2019 Level II Mock Exam AM

2019 Level II Mock Exam AM
The morning session of the 2019 Level II Chartered Financial Analyst Mock ®
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes
1–6 Ethical and Professional Standards 18

7–12 Quantitative Methods 18
13–18 Financial Reporting and Analysis 18
19–24 Corporate Finance 18
25–30 Equity 18
31–36 Fixed Income 18
37–42 Derivatives 18
43–48 Alternative Investments 18
49–54 Portfolio Management 18
55–60 Portfolio Management 18
Total: 180
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© 2018 CFA Institute. All rights reserved.
2 2019 Level II Mock Exam AM
2019 LEVEL II MOCK EXAM AM
Lucas Thorpe Case Scenario

One month ago, Lucas Thorpe, a portfolio manager for an investment management
firm and a CFA Program Level II candidate, received a letter from Keiko Okada, CFA,
the designated officer for the CFA Institute Professional Conduct Program (PCP). The
letter explained that the PCP had received a complaint, accusing him of violating the
CFA Institute Code of Ethics and Standards of Professional Conduct. Okada requested
Thorpe’s cooperation, asking him to explain why he sold publicly traded Savanna
Honey Products (Savanna) shares for both his personal and client accounts. Okada
noted the anonymous complaint she received indicated that sales were executed one
day after his research visit to Savanna and the day before Savanna released an earnings
warning due to an expected significant drop in profit margins.
In his defense, Thorpe responded in a letter to Okada as follows: “I arranged the
research visit to Savanna as part of my routine review of the company. We’re a small
firm, so the portfolio managers do their own analysis. The earnings warning infor-
mation I received from the chief financial officer (CFO) of Savanna was freely given;
I didn’t ask for it. The CFO even stated he had been giving the same information to
any analyst who had visited in the last two days. My clients would have been harmed
if I had not sold, because other managers would be selling before me. Besides, what
I did is not illegal in my market. I treated my clients fairly; I sold Savanna shares for
all my clients before I sold my own.”
Concerned about the strength of his defense and to avoid any additional violations,
Thorpe consulted with the firm’s compliance officer. Consequently, to support his claim
that he did not violate Standard III (B): Fair Dealing and without violating his firm’s
policies or any applicable local laws, Thorpe provided Okada copies of documents for
all the trades executed for his clients, including contact details and the percentage of
assets under management (AUM) the trades represented.
Thorpe further stated in his letter to Okada that he received from the CFO six
very large gift baskets full of high-end honey products worth USD100 per basket.
He explained his firm has a very strict policy about accepting gifts valued at more
than USD100 per gift. Thorpe accepted and distributed the gift baskets on behalf of
himself and his five colleagues. However, he noted that the gifts in no way influenced
his investment decision.
Following Thorpe’s submission to the CFA Institute Professional Conduct Program,
Okada informs him he has been found in violation of the CFA Institute Standards
of Professional Conduct and will be publicly sanctioned and prohibited from future
participation in the CFA Program exams. Thorpe contests the sanction and asks to
present his case to a Disciplinary Review Committee Hearing Panel. While presenting
his case, Thorpe mentions he regularly collects information he finds in the public
domain when determining investment recommendations for his clients’ portfolios.
He states that for “fast-moving consumer goods” (FMCG), he collects data by talking
to industry experts who are former consultants of competing firms, making his own
observations of the number of times grocery store shelves are restocked as well as
gathering information from open specialty social media sites.
Thorpe continues by informing the Hearing Panel that he worked with his firm’s
compliance officer after the firm adopted the CFA Institute Code and Standards
to enhance its policies regarding the handling of material non-public information.
Currently the firm restricts proprietary and personal trading when portfolio managers
2019 Level II Mock Exam AM 3
are in possession of material non-public information. Thorpe shares with the Hearing
Panel the following draft policies being considered for adoption to ensure compliance
with Standard II(A): Material Nonpublic Information:
Policy 1 Portfolio managers are required to submit to the compliance officer
all research reports distributed to clients.
Policy 2 Heightened review of all trading when the firm is in possession of
material non-public information is required.
Policy 3 Receipt of potential material non-public information should be
reported at the next earliest compliance meeting.
Shortly after Thorpe’s presentation to the Hearing Panel, he states on his social
media page, “I’m desperate! I’m so afraid I’ll be permanently kicked out of the CFA
Program. But I’ve taken the following actions to protect myself no matter what the
outcome:
■ I’ve written to all my clients to reconfirm my commitment to continuing educa-
tion, but I left out the part about the potential sanction;
■ I complained to my compliance officer about how unfair I thought the Hearing
Panel process is in case my boss wants to fire me; and
■ I advertised in the CFA Society newsletter to promote my new consulting prac-
tice to help people going through a disciplinary review.”
1 As a result of Thorpe’s admission he traded in Savanna shares, which CFA

Institute Standard of Practice will Okada least likely investigate for a possible
violation?
A Professionalism
B Duties to Clients
C Integrity of Capital Markets
B is correct. Okada is least likely to investigate CFA Institute Standard III: Duties to Clients.
When trading in Savanna shares, Thorpe likely displayed loyalty, prudence, and care by
putting the interests of his clients before his own, as required under Standard III: Duties
to Clients. Thorpe, however, likely violated Standard II: Integrity of Capital Markets when
he traded on information that could be considered material and non-public. Despite
insider trading being legal in Thorpe’s jurisdiction, as a CFA candidate, he is required
under Standard I: Professionalism to uphold the stricter standard, which in this case is the
CFA Institute Code and Standards. By violating Standard II: Integrity of Capital Markets,
he has likely violated Standard I: Professionalism.
A is incorrect because despite insider trading not being against the law in Thorpe’s
jurisdiction, as a CFA candidate, he is required to uphold the CFA Institute Code of Ethics
and Standards of Professional Conduct. Because insider trading is a violation of the
Standards, he likely violated Standard I: Professionalism by not upholding the stricter
CFA Institute Standards. In this case, Standard II: Integrity of Capital Markets is stricter
than the laws of Thorpe’s jurisdiction.
C is incorrect because Thorpe likely violated Standard II: Integrity of Capital Markets
in that he traded on information that could be considered material, because a lower
earnings forecast would likely negatively affect the share price if it were known to the
public. The earnings warning was not yet available to the public, so by trading in advance
of the notice, Thorpe likely traded on material non-public insider information. Even
though insider trading is not illegal in Thorpe’s market, he has an obligation to follow
the stricter standard—the CFA Institute Code and Standards.
Guidance for Standards I–VII

LOS a
Section: Standard III: Duties to Clients
2 Should Thorpe most likely revise how he submitted his Fair Dealing defense to
avoid violating Standard III(E): Preservation of Confidentiality?
A No.
B Yes, he must delete the contact details.
C Yes, he must remove the AUM percentage details.
A is correct. It is not necessary for Thorpe to revise the information he submitted to

support his claim. Any information provided to the Professional Conduct Program as
evidence in an investigation of a member’s or candidate’s professional conduct is kept
in the strictest confidence. Therefore, a member or candidate under investigation who
submits confidential client information to the PCP is not in violation of Standard III(E):
Preservation of Confidentiality.
B and C are incorrect because any information submitted to the Professional Conduct
Program as evidence in an investigation of a member or candidate’s professional conduct
is kept in the strictest confidence.

