to pay to remove credit risk of the bond is:
A. $7.35.
B. $21.88.
C. $26.45.
Correct Answer: B
Reference:
The maximum amount a bondholder would be willing to pay to insurer to remove

the credit risk from the bond is $21.88 and is measured by the expected loss (see
below).
[ ] [
Expected loss = K 1 − e −λγ (T −t ) = 895 1 − e −0.55(0.03)(1.5) = $21.8794 ]

Questions 49 through 54 relate to Alternative Investments
Walter Associates (WALAS) Case Scenario
Walter Associates (WALAS) is a U.S. based asset management firm operating several
autonomous subsidiaries in America. Ellen Grant works for the Chicago subsidiary, one
of WALAS’s largest independent bodies responsible for the management of funds of
private wealth clients. Grant is part of the research department at the subsidiary and is an
expert in the valuation of private real estate investments. Grant just wrote an article about
real estate valuation that got published in the ‘Financial Universe’, a well-known
financial magazine. In the article, Grant mentioned the use of real estate indices as
investor benchmarks and also stated limitations in their construction. Grant made the
following comments about the two major types of indices—appraisal-based and
transaction-based.
Appraisal-based: “The return on the index is calculated as the sum of the income
return and the capital return. This is equivalent to the sum of the
cash return and the change in value of the index.”
Transaction-based: “A repeat sales index relies on sales of the same property and
hence, the change in value indicates how market conditions have
changed over time. On the other hand, a hedonic index includes
more than one property and hence, the change in value reflects the
differences in property characteristics and changes in market
conditions.”
Grant also explained the use of the cost approach to real estate valuation, and used the
example of a 15-year old industrial property to elucidate the methodology. The article
described the following property characteristics:
“The property has an effective age of 20 years. Although it was constructed in

accordance with appropriate construction standards, it has a smaller storage space than is
required by current standards. To construct a factory with the same storage space would
cost $25 million, but to construct one with a bigger storage space in accordance with
current standards would cost $28 million. The floor needs to be replaced at a cost of
$500,000, and some leakage repairs would cost $70,000. All these repairs will increase
the value of the factory by at least the amount they cost. The small storage space has
increased inventory storage costs by $30,000 per year. The remaining economic life of
the factory is 70 years, and the cap rate that appraisers use to value the property is 15%.
Also, based on comparable sales of land, the land is estimated to be worth $10 million.”

Grant is evaluating investment in a property that is expected to generate an NOI of

$1,000,000 next year. The property has an appraised value of $10 million and is 60%
financed by an interest-only loan at a 9% interest rate. If Grant plans to invest, he expects
to sell the property for $12 million after seven years. After his evaluation, Grant made the
following conclusions.
Conclusion 1: “The IRR that would be earned over the holding period is 11.5%.”
Conclusion 2: “The loan has increased the IRR that an equity investor would receive.
This reflects positive financial leverage.”
To corroborate his conclusions, Grant read a research article written by Jim Right, his
boss and a real estate analyst at the firm. Right had mentioned a number of commercial
and industrial properties in his paper, including a fully let property with a rent of $75,000
per year. The property was expected to generate an NOI of $50,000 per year. Right stated
that based on recent sales of comparable properties, the current value of the property was
$3 million. After reading the article, Grant approached Right and made the following
comment:
“I believe that the total return that an investor might expect to get from investment in this
property is 2.5%. This is equivalent to the all risks yield as well as the IRR or yield to
maturity of the investment.”
Grant is planning to invest some money in publicly traded real estate securities. When
talking to Right about it, Grant stated the following objectives that he wished to achieve
with the invested capital:
Objective 1: “Since most of my capital is invested in high-risk investments, I wish to

invest this money in a public equity real estate investment that has the
highest income yield and income growth potential.”
Objective 2: “Also, I would want to minimize taxes paid and increase the predictability
of my income.”

49. With respect to the comments in her article, Grant is most accurate with respect
to:
A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS k
Statement 1 is correct. The return on the index is calculated as the sum of the
index return and the capital return. The total return can also be thought of as
measuring the cash flow plus the change in value.
Statement 2 is incorrect. A repeat sales index relies on repeat sales of the same
property and hence, change in value between two dates indicates how market
conditions have changed over time. On the other hand, a hedonic index requires
only one sale. However, the way it controls for the fact that different properties
are selling each quarter is to include variables in the regression that control for
differences in the characteristics of the property. Since the index controls for these
differences, the change in value reflects changing market conditions only.
50. The value of the industrial property mentioned in Grant’s article using the cost
approach is closest to:
A. $28,134,446.
B. $29,392,857.
C. $31,134,445.
Correct Answer: C
Reference:

