CFA Level II Mock Exam 5 - Solutions (PM)

CFA Level II Mock Exam 5 – Solutions (PM)

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CFA Level II Mock Exam 5
June, 2016
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FinQuiz.com – 5th Mock Exam 2016 (PM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Economics 18
13-18 Financial Reporting and Analysis 18
19-24 Corporate Finance 18
25-42 Equity Investments 54
43-48 Fixed Income 18
49-54 Derivatives 18
55-60 Portfolio Management 18
Total 180


Questions 1 through 6 relate to Ethical and Professional Standards
Precision Investment Advisors Association Case Scenario
Tim Johnston works for Precision Investment Advisors Association (PIAAS), a financial
management firm targeting small and medium sized institutional clients. Even though
PIAAS is under no obligation to confer to the laws and practices set forth by the CFA
Institute Code of Ethics and Standards of Professional Conduct, Johnston strongly
believes that doing so would contribute positively towards PIAAS’s global competitive
standing. As a member of the CFA Institute, Johnston plans to encourage top
management to adopt the Standards and to align PIAAS’s policies and practices to better
match employer responsibilities set forth by the CFA Institute Standards of Professional
Conduct. During his meeting with Jeremy West, PIAAS’s CEO, Johnston handed over a
copy of the Code and Standards. Being a proponent of an ethical workplace, West
acknowledged Johnston’s concerns and appointed him at the task of analyzing current
firm policies. Johnston was predominantly concerned with how the firm’s client base was
handled by the portfolio managers at the firm, and whether policies related to client
dealing were in accordance with the Code and Standards. Johnston spent a week
analyzing manager-client relationships and gathered the following information:
Observation 1: “Winston Lee, a portfolio manager, manages a high-growth equity fund

at the firm. The fund has attracted more than twenty medium-sized firms
on account of above-average performance based on risk/return tradeoff.
However, preliminary analysis of the fund’s investors has revealed that
more than 20% of the participants have a risk profile considerably lower
than that of the fund. Moreover, Lee has taken no steps in elucidating
this fact to the investors and has continued to market the fund under the
same stance.”
Observation 2: “PIAAS’s policies necessitate portfolio managers to submit to clients,

semiannually, an itemized statement showing all debits, credits, and
transactions that occurred during the period. If requested by the client,
portfolio managers are obligated to provide such a statement on a more
frequent basis.”


Observation 3: “David Leach is a financial analyst at PIAAS who covers the U.S.
consumer industry and prepares research reports recommending
appropriate investment decisions regarding such stocks. Due to an
extensive review process at the firm, the recommendations floated by
Leach reach clients after three days. Leach has just changed his
recommendation for the Fruity Fun Inc.(FFI) stock from buy to sell.
Leach immediately initiates the distribution process, and makes sure that
the changed recommendation is distributed in an equitable manner to all
concerned clients. A day after the distribution, one of Leach’s clients
invested in FFI advises Leach to increase his portfolio holding of the
stock from 5% to 7%. To honor client directive, Leach feels obligated to
do as asked.”
Observation 4: “Markus Kurtz recently joined PIAAS as an investment manager. To

establish his position as a competent money manager, Kurtz requested
his brothers to open fee-paying accounts at the firm under his
management. In doing so, Kurtz disclosed his relationship with them to
the firm and to clients. In addition, he followed all firm policies in
developing their investment policy statements. Presently, Kurtz has a
reasonable customer base. Kurtz makes an investment in a new offering
by Lotech Inc. which he deems appropriate for all his clients under
management. The issue is oversubscribed so Kurtz forgoes sales to
himself and his family to free up additional shares for other clients. He
does this to eliminate the appearance of favoritism.”
Observation 5: “Cara Davies, an analyst at the firm, just found out that Arrow
Enterprises, is planning to issue equity to fund an expansion project.
Davies considers this issue as the perfect opportunity to increase returns
for five of her clients for whom this issue is appropriate. As she
indicates the lucrative nature of the investment to her clients, they
oversubscribe the issue. Cara allocates the partially executed orders
among the participating client accounts pro rata on the basis of order
size. In addition, three of the largest clients, representing more than 85%
of the order receive a slightly lower execution price and are charged a
somewhat lower commission.”


Observation 6: “Jeremy West, the CEO, has just offered a new fund to the public. To
attract clients to this new fund, West offers lower than average
management fees. This is because the fund includes three top performing
diversified funds managed by PIAAS’s competitor. The opportunity to
gain access to these funds, accompanied with lower management fees,
contributes to a large influx of clients. With hopes to add to PIAAS’s
client base, West welcomes every client expressing interest in the fund.”
In addition to the above observations, Johnston discovers that West had been hired by a
law firm to testify as a financial expert witness against fraudulent accounting practices in
Crossbow Enterprises. West states that given his personal research, his opinion may
prove detrimental to the law firm. West feels confused how to act with loyalty and care
for his client without comprising his ethical stance.
1. With respect to Observation 1 and Observation 2, is PIAAS in accordance with

the required procedures for compliance with loyalty, prudence and care as set
forth by Standard III—Duties to Clients of the CFA Institute Standards of
Professional Conduct?
A. Yes.
B. Only with respect to Observation 1.
C. Neither with respect to Observation 1 nor with respect to Observation 2.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
PIAAS is in accordance. Lee is a mutual fund manager, and as such, client loyalty
and care for those investing in the fund are not his responsibility, but the
responsibility of those who have an advisory relationship with them.
It is recommended by the Standard to submit to each client, at least quarterly, an
itemized statement showing the securities in possession of the member plus all
debits, credits, and transactions that occurred during the period. Hence, PIAAS is
in accordance with the required procedures.


2. With respect to Observation 3, to be in compliance with best practice under

Standard III of the CFA Institute Standards of Professional Conduct, Leach
should:
A. do as directed by his clients.

B. advice the clients of the changed recommendation before the order is
accepted.
C. inform his clients of the changed recommendation by an update or ‘flash’
report.
Correct Answer: C
Reference:
Leach should try to shorten the time frame between decision and dissemination.
Since that is not in control of Leach, he should communicate to his clients about
the changed recommendation, by an update or ‘flash’ report. Also, accepting an
order contrary to the changed recommendation without informing the client about
the changed recommendation is a violation. However, to eliminate this problem in
the future, sending a ‘flash’ report would be best practice.
3. Kurtz has most likely violated Standard lll-A of the Standards of Professional
Conduct by:
A. requesting his brothers to open up accounts at PIAAS.

B. forgoing sales to his own and his family’s accounts.
C. both requesting his brothers to open up accounts at PIAAS and forgoing
sales for his own and his family’s accounts.
Correct Answer: B
Reference:
Kurtz family has opened regular fee-paying accounts at the firm and hence,
should be given equal treatment. Since he deems the shares to be appropriate for
his family’s accounts, forgoing sales to them is a violation of the standards.


4. Is Davies’s handling of the transaction involving Arrow Enterprises issue most

likely in accordance with the CFA Institute Standards of Professional Conduct?
A. Yes.
B. Only with respect to the distribution of the partially executed order.
C. Only with respect to the execution price and commissions.
Correct Answer: B
Reference:
Allocating partially executed orders among the participating client accounts pro
rata on the basis of order size is not a violation of the Standards. However, all
client accounts participating in a block trade should be given the same execution
price and charged the same commission.
5. In attracting clients to the new fund offered, West has most likely:
A. not violated any Standards of Professional Conduct.

B. violated Standard III of the Standards of Professional Conduct.
C. violated Standard 4 of the Standards of Professional Conduct.
Correct Answer: B
Reference:
Although West cannot disobey a client request to invest in the new fund, he
should fully discuss the risks and provide reasons why it might not be suitable for
a client. This requirement may lead West to decline new customers if their
decisions are out of line with the stated requirements.
6. In the legal proceedings confronting West, if West decides to testify against the
law firm he will most likely:
A. violate Standard III of the Standards of Professional Conduct.

B. violate Standard 4 of the Standards of Professional Conduct.
C. not violate any Standards.


Correct Answer: C
Reference:
West should not let the law firm influence the testimony he is to provide in the
legal proceedings (the one he thinks is accurate).


