CFA Level II Mock Exam 5 - Solutions (AM)

CFA Level II Mock Exam 5 – Solutions (AM)

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

1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-24 Financial Reporting and Analysis 36
25-36 Equity Investments 36
37-42 Alternative Investments 18
43-54 Fixed Income 36
55-60 Derivatives 18
Total 180


Questions 1 through 6 relate to Ethical and Professional Standards
Timothy Vaughn Case Scenario
Timothy Vaughn is a portfolio manager at Horizon Asset Management specializing in

real estate securities. He is approached by Sylvia Walters, the manager of a real estate
investment trust (REIT) fund. Walters requests Vaughn to market the REIT index to his
clients and in return offers to pay a small service fee rate of 0.50%. After careful research
he concludes that despite the narrow scope of the fund, there is potential for
diversification as well as attractive risk and returns. He is unsure of the appropriate
course of action to take with respect to the service fees offered.
After consulting with a senior investment officer, Vaughn allocates the REIT fund to
suitable client accounts. A few days later, Walters modifies the policy of the fund. Under
the new policy, the fund is allowed to depart from its normal policies and strategies if
doing so is in the fund’s best interests. This change may include investing in derivatives
or ETFs outside the normal limits but in a manner consistent with fund objectives. She
notifies Walters of the policy change in a detailed email.
Walter’s email is redirected to a ‘spam’ folder in Vaughn’s inbox which he notices thirty
days later while clearing the contents of his inbox. He determines that informing clients is
not necessary as the fund’s allocation decisions will continue to remain consistent with
the objectives.
In an attempt to align the interests of junior portfolio managers with clients, Vaughn
designs a compensation scheme whereby each portfolio manager is required to achieve an
annual return of 5% to satisfy their clients’ minimum return objective. Any excess return
will be subject to evaluation to ensure unreasonable risks were not taken to achieve the
target. Bonuses are awarded to managers who have kept risk and return objectives in
consideration.
Unbeknownst to Vaughn, two managers make allocations to private real estate funds
which, although fall within permissible risk limits, require a significant initial investment
and are thus unaffordable by some clients.
During the course of his employment, Vaughn is offered to serve as the fund manager for
Vital Associates, a global asset management firm. He decides that he will accept the offer
after informing his employer and makes the necessary preparations for his departure.


Using public sources, he contacts clients who have closed their accounts at Horizon and
have moved to other asset managers. He also contacts clients who have received a request
for proposal by Horizon to manage their accounts but have not yet accepted.
On the day of his departure, Vaughn attends an investment conference hosted by Horizon
where Vital’s employees are also present. A research analyst at his new employer
discusses a research report he recently published on Think plc. He rated the manufacturer
as a buy and when asked his reason for doing so, the analyst made the following
justifications:
Justification 1: “I am using the company’s products for quite some time now and they
always manage to deliver superior quality.”
Justification 2: “My aunt serves as a department head at Think plc and she is highly
competent.”
Justification 3: “A client of ours happens to be the chief executive officer of Think plc.”
Upon joining Vital, Vaughn is requested to draft an ethical code of conduct for the
company.
1. With respect to the REIT fund arrangement, Vaughn’s best course of action
would have been to:
A. decline.
B. accept but decline the service fees offered.
C. accept but disclose the service fees received.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a


Vaughn’s best course of action would have been to accept the offer as long as the
service fees offered had been disclosed. By doing so, he would have complied
with the standards relating to disclosure of conflicts, additional compensation
arrangements, and independence and objectivity. The disclosure of conflicts
standard requires members and candidates to disclose all conflicts of interest that
may impair their independence and objectivity or interfere with the provision of
their duties to clients and employers. The service fees, although small, may
influence Vaughn’s judgment in favor of making the current and any future
allocations to the REIT fund. In this way, Vaughn would have also complied with
the standard relating to additional compensation arrangements. The disclosure
related to independence and objectivity requires members and candidates to make
reasonable efforts to achieve and maintain independence and objectivity in their
professional activities. By disclosing the fees offered Vaughn would have
alleviated any concerns which clients would have had regarding the effect of the
arrangement on their manager’s independent and objective judgment.
A is incorrect. Vaughn need not decline the offer as the arrangement does not
represent a violation of the CFA Institute Standards of Professional Conduct.
C is incorrect. The CFA Institute Standards of Professional Conduct do not

prohibit members and candidates from receiving additional compensation as long
as appropriate disclosure has been made.
2. Is Vaughn in violation of the CFA Institute Standards of Professional Conduct

with respect to his response to the REIT fund policy change?
A. No.
B. Yes, with respect to misconduct as he has demonstrated negligence.
C. Yes, with respect to communication with clients and prospects by failing
to inform clients of the change.
Correct Answer: C
Reference:


Vaughn is in violation of the CFA Institute Standards of Professional Conduct

with respect to his response to the REIT fund policy change because he has failed
to communicate the policy change to his clients and prospects. The standard
relating to communication with clients and prospects requires members and
candidates to promptly disclose any changes that might materially affect the
investment processes they use to analyze investments, select securities and
construct portfolios. While the new policy continues to meet existing fund
objectives, the risk composition of the fund can change in a manner which is not
agreeable or suitable to Vaughn’s clients. Secondly, the use of derivatives
represents a significant policy change which mandates disclosure.
The fact that the email was sent to Vaughn’s spam folder and was not read earlier
by the portfolio manager cannot be attributed to the negligence of the manager.
His actions do not demonstrate an intentional attempt to be negligent towards his
duties towards his clients. Furthermore, his actions do not reflect adversely on his
professional competence. Therefore, he is not in violation of the standard relating
to misconduct in this regard.
3. The decision to implement the new compensation policy has led to a violation of
the CFA Institute Standards of Professional Conduct relating to:
A. suitability as it has led to inappropriate investment decisions.

B. responsibility of supervisors due to a failure to detect violations.
C. independence and objectivity as the policy will impair the ability to make
investment decisions in the best interests of firm clients.
Correct Answer: B
Reference:


By implementing the new compensation policy, Vaughn has only partially

completed his responsibility as a supervisor. Not only is he required to take
reasonable steps to prevent a violation of the Code and Standards but he is
required to detect violations and take appropriate action. By failing to monitor
unsuitable portfolio allocations, Vaughn is in violation of the standard relating to
responsibilities of supervisors, which requires members and candidates to make
reasonable efforts to prevent and detect violations of laws, rules, regulations and
the Code and Standards by anyone subject to their supervisory authority.
A is incorrect. Evidence of the portfolio managers making an unsuitable portfolio

allocation does not necessarily mean that the compensation policy is unsuitable.
In fact the policy stresses on meeting client risk and return objectives, which is
consistent with this standard.
C is incorrect. There is no evidence, which indicates that Vaughn or the junior

portfolio managers have failed to make reasonable efforts to achieve and maintain
independence and objectivity in their professional activities.
4. Which of Vaughn’s departure preparations will most likely lead to a violation of

the CFA Institute Standards of Professional Conduct? Contacting Horizon’s:
A. current clients only.

B. prospective clients only.
C. both current and prospective clients.
Correct Answer: B
Reference:
When leaving their current employers, departing employees must continue to act
in their employer’s best interests. Activities which constitute a violation include
misappropriation of employer’s clients or client lists prior to cessation of the
employment. Even if Vaughn obtained information concerning current clients
from public sources, he cannot contact them until his resignation is effective. In
addition, the clients which have received a request for proposal are prospective
clients of Horizon and can only be contacted either with the consent of the
employer or otherwise through public sources after resignation. Therefore,
Vaughn is in violation by contacting both current and prospective clients.


5. In context of the justifications provided by the research analyst, which of the

following most likely represents a potential conflict of interest requiring disclosure
under the CFA Institute Standards of Professional Conduct?
A. Justification 1.
B. Justification 2.
C. Justification 3.
Correct Answer: C
Reference:
Justification 3 represents a potential conflict of interest situation. A client who is

the chief executive officer of a company, which is the subject of a research report
represents a potential conflict of interest situation on two counts. Firstly, Vital
may be inclined to give this client special treatment due to the special relationship
(s) he has with the subject company. Secondly, as a chief executive officer the
client will have significant influence in Think plc and in order to continue
generating business from the client, the analyst may be inclined or pressured to
issue a favorable recommendation.
6. Which of the following provisions will most likely comply with the CFA Institute
Code of Ethics?
A. Uphold integrity in the workplace and act in a respectful manner towards

fellow colleagues.
B. Exercise reasonable care and judgment to achieve and maintain
independence in professional activities.
C. Providing assistance, either direct or indirect, to others in the violation of
company policies must be avoided.
Correct Answer: A
Reference:


A is correct. The CFA Institute Code of Ethics requires members and candidates
to act with integrity, competence, diligence, respect and in an ethical manner with
employers, employees and colleagues in the investment profession.
B is incorrect. This reflects a provision of the CFA Institute Standards of
Professional Conduct relating to independence and objectivity.
C is incorrect. This reflects a component of the CFA Institute Standards of

Professional Conduct relating to knowledge of the law which prohibits members
and candidates from participating or assisting in the violation of laws, rules and
regulation and the Code and Standards.