LOS a
Section: Standard III(E): Preservation of Confidentiality
3 Did Thorpe most likely violate CFA Institute Standard I: Professionalism by

accepting the CFO’s six gift packages?
A No.
B Yes, he violated Standard I(C): Misconduct.
C Yes, he violated Standard I(B): Independence and Objectivity.
A is correct. Thorpe did not violate CFA Institute Standard I: Professionalism. Thorpe
was unlikely to be influenced by the gift baskets when making the investment decision,
because his primary interest was to protect his clients and himself and the share price
was anticipated to fall after the earnings warning was publicly released. Standard I(B):
Independence and Objectivity prohibits the acceptance of gifts that would jeopardize
a member’s or candidate’s independence and objectivity. In addition, because the gift
baskets’ total value was USD600 and they were being shared among six people, Thorpe
was in compliance with the firm’s gift policy of not accepting a gift valued at more than
USD100. Standard I(D): Misconduct requires Thorpe to comply with his firm’s policies so
as to not reflect adversely on his professional reputation and integrity. Thorpe most likely
did not violate any CFA Institute Standard I: Professionalism provisions when accepting
the gift baskets on behalf of his colleagues.
B is incorrect because even though the gift baskets’ total value was USD600, they
were shared among six people; therefore, Thorpe was in compliance with the firm’s policy
of not accepting a gift valued at more than USD100 per gift. Standard I(D): Misconduct
requires Thorpe to comply with his firm’s policies so as to not reflect adversely on his
professional reputation and integrity.
C is incorrect because Thorpe was unlikely to be influenced by the gift baskets when
making the investment decision because his primary interest was to protect his clients
and himself and the share price was anticipated to fall after the earnings warning was
publicly released. Standard I(B): Independence and Objectivity prohibits the acceptance
of gifts that would jeopardize a member’s or candidate’s independence and objectivity.

LOS a
Sections: Standard I(B): Independence and Objectivity; Standard I(D): Misconduct
4 Which of Thorpe’s information-gathering techniques described to the Hearing

Panel most likely requires him to exercise more care to avoid violating the CFA
Institute Standards of Professional Conduct?
A Data from social media
B Use of industry consultants
C Grocery turnover observations
B is correct. Thorpe’s use of industry experts who are former consultants of competitors
of Savanna puts him at risk of violating Standard II: Integrity of Capital Markets. Even
though the experts are former consultants, they still may be in possession of pertinent
confidential information that is material and non-public. Standard II: Integrity of Capital
Markets dictates that members and candidates are ultimately responsible for ensuring they
are not requesting or acting on confidential information received from external experts.
A is incorrect because the use of data from a specialty social media site open to the
public would not cause Thorpe to gather material non-public information, so he would
not be in violation of Standard II: Integrity of Capital Markets.
C is incorrect because Thorpe’s personal observations of grocery stock turnover of
products would be considered non-material and public information. Therefore, infor-
mation collected via this technique would be used as part of a mosaic of gathering data
to determine an investment recommendation. No violation of Standard II: Integrity of
Capital Markets has taken place.

LOS a
Section: Standard II: Integrity of Capital Markets
5 Which of the draft policies concerning Standard II(A): Material Nonpublic

Information should Thorpe’s firm most likely adopt?
A Policy 1
B Policy 2
C Policy 3
B is correct. Thorpe’s firm should adopt Policy 2: Heightened review of all trading when the
firm is in possession of material non-public information is required. This is a recommended
procedure to prevent a violation of Standard II(A): Material Nonpublic Information in that
it helps to restrict the flow of confidential information to those who need to know the
information to perform their jobs effectively. Any trading in a restricted security could
help detect information leaks.
A is incorrect. To prevent potential violations of Standard II(A): Material Nonpublic
Information, the policy should state that the research reports should be reviewed by
the compliance officer prior to, not after, client distribution. The compliance officer will
review the reports to determine whether any of the recommendations are based on
material non-public information.
C is incorrect because a recommended procedure for Standard II(A): Material Nonpublic
Information is that such information should be reported to the compliance officer imme-
diately upon receipt. Waiting until the next compliance meeting, which could be days or
even weeks later, would be inconsistent with the recommended procedures.

LOS b
Section: Standard II(A): Material Nonpublic Information
6 Which of Thorpe’s actions after the Hearing Panel presentation most likely vio-
lated CFA Institute Standards?
A His letter to his clients
B His complaint to the compliance officer
C His new disciplinary review consulting practice
C is correct. Thorpe violated Standard IV(A): Loyalty by establishing a new disciplinary

review consulting business that would deprive his current employer of his time and
energy, because Thorpe would likely spend a great amount of time to develop his own
business. He did not violate Standard VII: Responsibilities as a CFA Institute Member or
CFA Candidate by writing to his clients to reaffirm his commitment to continuing edu-
cation despite not informing them of a potential sanction, because the sanction had yet
to be finalized. Nor did he violate Standard VII by making a complaint to his compliance
officer; Members and Candidates are allowed to express opinions about the program
and CFA Institute.
A is incorrect because Thorpe did not violate Standard VII by writing to his clients
to reaffirm his commitment to continuing education despite not informing them of a
potential sanction, because the sanction had yet to be finalized.
B is incorrect because Thorpe did not violate Standard VII by making a complaint to
his compliance officer; Members and Candidates are allowed to express opinions about
the program and CFA Institute.

LOS a
Section: Standard VII(A): Conduct as Participants in CFA Institute Programs
Litvenko Consulting Case Scenario

Yuri Litvenko is the founder and primary analyst for Litvenko Consulting, a firm that
specializes in analysis and modeling for investment advisories. Litvenko has recently
taken on a new client, Linda Epstein. Epstein manages an equity fund and is seeking
new strategies that will help her excel in picking companies for the fund that will out-
perform the market. Litvenko suggests a quantitative approach to selecting securities.
According to his research, a multiple regression can provide a useful screen for new
stocks. He proposes the following model:
Rt+1 = b0 + b1 × (Rmt – Rft) + b2 × SMBt + b3 × HMLt + b4 × Dt + b5 × RIt,
where
Rt+1 = the expected return on the security in the next period

Rmt = the return on the relevant market index
Rft = the risk-free rate
SMBt = the excess return of the smallest-decile market-cap stocks over the
biggest-decile ones
HMLt = the excess return of the highest-decile book-to-market stocks over the
lowest-decile ones
Dt = the current dividend yield
RIt = the company’s earnings reinvestment rate
Litvenko tells Epstein that he will use five years of quarterly historical data to esti-
mate the model and advises her to select those securities with returns above her target
threshold for further analysis. As an example, he estimates the model for Storcon, Inc.,
a building construction firm, and provides the results shown in Exhibit 1.
Exhibit 1 Selected Regression Data for Storcon, Inc.

Coefficient Input Value
Intercept (b0) 0.040

Market index (Rmt) – Risk-free rate (Rft) 0.780 (0.161 – 0.034)
Small minus big (SMBt; from Fama–French Model) 0.025 2.96
High minus low (HMLt; from Fama–French Model) 0.132 –0.18
Dividend yield (Dt ) 0.120 0.054
Reinvestment rate (RIt) 0.050 0.586
Epstein remarks that the model is fine, but it doesn’t seem particularly unique.
Additionally, she is concerned as to whether it matters that some of the variables, such
as dividend yield and reinvestment rate, appear to be related to each other.
Epstein asks Litvenko whether it is possible to identify companies that are likely to
outperform the market in the next period rather than just trying to predict the return
for a company. He replies that his model as stated would not be a suitable approach
for identifying outperformers, but there are ways to conduct such an analysis.
Litvenko tells Epstein that he can use a dataset harvested from social media to
develop better predictive models based on behavioral factors. While he has limited
computing power and has not yet worked with the data, he believes that it offers a
unique opportunity to implement innovative strategies if the right tools are used.
Epstein agrees to a trial with the new data, and Litvenko considers how best to approach
the problem using machine learning. He begins by creating the data description table
shown in Exhibit 2 for those variables he would like to include, with the goal of creating
a model to predict which mid-cap stocks will outperform the index. All variables will
be measured continuously over a four-year period.
Exhibit 2
List of Variables to Be Used in Machine Learning Trial