Questions 7 through 12 relate to Economics
Allan Associates Case Scenario
Armando Franco is a free-lance economist who formerly worked as a full-time employee

at Allan Associates (ALASS), an investment advisory firm in Massachusetts. His work at
ALASS was much appreciated; consequently, he was often called by the firm’s research
department for assistance on several ongoing projects. Presently, Franco is working with
the research team at ALASS to determine global macroeconomic forecasts for their
international investments. As a first step, Franco performed cross-country comparisons of
the GDP growth rate. Since each country presented data in its own currency, Franco was
converting the data into U.S. dollars for an accurate comparison. Mike Derry was one of
the analysts working with Franco in the estimation process. When Derry asked about the
conversion, Franco made the following comment:
“The conversion can be made using either current market exchange rates or the exchange
rates implied by purchasing power parity (PPP). I prefer using the market exchange rates
because they account for a wide range of goods and services and express market
expectations. On the other hand, PPP only rarely ever holds in the short-term, and is only
applicable over significantly long investment horizons.”
As a second step, Franco used his estimated economic growth figures to determine stock
prices and stock market growth. He made the following comment:
“Over long horizons, the percentage change in stock market value will equal the
percentage change in GDP because the share of profits in GDP and the change in the
price earnings multiple over the long-term would be approximately zero.”
As they developed their forecasts, Derry inquired about the determinants of a country’s
long-run economic growth. Franco stated that a number of theoretical explanations
existed to explain the relationship between a country’s output and inputs. Talking about
the Cobb-Douglas production function, Franco made the following comment:
“When the share of GDP paid out to the suppliers of capital is close to zero, diminishing
marginal returns to labor will be quite significant.”
Elaborating further, Derry made the following comment:
“I believe that if the share of GDP paid out to the suppliers of capital is close to one, the
capital elasticity of output would be high.”


Franco used macroeconomic forecasts provided by the research department at ALASS to

decompose the GDP growth of Germany into its constituents. Exhibit 1 displays the data
provided by the firm.
Exhibit 1
Macroeconomic forecasts for Germany
Expected growth rate of capital 1.5%
Expected growth rate of labor 2.3%
α 0.6
Potential GDP growth rate 6.7%
After expressing his conclusions about the growth rate of Germany and possible potential
investments in the country, Franco asked Derry to obtain labor workforce information in
Brazil and Mexico, two of the developing economies. Exhibit 2 displays the data
accumulated by Derry.
Exhibit 2
Labor Input Data in Brazil and Mexico (2011)
Brazil Mexico
Population 50.5 million 54.5 million
Immigration (2005-2011) 6.758 million 2.198 million
% of population under 15 22 17
% of population over 60 12 18
Male participation rate 70% 90%
Female participation rate 90% 70%
Unemployment rate 23% 32%
Income tax rate 35% 20%
Derry was performing his own analysis on the investment outlook of two alternative
economies. Exhibit 3 displays the data he is analyzing.


Exhibit 3
Macroeconomic Data
Country A Country B
Growth in labor
4.02% 8.88%
productivity
Growth in TFP 1.76% 2.32%
In addition, Derry gathered some important pointers about the path of the future economy
of Spain. A few of them are given below:
• The economy has experienced a slight, permanent increase in labor productivity

growth.
• The current economy operates at a level that is significantly above potential GDP.
• The economy has also seen a slight increase in the share of ICT investments in the
economy.
Derry plans to discuss these pointers with Franco toward the determination of a plausible
future outlook for Spain’s economy.
7. Is Franco most likely correct with respect to his comments about the conversion of
GDP and stock market value?
A. Only with respect to stock market value.

B. Both with respect to stock market value and conversion of GDP.
C. Neither with respect to stock market value nor conversion of GDP.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, LOS c


Drivers of potential GDP are ultimately the drivers of stock market price
performance over the long-term because the ratio of earnings to GDP and the
change in the price earnings ratio are approximately zero over the long-term.
Cross-country comparisons of GDP should be based on purchasing power parity

rather than current market exchange rates. Market rates are very volatile and
ignore prices of non-traded goods and services.
8. With respect to the Cobb-Douglas production function, are Franco and Derry most
likely correct?
A. Only Franco is correct.

B. Only Derry is correct.
C. Neither Franco nor Derry is correct.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, LOS d
Franco is incorrect. A value close to zero will mean that diminishing marginal
returns to capital are very significant, but diminishing marginal returns to labor
are insignificant.
Derry is correct. α can also be defined as the elasticity of output with respect to
capital. When α is close to 1, diminishing returns are low, so elasticity is high.
9. With respect to Germany, the expected total factor productivity growth is closest
to:
A. 4.88%, and an increase in TFP will not affect the relative productivity of
the other inputs.
B. 4.72%, and an increase in TFP boosts the relative productivity of the other
inputs.
C. 2.90%, and a permanent increase in TFP increases the level of potential
GDP.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, Section 4.1


6.7% = 0.6(1.5) + 0.4(2.3) + TFP growth

TFP = 4.88%
An increase in TFP does not affect the relative productivity of the other inputs.
10. Which one of the following comparative statements is most consistent with the
data given for the Brazilian and Mexican economies?
A. The contribution of number of average hours worked to output will be

greater for Mexico than for Brazil.
B. Future growth in GDP is likely to be higher for Brazil than for Mexico.
C. The growth rate in labor force will differ more from the population growth
for Mexico than for Brazil.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, LOS g
The income tax rate in Mexico is much lower than in Brazil, which motivates
people to value labor income more in Mexico. In addition, a higher male
participation rate than a female participation is indication of a longer workweek in
Mexico (since females tend to work part-time). A reversal of the higher
unemployment rate could also add to the increase in the number of average
working hours for Mexico.
Option B is unlikely. The significantly high immigration for Brazil is not

sustainable and is likely to slow. This will result in slower growth in the
population and the labor force.
Option C is unlikely. For both countries, the participation rates are relatively high.
It is more likely that males would enter the workforce at a much higher rate than
females. Since for Brazil, the male participation rate is lower, the growth rate in
labor force will differ more from the population growth for Brazil (if at all).


11. Derry’s analysis of the two economies will least likely lead him to believe that:
A. The growth in per capita income is most likely more sustainable in

Country B than in Country A.
B. Growth in GDP would be higher in Country B but real GDP would be
higher in Country A.
C. TFP is a greater source of economic growth in Country A than Country B.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, LOS h
The contribution of capital deepening for Country A is 2.26% (4.02-1.76) and for
Country B is 6.56% (8.88-2.32). Capital deepening contributes much more to
labor productivity for Country B than for Country A. This also implies that the
contribution of productivity is higher for Country B, and such growth is likely to
be more sustainable.
12. Using the data provided about Spain’s economy, which of the following
investments would be most attractive?
A. Stocks.
B. Bonds.
C. Neither stocks nor bonds.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 14, LOS c&h
An increase in labor productivity is positive for equity prices. A growing share of

ICT investments is also likely to boost the growth rate of potential GDP, which is
again positive for stocks. Since the economy is operating above its potential,
interest rates are likely to rise, which will cause bond prices to fall. Hence, stocks
are the most attractive investment in this case.


Questions 13 through 18 relate to Financial Reporting and Analysis
Black-Crow Investments Case Scenario
Black-Crow Investments (BCI) is a financial institution with a huge client base that
includes high net worth private wealth clients and institutional portfolios. Irene Crawford
manages BCI’s institutional wing with over 30 portfolios and fifteen portfolio managers.
During her regular analysts’ performance review, Crawford met with Riley Padget, an
analyst with a $50 million assigned portfolio related to a U.S. based endowment fund.
Orange Products (ORP) is one of the firms that the fund is invested in. ORP has recently
acquired 80% of the outstanding shares of Ginger Company (GCO) to diversify its asset
base and increase profitability. Padget was attempting to quantify the effect of this
acquisition on ORP’s financial statements. Exhibit 1 displays the financial information
from the two companies immediately prior to the exchange.
Exhibit 1
Pre-Acquisition Financial Information (in US thousands)
ORP Book
GCO’s Book Values
Values
Cash and receivables 10,000 5,000
Inventory 17,000 6,500
PP&E 42,000 8,000
Long-term debt 25,000 2,100
Capital stock ($1 par) 4,000 2,000
Additional paid-in-
7,000 4,400
capital
Retained earnings 33,000 11,000
The fair value of GCO’s property is $22,000 and of GCO’s long-term debt is $3,500. For
the remaining numbers, book values equal fair market values. ORP issued 2 million
shares of par value common stock. The market value of ORP’s shares at the time of
acquisition was $25/share. The fair market value for GCO’s shares was $45 million.
After a comprehensive estimation of the acquisition value, Padget prepared a report that
he presented to Crawford for review. In the report, Padget wrote the following
statements:


Statement 1: “Even though the net income shown on ORP’s consolidated statements
would be the same regardless of whether the full goodwill or partial
goodwill method is used, under the partial goodwill method, return on
assets and return on equity ratios will be higher.”
Statement 2: “Relative to the acquisition method, under the pooling of interests method,
although net income would be the same, assets would understated, and
return on assets would be overstated.”
In addition to the evaluation of ORP’s acquisition of GCO, Padget was also performing a
goodwill impairment test of the cash-generating unit of a U.S. based interior décor firm.
The unit has a carrying value of $2.5 million which included $1,300,000 of allocated
goodwill. The recoverable amount of the unit was estimated to be $2 million. Padget
estimated that the fair value of the unit equaled its recoverable amount, and the fair value
of its identifiable net assets as of the impairment test date was $1.2 million. An initial
review of the estimated numbers confirmed Padget’s belief that goodwill was impaired
and needed to be written down.
As Crawford continued with reading Padget’s report, she wondered how the acquisition
would be reported under the pooling of interests method. Although the method was no
longer allowed for accounting for business combinations, Crawford wanted to be aware
of the method’s consequences on consolidated financial statements and reported figures.
In addition, she wondered how contingent liabilities and indemnification assets would be
accounted for in an acquisition. Since Padget was the expert at the valuation and
reporting of acquisitions, Crawford asked him. Padget answered with the following
comments:
Comment 1: “If the financial statements are prepared in accordance with U.S. GAAP,
only those contingent liabilities are recognized at of the acquisition date
that are probable and can be reasonable estimated.”
Comment 2: “If the acquire guarantees that its contingent liability will not exceed a
specified amount, the acquirer would recognize an indemnification asset
and only a partial contingent liability. If fair values are used, both the asset
and the liability would be reported at fair values.”