Questions 7 through 12 relate to Quantitative Methods
Capital Management and Statistical Service Providers Case Scenario
Capital Management and Statistical Service Providers (CMSSP) is a U.S. based entity
that offers investment management firms with macroeconomic and capital market
forecasts, and similar forecasting services. Kelly Cronin is one of the statistical experts at
CMSSP and is presently using internally-developed software to explain the relationship
between a company’s EPS growth and profitable opportunities as measured by the spread
between the equity return on new projects and the firm’s cost of equity capital. After
regressing a sample company’s historical EPS on its return spread for the past ten years,
Cronin presented the results to his superior, Brendan Tracy. Exhibit 1 displays the results
of the regression.
Exhibit 1
Explaining EPS growth by changes in the return spread
Coefficients Standard Error
Intercept 1.207 0.5522
Return spread 22.901 1.992
Regression Statistics
Standard error of estimate 1.120
Observations 62
Mean return spread 0.0943
Variance of the mean return spread 0.007721
Cronin emphasized that the outputs to this regression could be used to predict future EPS
growth given the return spread. Tracy was unsure of the accuracy of predictions produced
by the regression. As a first step, he planned to estimate a confidence interval to perform
a hypothesis test at a 5% level of significance. Tracy tested the significance of the
regression’s slope coefficient to be sure that any predictions based on the regression were
reliable.
As Tracy reviewed Cronin’s regression analysis, he was also not sure how the key inputs
to the regression could affect the ultimate results. When he asked Cronin, she stated that
the analysis was sensitive to a number of key assumptions. As she explained the effects
of some of these inputs and assumptions, Cronin made the following comments:


Comment 1: “The standard error of estimate is an important input for a hypothesis test.
Small standard errors result in both tighter confidence intervals and tighter
prediction intervals.”
Comment 2: “The estimated value for the variance of the independent variable can also
affect hypothesis testing. The higher the assumed variance, the tighter the
prediction intervals. However, changes in the assumed variance will have
no effect on the confidence interval.”
Comment 3: “Assuming a single independent variable, a smaller sample size would be

reflected in a large prediction interval. If the sample size is increased, not
only with the prediction intervals tighten, the confidence intervals would
also tighten as the critical t-value decreases.”
Comment 4: “As the level of significance is decreased, the confidence interval would
tighten increasing the probability of the Type I error. This is also true for
the prediction interval.”
Tracy had just developed an ANOVA table for distribution to one of the firm’s clients.
The table showed the results of regressing the returns to technology stocks on the returns
to the market index and the market P/E ratio. The regression included 1,000 observations.
The sum of squared errors equaled 1,595.340 and the total sum of squares equaled
3,887.492. Apart from computing the combined significance of the independent
variables, Tracy formulated the following conclusions with respect to the F-statistic:
1. As the regression sum of squares is increased, the probability of the Type I error
is decreased.
2. As the sample size is increased, the probability of the Type II error is increased.
In addition to the above conclusions, Tracy also stated the following:
3. Since the R2 of the regression equals 0.56, the adjusted R2 will also effectively
equal 0.56.
4. In comparing the adjusted R2 or R2 of two models, it is imperative that the sample
sizes used to estimate the models are the same.
Tracy then shared his results with Cronin for further review.


7. Using the information provided in Exhibit 1, if the return spread equals 15%, the
95 percent prediction interval for EPS growth will be closest to:
A. 2.37% to 6.91%.
B. 2.40% to 6.88%.
C. 2.08% to 7.21%.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS i
The critical value of the t-statistic given a 95% confidence interval and 60 degrees
of freedom is approximately 2.00.
EPS growth = 1.207 + 22.901(0.15) = 4.6421%
Variance of the forecast error = 1.1202 [1 + 1/62 + (0.15-0.0943)2/(62-
1)0.007721] = 1.282895
Standard deviation = 1.132650
Prediction interval: 4.642-2.00(1.132650) to 4.642 + 2(1.132650) or 2.3767% to
6.9073%
8. The confidence interval for the slope coefficient at the 5% significance level is
closest to:
A. 20.66 to 25.14.
B. 18.92 to 26.88.
C. 22.73 to 23.08.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS g
The confidence interval is:

22.901 -2(1.992) to 22.901 +2(1.992) or,
18.917 to 26.885


9. Cronin is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. Both comments 1 and 2.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS g & i
Comment 1 is correct. Smaller standard errors would result in tighter confidence

intervals and prediction intervals.
Comment 2 is correct. The higher the variance of the independent variable, the
lower the variance of the forecast error, and the tighter the prediction interval.
Confidence intervals do not depend on this input.
10. Cronin is most accurate with respect to:
A. Comment 3 only.
B. Comment 4 only.
C. Both comments 3 and 4.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS g & i
Comment 3 is correct. The larger the number of observations, the lower the
critical t-value, and the tighter the confidence intervals and prediction intervals.
Comment 4 is incorrect. Decreasing the level of significance increases the

probability of the Type II error.


11. The F-statistic for the regression that Tracy is estimating is closest to:
A. 346.96.
B. 716.23.
C. 1,214,73.
Correct Answer: B
Reference:
RSS = 2,292.152
F-statistic: [2,292.152/2]/1,595.340/(1000-3) = 716.2346
12. Has Tracy most likely based his conclusions on sound financial theory?
A. Only with respect to Points 1 and 3.

B. Only with respect to Points 1, 2 and 3.
C. Only with respect to Points 2 and 4.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 10, LOS g & h
Point 1 is correct. Increasing the RSS will increase the value of the F-statistic.
This decreases the probability of the Type I error.
Point 3 is correct. An R2 of 0.56 would give an adjusted R2 of 0.559.
Point 2 is correct. As the sample size is increased, the value of the F-statistic is
increased.
The probability of incorrectly accepting the null hypothesis will increase (Type II
error).
Point 4 is incorrect. Only with respect to adjusted R2 do we need to be absolutely
sure that the sample sizes used to estimate the models are the same.


Questions 13 through 18 relate to Financial Reporting and Analysis
Investa-Corp Service Providers Case Scenario
Investa-Corp Service Providers (ICSP) is a financial advisory firm established to

exclusively serve large institutional clients, including foundations, endowments and
pension plans. Anna Gunn is the chief research analyst; the person in charge of
supervising and overseeing ICSP’s pension funds. Gunn is particularly interested in the
pension plan offered by Lavender Products (LAPRO), a renowned U.S. based firm in the
cosmetics and fashion industry. To discuss the appropriate asset allocation of LAPRO’s
pension portfolio, Gunn met with Bryan Cranston, a member of LAPRO’s board of
directors. Since Cranston was also a financial expert, he understood the implications of
changes in pension plan assumptions on the reported numbers in the financial statements.
While in conversation with Gunn, Cranston mentioned the following changes:
Change 1: “Due to increased inflation, the board has decided to increase the estimate of
the interest rate applicable to our pension plan.”
Change 2: “Since our pension portfolio has been increasingly investing in equities, our
board has revised upward, the estimate of expected return on our plan
assets.”
In incorporating these revised estimates in his calculations, Gunn tried to determine the
affect they would have on LAPRO’s financial statements. In doing so, she gathered the
following information about the firm’s pension plan.
Exhibit 1
LAPRO’s Pension Plan Status for the year 2010 (in US$ millions)
Beginning Projected Benefit Obligation $3,125
Ending Projected Benefit Obligation $5,520
Beginning plan assets 1,555
Ending plan assets 2,905
Employer Contributions 950
Payments to retirees 1,120


Reviewing the plan’s history, Gunn established that LAPRO frequently made
contributions to the pension plan in excess of those required by regulation. Around two
years ago, when the firm’s total pension cost for the period equaled $260 million, the
firm also disclosed that it made a contribution of $350 million. Gunn reached the
following conclusion:
“Given LAPRO’s effective tax rate of 23.5%, the firm’s CFO for that year should be
increased by $68.85 million and CFF should be decreased by $68.85 million“.
As Gunn was going through LAPRO’s financial statements, notes to the statements, and
similar disclosures, she found out that, in addition to promised future payments to its
employees, the firm also offered share-based compensation including stock grants and
stock options. An excerpt from Note 3 related to stock compensation plans is provided in
Exhibit 2.
Exhibit 2
Stock-based compensation in Note 3 to the Financial Statements of LAPRO
As of December 31, 2007, the firm had approximately $220

million of total unrecognized compensation cost related to
compensation arrangements granted. The vesting period equals
3.57 years. This cost does not include any future compensation
awards.
Realizing that this expense was considerable relative to the firm’s total assets during the
same period, Gunn called Cranston to discuss the implications of such costs. Gunn made
the following comments:
Comment 1: “During the period under analysis, compensation expense related to options
will approximately equal $62 million for the years 2008 and 2009.”
Comment 2: “This compensation expense will reduce retained earnings, and will thus
reduce the firm’s equity.”