■■ Russell Midcap Index % change
■■ Pro-government posts, likes, shares/retweets
■■ Anti-government posts, likes, shares/retweets
■■ Russell Midcap Index individual component stock positive tweets, nega-
tive tweets
■■ Selected mid-cap company stock returns
■■ List of mid-cap companies labeled as to whether they outperformed the
index or not
Before he can view meaningful results, Litvenko realizes he will have to train the
machine learning model so that it follows the correct path. Because he is new to the
machine learning approach, he begins by identifying the principles of model speci-
fication and model training. He makes the following list of the steps he believes are
involved in the machine learning model training process:
1 Find the appropriate underlying economic theory.
2 Establish training and validation samples.
3 Improve the classification accuracy of the model.
Litvenko later studies the model created by the computer. While he is generally
satisfied with its fit, he is concerned that the large number of variables used may mean
that he is “overfitting” his model, with some variables adding little to its explanatory
power. He is also convinced that the relationships he is observing between the binary
outcome and the explanatory variables are non-linear. He considers alternatives to
his modeling approach to address these concerns.
7 Based on the information provided in Exhibit 1, Epstein’s estimate of the next
period return on Storcon, Inc., is closest to:
A 18.5%.
B 22.5%.
C 27.3%.
B is correct. Epstein estimates the next-period return as
Rt+1 = b0 + b1 × (Rmt – Rft) + b2 × SMBt + b3 × HMLt + b4 × Dt + b5 ×

RIt
= 0.04 + 0.78 × 0.127 + 0.025 × 2.96 + 0.132 × (–0.18) + 0.12 ×
0.054 + 0.05 × 0.586
= 0.04 + 0.099 + 0.074 – 0.024 + 0.006 + 0.029
= 0.225 = 22.5%,
where
Rt+1 = the expected return on the security in the next period

Rmt = the return on the relevant market index
Rft = the risk-free rate
SMBt = the excess return of the smallest-decile market-cap stocks over
the biggest-decile ones
HMLt = the excess return of the highest-decile book-to-market stocks
over the lowest-decile ones
Dt = the current dividend yield
RIt = the company’s earnings reinvestment rate
A is incorrect because it fails to include the intercept.
Rt+1 = b1 × (Rmt – Rft) + b2 × SMBt + b3 × HMLt + b4 × Dt + b5 × RIt

= 0.78 × 0.127 + 0.025 × 2.96 + 0.132 × (–0.18) + 0.12 × 0.054 +
0.05 × 0.586
= 0.099 + 0.074 – 0.024 + 0.006 + 0.029
= 0.185 = 18.5%.
C is incorrect because it ignores the minus sign on the HML input value.
Rt+1 = b0 + b1 × (Rmt – Rft) + b2 × SMBt + b3 × (–HMLt) + b4 × Dt + b5 ×

RIt
= 0.04 + 0.78 × 0.127 + 0.025 × 2.96 + 0.132 × 0.18 + 0.12 × 0.054 +
0.05 × 0.586
= 0.04 + 0.099 + 0.074 + 0.024 + 0.006 + 0.029
= 0.273 = 27.3%.
Multiple Regression and Machine Learning

LOS e
Section 2.2
8 Epstein’s concern regarding the relationship between the dividend yield and the
reinvestment rate variables is most appropriately addressed by evaluating the:
A R2 and t-statistics.
B Durbin–Watson statistic.
C Breusch–Pagan test results.
A is correct. The concern that Epstein has in regard to the relationship between the
dividend yield and the reinvestment rate is that the two independent variables are
likely highly correlated with one another—which is referred to as multicollinearity.
There is no specific test for multicollinearity. However, it can be identified by large R2
values and significant F-statistics, combined with low or insignificant t-statistics due to
inflated standard errors.
B is incorrect. The Durbin–Watson statistic is used to test for serial correlation.
C is incorrect. The Breusch–Pagan test is used to diagnose heteroskedasticity.

LOS l
Section 4.3.2
9 The most appropriate way to address the outperformance issue discussed by

Epstein and Litvenko is to:
A use a probit model.
B add a dummy variable to the regression.
C replace one or more of the independent variables with its logarithmic
transformation.
A is correct. A probit model is appropriate for a binary decision, such as whether a security
is likely to outperform the market or not.
B is incorrect. A dummy variable is a qualitative independent variable. A model to
classify outcomes as binary requires a qualitative dependent variable.
C is incorrect. A logarithmic transformation of an independent variable is appropriate
when its relationship with the dependent variable is non-linear, but it will not change
the form of the dependent variable to binary (outperforms or does not).

LOS n
Section 6
10 Given Litvenko’s resources and experience and using the variables shown in
Exhibit 2, the type of machine learning he should use is best described as:
A deep learning.
B supervised learning.
C unsupervised learning.
B is correct. Supervised learning is a form of machine learning where labeled or tagged

data are used to train an algorithm to take a set of inputs X and ﬁnd a model that best
relates them to Y. The mid-cap company list is a labeled data item.
A is incorrect. Deep learning requires large quantities of data and fast computers to
train models. It takes a set of input data and passes it through multiple layers of functions
to generate a set of probabilities.
C is incorrect. Unsupervised learning does not tag or label data and allows the com-
puter to find structure within the data without guidance.

LOS p
Section 7.3
11 The item from Litvenko’s list that best describes a step in the machine learning
model training process is:
A Item 1.
B Item 2.
C Item 3.
B is correct. Establishing training and validation samples is one of the steps in the pro-
cess of training machine learning (ML) models. The emphasis in ML contexts is typically
on improving the accuracy in classification or prediction, but that is not a step in the
process. Finding the appropriate underlying economic theory is the first principle of
financial economic modeling but is not a step in training ML models.
A and C are incorrect.

LOS r
Section 7.5
12 The concerns Litvenko has with his machine learning model can best be
addressed using which of the following alternative modeling approaches?
A CART approach
B Clustering algorithm
C Penalized regression technique
A is correct. The CART (classification and regression trees) approach is most commonly
used when the outcome is binary (outperforms or does not) and there may be significant
non-linear relationships among variables. Variables are added in order of the greatest
contribution to misclassification error reduction and cease being added when there is
no further meaningful reduction possible.
B is incorrect. Clustering algorithms are a form of unsupervised learning that groups
unlabeled data objects according to machine-identified patterns within the data, with
no theory or predetermined relationships.
C is incorrect. Penalized learning reduces the number of independent variables, but
it assumes linear relationships.

LOS q
Section 7.4.1.2
Trana Case Scenario

Marcus Eriksson, chief financial officer of Trana AB, and Katrina Lars, director of
financial reporting, are preparing the company’s 2015 annual report. Today’s meeting
is to discuss the transactions and disclosures related to Trana’s foreign operations.
Trana, which reports under International Financial Reporting Standards (IFRS), is
a Sweden-based retailer operating stores in three geographic locations: Sweden,
the eurozone (with a current presence only in France, Germany, and Italy), and the
United States. The stores in the eurozone and the United States are operated through
a wholly owned subsidiary in each region. Consistent with Swedish accounting prac-
tice, the annual report includes separate financial statements for the parent company
(Trana) and consolidated, or group, financial statements. The income statements are
presented in Exhibit 1.
Exhibit 1 Trana AB Income Statements for the Years Ended 31 December

Consolidated Parent
Income Statement Income Statement
(SEK millions) (SEK millions)
2015 2014 2015 2014
Sales 30,200 26,892 4,700 4,653

Cost of goods sold 13,590 12,639 2,600 2,650
Gross profit 16,610 14,253 2,100 2,003
Selling expenses 10,872 9,143 1,500 1,525
Admin. expenses 1,510 1,076 260 200
Operating profit 4,228 4,034 340 278
Net other costs/losses 10 15 2 3
Earnings before taxes 4,218 4,019 338 275
Income taxes 1,122 1,071 74 61
Net profit 3,096 2,948 264 214
Eriksson and Lars start the meeting by reviewing some of the relevant currency
exchange rates, shown in Exhibit 2. The functional currency for the eurozone and
US subsidiaries is the local currency (EUR and USD, respectively), thus the financial
statements of both are translated using the current rate method. Both subsidiaries
are consistently profitable.
Exhibit 2 Exchange Rates

SEK per EUR SEK per USD
Beginning 2014 8.43 6.32

Average 2014 8.555 6.35
End of 2014 8.88 6.38
Average 2015 9.125 7.595
End of 2015 9.31 8.81
Next, they review the performance and related disclosures by region. The number
of stores operated in each region is shown in Exhibit 3.
Exhibit 3 Number of Stores by Region