13. Using the information in Exhibit 1, the total assets on the consolidated balance
sheet under partial goodwill method will most likely be:
A. $6 million less than under U.S. GAAP.

B. $11 million greater than under U.S. GAAP.
C. equal to the total assets reported under U.S. GAAP.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b
Under the full goodwill method:

Fair value of GCO: $45,000,000
Fair value of GCO’s identifiable net assets: $30,000,000
Goodwill: $15,000,000
Total assets: 15,000+23,500+64,000+15,000 = $117,500,000
Under partial goodwill:
Acquisition price: $50 million
Less 80% of fair value: $24 million
Goodwill: $26 million
Total assets: 15,000+23,500+64,000+26,000 = $128,500,000
14. Using the information in Exhibit 1, the total equity on the consolidated balance
sheet under U.S. GAAP will be closest to:
A. $103 million.
B. $111 million.
C. 118.4 million.
Correct Answer: A
Reference:


Non-controlling interest:
Under full goodwill: 20% (45 million) = $9 million
Capital stock: 4,000,000+2,000,000 = 6,000,000
Additional paid-in-capital: increased by 50 million-2 million = $48 million, so
total = 55 million
Retained earnings: 33 million
Total: $103 million
15. Padget 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:
Statement 1 is incorrect. Net income to parent’s shareholders is the same, but

return on assets and return on equity will be different under the two methods.
Statement 2 is incorrect. Net income is generally higher under the pooling of

interests method, because assets are recorded at book values which results in
lower depreciation.
16. Assuming that a cash-generating unit and a reporting unit are analogous terms, the
goodwill impairment under U.S. GAAP will be:
A. $300,000 smaller than the impairment under IFRS.

B. $1,250,000 less than the impairment under IFRS.
C. equal to the impairment under U.S. GAAP.
Correct Answer: A
Reference:


Under U.S. GAAP:

2,000,000 – 1,200,000 = $800,000
$1,300,000 - $800,000= $500,000
Under IFRS:
2,000,000-1,200,000 = $800,000
17. Using Exhibit 1 and ignoring non-controlling interests, if the pooling of interests
method was used to account for the business combination, total stockholders’
equity on the consolidated financial statements would be:
A. $18 million lower than under the acquisition method.

B. $37 million lower than under the acquisition method.
C. $48 million lower than under the acquisition method.
Correct Answer: B
Reference:
Under pooling of interests:

Capital stock: 4 + 2 = $6 million
Retained earnings: 33+11 = 44 million
Additional paid-in-capital: $7 million
Total equity: $57 million
Under acquisition method:

$94 million (ignoring non-controlling interests)
94-57 = $37 million.
18. Padget is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.
Correct Answer: A
Reference:


Comment 1 is correct.
Comment 2 is incorrect. The entire indemnified liability would be recognized at

the same time as the indemnification asset is recognized.


Questions 19 through 24 relate to Corporate Finance
Aorta Investments Case Scenario
Keith Peterman is a portfolio manager at Aorta Investments (AOIN), a capital

management firm that deals with portfolios of institutional clients and multinational
corporations engaging in business combinations. Peterman is the chief portfolio manager
for the All-Right Pension Plan (ARPP), a $55 million worth pension portfolio invested in
bonds, U.S. stocks, emerging market equities, commodities and real estate. During its
recent IPS review, Peterman determined that the pension plan’s average life was
significantly reduced over the past couple of years. Accordingly, he planned to tilt the
portfolio’s composition toward investment-grade fixed-income securities and dividend
paying stocks. Peterman invited Damon Lemay, an equity analyst, to help with the
analysis of probable stock investments. Expo Enterprises (Expo) and Azure Products
Incorporated (API), were two firms that Lemay was scrutinizing for income potential.
Expo’s financial statements revealed that the firm paid a semiannual dividend of
$3.5/share over the prior two years and $4.6/share for three years prior. The dividend
payout for the firm over the same period ranged from 30%-55% with an average of 42%.
The firm’s board of directors had estimated that the adjustment to dividends would take
place over ten years. Expo’s earnings for the current year equaled $15.50/share. The
MD&A estimates expected EPS to equal $17.30/share for the coming year. Lemay used
this information to gauge the expected increase in the firm’s dividends.
Azure Products Incorporated (API) is a firm that manufactures educational toys for
children below the age of fifteen. Lemay collected the following information from API’s
financial statements.
Exhibit 1
Selected Financial Statement Information for the year 2011
(in US$ ‘000 except ratio information)
Earnings $1,100
Debt/Assets Ratio 0.40
Sales $32,500
Capital expenditures as a percent of sales 5.00%
Target payout ratio 30%
Highest historical payout ratio 50%
Lowest historical payout ratio 22%


In addition to the above data, Lemay also included the following excerpt from API’s
annual report as part of analysis:
“API expects earnings to increase by 2% over the coming year. Sales are expected to
increase by 5% over the same year and capital expenditures would increase to 8% of
sales. API plans to issue a bond worth $516,000 to finance part of this outflow.”
Apart from assisting Peterman with the pension portfolio, Leman is working with Greg
Smith to assess a statutory merger between ELX Products and WinBit Associates, with
ELX as the acquirer. The transaction is to be a stock purchase. Smith has estimated the
following pre-merger values for the respective firms.
Exhibit 2
Merger Information
ELX Products WinBit Associates
EPS $6.7/share $4.5/share
P/E 16.50 13.00

Total shares
250,000 100,000
outstanding
Market value of equity $13,500,000 $5,500,000
After presenting the data, Smith posed the following questions:
Question 1: “If markets are efficient, what will the post-merger P/E ratio of the merged
company equal?”
Question 2: “If investors believe that there are expected gains from synergy, how will
the share price of ELX Products react after the merger?”
As Leman investigated the merger data to answer Smith’s questions, he read an article
describing the various types of mergers and their valuation procedures. The article made
the following comments:
Statement 1: “The industry life cycle stage suggests the types of mergers that would be
prominent amongst companies within that industry. For example, if an
industry is in the mature growth phase or is approaching stabilization and
market maturity, vertical mergers would be most prominent.”


In addition to the valuation of mergers, the article also commented on anti-takeover

strategies. The following statement was made in this regard:
Statement 2: “Fair price amendments are shark repellents that protect against price
declines and two-tiered tender offers.”
While describing M&A transaction characteristics, the article presented the following
example based on two companies operating in the U.S. markets:
“An acquirer plans to acquire 80% of the target’s assets. The target has several
capitalized lease obligations shown on its balance sheet, and several contingent liabilities
not included in the statements. The corporate tax rate for both companies is 30% equal to
the shareholder tax rate in the country. The target has shown considerable accumulated
tax losses in the current year.”
Finally, the article presented a list of some other takeover defenses including:
• Poison puts.
• Leveraged recapitalization.
• Leveraged buyout.
19. For Expo Enterprises, assuming the firm uses a target payout adjustment model,
the expected dividend for the current year will be closest to:
A. $7.076.
B. $7.266.
C. $7.756.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS f
Increase in earnings: 17.30-15.50 = $1.8

Expected dividend: 7 + (1.8 × 0.42 × 0.10) = $7.076


20. Given the facts about Azure Products Incorporated, the most likely implied
dividend payout ratio for the coming year is closest to:
A. 0%.
B. 36%.
C. 22%.
Correct Answer: A
Reference:
Given that Azure plans to issue a bond to finance its capital expenditures,
indicates that it uses a residual dividend policy. Additionally, it prefers low cost
debt over costlier external equity financing.
For the coming year: (in thousands)

Earnings: $1,122.
Sales: $34,125
Capital expenditures (@8%) = $2,730
Financed with new debt: 0.40(2,730) = $1,092
Financed with equity: 0.60(2,730) = $1,638
Since earnings are lower, the implied dividend payout will be 0 because the
residual cash flow will be 0. The remainder ($516,000) will be financed with debt.
21. The best answer to Smith’s questions is that the P/E ratio would equal:
A. 14.75 and the share price would rise by 3.00%.