As Gunn was working on LAPRO’s pension plan assessments, she received a call from
Todd Willington, a close friend working as an independent consultant. Willington invited
Gunn over to discuss the performance of Austin Steel Company (ASC), a steel giant
operating in the U.S. When Gunn reached Todd’s place, he stated that ASC’s financial
statements included a considerable amount of revaluation surpluses and impairment
charges and he was not sure how this affected ASC’s performance ratios. Todd provided
Gunn with the information given in Exhibit 3.
Exhibit 3
ASC’s Excerpts from Financial Statements as of December 31 (in $ millions)
2010 2011
Total assets 2,500 3,400
Total liabilities 1,450 2,333
Revaluation surplus - 275
Depreciation expense 250 310

*The increase in depreciation expense relates to the revaluation surplus
In addition to the information provided in the Exhibit, Todd also told Gunn that ASC
owns a melting machine with a carrying value of $60,000. However, just recently, ASC’s
management determined that the future cash flows generated from the machine equaled
only $10,500/year for the next six years. As such, the firm has reported an impairment
loss in its financial statements. The firm uses a discount rate of 10%.
As a final favor, Todd inquired about the affects of capitalizing versus expensing the
purchase of a long-lived asset on a firm’s financial statements. Gunn stated that if a firm
continued to purchase assets such, that in a particular year, the depreciation expense
equaled the capital expenditures made by the firm, pretax profits would be reduced by the
same amount regardless of whether the firm capitalized or expensed the purchase. Todd
was intrigued and added that, for a company capitalizing an expenditure, current
profitability would be enhanced and the firm would experience a favorable cash flow
impact. This was because an expenditure that was capitalized appeared as an investing
cash outflow and not as an operating one.


13. Given the changes in assumptions related to LAPRO’s pension plan, compared to
an identical firm that prepares its financial statements under IFRS and follows
identical revisions, the current pension related expense in the income statement
would be:
A. higher for LAPRO, but the balance sheet effect would be the same.
B. lower for LAPRO, but the balance sheet effect would be the same.
C. lower for the IFRS firm, and the balance sheet effect would differ.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 19, LOS d
A higher interest rate would decrease the obligation reported on the balance sheet
under both U.S. GAAP and IFRS. A higher expected return on plan assets would
lower the periodic pension expense under U.S. GAAP only.
14. Is Gunn most likely correct with respect to her comment about adjusting for
LAPRO’s contributions to the pension plan, and what is the total periodic pension
cost for the year ended 2010 for LAPRO?
A. Yes, and the total periodic pension cost is $95 million.

B. No, and the total periodic pension cost is $1,045 million.
C. Yes, and the total periodic pension cost is $1,995 million.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 19, LOS f
Contribution exceeded pension cost by $90 million which is 90(1-0.235) = $68.85

million. Therefore, CFF would decrease by $68.85 million and CFO would
increase by $68.85. Hence, Gunn is correct.
Total periodic pension cost: Ending funded status-employer contributions-

beginning funded status
2,615-950-1,570 = $95 million


15. Gunn is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 19, LOS h
Comment 1 is correct. 220/3.57 = $61.625 million in 2008 and$ 61.625 million in

2009.
Comment 2 is incorrect. The recognition of option expense has no net impact on

total equity.
16. Using Exhibit 3, ignoring the effect of taxes and considering the revaluation
independent of any other changes, the adjusted leverage for ASC, as of December
31 2011, based on average figures, will be closest to:
A. 2.99.
B. 3.02.
C. 3.74.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 17, Los c
Ending assets= 3,400-275+60 (increased dep.) = 3,185

Ending shareholders’ equity: 1,067-275+60 = 852
Average assets: 2,500+3,185/2 = $2,842.5 million
Average equity: 1,050+852/2 = 951
Leverage: 2,842.5/951 = 2.99


17. With regards to the melting machine, the impairment loss under U.S. GAAP and
IFRS will be closest to:
A. $14,270 under U.S. GAAP and $14,270 under IFRS.

B. 0 under U.S. GAAP and $14,270 under IFRS.
C. 0 under IFRS and $14,270 under U.S. GAAP.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 17, Los c
Impairment loss under IFRS: 60,000- PV of 10,500 for 5 years at discount rate
10% = $14,270
Under U.S. GAAP: no loss because carrying amount is less than undiscounted
cash flows (63,000)
18. With respect to capitalizing vs. expensing, are Gunn and Todd most likely correct?
A. Only Gunn is correct.

B. Both Gunn and Todd are correct.
C. Neither Gunn nor Todd is correct.
Correct Answer: A
Reference:
Gunn is correct. If depreciation expense is exactly equal to capital expenditures,

capitalizing vs. expensing would not make a difference.
Todd is incorrect. Expensing results in a favorable cash flow impact because of

lower taxes paid.


Questions 19 through 24 relate to Financial Reporting and Analysis
Portico Enterprises Case Scenario
Michael Norris is a research analyst working for Old Rock Investments (ORIN), a sell-
side investment firm in Oklahoma, USA. Norris has been advised to prepare a report on
Portico Enterprises (PENT), a firm that operates in the residential and commercial
construction industry. Based on a preliminary analysis of the firm, Norris determined that
the firm had considerable investments in the debt and equity securities of other
companies. Realizing that such investments could have a considerable impact on a
company’s financial position, Norris decided to perform a comprehensive analysis of
PENT’s intercorporate investments. He approached Diane Cross, a financial expert at
ORIN, to discuss details regarding the accounting treatments of various categories of
corporate investments. When talking about reclassifications of assets under IFRS and
U.S. GAAP, Cross made the following comments:
Statement 1: “Under U.S. GAAP, if a security is reclassified out of the held for trading
category, or is reclassified as held for trading from another category,
unrealized gains and losses are recognized in profit and loss. Although
under IFRS, reclassification out of held for trading is restricted, if done, the
treatment is similar to that under U.S. GAAP.”
Statement 2: “Under U.S. GAAP if a debt security is reclassified as available for sale
from held to maturity, or as held to maturity from available for sale, the
unrealized gains and losses are amortized over the remaining life of the
security as an adjustment to yield.”
Norris then presented Cross with data on held -for-trading investments made by PENT in
the securities of Spartan Products Inc. (SPInc.). While going through PENT’s notes to
financial statements, Norris found out that SPInc. had not made its currently due principal
and interest payments to PENT. In addition, market information speculated that SPInc.
was at the brink of bankruptcy due to severe financial losses. As Cross heard this
information, she stated that PENT should immediately recognize an impairment loss
related to the securities in its financial statements. Since PENT prepared its statements in
accordance with U.S. GAAP, the cost basis of the securities would be written down and
an impairment loss would be reported in the income statement.
Norris also stated that PENT had invested in the debt securities issued by Spot
Enterprises (SPEN). The securities appeared in the financial statements under held-to-
maturity investments, and amounted to 15% of PENT’s total intercorporate investments.


Norris believed that the investment value was overstated since the securities could no
longer be easily traded due to a disappearance of an active market in them. In addition, a
downgrade of SPEN’s credit rating was anticipated which, if realized, could result in
considerable losses. As a result, Norris reduced the carrying amount of the securities by
an amount equal to the difference between their carrying value and the present value of
their estimated future cash flows discounted at their original effective interest rate. Norris
also recognized this loss in SPEN’s profit and loss.
To bring some numbers to the table, Norris presented the following exhibit displaying
information about the fair value of PENT’s investment in A-Dee Company Limited
(ADCL). PENT invested $550,000 in ADCL on 1 January 2010. The par value of the
securities at the time was $435,000. The stated rate equaled 7.5% and the market interest
rate was 5.0%.
Exhibit 1
PENT’s investment in ADCL
Fair value as of 31 December 2010 $650,000
Fair value as of 31 December 2011 $700,000
Benefiting from her meeting with Norris, Cross mentioned a report she was preparing on
the stock of AXE Associates. AXE, a U.S. based firm, had acquired 35% of the
outstanding shares of BLADE Incorporated, and had accounted for it using the equity
method. AXE paid $350 million in exchange for 35% of BLADE’s net assets that
equaled a book value of $275,000 and a fair value of $300,000. After listening to Cross,
Norris made the following comment:
Comment 1: “AXE would report goodwill on its balance sheet in addition to its
proportionate share of BLADE’s net assets adjusted for fair value. This
goodwill should be tested for impairment at least annually, and adjusted for
any losses. If the impairment loss is greater than the goodwill recognized,
the maximum loss would equal the carrying amount of goodwill.”
He continued with the following comment:
Comment 2: “AXE can choose to account for its equity method investment in BLADE
at fair value. If it does, the investment account on AXE’s balance sheet will
not reflect its proportionate share of BLADE’s profit or loss, dividends and
other distributions. In addition, goodwill is not created.”