Replacement cost: $28 million
Curable Physical Depreciation:

Floor: $500,000
Leakage repair: $70,000
Total: $570,000
Incurable Physical Depreciation:

20/90 = 0.222 × ($28 million – $570,000) = $6,095,555.495
Incurable functional obsolescence:

$30,000/0.15 = $200,000
Hence, value is:

$28,000,000 – 570,000 – 6,095,555 – 200,000 = $21,134,445
Plus the value of land of $10 million: $31,134,445.
51. Grant is most accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS m

Conclusion 1 is incorrect. 11.5% is the cash return, not the IRR.
Conclusion 2 is correct. The IRR based on an unleveraged investment in the

property is 11.98%.
FV: 12 million
PV: –10 million
PMT: 1 million
N=7
CPT I/Y: 11.98%
Hence, the property earns 11.98% before adding the loan, and the loan is at 9%,
so the investor benefits from the spread between the two rates.
52. With regards to the comment about the article that Right wrote, Grant is most
accurate with respect to the:
A. all risks yield only.

B. total return and the all risks yield only.
C. total return, all risks yield, IRR and yield to maturity.
Correct Answer: C
Reference:
For a fully let property, the capitalization rate is applied to the rent not the NOI.
The cap rate, also called the all risks yield is: 75,000/3,000,000 = 2.5% Since rent
is expected to be $75,000 per year (like a perpetuity) the cap rate will be the same
as the total return and the all risks yield will be an internal rate of return (IRR) or
yield to maturity.
53. With regards to objective 1, which of the following would be the most appropriate
real estate investment for Grant?
A. REIT
B. REOC
C. Neither REIT nor REOC.
Correct Answer: C

Reference:
REITs have the highest income yields and payout ratios, but since they cannot
retain significant cash flows (to meet tax requirements) income growth potential
may be low to moderate.
A REOC does not have the highest income yield but it may have high income
growth potential because REOCs are free to reinvest as much of their income as
they believe is appropriate to achieve growth.
54. With regards to objective 2, which of the following would be the most appropriate
real estate investment for Grant?
A. REIT
B. ROEC
C. Either REIT or REOC.
Correct Answer: A
Reference:
If REITs meet certain criteria (regarding distributions) they are exempt from
double taxation of income. Also, due to the contractual nature of REITs’ rental
income, earnings predictability is an advantage of investing in REITs.

Questions 55 through 60 relate to Portfolio Management
Star Capital Investment (Star-Cap) Case Scenario
Star Capital Investments (Star-Cap) is a leading investment management firm that offers
financial advice and portfolio management services to private wealth clients. Most of the
portfolio managers at Star-Cap follow active portfolio management strategies, and try to
add value through superior stock-selection. Craig Connolly is one of the most senior
investment advisors at the firm. Connolly has made several media appearances, and has
attended a number of financial conferences. During one such financial discussion held at
Comprehensive Investments, a financial firm, Connolly made the following comments:
Statement 1: “An investor with a long term horizon has the ability to take greater risk
than one with a shorter time horizon. Also, if such an investor often faces
unanticipated short-term liquidity needs, he should favor investments with
a longer time horizon, since such investments offer higher returns and are
less volatile.”
Statement 2: “Portfolio optimization is an important part of the planning step of the

portfolio management process, since it helps in setting appropriate
objectives based on an investor’s circumstances and the capital market
scenario.”
Connolly was just hired as a financial advisor by Charles Page, a well-reputed physician
in his mid-thirties. Page has an investment portfolio that is 30% invested in government
bonds, 25% in U.S. corporate bonds, 15% in developed market fixed income, and 25% in
equities with the remaining in cash. Page makes $250,000 a year, after-tax which is
needed to cover only his personal annual expenses of $170,000 since he is not married
and has no dependents. He recently inherited $300,000 after tax from his father’s estate
and has used that to pay all remaining mortgage payments on his home, and all lease
payments on his car. Page has medical insurance, and receives a $30,000 bonus from his
employer every year.
Connolly also manages a $558,000 portfolio for Jon Scot, a marketing specialist at a
multinational firm. The adviser has invested a portion of Scot’s funds in the Russell 1,000
small-cap equity index. Scot is unhappy with the investment stating Connolly has taken
too much risk with respect to his funds. Connelly responds by deciding to reduce the
riskiness of the investment to 16.2% using a combination of cash and the small-cap
stocks. The exhibit below summarizes selective financial information concerning the
investment (Exhibit 1).