Year Eurozone Sweden United States Total
2014 340 99 80 519

2015 400 100 80 580
In preparation for the meeting, Lars looked at the US region and calculated the
effect of the change in the SEK/USD exchange rate on the increase in sales from 2014
to 2015. Her notes include the following:
■■ In 2014, the sales per store, in SEK, were the same for both US and Swedish
stores.
■■ The sales per US store in USD remained constant in 2015.
Eriksson reminds Lars that Trana defines organic growth in retail as coming from
two factors:
1 increasing the number of stores, and
2 increasing the sales per store in the local currency.
He says that he wants to provide disclosures related to the organic growth rate in
domestic sales per store, by region, and asks Lars to calculate it for the eurozone region
where the sales figures (in millions) were SEK18,394 in 2014 and SEK21,640 in 2015.
In 2012, at the start of Trana’s expansion into North American markets, the com-
pany established a subsidiary, Anart Inc., in a South American country to benefit from
lower labor and shipping costs. The details of the Anart investment are as follows:
■■ Anart is 80% owned by Trana with 20% local investment.
■■ It sells all of its production to Trana and Trana’s other subsidiaries and deter-
mines the transfer price as full cost plus 5%.
■■ In 2015, sales (in millions) from Anart to Trana companies were SEK4,485 with
net profit of SEK204.
■■ The corporate tax rate in the country is 10%.
Throughout 2013, the South American country experienced high rates of infla-
tion, approaching 30% per year. Trana had originally assumed that the high inflation
rate was temporary, but it has shown no signs of decreasing and is now a concern.
Eriksson and Lars discuss the impact of Anart on Trana’s financial statements and
Eriksson asks Lars:
“Is the same accounting method being used this year to account for Anart
in the consolidated financial statements as in prior years?”
Eriksson reminds Lars that there is a proposal in Sweden to reduce the corporate
tax rate from the current 22% to 16.5%. He would like to provide pro-forma disclosures
related to the potential change in net income this change could provide for Trana.
He reminds Lars that the average tax rate for the eurozone countries where Trana
operates is 30% and 25% in the United States. Sweden operates under a tax treaty with
all countries in which it has subsidiaries, such that it will owe taxes on foreign earned
income to the extent that the Swedish rate exceeds the foreign rate.
In closing the meeting, Eriksson mentions that Trana is undertaking a compre-
hensive review of its operations in 2016, and its objectives include reducing overall
tax costs by lowering its effective tax rate and reducing foreign exchange gains and
losses reported on the income statement.
13 Using Exhibits 1, 2, and 3 and Lars’s notes about the US operations, the change
in sales reported for the US region (in SEK millions) explained by the change in
the SEK/USD exchange rate in 2015 is closest to:
A SEK737.
B SEK813.
C SEK1,432.
A is correct. The number of stores in the United States is the same in 2014 and 2015
(80). The average sales per US store in 2014 is the same as the Swedish stores, and the
USD sales are the same in both years. But when sales are converted into SEK, the values
reflect the change in the exchange rate over the period.
Calculations SEK (millions)
Number of stores in the United States 80

(Exhibit 1)
Average sales/US store in 2014 SEK4,653/99 stores = 47/Store
(same as the Swedish stores in 2014)
Sales/US store (in USD millions) based on (SEK47/Store)/(SEK6.350/USD) = USD7.40/
average exchange rate in 2014 Store
Total USD sales (in USD millions) in 2014 80 stores × (USD7.40/Store) = USD592.13
and 2015 (same both years in USD)
Total USD sales in 2014 in SEK USD592.13 × (SEK6.350/USD) = 3,760
Sales in USD in 2015 (the same as 2014), USD592.13 × (SEK7.595/USD) = 4,497
converted at the 2015 average rate
Increase in sales because of change in exchange rate 737
B is incorrect. It uses the average sales overall, not the Swedish ones to determine
sales level.
Number of stores in the United States 80

Average sales/US store (in millions SEK) is the same In 2014: SEK26,892/519 store = (the error)
as total stores in 2014 SEK51.815/store
Sales/US store (in millions USD) SEK51.815/store/6.35 SEK/USD =
based on average exchange rate in 2014 $8.160/store
Total USD sales (in millions USD) in 2014 and 2015 80 store × 8.160 USD/store =
(same both years in USD) 652.79 USD
Total USD sales in 2014 (in millions SEK) 652.79 USD × 6.350 SEK/USD SEK4,145
Sales in USD in 2015 (the same as 2014) 652.79 USD × 7.595 SEK/USD SEK4,958
Converted at the 2015 average rate
Increase in sales (in millions) due to change in exchange rate SEK813
C is incorrect. It uses year-end rates instead of average rates to convert sales
Number of stores in United States 80

Average sales/US store (in millions SEK) In 2014: SEK4,653/99 stores =
(same as the Swedish stores in 2014) SEK47/store
Sales/US store (in millions USD) SEK47/store/6.380 SEK/USD = (the error)
based on ending exchange rate in 2014 $7.367
Total USD sales (in millions USD) in 2014 80 stores × $7.367/store = $589.36
Total USD sales in 2014 (in millions SEK) $589.36 × 6.380 SEK/USD SEK3,760
Sales in USD in 2015 (the same as 2014) $589.36 USD × 8.810 SEK/USD SEK5,192
Converted at the 2015 closing rate (the error)
Increase in sales (in millions) due to change in exchange rate SEK1,432
Multinational Operations
LOS c
Sections 3.2, 3.4
Integration of Financial Statement Analysis Techniques
LOS c
Section 2
14 Using Eriksson’s definition, the organic growth rate in sales per store in the
eurozone region between 2014 and 2015 that Lars calculates is closest to:
A 0%.
B –6.2%.
C 10.3%
B is correct. To reflect the growth in domestic sales per store, it is necessary to elim-
inate the foreign exchange effect.
2014 2015
European sales (given) (in SEK18,394 SEK21,640

millions)
Exchange rate (average rate SEK8.555/EUR SEK9.125/EUR
used for sales under current
method)
Sales EUR2,150 EUR2,372
Number of stores 340 400
Sales/Store EUR6.32/Store EUR5.93/Store
Growth rate (5.93 – 6.32)/6.32 –6.2%
A is incorrect. This does not adjust for the FX.
2014 2015
European sales (in millions) SEK18,394 SEK21,640

# of stores 340 400
Sales/store in SEK SEK54.10 SEK54.10
Growth rate (no change) 0.0%
C is incorrect. It is the growth rate in Euros in total, not adjusting for the increase in
the number of stores.
(2,372 – 2,150)/2,150 = 10.3% (numbers from A’s justification table)
LOS i
Section 5.1
15 The best estimate of the proportion of Anart’s sales that is reflected in Trana’s
consolidated income statement is:
A 0%.
B 100%.
C 80%.
A is correct. Trana owns 80% of Anart. Because this is a controlling interest, Trana would
consolidate Anart into the group financial statements. Even though Trana owns only
80%, consolidation requires the inclusion of 100% of the subsidiary’s assets, liabilities,
revenues, and expenses (excepting intercompany sales, which are eliminated on consol-
idation to prevent double counting). Therefore, because Anart sells all of its production
to Trana and Trana’s other subsidiaries, none of Anart’s sales would be included in the
consolidated income statement.
B is incorrect. Even though Trana only owns 80%, consolidation requires 100% inclusion
of the subsidiary’s assets, liabilities, revenues, and expenses. Intercompany sales (here
100%), however, must be eliminated
C is incorrect. Even though Trana only owns 80%, consolidation requires 100% inclusion
of the subsidiary’s assets, liabilities, revenues, and expenses. Intercompany sales (here
100%), however, must be eliminated.
Intercorporate Investments
LOS c
Sections 2, 6.5
16 Which of the following is Lars’s most appropriate answer to Eriksson’s question