Cross also mentioned the sale of inventory by AXE to BLADE in the year 2011. The
inventory’s cost and sale price equaled $100,000 and $250,000 respectively. BLADE
resold that inventory $150,000 of that inventory during the same y ear. The remainder
was sold in 2012. Exhibit 2 displays some information about BLADE Inc.
Exhibit 2
BLADE Incorporated
Net income 2011 1,300,000
Net income 2012 1,600,000
Excess purchase price attributable 50,000

to property
Property’s remaining life 10 years
Cross was trying to determine the effect of this sale on the reported equity income in
AXE’s balance sheet.
19. Cross is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. Neither statement 1 nor statement 2.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS a & b
Statement 1 is correct. The treatments are similar under U.S. GAAP and IFRS.
Statement 2 is incorrect. If a debt security is reclassified as available-for-sale from
held-to-maturity, the unrealized gain or loss is reported in other comprehensive
income (not amortized).


20. Is Norris’s treatment of impairment losses on the securities of SPInc. and SPEN
most likely justifiable?
A. Yes.
B. No, because their measurement and reporting of losses is incorrect.
C. No, because their analysis leading to the determination of impairment is
incorrect.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b
Although his treatment of SPInc. is correct, his analysis of SPEN is not. The
disappearance of an active market for an entity’s securities is not evidence of
impairment. In addition, losses expected as a result of future (anticipated) events,
such as the downgrade, are not recognized no matter how likely.
21. If PENT’s investment in ADCL was initially recognized as either held-to-maturity

or held-for-trading, and the securities were sold on 1 January 2012 for $675,000,
which of the following would best describe the gain/loss to be reported on the
income statement?
A. The amount of realized gain under held-to-maturity would be $135,506,

and the realized loss under held-for-trading would be $25,000.
B. The amount of realized gain under held-for-trading would be $25,000, and
the realized gain under held-to-maturity would be $130,125.
C. The amount of realized gain under held-for-trading would be $25,000, and
the realized loss under held-for-trading would be $125,000.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS b & c


Carrying value at the end of 2011: 550,000 + 27,500 – 32,625 = $544,875

Carrying value at the end of 2012: 544,875 +27,243.75 -32,625 = $539,493.75
(add interest income at market rate and subtract interest payment at stated rate)
Gain if held-to-maturity:
675,000-539,493.75 = $135,506.25 (SP less carrying value)
Gain if held-for-trading:
675,000-700,000 = -$25,000 (SP less previously recorded fair value)
22. With respect to AXE’s investment in BLADE, Norris is least accurate with
respect to:
A. Comment 1 only.
B. Comment 2 only.
C. neither comment 1 nor comment 2.
Correct Answer: C
Reference:
Comment 1 holds true under U.S. GAAP.

Comment 2 is also correct.
23. Ignoring any prior equity income, the reported equity income related to BLADE
on AXE’s balance sheet in 2012 will be closest to:
A. $429,000.
B. $541,000.
C. $579,000.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS c


Profit on sale: 250,000-100,000 = 150,000

150,000/250,000 = 60% is resold, 40% is unsold.
Unrealized profit: 150,000 (0.40) = 60,000

AXE’s share of unrealized profit: 60,000 (0.40) = $24,000
In 2012, equity income will be:

1,600,000 (0.35) = $560,000
Less: Amortization = $5,000
Plus: Realized profit: $24,000
Equity income: $579,000
24. Ignoring any prior equity income, if the sale of inventory was by BLADE to
AXE, the reported equity income on AXE’s balance sheet in 2012 would have
been closest to:
A. $579,000.
B. $615,000.
C. $705,000.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 18, LOS c
AXE’s share of unrealized profit: $24,000
This will be realized in 2012. So the equity income will be the same.


Questions 25 through 30 relate to Equity Investments
Insta-Call Cellular Products Case Scenario
Cynthia Philips is an investment expert at the corporate finance department of Insta-Call

Cellular Products (ICCPInc.), a firm that specializes in manufacturing high-end cellular
devices including smart phones. During their recent meeting, the board of directors at the
firm recognized the portable gaming industry as a profitable segment of the technology
market that the firm could target. As the appointed head of the project’s evaluation team,
Philips planned to estimate future cash flows and apply the NPV criterion for an accurate
capital budgeting decision. While calculating the increase in revenues attributed to the
addition of portable gaming devices to the product mix, Philips determined that such
devices would have a potential substitution effect on the smart phone market. Hence,
Philips accumulated all the relevant data that would aid him with his analysis. Exhibit 1
displays this information.
Exhibit 1
Revenue Projections for fiscal year 2012 and 2013 (in US$ ‘000)
FY 2012 FY2013E
Consolidated Revenue $45,000,000 $54,000,000
COGS 12,000,000 -
Operating Expenses 15,500 -
Total portable gaming device(PGD) - 110,000 units
shipments
% of shipments to individuals - 67%
% of shipments to corporations - 33%
Cannibalization factor, individual - 35%
Cannibalization factor, corporations - 15%
Average selling price of PGD to - $350/unit
individuals
Average selling price of PGD to - $500/unit
corporation
*The revenue figures are pre-cannibalization numbers.
In addition to the above data, Philips also made the following assumptions for
determining expected values:


Assumption 1: “The $ change in cost of goods sold would be the same as the $ change
in revenue.”
Assumption 2: “The operating expenses would change at half the rate of the change in
revenue.”
Assumption 3: “Cash taxes as a percent of FY2012’s revenue would be the assumed tax
rate.”
Besides estimating the effects on the firm’s financials of investing in the project, Philips
also formulated the following conclusions:
Conclusion 1: “Relative to pre-cannibalization, post-cannibalization numbers would

make the firm look more expensive in terms of the P/E multiple.’
Conclusion 2: “Using post-cannibalization figures, the firm’s return on assets would be

lower than the pre-cannibalization return on assets. However, the
operating margin would be higher.”
Conclusion 3: “Although the effective tax rate, pre and post cannibalization, would be
the same, cash taxes would be lower post cannibalization.”
Conclusion 4: “Relative to the FY2012 values, the gross profit margin would remain the
same whether or not cannibalization is considered.”
The capital budgeting division at ICCPInc. was also evaluating an acquisition of Connect
Networks (CNET), a small, private firm in a similar business. Anne Webb was the
valuation expert involved with writing a feasibility proposal to the firm’s board. Exhibit 2
displays the data gathered by Webb.
Exhibit 2
Connect Networks Operating income
Gross Profit $355,000
Selling, general, and admin expenses $125,500
Depreciation $40,000
Taxes $47,375
Operating income after taxes $142,125


To determine the firm’s free cash flow to the firm, Webb made the following
assumptions:
• Revenues would increase by $150,000 and gross profit would be 30% of

revenues.
• Expected total revenues would equal $689,000 and depreciation would be 7.5% of
revenues.
• SG&A expenses are expected to stay at their current normalized level, and the tax
rate is also expected to remain constant.
• Working capital equal to 15% of revenues is required.
• Capital expenditures are expected to equal depreciation expense plus 6.0% of
incremental revenues.
• The required returns on working capital and fixed assets are 6.0% and 12%
respectively.
• The discount rate for intangible assets is found by equating the WACC with the
weighted values of working capital, fixed assets, and intangible assets, and is
equal to 10%.
Webb also determined the following:
• The CEO of CNET’s received compensation for the year was $50,000 less than
the normalized compensation expense for a similar company’s CEO.
• Certain real estate assets for CNET were not used in the core operations of the
firm. Expenses associated with the assets totaled $20,000, including $10,000
reflected in SG&A expenses and the remaining included as depreciation expense.
• CNET’s capital structure has an insignificant amount of debt. Hence, Philips
believes that interest expense should be excluded from calculations.
• A small office was just acquired by CNET for running its operations. Expenses
related to this office equal $30,000 and are reflected in SG&A expenses.
Webb then proceeded with writing the report.
25. Philips is least accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. Neither conclusion 1 nor conclusion 2.
Correct Answer: B


Reference:
CFA Level II, Volume 4, Study Session 11, Reading 33, LOS j
Conclusion 1 is correct. Post cannibalization EPS is lower than pre-

cannibalization EPS, which means that post cannibalization P/E would be higher.
Conclusion 2 is incorrect. Post cannibalization operating margin would be lower.
26. Philips is most accurate with respect to:
A. Conclusion 3 only.
B. Both conclusions 3 and 4.
C. Neither conclusion 3 nor conclusion 4.
Correct Answer: B
Reference:
Conclusion 3 is accurate. Lower pretax income would result in lower cash taxes
paid.
Conclusion 4 is accurate. Since the $ change in COGS is the same as the $ change
in revenues, gross profit would remain the same.
27. Using the numbers in Exhibit 1, the post cannibalization expected cost of goods
sold would be closest to:
A. $9,249 million.
B. $14,801 million.
C. $19,033 million.
Correct Answer: A
Reference:


Since the $change in revenue is the same as the $change in COGS, we can find
the $change in revenue post-cannibalization:
[110 million × 0.67 ×0.35] + [110 million ×0.15×0.33] =25.795 + 5.445= 31.24
million
Impact on revenue: [25.795 × $350] + [5.445×$500] = $11,751 million