Exhibit 1
Expected return 12.5%
Expected volatility 18.0%
Risk-free rate 2.2%
Sharpe ratio 0.572
Robert Dawson is one of Connelly’s associates. Dawson has closely followed Connelly’s
small-cap equity investment. He discusses with Connelly the importance of arbitrage
pricing theory in providing a useful estimation of the expected return on a stock in
equilibrium and contrasts the macroeconomic multifactor model with the fundamental
factor model. Dawson has developed the following one-factor APT model to explain the
returns on stock portfolios:
E(R)p= 0.095 + 0.078βp.1
Exhibit 1 shows a set of four portfolios, each of which is well-diversified. Portfolio’s A

and B have expected returns and factor sensitivities that are consistent with the factor
model that Dawson developed.
Exhibit 2
Portfolio Expected return Factor sensitivity
A 13.4% 0.50
B 14.96% 0.70
C 14.76% 0.60
D 14.83% 0.65
Dawson is also analyzing two stocks for inclusion in his own portfolio. Exhibit 2 displays
some information about the stocks.
Exhibit 3
Stock Dividend yield Financial leverage
A 3.2% 0.50
B 2.2% 0.70

Dawson will use these two factors to determine the expected return of the two stocks. The
average dividend yield across all stocks Dawson is considering is 1.8% and the standard
deviation of dividend yields is 2.5%. Also, average financial leverage across all stocks is
0.45, and the standard deviation of leverage is 0.13. After his evaluation, Dawson made
the following comment to Connolly:
“The intercept of a fundamental factor model equals the return to a portfolio that has unit
sensitivities to all factors under analysis. This also equals the return to the average stock
in the market.”
Connolly has been asked to manage the portfolio of Leon Ura, an entrepreneur. Despite
his significant financial base, Ura maintains a modest lifestyle and will donate his
portfolio to charities upon his death. He has approached the manager specifying a
minimum expected return and maximum risk level for his portfolio. Connolly will be
using mean variance optimization for constructing the client’s portfolio. However, he
notes that the approach can be subject to limitations.
55. Connolly is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.
Correct Answer: C
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 56, LOS b & e
Statement 1 is incorrect. With a focus on risk, even an investor with a long-term

horizon may limit risk because of sensitivity to the possibility of interim losses. If
an investor often faces unanticipated short-term liquidity needs, he should favor
investments with a shorter time horizon, so as to limit the risk of loss of value
(even though his horizon is long, he faces a significant liquidity constraint).
Statement 2 is incorrect. Portfolio optimization—quantitative tools for combining

assets efficiently to achieve a set of return and risk objectives—plays a key role in
the integration of strategies with expectations in the execution phase.

56. Page most likely has:
A. an average risk tolerance.

B. a below average willingness to take risk and an above average ability to
take risk.
C. an above average ability to take risk and an average willingness to take
risk.
Correct Answer: B
Reference:
CFA Level II,Volume 6, Study Session 18, Reading 56, LOS e
Page has an above average ability to take risk. This is because:
• He has a long time horizon.

• His income more than covers his expenses.
• He has no apparent out of the ordinary liquidity needs.
• He has no dependents.
However, Page most likely has a below average willingness to take risk. This is
evident from the composition of his portfolio, 75% of his assets are invested in
bonds and only 25% in stocks.
57. To reduce the riskiness of Scot’s investment, the proportion and position of cash
employed should be respectively closest to:
Position: Proportion:
A. Short 4%.
B. Long 10%.
C. Long 90%.
Correct Answer: B
Reference:
The reduction in volatility will be achieved by investing a portion of the client’s

funds (or taking a long position) in cash.
The proportion that must be invested in small-cap stocks is 90% (16.2%/18.0%)

leaving a 10% (100% - 90%) weight in risk-free cash.

58. Using Exhibit 1, which of the following is most accurate?
A. An arbitrage opportunity involving portfolios A, B and D exists that would

provide an excess return of 26 bps
B. An arbitrage opportunity involving portfolios A, B and C exists that would
C. An arbitrage opportunity involving portfolios A, C and D exists that would
Correct Answer: A
Reference:
CFA Level II,Volume 6, Study Session 18, Reading 53, LOS b
Portfolios A and B have expected returns that are consistent with the APT model
(hence they offer no excess return). However, if we construct a portfolio
consisting of 50% is portfolio A and 50% in B, we can create a portfolio with the
same factor sensitivity as portfolio C (0.60). Such a combination should earn an
expected return of 14.18% but portfolio C offers a return of 14.76% (58 bps
more). So an investor could buy portfolio C and short the same amount of an
equally weighted portfolio of portfolio A and B, to earn this extra return (the
factor risk will be eliminated).
Also, a similar arbitrage opportunity exists with portfolios A, B and D. We could

sell a portfolio consisting of 25% of portfolio A and 75% of portfolio B and buy
an equal amount of portfolio D. The combination portfolio should earn a return of
14.57%, but portfolio D earns a return of 14.83% (26 bps more). The factor risk
will be eliminated.
Portfolio Expected return Factor sensitivity