B. 16.50 and the share price would not rise.
C. 15.76 and the share price would rise by 4.70%.
Correct Answer: C
Reference:


ELX share price: 16.50(6.7) = $110.55

WinBit share price: 13(4.5) = $58.50
ELX will issue 52,917 shares to buy WinBit.
Total shares will equal 250,000 + 52,917 = 302,917
Combined earnings will be: 1,675,000+450,000 = 2,125,000
New EPS: 2,125,000/302,917 = 7.015
If markets are efficient the post merger P/E would equal: 110.55/7.015 = 15.76
implying that the acquirer’s stock price would remain at $110.55.
However, if there are gains from synergy, then the share price would rise to
(16.50 × 7.015) = 115.747 or by 4.70%.
22. The article is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS d & f
Statement 1 is incorrect. Considering the two phases, horizontal mergers would be

most prominent.
Statement 2 is correct.
23. With respect to the example presented in the article, which of the following forms
of acquisition would be most suitable for the acquirer?
A. Stock purchase.
B. Asset purchase.
C. Cash purchase.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 9, Reading 28, LOS e


Since the corporate tax rate and shareholder tax rate is the same, the decision
criteria does not depend on taxes. Although in an asset purchase, acquiring
companies can avoid assuming the target’s liabilities, in this case, the acquirer is
purchasing almost all of the target’s assets (80%). Avoidance is fraught with legal
risk. In the U.S., for a stock purchase, an acquirer can use a target’s accumulated
tax losses. Hence, a stock purchase would be appropriate.
24. Which of the following takeover defense (s) mentioned in the article would most
likely raise the cost of acquisition?
A. Poison puts only.

B. Poison puts and leveraged buyouts only.
C. Poison puts, leveraged recapitalization, and leveraged buyouts.
Correct Answer: C
Reference:
All three forms of takeover defense raise the cost of acquisition.


Questions 25 through 30 relate to Equity Investments
Supreme Capital Management and Money Advisors Case Scenario
Supreme Capital Management and Money Advisors (SCMMA) is a wealth management

firm that not only offers portfolio management services, but also a wide variety of
investment vehicles to investors with surplus savings. The All Share Equity Fund (ASE)
and the Supreme Diversified Fund (SDI) are two such investment opportunities offered to
private wealth clients with total portfolio worth in excess of $5 million. Travis Nelson is
an equity analyst supporting the management of the ASE Fund. Nelson is projecting sales
and earnings for Country Fresh Beverages (CFB), a U.S. based firm that contributed 2%
to the overall return to the ASE Fund over the past year. CFB’s profits have been
sensitive to changes in the consumer price index and Nelson is estimating the impact of
such changes on the performance of the company. Before indulging into facts and
figures, Nelson established two important conclusions that formed the basis for his
analysis:
Conclusion 1: “Assuming that other financials remain unchanged and demand is price
inelastic, if an increase in the input costs for CFB is completely passed on
to consumers, the gross profit margin would decrease, but the net profit
would remain unchanged.”
Conclusion 2: “If demand for CFB’s products is unit elastic, even if an increase in input
costs is passed on to consumers, revenues will not benefit.”
For a comprehensive analysis, Nelson solicited information from SCMMA’s research

department about the inflation rate applicable to CFB and the firm’s reaction to such
expectations. The research department presented three scenarios of changes in input
prices, volume and sales prices, presented below:
Scenario 1: “The input prices will increase by 3.0% but prices will increase by 2.0%. In
addition, sales volume will grow by 1.5%.”
Scenario 2: “Both input prices and sales prices would increase by 4.0%. However, sales
volume would decrease by 5.0%.”
Scenario 3: “The price increase and volume growth for CFB due to inflation will be
1.0% and 7.0% respectively. Input prices, on the other hand, would grow by
4.0%.”


Nelson also gathered data on the current financial status of CFB. Exhibit 1 displays this
information.
Exhibit 1
CFB Data (in $ millions)
Sales 45,091
Cost of goods sold 33,209
While Nelson was evaluating the effect of inflation on CFB’s profit margins, Vivian Jim,
part of ASE Fund’s management team, updated him on the expected change in the fund’s
composition. The fund was to cash out of the stock investment in UpSize Inc. due to poor
risk-return tradeoff, and planned to invest the proceedings in the retail industry. Nelson
was advised to perform a comparative analysis of two retail companies, for which he was
provided with the data presented in Exhibit 2.
Exhibit 2
Selected Financial Information for Comparative Analysis (in ‘000)
Company A Company B
Net Sales $50,000 $150,000
COGS $18,500 $89,000
Selling, general and administrative $22,000 $25,000
expenses
Depreciation $2,000 $5,000
*Both companies have no other operating expenses
For an inclusive comparison, Nelson reviewed the firms’ notes to financial statements for
a decomposition of the line item titled ‘cost of goods sold’. The notes revealed that the
contribution of various inputs to COGS varied considerably for the two firms. As he
continued to analyze the impact of each element of COGS on the firms’ profit margins,
Nelson noted the following assuming a similar increase in input prices and an inability to
pass it through to consumers:
Observation 1: “If a component cost as a percentage of sales is equal for two companies,
the percentage decline in the gross margin and operating margin for a
given rise in its price will be the same for both the companies.”


Observation 2: “Assuming a price increase for only one component of COGS, if the
price increase relates to the largest component of COGS, the gross
margin decline will be the largest. Also, on a relative basis, the higher the
gross profit of a firm, the more severe the impact of a rise in input
prices.”
Observing Nelson’s analytical abilities, Jim was greatly impressed. Consequently, she
requested him to assist her in one of her assignments as a personal favor. The task
involved an analysis of three companies, each operating in different sectors of the U.S.
market. To properly value the companies’ stocks, Nelson asked Jim to bring in the past
five years financial data of each firm. In addition, Jim presented the following additional
information for more accurate valuations:
• Firm A has been experiencing a decline in sales prices for the past few years, and
this decline is expected to continue over the near future.
• Firm B’s suppliers are expected to experience a technological advancement that
would reduce their costs considerably. Part of this reduction in costs will be
transferred to the firm, which in turn, will affect sales prices.
• Government regulation in Firm C’s industry has always been intense and tilted
towards benefiting consumers. Global regulation has also impacted industry
revenues, but not so much for the firm.
Nelson planned to use this information and his knowledge of discounted valuation
procedures to estimate an intrinsic value for each of the firms.
25. Nelson is most accurate with respect to:
A. Conclusion 2 only.
B. Both conclusions 1 and 2.
C. Neither conclusion 1 nor conclusion 2.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 11, Reading 33, LOS i


Conclusion 1 is correct. A 10% increase in price to offset a 10% increase in costs

would decrease the gross profit margin, but would not affect the absolute amount
of gross profit. Given that other financials remain unchanged, the net profit would
also remain unchanged.
Conclusion 2 is correct. If demand is unit elastic, an increase in price will

decrease sales by the same percent. For revenues to benefit, price should be
inelastic (the condition is greater than unit price elasticity).
26. With regards to Country Fresh Beverages, which of the above scenarios will
result in the highest gross margin for the firm?
A. Scenario 1.
B. Scenario 2.
C. Scenario 3.
Correct Answer: B
Reference:


No calculations are necessary. The highest gross margin would be for the case
will sales prices and input prices rise by the same amount. However, calculations
are given below:
Scenario 1: Revenue growth: 3.53% [(1.02)(1.015)-1], COGS growth: 4.545%

Sales: 46,683
COGS: 34,718
Gross Profit: $11,965
Gross profit margin: 0.256
Scenario 2:
Sales: 44,550
COGS: 32,810
Gross Profit: 11,740
gross profit margin: 0.2635
Scenario 3:
Sales: 48,730
COGS: 36,955
gross profit: 11,775
gross profit margin: 0.2416
27. With regards to Country Fresh Beverages, which of the above scenarios will
result in the highest gross profit for the firm?
A. Scenario 1.
B. Scenario 2.
C. Scenario 3.
Correct Answer: A
Reference:
Gross profit is highest for Scenario 1 (as given in the answer to the previous
question). This is because the volume growth more than offsets the margin
decline.


28. Assuming 5% inflation for all costs except depreciation, and that companies are
not able to pass on this increase through higher prices, using the information
provided in Exhibit 2, Company:
A. B will experience the greatest reduction in gross profit margin, but

Company A will experience the greatest reduction in operating profit
margin.
B. A will experience the greatest reduction in gross profit margin, but
Company B will experience the greatest reduction in operating profit
margin.
C. B will experience the greatest reduction in both gross profit and operating
profit margin.
Correct Answer: A
Reference:
Company A’ COGS are 37% of sales whereas Company B’s COGS are 59% of
sales. Company B, with the highest COGS as a percent of sales, will experience
the greatest negative impact on gross profit margin. Also, the company with
highest operating costs as a percent of sales will experience the greatest reduction
in operating margin. Company A with operating costs at 48% of sales will
experience the greatest reduction.
29. Nelson is most accurate with respect to:
A. Observation 1 only.
B. Observation 2 only.
C. Both observations 1 and 2.
Correct Answer: A
Reference:


Observation 1 is correct. If the component cost as a percent of sales is equal, a

change in price will cause similar changes in margins for the two firms.
Observation 2 is incorrect. The higher the component cost as a percent of sales or

the higher the COGS as a percent of sales (for equal percentage of component
cost) the more severe the impact.
30. Nelson’s source of financial information to aid valuation will be most appropriate
for:
A. Firm A and B only.