So post-cannibalization revenue = 54,000-11,751 = $42,249.25 million
$change: 42,249.25-45,000 = -$2,750.75 million
COGS: 12,000-2,750.75 = $9,249.25 million
28. The normalized earnings for CNET are closest to:
A. $119,625.
B. $127,125.
C. $142,125.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOS e
SG&A expenses should be: 125,500+50,000-10,000 = $165,500

Depreciation: 40,000-10,000 = 30,000
Normalized operating income after taxes: 355,000-165,500-30,000 = 159,500-
39,875 (tax at 25%) = $119,625
29. Given Webb’s assumptions, the expected residual income associated with CNET
is closest to:
A. $17,263.
B. $47,263.
C. $33,263.
Correct Answer: A
Reference:


Pro forma values:

Revenues: 689,000+150,000 = $839,000
Gross profit:$251,700
Less SG&A: 165,500
Less Dep: 51,675
Operating income: 34,525
Normalized earnings after tax: $25,894
Working capital: 150,000 ×0.15 = 22,500
Capital expenditures: 51,675 + 9,000 = 60,675
Residual income: 25,894 – 0.06(22,500) – 0.12(60,675) = $17,263
30. Is Webb’s method of estimating the discount rate applicable to intangible most
likely correct?
A. Yes.
B. No, because market return levels must be considered.
C. No, because market return levels and CNET’s borrowing costs must be
considered.
Correct Answer: A
Reference:
The method is correct. One way to estimate the discount rate applicable to
intangible assets is to find the amount that equates the WACC with the weighted
values of working capital, fixed assets and intangible assets.


Questions 31 through 36 relate to Equity Investments
Ascend Venture Exploration Case Scenario
Ascend Venture Exploration (AVEX) is an investment firm prominent for its investments
in venture capital and private equity in USA. The key to the above-average success rate
for AVEX’s funds is the extensive research of target companies by a specialized group of
professionals at the firm. Every aspect of the future performance of each company is
analyzed, including financial, operational, and strategic areas as well as the probability of
litigation and other legal issues. Carolyn Pickman is the senior financial executive (SFE)
of AVEX who has been involved with several of AVEX’s successful ventures. Pickman
leads the management team of The AVEX Panorama Fund (APF), a fund with an average
life of 5 years. Pickman is working with Andrew Bean to develop a value indication for
Trust Pharmaceuticals (TPH), a private company operating in Dallas, Texas. Bean
believes that the market value of invested capital to EBITDA multiple would be
appropriate to determine a value estimate for TPH. Following Pickman’s instructions,
Bean obtained financial information of several public companies that he believed could
serve as guidelines for valuing TPH. Bean presented the following results of his research:
• The mean MVIC to EBITDA multiple using multiples of comparable public

companies is 8.5.
• Since most guideline firms were characterized by high growth and high leverage,
an 18% downward adjustment for TPH’s relative risk and growth characteristics
is warranted.
• Normalized EBITDA for TPH equals $14.5 million.
• The face value of debt capital for TPH equals $3.5 million.
• The present state of the pharmaceutical industry is characterized by acquisition
activity involving several public companies. Research on the pricing and
valuation of these transactions indicates an equity control premium of 55%.
• TPH is operating at a debt/equity ratio of 65/35.
• TPH is expected to experience significant volatility in the near future financial
performance.
After reviewing Bean’s research, Pickman made the following comment:
“I believe that similar information could be used for value estimation of a relatively large
minority interest in TPH based on the guideline transaction method.”
Bean agreed and responded with the following comment:


“If a small equity interest in TPH is to be calculated, a reduction to value associated with
lack of ready marketability would be necessary. Given my study, a 35% lack of
marketability discount would be needed to accurately measure the value of a small equity
interest in TPH.”
Pickman was skeptical of Bean’s analysis and the accuracy of his accumulated data. To
verify Bean’s reported figures, Pickman obtained a research report written by Stephen
Misek, a private equity analyst at AVEX, on the valuation of TPH. Misek had presented
TPH’s value using both the guideline public company method and the guideline
transaction method. While reading the report, Pickman pinpointed the following:
• The EPS growth rates of comparable public companies averages approximately

7.0% below the average EPS growth rate for TPH.
• The risk level of guideline companies merits a 10% upward adjustment to the
baseline multiple.
• Given information about recent acquisitions of similar companies, the differences
in risk and growth prospects of the acquired companies relative to TPH is similar
to the differences reported under the GPC method.
• The average MVIC to EBITDA pricing multiple of comparable public companies
equals 12.00.
As Pickman approached the conclusion of Misek’s report he read that a multiple of 17.00
was applied to normalized EBITDA to determine value under the GTM method.
Given the contrast in Bean’s valuation relative to Misek’s, Pickman initiated a study on
the appropriateness of various valuation procedures given the unique characteristics of
the private firm under study. After careful investigation, Pickman discovered that the
choice of valuation method depended on the stage of the firm’s life cycle and on whether
a controlling or minority interest is to be valued. Specifically, Pickman studied the
following three cases:
Firm A: A minority interest in a development stage entity.

Firm B: A controlling interest in an early stage company.
Firm C: A minority interest in a later stage entity.


31. The value of Trust Pharmaceuticals using the guideline public company method is
closest to:
A. $117,020,012.
B. $153,150,750.
C. $163,706,387.
Correct Answer: A
Reference:
Initial MVIC to EBITDA multiple: 8.5

Downward adjustment 18%: 6.97
Upward adjustment for control premium: Equity control premium: 55% (35%) =
19.25%, so: 8.311
Value: 14.5 million × 8.311 = 120,520,012 -3.5 million = $117,020,012
32. The calculation of value for Trust Pharmaceuticals given Bean’s research will
most likely be:
A. Overstated due to the use of normalized EBITDA since actual volatility in

earnings will be greater.
B. Understated given TPH’s debt/equity ratio and volatility in financial
performance.
C. Correctly stated, since the research of guideline companies is correctly
applied under the guideline company method.
Correct Answer: B
Reference:
Companies with high leverage and/or significant volatility in financial

performance usually have debt valued at significant discounts from face value. In
this case, Bean has used face value instead of the market value of debt. A higher
face value of debt will result in a lower value for the company.


33. Assuming the baseline multiple for the GPC and GTM methods are the same, the
value for a large, minority interest in TPH using the GTM method will be closest
to:
A. $41,979,250.
B. $78,109,987.
C. $81,250,582.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOS I & k
Discount for lack of control: 1-[1/(1+0.1925)] = 16.1425%
So,

DLOC: 16.1425% : 5.844868 (because in GTM, control premium is incorporated
in the multiple)
Value: 84,750,524-3.5 million =$81,250,582
34. Using the GTM method, the adjusted multiple to value a small minority interest in
TPH will most likely be:
A. 35% lower than the multiple used to value a large minority interest in
TPH.
B. 54% lower than the multiple used to value a large minority interest in
TPH.
C. 32% lower than the multiple used to value a large minority interest in
TPH.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOS I & k


A small interest will also be less marketable. A combined DLOC and DLOM will
equal a total discount of:
[1-(1-0.161425)(1-0.35)] = 45.492625%
DLOC+DLOM: 45.4926%: 3.799164
This is 35% lower than 5.844868
35. The control premium that Misek is assuming is closest to:
A. 18.90%.
B. 20.36%.
C. 41.67%.
Correct Answer: B
Reference:
Baseline multiple: 12
Upward Adjustment: 10%: 13.20
Upward Adjustment for growth: 7.0%: 14.124
Since the multiple using the GTM method incorporates a control premium, for
equivalence (of 14.124 vs. 17.00), a control premium of 20.3625% is justifiable.
36. The prior transaction method would be most appropriate for valuing:
A. Firm A.
B. Firm B.
C. Firm C.
Correct Answer: A
Reference:
The prior transaction method is most relevant when valuing a minority interest in
a company. Also, at the development stage, companies go through several rounds
of financing, and as such, a series of prior transactions are available for valuation
evidence.


Questions 37 through 42 relate to Alternative Investments
Commercial Equity REIT Case Scenario
Jon Olson, a financial expert, has worked in the investment industry for over fifteen years
as a research analyst and money manager. Over the years, Olson has gained substantial
knowledge of the workings of capital markets and has undergone extensive research in
many sectors of the global debt and equity markets. In his attempt to impart this
knowledge to emergent professionals in his field, Olson volunteered to offer his
specialized guidance to a group of young portfolio managers. The group was
predominantly interested in the valuation of alternative investments, especially public and
private real estate. To illustrate the appraisal of a REIT, Olson presented a case study of
Commercial Equity REIT (CER), with the property portfolio comprising of commercial
real estate in and around the state of Illinois. Exhibit 1 displays information that was part
of the case study.
Exhibit 1
Commercial Equity REIT (in thousands of US$ except growth rate)
Last year NOI $550,120
Expected growth in NOI 2.07%
NOI of comparable transactions 575,000
Average value of comparable property 5,950,000
Cash and accounts receivable 167,000
BV of land held for future development 45,000
MV of land held for future development 53,500
Goodwill 75,500
Total debt 1,450,000
Deferred tax liabilities 210,000
*The number of shares outstanding is 100,000 and the current market price for the REIT
is $32.89/share
As Olson talked about the performance of this REIT, he made the following comment:
“Value-oriented investors would be particularly interested in purchasing this REIT for

value-addition.”