concerning the accounting method used for Anart in 2015?
A No, the current rate method is being used, after restating nonmonetary
items for inflation.
B No, the current rate method is being used, after restating all accounts for
the general price index.
C Yes, the temporal method is being used, as in past years.
A is correct. Because Anart is an extension of Trana (Anart sells 100% of its production to
the group) its functional currency would be the Swedish krona, not the local currency,
and it would be considered an integrated foreign operation. As an integrated foreign
operation, Trana would normally, and historically, have accounted for Anart using the
temporal method. But the country in which Anart operates is experiencing high inflation;
three years (2013–2015) of rates near 30% would exceed the 100% indicator of hyperin-
flation. Therefore, under IFRS, the nonmonetary items must be adjusted for the loss in
purchasing power to better reflect economic reality. Note that only the nonmonetary
items are adjusted because monetary ones would already be expressed in the monetary
unit current at the balance sheet date.
B is incorrect. Only nonmonetary items are affected by the loss of purchasing power
and must be restated.
C is incorrect. Now that the high inflation has lasted at least three years it can be
considered hyperinflation, and different translation methods must be used to reflect
economic reality.
LOS g
Sections 3.2.2, 3.2.4, and 3.5
17 If the proposed reduction in Swedish tax rates had been in effect in 2015, the
increase in Trana’s net profit (in SEK millions) would have been closest to:
A SEK31.2.
B SEK18.6.
C SEK29.8.
A is correct. The proposed change in Swedish tax rates would have affected the
income earned in Sweden (SEK338 before tax) and the pre-tax income earned in the
South American subsidiary (SEK227, see calculation in following table) because the tax
rate there is lower than in Sweden and hence subject to tax at Swedish rates. The income
earned in tax jurisdictions with rates higher than Sweden’s (Europe and the United States)
are not subject to tax in Sweden and thus would not have been affected.
Tax Effect Under

as Reported Proposal
(22%) (16.5%) Difference
Swedish earnings SEK338 74.4 55.8 SEK18.6

before taxes (EBT)
South American SEK227 50.0 37.4 SEK12.6
EBT*
Total SEK31.2
* To calculate EBT, divide net profit of SEK204 by (1 – tax rate): 204/(1 – 0.10) = SEK227.
B is incorrect. It is only the EBT in Sweden: 338 × (0.22 – 0.165) = 18.6.

C is incorrect. It uses net profit as given for South America and fails to adjust it back
to EBT: (338 + 204) × (0.22 – 0.165) = 29.81.
LOS h
Section 4
18 Which of the following strategies would be most likely to help Trana achieve at
least one of the objectives mentioned by Eriksson for 2016?
A Raise the price at which Anart sells its goods to other group members
B Increase the number of stores in the US region
C Initiate a hedge on the net asset position of the eurozone subsidiary
A is correct. Anart operates in a South American country with the lowest tax rate of the
group—10% versus 25% in the United States, 30% in the eurozone, and 22% (or 16.5%)
in Sweden. If more of the corporate profits are earned by Anart, the effective tax rate
will decrease.
■■ Anart currently earns a return of 204/4,485 = 4.5%, whereas the overall corporate
profit rate is 10.3% (3,096/30,200).
■■ Any income taxed in South America would be eligible for a tax credit in Sweden,
and Trana would be liable for the tax difference between the local 10% rate and
the rate in Sweden (22% or 16.5%).
■■ To the extent that taxable income can be diverted from the US or eurozone oper-
ations (where the rates are higher than Sweden’s), it would result in an overall tax
saving for Trana.
■■ By increasing the price at which Anart sells goods to the US and eurozone subsid-
iaries, it would increase the taxable income earned in South America and reduce
the taxable income (through higher cost of goods sold) in the United States and
the eurozone. Because of the tax treaty with Sweden, there would be no net
tax savings on the goods sold to US and eurozone stores by Anart if the prices
change.
Because both retail subsidiaries are translated using the current rate method, all
foreign exchange gains/losses are reported in other comprehensive income not on
the income statement. Therefore, the effects of hedging the exposure in the eurozone
subsidiary would also be reported in other comprehensive income and not affect the
income statement.
Increasing the number of stores in the US would increase the amount of income in
the highest tax jurisdiction and hence increase taxes, not lower them.
B is incorrect. Increasing the number of stores in the US region will not affect the tax
rate, but would increase taxable income because the tax rate there is greater than in
Sweden and would not affect foreign exchange gains and losses on the income statement
because it is self-sustaining, and the gains and losses go to other comprehensive income.
C is incorrect. The eurozone subsidiary is also self-sustaining, and any effect of hedging
its net asset position would go to other comprehensive income, not net income. The
eurozone’s taxes are higher than in Sweden, so there would be no lowering of taxes either.
LOS h
Section 4
Barbara Carlyle Case Scenario

Barbara Carlyle is a financial adviser to high-net-worth individuals. She is currently
reviewing the equity portfolio of a client and is considering adding new securities to
it, as the client has indicated a preference for more income-producing securities. With
this in mind, Carlyle takes a closer look at Avignon Corporation (“Avignon”), a chain
of Canadian boutiques that has recently registered unusually high sales, resulting in
large increases in the company’s cash balance. Avignon’s current stock price is C$47.33.
Exhibit 1 shows earnings and dividends for the preceding four years.
Exhibit 1 Avignon Corporation Earnings and Dividend

History
2013 2014 2015 2016
EPS C$1.38 C$1.39 C$1.37 C$1.44

DPS C$0.20 C$0.22 C$0.22 C$0.22
Carlyle reviews analysts’ reports. She notes the significant change in cash due to
the high sales volume and wonders whether that will prompt a dividend increase.
However, most analysts have stated that because the industry is cyclical, the increase
in sales is believed to be temporary.
Carlyle asks her assistant, Richard Lee, to investigate whether Avignon might use
its surplus cash for a share repurchase rather than for dividends. Lee, a junior analyst,
comments that share repurchases can be beneficial for several reasons:
1 The distribution of cash among shareholders is equivalent to what would have
otherwise been distributed to them as dividends.
2 Share repurchases provide greater flexibility to management than the payment
of cash dividends.
3 When directly negotiated, share repurchases can be used to purchase stock for
less than the current market price.
Lee believes that looking at other companies that have completed share repurchases
could be helpful to his analysis. He looks at the history of SpeedyPro Inc. (“SpeedyPro”),
a US-based industrial services company whose business depends heavily on the petro-
leum exploration and production sector. SpeedyPro made its first share repurchase
in early 2017 using surplus cash. SpeedyPro’s selected financial information just prior
to the repurchase is shown in Exhibit 2.
Exhibit 2 SpeedyPro, Inc. Selected Financial Information

as of Year-End 2016
Net income $124 million
EPS $1.24
Shares outstanding 100 million
Details of share repurchase
Cash available for repurchase $836 million
Share price at time of repurchase $38.00
Premium over current share price for 10.0%
repurchase
Lee returns to Carlyle to continue the discussion. Carlyle explains to Lee that a
complete analysis of the impact of a share repurchase should also include an evalua-
tion of the effects on leverage. She points out that Avignon’s most recent bond issue
includes a covenant that limits the company’s debt-to-equity ratio to 35%. She asks
Lee to prepare an analysis for Avignon, using the information in Exhibit 3, to see if
the debt covenant will be violated if the company repurchases shares.
Exhibit 3 Avignon Corporation Selected Financial

Information as of Year-End 2016
Book value of equity C$3,600 million
Shares outstanding 200 million
Expected share repurchase price (at market) C$32.00
Cash available for repurchase C$155 million
Debt-to-equity ratio 30.0%
After-tax cost of debt 5.0%
19 Based on Exhibit 1, Avignon’s current dividend policy is best described as a:

A residual dividend policy.
B constant dividend payout ratio policy.