B. Firm A and C only.
C. Firms A, B and C.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 11, Reading 33, LOS l
Past information will only be valid for firms that will not experience significant
changes going forward (also called determining inflection points). For Firm A and
Firm C, the trends that were in the past are expected to continue in the future. But
for Firm B, the change in price is something that would justify an inflection point,
and the use of past information to determine the future price for the firm would
not be appropriate in this case.


Speed Auto Products Case Scenario
Graham Clark is a market analyst and financial advisor by profession with a personal
portfolio worth $75,000 invested in stocks, bonds, emerging market equities, and REITs.
Clark had planned for a vacation a couple of months back, and is now enjoying his week
off from work. During this time, Clark reviews the performance of his own portfolio,
especially the portion invested in U.S. equities. One particular investment—the stock of
Speed Auto Products (SAP)—particularly catches Clark’s interest owing to its past trend
of return and risk. As a strong proponent of market-based valuation, Clark is determined
to use the price-earnings multiple to appraise the value of his investment in SAP. To
initiate his evaluation, Clark uses the data provided in Exhibit 1.
Exhibit 1
Earnings per share data for Speed Auto Products
First two First Second
2010 quarters of quarter of quarter of
2010 2011 2011
Reported EPS $12.15 $5.50 $4.50 $5.24
Core EPS $15.64 $6.71 $5.67 -
Clark believes that for the second quarter of 2011, a number of items included in the EPS
figure are transitory in nature. To only include in his analysis components that will persist
in the future, Clark gathers the following information:
§ The earnings per share figure includes gain from the sale of unused machinery of
$1.22/share.
§ SAP has determined that the net book value of its welding equipment is lower
than its replacement value. For this reason, an asset write-down of $1.75/share is
included in reported EPS.
§ The two step process of checking for goodwill impairment has resulted in a loss
of $1.88/share.
§ SAP has increased its estimate of the useful lives of some of its assembly
equipment from ten to fifteen years. Clark believes that this decrease in
depreciation of $0.75/share is unjustifiable.


Additionally, Clark analyzes the strategic stance of the firm and discovers the following:
• SAP has experienced significant supplier power over the past couple of years. To
mitigate this effect, about three years ago, SAP engaged in backward integration
to not only reduce supplier control but also to increase the quality of its products.
• SAP’s book value per share has been following a stable, rising trend over the past
five years, with a rise of 120%. EPS follows a similar, unwavering pattern.
• SAP offers its executives with stock options as bonuses, in addition to the basic
salary. SAP’s capital structure also contains a minimal amount of convertible
bonds.
For an all-inclusive study of SAP’s financial performance, Clark scrutinizes SAP’s

financial statements and notes to financial statements. Performing a few calculations,
Clark develops the following Exhibit.
Exhibit 2
Selected Financial Information for SAP as of 31 December 2011
Long-term dividend payout ratio 55%
Market price per share $186/share
Forward PEG ratio 0.77
Beta 0.90
Market risk premium 10.0%
Risk-free rate 5.0%
Long-term growth rate 7.0%
Knowing that no assessment is complete without a comparative analysis, Clark reviews

the automotive industry and selects three similar firms for a peer-group comparison.
Exhibit 3 offers facts about their fundamentals.
Exhibit 3
Valuation Data for the Automotive Industry (December 31 2011)
Five-year EPS
Company Forward P/E Beta
growth rate
Total-X 14.68 15.00% 1.12
Pace-Q 5.50 9.90% 0.70
Moto-J 13.50 12.00% 1.38


Lastly, Clark contacted Bryan Burger, a research expert, to provide him with data on
SAP’s historical P/Es. Burger presented the following Exhibit.
Exhibit 4
Historical P/Es for SAP
2010 2009 2008 2007 2006
6.78 5.11 10.11 8.20 8.98
While in conversation with Burger, Clark asks for Burger’s stance on SAP stock’s
valuation. Based on his own P/E analysis, Burger provides Clark with an estimate of
intrinsic value. After hearing what Burger has to say, Clark thinks to himself:
“I believe Burger’s estimate of intrinsic value is overstated.”
31. The trailing P/E for SAP as of the end of the second quarter of 2011 using core
earnings is closest to:
A. 8.36.
B. 8.65.
C. 9.37.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS d& e
Core EPS for the second quarter of 2011: 5.24-1.22+1.75+1.88-0.75 = $6.9

Trailing core EPS: 15.64-6.71+5.67+6.9 = $21.5
P/E: 186/21.5 = 8.65
32. The most appropriate measure of EPS to determine SAP’s P/E multiple is:
A. Diluted, trailing core EPS.

B. Diluted, core forward EPS.
C. Normalized, diluted core EPS.
Correct Answer: B
Reference:


A diluted measure is appropriate since the firm has convertible bonds in its capital
structure. Additionally, because of backward integration, trailing EPS may not be
reflective of SAP’s value going in the future. Hence, an estimate of forward-
looking EPS is more appropriate. Core EPS removes all the transitory portions of
the EPS figure, so it is appropriate in this case. The EPS and book value do not
show cyclicality in their trends, so normalizing would not be necessary in this
case.
33. The fundamental forward P/E for SAP is closest to:
A. 6.43.
B. 7.86.
C. 8.41.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS h
r = 5+0.90(10) =14%
P/E: 0.55/0.14-0.07 = 7.857
34. Based on peer-group comparison, the stock that represents the most
undervaluation is the stock of:
A. SAP.
B. Total-X.
C. Pace-Q.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS k


PEG ratio = Forward P/E / Expected Earnings growth rate

PEG ratios:
Total-X: 0.9786
Pace-Q: 0.555
Moto-J: 1.125
SAP:0.77
Pace-Q has the lowest PEG ratio and the lowest level of risk too. Hence, it
appears the most undervalued.
35. Assuming equivalent EPS forecasts, Clark’s belief about Burger’s estimate of
intrinsic value will least likely be true if, in contrast to Burger, Clark has used:
A. a lower estimate of PEG and a lower estimate of growth rate.

B. basic EPS rather than diluted EPS.
C. Justified forward P/E rather than justified trailing P/E.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS j & k
Diluted EPS is mostly lower than basic EPS, but that is not always the case.
Hence, if Clark used basic EPS, his P/E estimate could have been higher than
Burger’s estimate using diluted EPS. The rest hold true.
36. Based on historical values as a benchmark and using SAP’s core EPS as of the
end of the 2nd Quarter of 2011, SAP’s stock is most likely:
A. undervalued.
B. overvalued.
C. either overvalued or undervalued.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, Section 3.1.5.4


Median P/E: 10.11

Mean P/E: 7.836
Core EPS: $21.5 (as calculated for part 1 above).
Value using median: $217.365
Value using mean: $168.474
Given a current MP of $186/share, the stock is either overvalued (if benchmark is
mean) or undervalued (if benchmark is median).


Russian Health Care Technology Industry Case Scenario
Marc Stanco, an equity analyst at Blue Sphere Investments (BSIN), specializes in the
pharmaceutical and health care industry in the U.S. and abroad. Formerly, Stanco has
always used the bottom-up approach in his stock selection and investment decision
making, and, in doing so, has managed to realize reasonable returns for his clients.
However, owing to a recent trend of falling returns, Stanco plans to use a hybrid
approach in assessing the suitability of investment options. Primarily, he wants to
develop a good understanding of the root causes of profitability in the health care
technology industry in Russia, along with the industry’s competitive structure. For this,
Stanco requested the industry analysis department at BSIN to provide him with a
comprehensive evaluation of the industry. A few days later, Stanco received the report.
Exhibit 1 displays an excerpt from the report elucidating the forces operating in the health
care technology industry.
Exhibit 1
Excerpt from “The Russian Health Care Technology Industry Report”
“……Some couple of years back, the health care technology industry was still in its
developmental stages. However, recently, the industry picked up and enjoyed high
growth and increased profitability owing to the increased reliance on medical and health
equipment of hospitals and therapeutic clinics. The industry is characterized by the
emergence of many new firms offering novel products marked with innovation and
creativity. Diagnostic software, centralized patient information databases, electronic
checks and balances, and a 24-hr patient-doctor communication are some of the few
pioneering products offered by the industry. Instead of physical capital, start-ups need
professional expertise and originality to develop products that could be incorporated by
hospitals and health care endowments. Hence, they have competed with incumbents on
the basis of superior products, with many incumbents being taken down by new firms
offering better software. Due to the nature of its customers’ operations, the accuracy and
quality of the industry’s products is critical. The administrative and management
capabilities of hospitals depend on such outsourced products and any lack of quality
could prove detrimental to ultimate consumers. Once a health care facility adopts an
application, replacing it involves considerable time and effort, which is why they take
their time searching for the best possible option. Over the years, the industry has seen a
rise in firms, with competition being in flux. The industry has also experienced a
relatively volatile and unstable demand pattern……”


Stanco used this report to establish his opinion about the future profitability of the
industry, and the competitive underpinnings in play. In addition to the above report,
Stanco collected the annual reports of a few successful firms operational in the sector.
Exhibit 2 displays an excerpt from the ‘Management Discussion & Analysis” of
Equilateral Technologies (EQT), one of the pioneers in the industry.
Exhibit 2
Excerpt from MD&A of EQT
“….To ensure success, our top management works with the board to marshal resources
and plan thoroughly so that our strategy is not poorly executed. This involves successive
rounds of planning, the use of quantitative methods and special analytical software to
project well into the future….”
Stanco wondered how much EQT’s planning technique would contribute to its success.
37. The Russian health care industry’s barriers to entry are most likely:
A. Low.
B. High.
C. Modest.
Correct Answer: A
Reference:
Barriers to entry are low:
• Fixed capital requirements are low.