Elaborating on the conceptual basis for the application of NAV-based measures to

determine appropriate investment decisions, Olson made the following comments:
Statement 1: “Investors may be willing to purchase a REIT trading at a premium to

NAV if the management team of the REIT has better opportunities to grow.
As such, the NAV approach implicitly incorporates the going concern
assumption and can be used to value a pool of assets.”
Statement 2: “NAV estimates become particularly useful when markets become illiquid
and public equity investors cannot ascribe an accurate value to businesses.
As such, the NAV reflects the value of a REIT’s assets to a private market
buyer.”
In addition to using NAV as a measure of valuation, Olson also mentioned other relative
value approaches to determine a REIT or REOC’s investment attractiveness. He stated
that price multiples based on FFO and AFFO were appropriate in determining a REIT
stock’s relative value. David Eubanks, one of the group participants, responded to the
discussion with the following question:
“How will the price multiples based on FFO and AFFO behave during economic
downturns? Also, how does a company’s capital structure affect these multiples?”
Eubanks answered with the following comment:
“Although the absolute value of multiples during downturns would be lower, relative
P/FFO and P/AFFO multiples could be higher. Also, since neither FFO nor AFFO take
into account differences in leverage, changing capital structures will not affect valuation
based on these multiples unless used in conjunction with effects of leverage levels.”
Olson then displayed the following exhibit to illustration the calculation of such
multiples.


Exhibit 2
Residential REIT Incorporated (in US$ thousands)
Gross rental revenue $889,450
Estimated vacancy and collection losses 75,650
Property taxes 64,000
Other operating expenses 145,000
Depreciation $55,000
General and administrative expenses $110,000

Maintenance type capital expenditures and
$41,000
leasing commissions
Non-recurring capital expenditures $76,000
Interest expense $23,000
Non-cash rent 53,000

*The market price of the REIT equals $67/share and the no. of shares outstanding is 100,000.
In conclusion, Olson talked about the discounted cash flow approach as it applied to the
valuation of REITs and REOCs. Olson used the example of a REIT with the underlying
portfolio including shopping centers and malls in the busiest areas of Minneapolis. To
explain the estimation of a suitable growth rate for the REIT, Olson stated that the REIT
would experience an increase in growth over the coming few years. He also presented the
following information:
• Leverage is expected to increase by 5-6% over the same period.

• Return from reinvestment is expected to increase by 1%.
• The percentage return from investment activity is also expected to increase by
1.5%.
In addition to the above, Olson included the following data in the analysis covering the
same time period:
1. The company reduced their estimate of depreciable lives, increasing the rate of
depreciation.
2. The going-in cap rates in the future would be slightly lower than the interest rates
on new loans.


3. The REIT is expected to undergo a repositioning of a material portion of its

portfolio into higher quality properties.
Olson then advised the group to go through the example and write their conclusions on a
piece of paper.
37. As reinforced by Olson, would value-oriented investors most likely be interested

in the commercial equity REIT under analysis?
A. Yes.
B. No, because companies planning IPOs and secondary offerings would be
interested in buying this REIT.
C. No, because sector-focused real estate investors, not value oriented
investors, would purchase this security.
Correct Answer: A
Reference:
Value-oriented investors are interested in REITs that are trading at a discount to

NAV. For this, we need to calculate the NAV:
Cap rate: 575,000/5,950,000 = 9.664%
550,120+ 11,387.484 = 561,507.484/0.09664 = $5,810,300.952+167,000+53,500-
1450000 = $4,580,801
The number of shares outstanding is 100,000, so NAV/share is : $45.808/share
Since the REIT is trading at a significant discount to NAV (32.89/share), value-
oriented investors would like to purchase this REIT.
38. Olson is most accurate with respect to:
A. Statement 1 only.
B. Both statements 1 and 2.
C. Neither statement 1 nor statement 2.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, Los e


Statement 1 is incorrect. NAV implicitly treats a company as an individual asset

or a static pool of assets and is not consistent with the going concern assumption.
Statement 2 is incorrect. NAV estimates can become quite subjective and less
reliable when markets become illiquid.
39. Will Olson’s answer with regards to price multiples most likely prove helpful to
Eubank?
A. Only with respect to economic downturns.

B. Neither with respect to economic downturns nor with respect to leverage
levels.
C. Both with respect to economic downturns and leverage levels.
Correct Answer: A
Reference:
Relative price multiples can be higher during economic downturns. As capital

structures change, the risk associated with the company increases. As such, an
increase in leverage cause equities’ FFO and AFFO multiples decrease because
required return increases as risk increases.
40. Using the information provided in Exhibit 2, the P/FFO for the residential REIT is
closest to:
A. 12.50.
B. 14.20.
C. 16.07.
Correct Answer: B
Reference:


FFO equals:
889,450-75,650-64,000-145,000 = $604,800
604,800-110,000-23,000 = $471,800
FFO/share: 471,800/100,000 = $4.718/share
P/FFO: 67/4.718 = 14.20
41. Using the information provided in Exhibit 2, the P/AFFO for the residential REIT
is closest to:
A. 15.16.
B. 17.73.
C. 22.20.
Correct Answer: B
Reference:
FFO: 471,800
AFFO: 471,800 – 53,000-41,000 = $377,800/100,000 = $3.778/share
P/AFFO = 67/3.778 = 17.734
42. With respect to the shopping center REIT, which of the data provided by Olson is
least consistent with the estimated percentage changes provided earlier?
A. 2 only.
B. 1 and 2 only.
C. 2 and 3 only.
Correct Answer: C
Reference:
The cap rates are lower than the interest rate, which implies a negative leverage
spread. This will induce the firm to reduce leverage not increase it. Also, a
material repositioning of the portfolio is likely to cause cash flow growth pressure
in the near term and a decrease in return from investment activity over the coming
year or so. Higher rates of depreciation will allow the REIT to retain cash flow
without incurring income taxes and is likely to increase reinvestment return.


Questions 43 through 48 relate to Fixed Income
Ben Sloane Case Scenario
Ben Sloane works as a fixed-income analyst at PiperCoons& Associates (PCA), a U.S.

based financial firm established by two successful entrepreneurs, Michael Coons and
Duncan Piper. Sloan is assessing the credit quality of a few fixed income securities for
inclusion in an endowment fund assisting the health care industry. Due to the dependence
of its beneficiary on the income provided by the fund, Sloane planned to opt for
investments that were investment grade. To further his goal, Sloane read an article about
structural models used by credit rating agencies to assess the quality of corporate debt.
Illustrating the option analogy, the article made the following comments:
Comment 1: “According to the structural model, a company’s equity has the same
payoff as a European call option on the company’s assets with a strike price
equal to the face value of the company’s liabilities and a maturity equal to
the maturity of the company’s liabilities.”
Comment 2: “A company’s debt is equivalent to owning a riskless bond and going short
a European put option on the assets of the company. According to this debt
option analogy, the value of risky debt representing credit risk equals the
value of the sold insurance policy.”
Sloane needed to understand the model’s underlying assumptions and calculations to

accurately apply it to determine credit risk. To explicitly calculate the credit risk
measures, Sloane gathered information about a hypothetical company’s debt and assets.
Exhibits 1 and 2 display this information.
Exhibit 1
Hypothetical Company
Asset value $3,500
Expected return on assets 5.00%
Face value of debt $2,800
Time to maturity of debt 1 year
Risk-free rate 2.00%


Exhibit 2
N(-d1) 0.1050
N(-d2) 0.1562
N(-e1) 0.0875
N(-e2) 0.1350
Sloane used this information to estimate the credit risk measures for the company. He,
however, knew that the model’s underlying assumptions and their accuracy could greatly
affect the reliability of the calculated measures. He discussed the model’s weaknesses
and limitations with Michael Coons, one of the firm’s founders. Coons stated that the
computations under the structural model assumed that the debt and equity of a company
actively traded in the financial markets. He added that the calculations also depended on
observable variables like a company’s debt-to-equity ratio and asset return volatility.
Sloane agreed and stated that since the model used the riskless rate to discount future
cash flows, the present value of the credit loss did not accurately capture the risks of
those cash flows.
The conversation about the limitations of the structural model led Coons to talk about the
reduced form model. He stated that the credit risk measures for the hypothetical company
that Sloane was analyzing could also be determined using the reduced form model. Coons
provided the following additional information:
• Default intensity equals 0.04.