A 13.4% 0.50
B 14.96% 0.70
C 14.76% 0.60
D 14.83% 0.65

59. Which of the following is most accurate about the sensitivities of stocks A and B
to the fundamental factors, and is Dawson correct with respect to his comment
about the intercept of a fundamental factor model?
A. Stock A’s sensitivity to the dividend yield factor is 3.2%, and Dawson is
correct
B. Stock B’s sensitivity to the leverage factor is 0.25, and Dawson is
incorrect
C. Stock A’s sensitivity to the dividend yield factor is 0.56, and Dawson is
incorrect
Correct Answer: C
Reference:
CFA Level II,Volume 6, Study Session 18, Reading 53, LOS c
Factor sensitivities equal:
Stock A:
Dividend yield = (3.2 – 1.8)/2.5 = 0.56
Leverage = (0.50 – 0.45)/0.13=0.385
Stock B:
Dividend yield = (2.2 – 1.8)/2.5 = 0.16
Leverage = (0.70 – 0.45)/0.13 = 1.923
Dawson is incorrect. The intercept is the expected return to the average stock
when all factor sensitivities equal 0.
60. Which of the following statements accurately compares macroeconomic models

to fundamental factor models? In contrast to macroeconomic models, fundamental
factor models:
A. develop factor series first.
B. estimate factor returns through regressions.
C. estimate factor sensitivities through regressions.
Correct Answer: B
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 53, LOS d

Fundamental factor models, The former specify factor sensitivities first and then
estimate the factor returns through regressions. On the other hand,
macroeconomic factor models develop factor series first and then estimate the
factor sensitivities through regressions.

CFA Level II Mock Exam 3 - Solutions (PM)

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FinQuiz.com – 3rd Mock Exam 2016 (PM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Ken Ortega Case Scenario

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1. Which individual’s resume statement is most likely in violation of the CFA

Fluer’s statement is in violation of Standard VII(B) Reference to the CFA

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Fleur is in violation of the standard relating to misconduct as she has been

Fleur is not in violation of the standard concerning material nonpublic

3. By issuing the research report on Ricardole, Fleur is in violation of the CFA

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Fleur is in violation of the standard relating to misrepresentation. This is because

By not disclosing her attendance at the interview or details of the negotiations,

5. Are Ortega’s actions in violation of any CFA Institute Standards of Professional

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Ortega is in violation of the standard relating to misrepresentation. This is because

6. In context of his conversation with the volunteer, is Ortega’s statement is in

A. Yes, with respect to his complete statement.

Standard III(E) Preservation of Confidentiality requires members and candidates

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Questions 7 through 12 relate to Corporate Finance

Locha, Inc. Case Scenario

Locha, Inc. is a pharmaceutical company specializing in cancer-related research and

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Measure 3: Invite Fleet Distributors, a distributor of Trica’s products, to submit a

Rodney Clab, a health regulatory consultant to Locha

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7. Which of the following reasons is most likely a motivation behind Locha’s

A. Lock in key suppliers

Locha’s management wishes to increase their ability to influence market pricing.

C is incorrect. With Trica lacking a quality management team as well as there

A is incorrect. The proposed merger between Locha and Trica is an example of a

8. The proposed offer is most likely an example of a:

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A is incorrect. The proposed merger cannot be classified as a statutory merger.

9. Using the information in Exhibit 1, if the bootstrapping process works Trica’s

If the bootstrapping process is successful, Locha’s management will be able to

10. Which of the following statements is an accurate description of the measures

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Measure 3 is an example of a white knight defense mechanism. Fleet Distributors

Measure 1 is an example of a poison pill (flip-in) defense mechanism. This

Measure 2 is an example of a restricted voting rights provision. This provision

11. How many of the proposed members lack independence?

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Brown is an independent individual with no current or past association with the

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All calculations are in 000s.

Total present value = $(13,161.18 + 14,764.55 + 13,578.13 + 12,600.24 +

$’000, where applicable 2013 2014 2015 2016

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Questions 13 through 18 relate to Corporate Finance

Robert Somers and John Yildiz Case Scenario

Argument 1: “The design of the dividend policy should have no impact on

Yildiz objects to Somers’ argument by presenting the following counter-argument:

Factor 1: Rapidly developing companies design their dividend policy to provide

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13. Which of the following assumptions most likely underlie Argument 1?

A. Transaction taxes do not exist

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