• Incumbents do not seem to have much advantage with respect to size
or established brands as is evident from the fact that many incumbents
have been taken down.
• Many new firms have emerged indicating low barriers to entry.
• Industry growth is high so newcomers would most likely face less
retaliation, increasing their motivation to enter.
Although switching costs are high, the other factors would most likely override
this one factor.


38. Which of the following best describes the intensity of buyer power and the threat
of substitutes apparent in the Russian health care industry?
A. Buyer power is low but the threat of substitutes is high.

B. Buyer power is high but the threat of substitutes is low.
C. Buyer power, as well as the threat of substitutes, is low.
Correct Answer: C
Reference:
Buyer power is low:
• Switching costs are high.

• Buyers tend not to be price sensitive because the quality of their
services depends heavily on the quality of the industry’s product.
Considering threat of substitutes, although new firms have entered and have
offered many new products, switching costs are really high in terms of effort and
time. Therefore, it is safe to consider the threat of substitutes as low.
39. In the Russian health care industry, rivalry among competitors is most likely:
A. high but price competition is low.

B. high and price competition is also high.
C. modest and price competition is low.
Correct Answer: C
Reference:


With low barriers to entry, competitors have increased in number which indicates
high rivalry. But, on the other hand, the industry is in its growth stage with space
for more firms as profit margins are on the rising trend. Hence, the best estimate
is that rivalry is modest.
Price competition appears to be low:
• Each company offers unique products so products and services of

rivals are not identical.
• Fixed costs are low and marginal costs are higher.
• The product is not perishable.
• Capacity does not need to be expanded to remain efficient.
40. Which of the following strategic styles would have the best chances of success in
the Russian health care industry?
A. Adaptive.
B. Shaping.
C. Visionary.
Correct Answer: B
Reference:
Shaping is most appropriate because:
• The industry is in its high-growth phase.

• Barriers to entry are low.
• Innovation rates are high.
• Demand is volatile, so is hard to predict.
• Relative positions of competitors are in flux.
So the industry is unpredictable, but firms can strive to change it.


41. If Stanco plans to value a newcomer in the Russian health care industry he should
most likely employ:
A. Sensitivity analysis, with the resulting probability distributions of

estimates being highly skewed.
B. Scenario analysis, with the resulting distribution of intrinsic value
estimates being flat with fat tails.
C. A probability-weighted average of various scenarios, with the resulting
probability distribution of value estimates being steep and bounded on the
left by zero.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 11, Reading 33, Section 2.6
Companies mostly enter with an untested, innovative product, that can be worth
very little or a lot, depending on whether the product turns out to be a success. As
such, the probability distribution would have fat tails, and could also be skewed.
Scenario analysis is best in such a case to develop a base case. In fact, the
common approach is to use a probability-weighted average of various scenarios.
42. The top management and the board of directors at Equilateral Technologies
(EQT) have most likely agreed to follow:
A. the classical strategic style.

B. either the adaptive strategic style or the classical strategic style.
C. either the visionary strategic style or the classical strategic style.
Correct Answer: C
Reference:
Both the classical style and the visionary style rely on planning thoroughly,
marshalling resources, and implementing correctly. Hence, the visionary style has
much in common with the classical style.


Questions 43 through 48 relate to Fixed Income
South AM Financials Case Scenario
SouthAM Financials (SAF) is a financial firm which specializes in the valuation and
analysis of fixed-income securities. Lara Gavins is SAF’s senior manager. Gavins is
preparing introductory class for trainees in which she aims to address the following
objectives:
Objective 1: With the aid of a forward pricing model, explore arbitrage opportunities
using zero-coupon securities and hypothetical forward contracts on default
and interest-free loans.
Objective 2: Demonstrate the importance and application of swaps in valuing bonds.
Objective 3: Demonstrate how shaping risk can be managed using key rate durations for a
$300,000 portfolio comprising 1-, 4- and 8-year zero-coupon bonds.
To achieve her first objective, Gavins constructs three hypothetical loan contracts
(Exhibit 1) and collects data with respect to the relevant discount factors (Exhibit 2). In
addition to exploring arbitrage opportunities, she also aims to demonstrate how a
reinvestment rate can be determined using the forward rate model.
Exhibit 1
Hypothetical Loan Contracts
Year of Loan
Initiation; From Quoted
Contract Loan Tenor (Years) Today (T0) Contract Price*
A 3 2 0.8250
B 4 1 0.7769
C 4 3 0.6233
*Contract price is quoted per $1 of notional principal


Exhibit 2
Discount Factors
Maturity (Years) Rate (%)
1 2.5
2 3.0
3 4.0
4 4.9
5 5.7
6 6.9
7 8.8
To achieve her second objective, Gavins prepares three questions which she intends to
present to the trainees:
Question 1: In which scenario is the swap curve a more relevant measure of the time
value of money compared to the government’s cost of borrowing?
Question 2: Using the factors in Exhibit 2 as representatives of government bond yields,

which of the following swaps quotes the highest fixed rate?
Swap 1: Five-year fixed-for-floating LIBOR swap with a spread of 90 basis points.
Swap 2: Three-year fixed-for-floating LIBOR swap with a spread of 85 basis points.
Swap 3: Four-year fixed-for-floating LIBOR swap with a spread of 120 basis points.
To achieve her third objective, Gavins presents key rate durations and factor movements
for three maturity points on the yield curve (Exhibit 3). She aims to evaluate how a
steepening of the yield curve, by 200 basis points, will affect the value of the identified
portfolio.
Exhibit 3
Key Rate Durations and Factor Movements
Maturity point 1 4 8
Key rate duration 0.33 1.33 2.67
Factor movements -1 0 1


43. Based on the information presented Exhibit 1 and 2; does an arbitrage opportunity
exist with respect to contract A?
A. No.
B. Yes; the forward contract can be sold as part of an arbitrage strategy.
C. Yes; the forward contract can be purchased as part of an arbitrage strategy.
Correct Answer: B
Reference:
The current quoted forward price of $0.8250 is higher than the no-arbitrage price
of $0.8041. Therefore, the forward contract is overpriced and can be sold short to
generate arbitrage profits.
The no-arbitrage principle is based on the forward pricing model:

P(T*+ T) = P(T*)F(T*,T)
To determine whether an arbitrage opportunity exists with respect to Contract A

which has a forward rate of f(2,3), the no-arbitrage forward price is derived from
the equation and compared to the quoted forward price. The two- and five-year
discount factors first need to be computed to determine the no-arbitrage forward
price.
1
P(T + T * = 5) = = 0.7579
(1 + 0.057)5
1
P(T * = 2) = = 0.9426
(1 + 0.03)2
F(T*,T) = 0.7579/0.9426 = 0.80406 or 0.8041
44. Based on the information presented in Exhibit 1 and 2 and the forward rate model,
the reinvestment rate calculated for contract C is:
A. 10.49%.
B. 12.54%.
C. 17.07%.
Correct Answer: A


Reference:
With respect to Contract C, the reinvestment rate based on the forward rate model
is one that would make the investor indifferent between buying a seven-year zero-
coupon bond or investing in a three-year zero-coupon bond and at maturity
reinvesting the proceeds for four years. According to the forward rate model, this
rate is calculated as follows:
[1 + r (T * +T )](T *+T ) = [1 + r (T *)]T *[1 + f (T *, T )]T

[1 + 0.088]7 = [1 + 0.040]3 [1 + f (3,4)]4
f (3,4) = 0.125448 or 12.54%
45. The relevant curve and process employed to generate the rates in Exhibit 2,
respectively, is:
curve: process:
A. Par extrapolation.
B. Par bootstrapping.
C. forward extrapolation.
Correct Answer: B
Reference
The spot rates represent maturity points which are used to construct a zero-coupon
yield curve. The par curve, in turn, can be employed to construct a zero-coupon
yield curve. The spot rates are determined using the par yields and solving for the
zero-coupon rates one by one, from earliest to latest maturities, via a process of
forward substitution known as bootstrapping.
46. The most appropriate response to Question 1 is when:
A. bond markets are inefficient.