• Loss given default equals 45%.
Coons recommended Sloane to use the reduced form model to evaluate the securities’
credit risk. He stated that, theoretically, such models would perform better than credit
ratings and structural models due to the flexibility of their estimation procedures.
43. The article is most accurate with respect to:
A. Comment 1.
B. Comment 2.
C. both comments 1 and 2.
Correct Answer: C


Reference:
Comment 1 is correct. Comment 2 is also correct. The sold put option (insurance
policy) represents credit risk.
44. Assuming the data provided in Exhibits 1 and 2 is accurate, the present value of
the expected loss is closest to:
A. $56.05.
B. $55.19.
C. $61.20.
Correct Answer: C
Reference:
Expected loss: 2,800e-0.02(1)(0.1562)-3,500(0.1050) = $61.1997
45. For the hypothetical company that Sloane is assessing, the:
A. risk premium dominates the time value discount.

B. time value discount dominates the risk premium.
C. risk premium balances the time value discount.
Correct Answer: A
Reference:
The expected loss equals: 2,800(0.1350)-3,500e0.05(0.0875) = $56.048

Since the present value of expected loss is greater than the expected loss, the risk
premium must dominate the time value discount.


46. Do Coons and Sloane most likely capture the limitations of the structural model
accurately?
A. Only Coons does.

B. Only Sloane does.
C. Neither of them does.
Correct Answer: A
Reference:
Structural models assume that the company’s assets trade actively in financial
markets. They are also based on observable variables like a company’s debt-to-
equity ratio and asset return volatility.
Sloane does not capture the limitation accurately. The cash flows risks are
captured by replacing the actual probabilities with the risk-neutral probabilities.
The risk-neutral probabilities are determined by assuming that the asset value’s
expected return is the riskless rate r.
47. Using the reduced form model, with regards to the hypothetical company, the:
A. time value of money is dominated by the risk premium.

B. probability of default over the life of the debt is 5.0%.
C. risk premium is dominated by the time value of money.
Correct Answer: C
Reference:
Expected loss: 2,800[1-e -.04(0.45)(1)] = $49.95

Present value of expected loss: 2,800(0.955)[1-e-0.04(0.45)(1)] = $47.70
Since the present value is lower, the risk premium is dominated by the time value
of money.


48. Coons preference of the credit risk analysis approach is most likely correct
because:
A. the reduced form model helps incorporate changes in the business cycle
regardless of the estimation approach of the model’s parameters; the
structural approach does not provide this flexibility.
B. Even though credit ratings provide a cardinal ranking, they are inherent
with a conflict between stability and accuracy.
C. In the event of default, reduced form models allow a company’s different
liabilities to have different loss rates.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 15, Reading 46, LOS c, e & f
A is incorrect because only when using historical estimation can changes in the
business cycle be incorporated. Option B is incorrect because credit ratings do not
provide a cardinal ranking. Option C is correct. Reduced form models allow the
company’s different liabilities to have differed loss rates.


Questions 49 through 54 relate to Fixed Income
RoseDeco Case Scenario
Matt Curtis, a research analyst, is writing a research report on Rosemary Decorations

(RoseDeco), an event planning firm that specializes in handling corporate events. Curtis
is assessing the growth potential of RoseDeco’s stock and the income stability of its debt
securities. To establish the default probability for RoseDeco, Curtis requested the credit
department at his firm to provide him with the inputs to the regression model for
estimating the firm’s one-year default probability. Exhibit 1 displays the information
supplied to Curtis.
Exhibit 1
Logistic Regression
Coefficient Name Coefficient Value Input Value
Alpha -3
B1 1.12 0.0787
B2 -2.30 0.0560
B3 0.981 0.8700
B4 -0.425 0.1530
Before issuing a buy recommendation for the firm’s fixed-income securities, Curtis
planned to use credit spreads to estimate the credit risk measures for RoseDeco to ensure
that investment risk is properly accounted for. Curtis is particularly interested in a 10%
coupon bond issued by RoseDeco. The bond pays semiannually and is expected to return
the $1,000 principal and the last coupon payment in five years. The risk-free zero-coupon
yield on U.S. bonds is 0.672%. Curtis has determined that the credit spread for this
payment equals 0.476%. Curtis is using this data to estimate the expected loss with
respect to the last payment on this bond.
After completing the research report, Curtis met with Ryan White, a close friend from
college. White was now a renowned financial analyst in the U.S. working for a well-
established investment firm. Curtis talked about credit analysis models and their strengths
and limitations. When White analyzed Curtis’s workings of credit risk measures he made
the following comment:


“The decomposition of the credit spread in either the structural or reduced form models
assumes that markets are frictionless. This means that in most practical applications, the
expected percentage loss, as measured by the models, will be less than the credit spread.”
White continued the conversation about credit risk with an elaboration of the credit
quality of structured bonds. He made the following comments:
“For an asset-backed security, if there is a default in the collateral pool, the probability of
default can be estimated using either a structural model or a reduced form model.
However, the calculations are much more complex.”
Mentioning his current assignments, White stated that he was analyzing a convertible
bond issued by Magneto Enterprises (MAGEN), a large-cap U.S. firm. Exhibit 2 displays
key facts about the bond.
Exhibit 2
Magneto Enterprises Convertible Bond
Current market price $1,135.4
Conversion ratio 33.67
Current dividend yield 4.50%
Coupon rate 9.89%
Stock price $28.5
White knew that a convertible bond could be viewed as having an embedded call option
on the stock of the issuing firm. When he talked about this option with Curtis, Curtis
posed the following question:
“I believe that the theoretical value of this call option could be determined using the
Black Scholes option pricing model. However, if I want to estimate a price for this option
without using complicated models, how can I achieve my goal?”
While reviewing White’s analysis, Curtis disagreed with a few of his estimations based
on the traditional analysis of the bond. He was especially concerned with White’s
estimate of downside risk. Curtis believed that, although White’s calculations were
accurate, his forecasts overstated this risk measure. To illustrate his calculations, Curtis
cited the example of W&E Corporation’s convertible bond that had a market price of
$122.67. The bond was an annual pay, 6.0% coupon bond with 7 years to maturity. The
bond was not callable but was putable and had a YTM equal to 4.5%. Curtis stated the
market provided key information about the value of this bond.


49. Using the information provided in Exhibit 1, the one-year probability of default
for RoseDeco is closest to:
A. 2.3%.
B. 3.9%.
C. 9.5%.
Correct Answer: C
Reference:
Prob = 1/1+ e3-1.12(0.0787)+2.30(0.0560)-0.981(0.87)+0.425(0.1530) = 9.516%
50. Assuming that today is January 1 2010, Curtis’s estimate of the present value of
the expected loss due to credit risk for RoseDeco’s five year bond should be
closest to:
A. $23.67.
B. $24.79.
C. $27.05.
Correct Answer: A
Reference:
Final cash flow: 1000 + 50 = $1,050

Total yield: 0.672%+0.476% = 1.148%
Years to Maturity = 5
PV using total yield: 991.75
PV using risk-free rate: 1015.42
Difference is the present value of the expected loss: $23.67


51. With respect to his comments about credit spread and asset-backed securities, is
White most likely correct?
A. Yes.
B. Only with respect to credit spreads.
C. Only with respect to asset-backed securities.
Correct Answer: B
Reference:
White is correct with respect to credit spreads. The true credit spread will consist
of both the expected percentage loss and a liquidity risk premium. Hence, the
expected percentage loss will be less than the credit spread.
White is incorrect with respect to asset-backed securities. The probability of
default does not apply in this case; it is replaced by the probability of a loss.
52. The best response to Curtis’s question about the convertible bond is that the price
of the call option will be closest to:
A. $5.22.
B. $0.18.
C. $3.37.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS n
The price of the call option can be seen as the market conversion premium per
share. In this case it equals:
[1,135.4/33.67] -28.5 = $5.2214


53. Which of the following can be a possible explanation of Curtis’s belief of an

overstatement of White’s downside risk estimate with respect to Magneto’s
convertible bond?
A. Overestimating the rise in interest rates and issuer’s credit spread.

B. Underestimating the decline in interest rates and overestimating the
issuer’s credit spread.
C. Underestimating the decline in interest rates and issuer’s credit spread.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS n & o
Rising interest rates will cause the straight value to fall and downside risk
measure, which is measured by the premium over straight value, to rise. In
addition, an increase in the issuer’s credit spread will result in a downgrade of the
convertible bond and cause its floor value to fall. If Curtis overestimates the
increase in interest rates and the issuer’s credit spread, his estimate of the straight
value of the convertible bond may be lower than expected and downside risk
higher than expected.
54. Using traditional analysis, which of the following is most accurate about W&E
Corporation’s convertible bond?
A. The market estimates the value of the embedded options to equal $17.89.
B. The value of the embedded options is approximately equal to $13.83,
given that interest rates remain constant.
C. Due to the conflicting effects of the embedded options, market
information cannot be used to determine an estimate of their value.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS p


Convertible security value =

straight value + value of the embedded call on stock + value of put
122.67 = 108.84+ value of embedded call + value of put
Value of embedded call+ value of put = $13.83


Questions 55 through 60 relate to Derivatives
Comfort Beddings and Furnishers Case Scenario
Justin Martinez is the corporate head of the risk management department at Comfort
Beddings and Furnishers (CB&F), a multinational chain with headquarters in Houston,
Texas. Under Martinez’s instructions, CB&F has engaged in a number of forward
contracts and commodity futures to hedge against rising raw material prices and changing
market conditions. Following the advice of his second in command, Peter Rabel,
Martinez is now planning to use options for risk management purposes. However, since
the workings of the options market is new to him, Martinez would like to understand how
options are valued using the binomial model. Rabel obtained information on two options
and presented it to Martinez for review. The exhibit below displays this information.
Exhibit
Option Contract Information
Market
Underlying Price of
Exercise Price at Up Down Risk-free Option at
Option Price ($) T = 0 ($) Movement Movement Rate (%) T= 0 ($)
Call 55.00 55.00 +20% - 25% 2.00 $10
Put 50.00 50.00 +30% - 55% 2.00 $8
Martinez was skeptical of the quoted prices of the abovementioned options. He decided
to utilize his knowledge of option-pricing to obtain a minimum price for each of the
options under analysis. For this, Martinez used a risk-free rate of 5.0% and assumed no
cash payments during the life of the options.
While conversing with Rabel about the estimates he generated, Martinez talked about the

time value inherent in each option. Knowing that options expire in the future, Martinez
was sure that each option holder held value in terms of the chances that the underlying
price would move in their favor over the life of the option. However, he was not sure how
this value differed for European and American options. Martinez used the options under
analysis to calculate the approximate difference in time value inherent in American
options versus European option.