C stable dividend policy.
C is correct. Avignon’s current dividend policy would be classified as stable because

it has paid the same amount for the past three years regardless of earnings volatility.
A is incorrect. A residual dividend policy is based on paying out the full amount of
internally generated funds after capital expenditures. It is rarely used in practice because
it typically results in highly volatile dividend payments
B is incorrect. A constant dividend payout ratio policy pays a fixed percentage of
earnings, and the dividend will rise when earnings increase.
Dividends and Share Repurchases: Analysis

LOS g
Section 5.1
20 If the analysts’ beliefs about the increase in sales are correct, the change in divi-
dend policy that Avignon would most likely make would be to:
A declare a special dividend.
B increase the quarterly dividend amount.
C cut the quarterly dividend in anticipation of next year’s sales forecast.
A is correct. If analysts are correct that the change in sales is temporary, the company is
most likely to declare a special dividend. Companies, particularly in cyclical industries, may
choose to use special dividends to distribute more earnings during strong earning years.
B is incorrect. Most companies strive to maintain or increase their dividends and
will not increase the regular dividend unless they believe they can continue to pay at
or above that level. Rather, they will pay an extra dividend at the end of the year when
earnings are unusually good.
C is incorrect. A record of consistent or increasing dividends is widely interpreted as
a signal of profitability, and most companies strive to not reduce dividends.

LOS e, b
Section 2.2
21 Which of Lee’s statements to Carlyle about share repurchases is least accurate?

A Statement 2
B Statement 1
C Statement 3
B is correct. Statement 1 is least accurate. Although the amount of cash distributed is

the same, only those shareholders who have their shares purchased by the company
will receive any cash.
A is incorrect. Statement 2 is correct. Management is not obligated to follow through
after stating an intention to repurchase shares, whereas they must meet a declared
dividend statement.
C is incorrect. Statement 3 is correct. Research showed that 45% of private repurchases

between 1984 and 2001 were actually made at discounts, indicating that many direct
negotiation repurchases are generated by the liquidity needs of large investors who are
in a weak negotiating position.

LOS k
Sections 6 and 6.1
22 If SpeedyPro had used all of its surplus cash to repurchase its shares, based on
Exhibit 2, the percentage increase in EPS would have been closest to:
A 10%.
B 28%.
C 25%.
C is correct. The increase in EPS was 25%, calculated as follows:
Steps Calculation EPS
EPS before the repurchase from Exhibit 2 $1.24

Surplus cash available for repurchase $836 million
# shares outstanding before repurchase 100 million
Share price at time of repurchase $38.00
Price premium for repurchase 10%
Repurchase price per share $38.00 × 110% $41.80
# shares repurchased $836 million ÷ $41.80 per share 20 million
# shares outstanding after repurchase 100 million – 20 million 80 million
EPS after the repurchase $124 million ÷ 80 million shares $1.55
% increase in EPS ($1.55 – $1.24) ÷ $1.24 25%
A is incorrect because it applies the price premium (10%) to the EPS.

B is incorrect because it fails to include share premium.
Shares to purchase (in millions) = 836/38 = 22.
Shares outstanding after repurchase (in millions) = 100 – 22 = 78.
EPS after the repurchase = $124/78 = $1.59.
Change in EPS = 1.59/1.24 = 128% = 28.00% increase.

LOS i
Section 6.2.1
23 Based on Exhibit 2, SpeedyPro most likely repurchased shares using:

A a negotiated purchase agreement.
B a fixed-price tender offer.
C open market purchases.
B is correct. SpeedyPro offered a 10% premium over the current price. This is most con-
sistent with a fixed-price tender offer, which normally requires a premium. Negotiated
purchase agreements are almost as likely to take place at prices lower than market
because they are at prices above market, particularly when shareholders are trying to
meet liquidity needs. Open market purchases are market based and can be timed to
avoid price impact.
A is incorrect. Negotiated purchase agreements are almost as likely to take place
at prices lower than market as they are at prices above market when shareholders are
trying to meet liquidity needs.
C is incorrect. Open market purchases are market based and can be timed to avoid
price impact.

LOS h
Section 6.1
24 The best answer to Carlyle’s question about the potential violation of the debt
covenants is that the covenant:
A will be violated if Avignon uses debt to finance the repurchase.
B will be violated if Avignon uses the surplus cash to finance the repurchase.
C is not violated if Avignon repurchases shares.
A is correct. The debt-financed repurchase increases the debt-to-equity ratio above the
35% threshold and thus violates the debt covenant.
Book value of equity (millions) Exhibit 3 C$3,600

Cash available for purchase Exhibit 3 C$155
(millions)
Debt-to-equity ratio (D/E) before Exhibit 3 30.0%
Book value of debt (millions) 30% × C$3,600 C$1,080
D/E with cash repurchase C$1,080 ÷ (C$3,600 – C$155) 31.3%
D/E with debt-financed (C$1,080 + C$155) ÷ (C$3,600 35.8%
repurchase – C$155)
B is incorrect. The D/E stays below 35% when the company uses the surplus cash to
finance the repurchase. (See table above: 31.7%.)
C is incorrect. The D/E is above the 35% threshold when the repurchase is financed
with debt.

LOS i, k
Sections 6.3 and 6.4
Alice Zhang Case Scenario

The Stratton Club is a US-based small investment club formed by a group of friends
who had recently graduated from university. Today the club holds a regular bimonthly
meeting, and two members have new companies for the club to analyze. The club uses
a combination of comparables and forecasted fundamentals to make its investment
decisions.
Alice Zhang has done some preliminary research on Cratt Ltd. (Cratt). Located
in Pennsylvania, Cratt is a small manufacturer of products, supplies, and food for
domestic animals. Zhang starts by showing the club a recent news release from Cratt’s
website (Exhibit 1).
Exhibit 1 Cratt Ltd. Press Release Core EPS Announcement

We are pleased to report an increase in Core EPS from $1.01 to $1.31 for the
year-ended 31 December 2017. The company continues to pursue its growth-by-
acquisition strategy, acquiring smaller specialty companies in the pet supplies
industry. Acquisitions over the past two years have allowed us to increase our
asset base by 20%, and we expect similar opportunities for growth in the next
few years.
31 31
December 2017 December 2016
EPS $1.03 $0.89

Core EPS* $1.31 $1.01
* Core EPS is a non-GAAP measure that excludes acquisition charges of $0.18

and $0.12 in 2017 and 2016, respectively, as well as $0.10 in 2017 related to
the settlement of a lawsuit.
Zhang notes that Cratt is currently trading at $11.31 and reminds the club that
the company had been sued over patent infringement for producing coats and blan-
kets for dogs with the names and logos of local professional sports teams on them
without the teams’ permission. The company had settled quickly out of court to avoid
further negative publicity. Zhang believes the company will not be incurring legal fees
again in the foreseeable future but believes that because the company’s strategy is to
grow by acquisition, costs related to acquisitions will continue to be incurred and are
relevant in any analysis. She does not agree with the company’s exclusion of those
costs from core EPS. She calculates Cratt’s trailing price-to-earnings ratio (P/E) on
the basis of her beliefs.
Using data available from the New York Stock Exchange (NYSE), Zhang finds the
average P/E multiple for the Consumer Goods Index (14.8) and the Processed and
Packaged Goods sector of that index (32.9). She then performs a screen to narrow the
latter group down to other, smaller processed and packaged goods producers to create
her own index for comparison purposes. Partial results for the companies identified
in her screen are shown in Exhibit 2.
Exhibit 2 Partial Results of Market Screen of Companies in

Processed and Packaged Goods Zhang’s Index
Market Cap
Company in US$ millions P/E
FAF Inc. 5.81 12.9