B. the private sector is significantly larger than the public sector.
C. the swap market is more active than the government bond market.


Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS e
The swap curve is a relevant measure of the time value of money than the
government’s cost of borrowing in countries in which the private sector is bigger
than the public sector.
47. The most appropriate response to Question 2 is the:
A. three-year swap.
B. four-year swap.
C. five-year swap.
Correct Answer: C
Reference:
Swap 1 – Five-year fixed for floating LIBOR swap

Swap fixed rate = 5-year spot rate + swap spread = 5.70% + 0.90% = 6.60%
Swap 2 – swap fixed rate: 4.00% + 0.85% = 4.85%
Swap 3 – swap fixed rate: 4.90% + 1.20% = 6.10%
48. Using Exhibit 3, the sensitivity of the steepness movement (DS) as a result of
yield curve steepening upwards by 200 basis points is closest to:
A. 1.17.
B. 2.33.
C. 4.67.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 43, LOS k


When the yield curve steepens upwards by 200 basis points there is a downward
shift of the 1-year rate resulting in a gain of $2,000 (1 × 2% × $100,000), and an
upward shift for the 8-year rate resulting in a loss of $16,000 (8 × 2% ×
$100,000).
DS = - ($2,000 – $16,000)/[($300,000)(0.02)] = 2.3333 or 2.33


Questions 49 through 54 relate to Derivatives
Premier Hotels Case Scenario
Stern and Wiley Associates (S&WA) is a U.S. based financial services firm established
by entrepreneurs Mathew Stern and John Wiley. S&WA provides institutional investors
financial counseling and risk management services. Premier Hotels (PREM) owns and
operates a vast network of hotels in the northern part of the U.S, and is one of S&WA’s
most profitable clients. During the annual review meeting with PREM’s CFO Bernard
Winston, Winston stated that due to success in local markets, PREM was planning to go
global by opening its first international hotel in the United Kingdom. Based on pro forma
statements, PREM expects to receive €25 million in profits from the hotel and related
services in about 230 days. Skeptical about the future path of the euro relative to the
dollar, PREM advices Wiley to hedge PREM’s exposure to the volatility in the euro-
dollar exchange rate. Winston expresses the following concerns in achieving this
objective:
• PREM wishes to pay no cash up front.

• We wish to eliminate, and not just reduce, the risk of our cash inflow.
• The cash inflow is expected in about 230 days, at which time, we would want
to hedge exchange rate risk.
• PREM does not deem fit to close out or reverse the hedged position before
term. However, we would like to mark-to market the position every 100 days.
After discussing a few other details, Winston states that PREM expects a summary of the
hedging strategy from S&WA in a couple of days. As the meeting concludes, Wiley calls
for two of the firm’s senior most financial associates and asks them to assess the
appropriate risk-management technique before obtaining quotations from derivative
dealers. The associates present Wiley with the data given in Exhibits 1 and 2.
Exhibit 1
Information as of February 1, 2011
U.S. interest rate 7.5%
U.K interest rate 6.0%
Current spot exchange rate $1.15/€
*Interest rates are expected to remain fixed over the period under study. The rates are
based on annual compounding.


Exhibit 2
Information as of February 1, 2011
Spot exchange rate after 80 days $1.05/€
Spot exchange rate after 100 days $0.95/€
Spot exchange rate at expiration $1.16
After reviewing the data, Winston concludes that a forward contract on the euro in terms
of dollars would be appropriate for eliminating PREM’s risk concerns. After contacting
numerous dealers, Winston decides to transact with Double-X Dealers (DXD), that quote
a price of 1.16 $/€ for a contract with the required maturity. Winston believes that the
probability of default with DXD is only 30%, whereas for other dealers with similar
quotations, the probability ranges from 40%-60%. Using his own analysis, given the
information gathered, Winston then begins preparing the presentation to be made to
PREM’s board in the scheduled meeting.
49. As of February 1 2011, given the information about the forward contract, the:
A. forward premium approximately equals 0.7%.

B. formula for the valuation of the forward contract is a reflection of what is
termed as covered interest rate parity.
C. covered and the uncovered interest rate parity hold.
Correct Answer: C
Reference:
The no arbitrage forward price is:

[1.15/(1.06)230/365] (1.075)230/365 = $1.160228


Since DXD quotes a forward price of $1.16, interest rate parity (or in other words,
covered interest rate parity) hold. Uncovered interest rate parity states that
forward prices are unbiased predictors of future spot rates. Since the spot rate at
expiration equals the forward price as of February 1 2011, it is safe to say that as
of this date, uncovered interest rate parity also holds. The forward premium
should approximately equal the difference in interest rates. Option B is incorrect.
Covered interest rate parity defines the pricing of the forward contract.
50. Assuming that PREM follows Winston’s advice, the contract value to PREM 80
days after contract initiation is closest to:
A. $2,526,751.
B. $2,631,977.
C. -$2,212,593.
Correct Answer: A
Reference:
To hedge the risk, PREM should go short the forward contract (sell euros in the
future). Contract value after 80 days will be:
$1.05/(1.06)150/365 – 1.1602/(1.075)150/365 = -$0.1011 per euro.
Since this is the value to the long, the value to PREM will be $0.1011/euro. The
notional principal is $25 million, the value to PREM will be: 25 million × 0.1011
= $2,526,751
51. The first marking-to-market of the forward contract will reveal an expected credit
loss to PREM closest to:
A. $5,062,091.
B. $5,005,240.
C. $1,501,572.
Correct Answer: C
Reference:


The first mark-to-market will be in 100 days. Contract value in 100 days is:
$0.95/(1.06)130/365 -1.1602/(1.075)130/365 = -$0.2002 per euro
So the value to PREM is 0.2002 × 25 million = $5,005,240.
Since the probability of loss is 30%, the expected credit loss will be: $1,501,572
52. Given the information in the vignette, the most appropriate derivative to hedge
PREM’s risk would be a(an):
A. option.
B. futures contract.
C. forward contract.
Correct Answer: C
Reference:
CFA Level II, Volume 6, Study Session 16, Reading 47, Section 6
PREM wants to hedge a specific event at a target horizon date. Using a futures
contract would produce interim cash flows that can lead to imperfections in the
hedge transaction. Also, PREM does not want to invest anything upfront, so
options are not viable. Given that PREM does not wish to close out the position,
the illiquidity of most forward contracts would not be a problem. Hence, a
forward contract would be most appropriate.
53. If after the first mark-to-market, the revised forward price is $0.961/€, which of
the following describing the settlement between the long and the short parties to
contract is most accurate?
A. PREM will pay $2,764,918 to the dealer before the revision is made.
B. PREM will receive $4,731,015 from the dealer before the revision is
made.
C. PREM will receive $4,848,501 from the dealer before the revision is
made.
Correct Answer: C


Reference:
Given the forward price, we can find the spot rate prevalent at the time:
[x/(1.06)130/365](1.075)130/365 = $0.961, x = $0.956202
Given the spot rate, the contract value is:
$0.956/(1.06)130/365 - $1.160/(1.075)130/365 = -$0.1939/euro
Since PREM is short, it will receive 0.1939 (25 million) = $4,848,501 from the
dealer.
54. Which of the following statements contrasting futures with forwards is most
consistent with the characteristics of such contracts?
A. Futures markets provide much greater transparency to financial markets

than do forward markets.
B. All futures contracts, being traded on an exchange, are characterized with
a high degree of liquidity.
C. Futures prices provide a greater indication of the direction of future spot
prices than do forward prices.
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 16, Reading 48, Section 8
With an open, standardized, and regulated market for futures contracts, their
prices can be disseminated to other investors and the general public. Hence,
futures markets thus provide greater transparency to the financial markets. Option
B is incorrect; forward and futures prices provide similar information. Option C is
incorrect; not all futures contracts have a high degree of liquidity.


Questions 55 through 60 relate to Portfolio Management
Peter Davis, CFA, Case Scenario
Peter Davis, CFA, is a portfolio manager at Service Wealth Management (SWM). Davis
is preparing a presentation for his team of junior portfolio managers in which he aims to
demonstrate the potential benefits for investors in considering multiple risk dimensions
when modeling asset returns. He aims to achieve this by drawing a comparison between
multifactor models and CAPM. The opening statement of his presentation is as follows:
Statement: “Multifactor models allow investors to tilt away from a traditional money
market fund and gain portfolio exposure to numerous systematic and non-systematic risk
factors in order to enhance portfolio returns.”
Davis moves on to demonstrate how an individual’s financial wealth and circumstances

influence his or her investment choices. He presents information on three hypothetical
investors – Jane, Carla and Kevin:
• Jane works as a tax advisor at an audit firm. Her annual income is £68,000. Her
earnings are unable to sustain her lavish lifestyle.
• Carla runs her own dental practice. Her earnings are more than sufficient to
sustain her lifestyle. She has no other sources of income beyond her business
income.
• Kevin has inherited a significant sum of money from his deceased father’s estate.
Kevin is retired and has invested the amount received in his investment portfolio.
The investment income earned on his portfolio is more than sufficient to sustain
his lifestyle.
Raul Montgomery is one of Davis’s clients. Montgomery has expressed an interest in

expanding his all-equity portfolio. Davis follows up on his client’s request by considering
fixed-income securities and commercial real estate as potential asset classes.
For the fixed-income allocation, Davis’ is inclined towards risky assets which will
provide a hedge against bad consumption outcomes. He evaluates three bond issues on
the basis of the covariance between Montgomery’s inter-temporal rate of substitution and
the future price of the issue. The exhibit below summarizes the results of his findings.