When Martinez presented his results to Rabel for elaboration, Rabel agreed with most of
the conceptual underpinnings underlying his evaluation. However, Rabel stated that
assuming no cash flows during the options’ lives was a somewhat unrealistic assumption.
Rabel advised Martinez to alter this assumption and recalculate the option prices. After
the necessary modifications, Martinez formulated the following conclusions:
Conclusion 1: “The minimum prices for the European options would decrease but those
for American options would remain unchanged.”
Conclusion 2: “With cash flows, the value of an American call option will be greater
than the value of an identical European call option. However, the
relationship between a European put option and an identical American
put option will not change with the existence of cash flows.”
In addition to the above change, Rabel also expected the following changes in interest
rates and volatility trends:
• Interest rates were expected to increase significantly in the near future.

• Volatility in security prices was also expected to rise over the coming fiscal
year.
Intrigued with the results to his analysis, Martinez extended his research by including the
following options for further clarification:
Option: 1: “An embedded put option with a price of $9.07.”

Option 2: “A call option on a stock with a price of $7.05.”
Option 3: “A European put option on a stock with a price of $3.09.”
Martinez would like to expand his knowledge on options valuation and for this he has
undertaken a study of the Black-Scholes-Merton option pricing model. He begins his
study by taking the risk-free rates and underlying prices collected in the Exhibit and
assumes the following scenarios on T = 0 holding all else constant.
Assumption 1: The price of the stock underlying the call and put option increases to $56
and $53 respectively.
Assumption 2: The risk-free rate declines to 1.5%.


55. Which of the following statements is most likely accurate regarding the model
being used by Rabel and Martinez for call and put options?
A. The model is a complex model.

B. The model can be extended to price American options.
C. Underlying prices are assumed to follow a lognormal distribution.
Correct Answer: B
Reference:
The binomial model is a relatively simple model requiring a minimum of

mathematics. The model can be used to price American options.
The Black-Scholes-Merton model assumes that the underlying prices follow a

lognormal price distribution.
56. Using a one-period binomial model, the call option (Exhibit) should sell for a
current price of:
A. $6.47.
B. $11.00.
C. $11.86.

Correct Answer: A
Reference:


S+ = Su = (55)(1.20) =66.00
S- = Sd = (55)(0.75) = 41.25
Option values at T = 1
c+ = Max (0, S+ - X) = Max(0, 66.00 –55.00) = 11.00
c- = Max (0, S- - X) = Max(0, 41.25 – 55.00) = 0.00
1 + r − d 1 + 0.02 − 0.75
Probability of up-move (π)= = = 0.60
u−d 1.20 − 0.75
Probability of down move = 1 – π = 1 – 0.60 = 0.40
Call option value =

(0.60)(11.00 ) + (0.40 )(0.00 ) = $6.47
1.02
57. Based on the information presented in the exhibit regarding the put option and
using a one-period binomial model, does an arbitrage opportunity exist to earn
riskless profits at T = 0 (assumeπu= 67% and πd= 33%)?
A. No.
B. Yes, the put option can be purchased in the market today.
C. Yes, the put option can be sold short in the market today.
Correct Answer: B
Reference:


To determine whether an arbitrage opportunity exists, it is first necessary to

determine the intrinsic value of the option using the one-period binomial model:
S+ = Su = (50)(1.30) = 65.00
S- = Sd = (50)(0.45) = 22.50
Option values at T = 1
p+ = Max (0, X –S+) = Max(0, 50.00 – 65.00) = 00.00
p- = Max (0, X – S-) = Max(0, 50.00 –22.50) = 27.50
Put option value =

(0.63)(00.00 ) + (0.33)(27.50 ) = $8.89
1.02
Given that the put option is selling in the market for $8.00, it is underpriced.
There is an arbitrage opportunity for investors to purchase the put option to
generate riskless profits.
58. Are Martinez’s conclusions most likely consistent with sound option pricing
theory?
A. Yes.
B. Only conclusion 1 is consistent.
C. Only conclusion 2 is consistent.
Correct Answer: B
Reference:
Conclusion 1 is consistent. With cash flows, the lower bounds for the European
options would be adjusted for the present value of the cash flows. However, for
American options, the bounds will remain the same because such options can be
exercised early to take advantage of the cash flows.
Conclusion 2 is inconsistent. The value of an American call option can be higher

than the value of a European put option. However, it is possible that the cash flow
is not high enough to justify early exercise.


59. With respect to the additional options analyzed by Martinez, under the interest
rate assumption, the price increase will be highest for:
A. Option 1 and price decrease will be highest for Option 3.

B. Option 2 and the price decrease will be highest for either Option 1 or
Option 3.
C. Option 1 or Option 2, and the price decrease will be highest for Option 3.
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 17, Reading 49, Section 5.8
A rise in interest rates will cause the embedded options price to increase the most.
Options embedded in bonds are very sensitive to changes in interest rates. For the
put option, the price will actually decrease.
60. Considering Assumption 1, which of the following scenarios is most likely correct
with respect to option deltas?
A. The call delta will move towards 0.0.

B. The call delta will increase towards 1.0.
C. The put delta will decrease towards –1.0.

Correct Answer: B
Reference:
The call delta will move toward 1.0 as the underlying price rises as is the case
assumed in Scenario 1 where the underlying price increased from $55 to $57.
The put delta will increase toward 0.0 as the underlying price moves up as is the
case in Scenario 1 where the underlying price increased from $50 to $53,

CFA Level II Mock Exam 5 - Solutions (AM)

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

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Timothy Vaughn Case Scenario

Timothy Vaughn is a portfolio manager at Horizon Asset Management specializing in

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C is incorrect. The CFA Institute Standards of Professional Conduct do not

2. Is Vaughn in violation of the CFA Institute Standards of Professional Conduct

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Vaughn is in violation of the CFA Institute Standards of Professional Conduct

A. suitability as it has led to inappropriate investment decisions.

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By implementing the new compensation policy, Vaughn has only partially

A is incorrect. Evidence of the portfolio managers making an unsuitable portfolio

C is incorrect. There is no evidence, which indicates that Vaughn or the junior

4. Which of Vaughn’s departure preparations will most likely lead to a violation of

A. current clients only.

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5. In context of the justifications provided by the research analyst, which of the

Justification 3 represents a potential conflict of interest situation. A client who is

A. Uphold integrity in the workplace and act in a respectful manner towards

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C is incorrect. This reflects a component of the CFA Institute Standards of

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Questions 7 through 12 relate to Quantitative Methods

Capital Management and Statistical Service Providers Case Scenario

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Comment 3: “Assuming a single independent variable, a smaller sample size would be

In addition to the above conclusions, Tracy also stated the following:

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The confidence interval is:

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9. Cronin is most accurate with respect to:

Comment 1 is correct. Smaller standard errors would result in tighter confidence

10. Cronin is most accurate with respect to:

Comment 4 is incorrect. Decreasing the level of significance increases the

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A. Only with respect to Points 1 and 3.

Point 3 is correct. An R2 of 0.56 would give an adjusted R2 of 0.559.

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Questions 13 through 18 relate to Financial Reporting and Analysis

Investa-Corp Service Providers Case Scenario

Investa-Corp Service Providers (ICSP) is a financial advisory firm established to

Ending Projected Benefit Obligation $5,520

Beginning plan assets 1,555

Ending plan assets 2,905

Employer Contributions 950

Payments to retirees 1,120

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As of December 31, 2007, the firm had approximately $220

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Total assets 2,500 3,400

Total liabilities 1,450 2,333

Revaluation surplus - 275

Depreciation expense 250 310

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A. Yes, and the total periodic pension cost is $95 million.

Contribution exceeded pension cost by $90 million which is 90(1-0.235) = $68.85

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