Mila Industries Inc. 26.21 12.4
Watson Brothers Co. 545.62 5.2
Lane Foods Ltd. 700.15 21.1
Delta Delights Inc. 575.53 18.4
Zhang observes that Lane Foods must have both a higher-than-average growth
rate and risk to justify its high P/E and that perhaps they should consider looking at
Lane as a potential investment at their next meeting.
The club members further discuss Zhang’s index and the wide range in both
market capitalizations and P/Es for companies in the index. The discussion focuses
on whether the arithmetic mean of the index is the best value to be using in their
analysis. Zhang remembers learning about the weighted harmonic mean. She decides
to calculate the weighted harmonic mean for the index and makes the following
statement to support her decision:
“The harmonic mean can be used to mitigate the effects of both large and
small outliers.”
Moving on from Cratt, Tom Kaminski, another group member, presents some
preliminary research on Rapier Ltd., an integrated producer in the forest products
industry. Kaminski explains that the industry is cyclical and is currently at mid-c ycle.
He notes that over this portion of the current cycle, Rapier has shown steady growth
in total assets. Kaminski realizes he needs to take these factors into consideration
when calculating normalized EPS to determine Rapier’s P/E.
The meeting continues with Kaminski providing some follow-up from the club’s
last meeting:
“I have more information on KPK Inc., which we discussed in our last
meeting. You may recall that we settled on a discounted cash flow model
that we considered appropriate for the stock. I have used it to calculate the
justified fundamental P/E. In addition, along with current and forecasted
EPS for the next four quarters, I have determined other P/Es for the stock
(Exhibit 3). Because the stock is part of the NYSE Consumer Goods Index
that Zhang mentioned earlier, I have also included the index P/E. Based on
this analysis, I recommend that the club buy KPK shares.”
Exhibit 3 Various P/E Multiples Related to KPK Inc. and Its Industry
Justified Consumer Goods
Trailing P/E Forward P/E (Fundamental) P/E Index P/E
14.6 13.7 15.0 14.8
25 Based on Exhibit 1 and Zhang’s beliefs about recurring costs, her trailing P/E is
closest to:
A 10.98.
B 10.01.
C 8.64.
B is correct. Zhang believes that the acquisition costs will continue to be incurred and,
therefore, should not be excluded from Cratt’s core EPS; however, the legal costs are
non-recurring and should be excluded.
Using that definition, recurring EPS in 2017 = $1.03 + 0.10 = $1.13. Trailing P/E = $11.31 ÷
$1.13 = 10.01.
A is incorrect. It uses the GAAP (reported) EPS: P/E = $11.31 ÷ 1.03 = $10.98. But that
includes the legal fees, which Zhang believes will not recur and should not be included.
C is incorrect because it uses core EPS as reported by Cratt: P/E = $11.31 ÷ 1.31 = $8.64,
which excludes the acquisition costs.
Market-Based Valuation: Price and Enterprise Value Multiples

LOS e
Section 3.1.2.1
26 Zhang’s observation about Lane Foods’ high P/E is best described as:
A correct.
B incorrect with respect to the growth rate.
C incorrect with respect to the risk.
C is correct. The observation about Lane’s P/E is incorrect with respect to risk. Companies
with higher-than-average risk (operating or financial) have lower P/Es, not higher ones.
She is correct with respect to the growth rate. Companies with higher-than-average
growth rates have higher P/Es.
A is incorrect. The observation is incorrect with respect to the risk. Companies with
higher-than-average risk (operating or financial) have lower P/Es, not higher ones. She
is correct with respect to the growth rate. Companies with higher-than-average growth
rates have higher P/Es.
B is incorrect. She is correct with respect to the growth rate. Companies with higher-
than-average growth rates have higher P/Es.

LOS g
Section 3.1.5.1
27 The weighted harmonic mean of the P/Es in Zhang’s index (Exhibit 2) is closest
to:
A 11.1.
B 10.8.
C 15.4
B is correct. The weighted harmonic mean is the value obtained by calculating the
weighted average (based on market capitalization weights) of the reciprocals of the
observations (the P/E) and then taking the reciprocal of the average. The weighted
harmonic mean for Zhang’s index in Exhibit 2 is calculated as follows:
(1) (2) (3) (4) (5)

Market Cap Weighted
Market Cap % Using 1/(P/E) Harmonic
($ millions) Column 1 P/E 1 ÷ (3) Mean
Index (Ex 2) (Weighting) (Ex 2) (Reciprocal) (2) × (4)
FAF Inc. 5.81 0.3 12.9 0.077519 0.0002

Mila Industries Inc. 26.21 1.4 12.4 0.080645 0.0011
Watson Brothers Co. 545.62 29.4 5.2 0.192308 0.0566
Lane Foods Ltd. 700.15 37.8 21.1 0.047393 0.0179
Delta Delights Inc. 575.53 31.1 18.4 0.054348 0.0169
Total 1,853.32 100% 0.0928
Average (arithmetic mean) 14.00
Weighted harmonic mean 1 ÷ (0.0928) =
10.8
A is incorrect. It is the harmonic mean—equally weighted by the number of stocks

(20% each) times E/P. Calculations are shown below.
C is incorrect. It is weighted correctly but multiplied by P/E, not its reciprocal, E/P.
Calculations are shown below.
Mkt. Cap Mkt. Cap Harmonic

Index ($ millions) P/E % Mean (1/5) Weighted P/E
FAF Inc. 5.81 12.9 0.3 0.01550 0.04044

Mila Industries Inc. 26.21 12.4 1.4 0.01613 0.17536
Watson Brothers Co. 545.62 5.2 29.4 0.03846 1.53089
Lane Foods Ltd. 700.15 21.1 37.8 0.00948 7.97119
Delta Delights Inc. 575.53 18.4 31.1 0.01087 5.71394
Total 1,853.32 100% 0.0904 15.4 (C)
Average 370.66 14.00 1/0.0904 =
11.1 (B)

LOS q
Section 7.1
28 Zhang’s statement to support using the harmonic mean is best described as:
A incorrect with respect to large outliers.
B incorrect with respect to small outliners.
C correct.
B is correct. Zhang’s statement is incorrect with respect to small outliers. The harmonic
mean tends to mitigate the impact of large outliers. It may aggravate the impact of small
outliers, but such outliers are bounded by zero on the downside.
A is incorrect. The harmonic mean may aggravate the impact of small outliers, but
such outliers are bounded by zero on the downside.
C is incorrect. The harmonic mean may aggravate the impact of small outliers, but
such outliers are bounded by zero on the downside.

LOS q
Section 7.1
29 When determining Rapier’s P/E, the most appropriate method for Kaminski to
use to calculate the company’s normalized EPS is the:
A average ROE over the most recent full cycle times the current book value
per share.
B current EPS because Rapier is mid-c ycle.
C average EPS over the most recent full cycle.
A is correct. The average ROE over the most recent full cycle times the current book value
is the most appropriate method to use to calculate normalized EPS in cyclical industries
when there have been changes in the company’s size, as is the case for Rapier and its
asset growth.
B is incorrect. Even though the company is mid-c ycle, the current EPS may not be the
same as the average or normalized EPS over the cycle.
C is incorrect. Averaging the EPS over the cycle is one way to calculate normalized EPS
in a cyclical industry but does not account for changes in the business’s size.

LOS e
Section 3.1.2.2
30 Which of the following best supports Kaminski’s recommendation for KPK? The
justified (fundamental) P/E is greater than the:
A trailing P/E.
B forward P/E.
C index P/E.
A is correct. Kaminski recommends that the club invest in KPK. That would be appropri-
ate if the company is currently undervalued. He has forecasted a share price based on
fundamentals (DCF) and has forecasted EPS. Therefore, the club can calculate a justified
(fundamental) P/E based on those inputs and compare it with the other P/E values to
determine the attractiveness of the stock. The justified (fundamental) P/E would be a
better metric to base the decision on than one of the other P/Es because it is supported
by company fundamentals. From Exhibit 3, the justified (fundamental) P/E is greater than
the trailing P/E. Therefore, KPK is currently undervalued by (15.0 – 14.6) ÷ 14.6 = 2.7%,
and the club should invest.
B is incorrect. The forward P/E is not the most reliable P/E, because it is not based on
company fundamentals.
C is incorrect. The index is a general comparable and does not represent the value of
the company as well as the justified P/E. Therefore, it not as reliable a buy signal.