Exhibit: Covariances
For Potential Bond Issues
Bond Issue Covariance
1 + 135.0
2 - 120.6
3 - 190.4
Davis would like to build on his analysis and evaluate the impact of the three factors on
Montgomery’s inter-temporal rate of substitution:
Factor 1: He has inherited $3 million as part of his deceased father’s estate.
Factor 2: Monetary authorities have raised the short-term risk-free rate in an effort to
boost savings and economic growth.
Factor 3: Economic analysts forecast that the output gap is projected to widen over the
course of the coming few months.
Davis concludes his search for potential securities with an analysis of commercial real
estate. Prior to selecting securities, he would like to ascertain how the asset class
performs during an economic recession. In addition, Davis would like to determine how
risk premiums demanded on the asset class fare relative to default-free government
bonds.
55. Is Davis correct with respect to his opening statement?
A. Yes
B. No, multifactor models do not allow investors to gain exposure to
systematic risk factors.
C. No, the CAPM assumes investors make an investment by combining the
risk-free asset with the market portfolio.
Correct Answer: C
Reference:


C is correct. Davis is incorrect with respect to his opening statement. CAPM

results in investors investing in a combination of the risk-free asset (or money
market fund) and capitalization-weighted indexes, varying their weights in
accordance with their risk tolerances.
B is incorrect. A multifactor approach will allow investors to tilt their portfolios

towards systematic risk exposures in which they have competitive advantage.
Constructing a portfolio in accordance with the multifactor approach will
eliminate exposure to nonsystematic or asset-specific risk; this is because the
portfolio is diversified as a result of the inclusion of multiple assets.
56. Considering the information provided on the three hypothetical investors, an

investment in cyclical stocks would be most appropriate for:
A. Jane.
B. Carla.
C. Kevin.
Correct Answer: C
Reference:
C is correct. Kevin’s financial wealth is independent and, being retired, he has no

job loss concerns. He has competitive advantage in bearing business cycle risk
and so his optimal portfolio should be tilted more towards the business cycle risk
factor. Therefore, an investment in cyclical stocks will be most appropriate for
this investor.
A is incorrect. Out of the three investors being discussed, Jane’s financial wealth
is most dependent on income from her salary. Her income is highly sensitive to
business cycle risk and therefore an allocation to procyclical stocks will be least
suitable for her investment portfolio.
B is incorrect. Carla’s earnings are dependent on income from self-employment.

Therefore, Davis should expect her income to be more sensitive to business cycle
risk relative to Kevin’s. Relative to Kevin’s investment portfolio, this sensitivity
will make an investment in procyclical stocks less suitable for Carla unless she is
compensated with an adequate premium.


57. Using the data in Exhibit 1, Davis will conclude that the issue with the highest
risk premium is most likely:
A. 1.
B. 2.
C. 3.
Correct Answer: C
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS a & b
The larger the magnitude of a negative covariance between an investor’s inter-

temporal rate of substitution and the future price of an asset, the larger the size of
the risk premium. The risk premium will be greatest for bond issue 3.
Based on the formula below, a negative covariance term implies that a risky
asset’s payout will decline (increase) when the investor’s inter-temporal rate of
substitution is high (low). A negative covariance term will decrease the current
market price of the asset which, in turn, will lead to investors demanding a
positive risk premium to compensate.
~
Pt ,s =
[
Et Pt +1,s −1 ] + cov [P~ ~
,m ]
t t +1, s −1 t ,1
1 + lt ,1
58. Using the data in Exhibit 1, which bond issue will generate the highest returns
when the marginal utility of an investor’s consumption today is high?
A. 1
B. 2
C. 3
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS a & b


An issue which generates high returns when the marginal utility of an investor’s
consumption today is high provides a hedge against bad consumption outcomes.
During bad economic times, an investor’s marginal utility of consumption is high
as the labor market contracts. Any asset which generates high returns during these
times will provide a type of hedge against bad consumption outcomes. The
covariance term for such an asset class would be positive. Issue 1 fits this
description.
59. Considering the three factors identified by Davis, Montgomery’s inter-temporal

rate of substitution will least likely decrease as a result of:
A. Factor 1.
B. Factor 2.
C. Factor 3.
Correct Answer: C
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS a & c
C is correct. A change in inflation expectations will have no direct impact on an

investor’s inter-temporal rate of substitution.
A is incorrect. An increase in financial wealth will decrease Montgomery’s inter-

temporal rate of substitution. The increase in wealth will increase his future
consumption relative to today’s consumption which, in turn, will result in a
decline in his marginal utility of future consumption and thus the inter-temporal
rate of substitution.
B is incorrect. A higher real rate of interest will induce investors to save for future
consumption. A higher amount of savings will contribute to a larger financial
wealth base in the future. Therefore, Montgomery’s marginal utility of
consumption in the future will decline leading to a decline in the inter-temporal
rate of substitution.


60. Which of the following statements accurately compares commercial real estate to
equities or default-free government bonds?
A. Relative to equities, income on commercial real estate is most often

sensitive to the economic cycle.
B. Risk premiums are closer to those demanded on equities than those on
government bonds.
C. Relative to equities, commercial real estate is a better hedge against bad
consumption outcomes.
Correct Answer: B
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS m
B is correct. The pro-cyclical nature of commercial property prices means that

investors will demand a relatively high risk premium for investing in this asset
class. It has been observed that the sharp falls in capital values in recessionary
periods resemble the sort of falls investors in equity experience. Therefore, the
premium demanded by investors on their commercial property equity investments
will be closer to that demanded on equities than on default-free government
bonds.
A is incorrect. The rental income on commercial real estate is stable in nominal

terms and almost immune to the business cycle. On the other hand, dividend
income generated on equity securities is sensitive to the economic cycle as it is
dependent on the earnings of the issuing corporations.
C is incorrect. Similar to equities, commercial real estate is a poor hedge against

bad consumption outcomes; this is because a decline in the capital values of this
asset category tends to coincide with economic recessions.

CFA Level II Mock Exam 5 - Solutions (PM)

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FinQuiz.com – 5th Mock Exam 2016 (PM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Precision Investment Advisors Association Case Scenario

Observation 1: “Winston Lee, a portfolio manager, manages a high-growth equity fund

Observation 2: “PIAAS’s policies necessitate portfolio managers to submit to clients,

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Observation 4: “Markus Kurtz recently joined PIAAS as an investment manager. To

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1. With respect to Observation 1 and Observation 2, is PIAAS in accordance with

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2. With respect to Observation 3, to be in compliance with best practice under

A. do as directed by his clients.

A. requesting his brothers to open up accounts at PIAAS.

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4. Is Davies’s handling of the transaction involving Arrow Enterprises issue most

A. not violated any Standards of Professional Conduct.

A. violate Standard III of the Standards of Professional Conduct.

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Questions 7 through 12 relate to Economics

Allan Associates Case Scenario

Armando Franco is a free-lance economist who formerly worked as a full-time employee

Elaborating further, Derry made the following comment:

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Franco used macroeconomic forecasts provided by the research department at ALASS to

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• The economy has experienced a slight, permanent increase in labor productivity

A. Only with respect to stock market value.

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Cross-country comparisons of GDP should be based on purchasing power parity

A. Only Franco is correct.

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6.7% = 0.6(1.5) + 0.4(2.3) + TFP growth

A. The contribution of number of average hours worked to output will be

Option B is unlikely. The significantly high immigration for Brazil is not

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A. The growth in per capita income is most likely more sustainable in

An increase in labor productivity is positive for equity prices. A growing share of

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Questions 13 through 18 relate to Financial Reporting and Analysis

Black-Crow Investments Case Scenario

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A. $6 million less than under U.S. GAAP.

Under the full goodwill method:

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15. Padget is most accurate with respect to:

Statement 1 is incorrect. Net income to parent’s shareholders is the same, but

Statement 2 is incorrect. Net income is generally higher under the pooling of

A. $300,000 smaller than the impairment under IFRS.

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Under U.S. GAAP:

A. $18 million lower than under the acquisition method.

Under pooling of interests:

Under acquisition method:

18. Padget is most accurate with respect to:

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Comment 2 is incorrect. The entire indemnified liability would be recognized at

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