Sections 3.1.4.1 and 3.1.1
LOS j, b, d
Diane Muniz Case Scenario

Diane Muniz is the fixed-income trading strategist at Greentown Capital Management,
an investment firm based in Miami, Florida. Muniz is running a training session for
three recently hired junior analysts, Amanda Morgan, David Scahill, and Hamza Gomaa.
Muniz welcomes Morgan, Scahill, and Gomaa to the firm and states that at today’s
session they will be discussing bonds with embedded options. She asks the group,
“Can any of you list a few general characteristics of bonds with embedded options?”
Morgan responds with the following statements:
Statement 1 “Depending on the type of bond, the embedded option can be
exercised by either the bondholder or the bond issuer to exploit
interest rate movements.”
Statement 2 “However, both types of options—bondholder and bond issuer
options—cannot be embedded in the same bond.”
Statement 3 “The embedded options cannot be traded independently of the
bond.”
Muniz moves on to a discussion of the valuation of risky bonds with embedded
options and asks if there is a metric that can be used to determine relative value and
how such a measure is calculated. In response Scahill states: “The option-adjusted
spread, or OAS, can be used to determine the value of a risky bond with embedded
options. When assessing relative value for two bonds that are otherwise similar
in all respects, the bond with the lower OAS is most likely underpriced or cheap.”
Morgan adds: “The OAS is a variable spread that is based on the likelihood of cash
flows occurring.” Gomaa disagrees with Scahill and Morgan, stating: “I believe OAS
is the constant spread that when added to all one-period forward rates on the inter-
est rate tree, equates the present value of the bond’s cash flows to the market price.
Furthermore, for two bonds that have similar characteristics and credit quality, the
bond with the higher OAS is underpriced.”
Scahill then asks, “While we are on the topic of OAS, a question that comes
to mind is how the interest rate volatility assumption impacts the OAS of callable
and putable bonds.” Morgan responds, “It is my understanding that as interest rate
volatility declines, the OAS for callable bonds decreases while the OAS for putable
bonds increases.”
In order to initiate discussion on the interest rate risk of bonds with embedded
options, Muniz asks the group to use the information presented in Exhibit 1 to cal-
culate the effective duration of a 5% annual coupon bond with 2 years remaining to
maturity and callable in 1 year. The current price of this bond is $100.50, and the face
value is $100.00
Exhibit 1 Bond Price Information

Shift in Yield Bond Price
+10 basis points $100.32

–10 basis points $100.64
Muniz states that effective duration indicates the sensitivity of a bond’s price to
interest rate changes and is a measure of interest rate risk. She notes: “When interest
rates rise and are high relative to the bond’s coupon rate, the effective duration of
a callable bond falls and is lower than the effective duration of an otherwise similar
straight bond. On the other hand, for the same interest rate scenario, the effective
duration of a putable bond will be similar to the effective duration of a comparable
straight bond.”
Muniz wraps up the training session by posing the following question: “If you expect
a steepening of the yield curve, what duration measure provides the best indication
of the interest rate risk for a callable bond?” The group is asked to submit answers to
Muniz the following day.
31 Which of Morgan’s statements is least likely correct:
A Statement 1.
B Statement 2.
C Statement 3.
B is correct. Statement 2 is incorrect. Both bondholder options and issuer options can
be embedded in the same bond. For example, convertible bonds contain a conversion
option that allows the bondholder to convert bonds to the issuer’s common stock. At
the same time, the convertible bond can have an embedded call option that allows the
issuer to call the bond issue to take advantage of low interest rates or to force conversion.
A is incorrect. Statement 1 is correct.
C is incorrect. Statement 3 is correct.
Valuation and Analysis: Bonds with Embedded Options

LOS a
Section 2.2
32 In response to Muniz’s question about the valuation of bonds with embedded

options and relative value analysis, who is most likely correct?
A Morgan
B Gomaa
C Scahill
B is correct, Gomaa is correct. The option-adjusted spread (OAS) is the constant spread
that is added to all one-period forward rates on the interest rate tree and results in the
present value of the bond’s cash flows, or arbitrage-free value, equaling the bond’s
market price. Gomaa also correctly describes how to use OAS for relative valuation. For
two bonds that have otherwise similar characteristics, the bond with the higher OAS is
underpriced, or, alternatively, the bond with the lower OAS is overpriced.
A is incorrect. Morgan is incorrect. The OAS is the constant spread that is added to all
one period forward rates on the interest rate tree (not the term structure) and results in
the present value of the bond’s cash flows, or arbitrage free value, equaling the bonds
market price.
C is incorrect. Scahill is incorrect. For two bonds that are otherwise similar in all respects,
the bond with the lower OAS is most likely overpriced not underpriced.

LOS g
Section 3.6.1
33 Is his response to Scahill’s question regarding the impact of changes in interest

rate volatility on the OAS of callable and putable bonds, Morgan is most likely:
A incorrect about callable and putable bonds.
B correct about callable bonds and incorrect about putable bonds.
C correct about putable bonds and incorrect about callable bonds.
A is correct. Morgan’s response to Scahill is incorrect. As interest rate volatility declines,

the embedded call option becomes cheaper; thus, the higher the arbitrage-free value
(or model value) of the callable bond.
Callable bond value = Value of straight bond – Value of call option
A higher value for the callable bond means that a higher spread needs to be added
to one-period forward rates to make the arbitrage-free bond value equal to the market
price (i.e., the OAS is higher). For putable bonds as interest rate volatility declines, the
value of the put option declines as does the arbitrage-free value of the putable bond.
Putable bond value = Value of straight bond + Value of put option
This implies that a lower spread needs to be added to one-period forward rates to
make the arbitrage free bond value equal to the market price. Thus, in this instance, the
OAS is lower.
B is incorrect. Morgan is correct about the impact on OAS for callable bonds.
C is incorrect. Morgan is correct about the impact on OAS for putable bonds.

LOS h
Section 3.4, 3.6.1, 3.6.2
34 Based on the information presented in Exhibit 1, the effective duration of the

5% coupon bond is closest to:
A 3.18.
B 0.70.
C 1.59.
C is correct.
(PV− ) − (PV+ )
Effective Duration =
2(∆Curve)(PV0 )
100.64 − 100.32
= = 1.59
2(0.001)(100.5)
A is incorrect. It is incorrectly calculated as:
100.64 − 100.32
= 3.18
(0.001)(100.5)
B is incorrect. It is incorrectly calculated as follows:
100.64 − 100.5
= 0.697 or 0.70
2(0.001)(100.32)

LOS i
Section 4.1.1
35 Muniz’s comments regarding effective duration are most likely:

A correct with regard to callable bonds and incorrect with regard to putable
bonds.
B incorrect with regard to callable and putable bonds.
C incorrect with regard to callable bonds and correct with regard to putable
bonds.
B is correct. Muniz’s comments on the effective duration of callable and putable bonds
are incorrect. For callable bonds, when interest rates rise and are high compared to the
bond’s coupon rate, the call option is out of the money and the price of the callable
bond and an otherwise identical straight bond are almost the same. Thus, the effect of
an interest rate change on the price of a callable bond and the straight bond is similar—
that is, the effective duration of the callable and straight bonds is similar. For putable
bonds, when interest rates rise and are high compared to the bond’s coupon rate, the
put option is in the money and the price of the putable bond will not fall as much as the
straight bond because the investor can put the bond. Thus, the effective duration of the
putable bond is lower than the effective duration of the straight bond.
A is incorrect. Muniz’s comments on the effective duration of callable and putable
bonds are incorrect.
C is incorrect. Muniz’s comments on the effective duration of callable and putable
bonds are incorrect.

LOS j
Section 4.1.1
36 For the interest rate scenario presented by Muniz, the most appropriate dura-
tion measure is:
A key rate duration.
B one-sided up duration.
C effective duration.
A is correct. A bond’s sensitivity to changes in the shape of the yield curve, steepening
or flattening, is captured by key rate duration. One-sided duration (up or down) is better
than effective or two-sided duration at capturing the interest rate sensitivity of a callable
or putable bond but only for a parallel shift in the yield curve, not for changes in the
shape of the yield curve.
B is incorrect. A bond’s sensitivity to changes in the shape of the yield curve, steep-
ening or flattening, is captured by key rate duration. One-sided duration (up or down) is
better than effective or two-sided duration at capturing the interest rate sensitivity of a
callable or putable bond but only for a parallel shift in the yield curve, not for changes
in the shape of the yield curve.
C is incorrect. A bond’s sensitivity to changes in the shape of the yield curve, steep-
ening or flattening, is captured by key rate duration. One-sided duration (up or down) is
better than effective or two-sided duration at capturing the interest rate sensitivity of a
callable or putable bond but only for a parallel shift in the yield curve, not for changes
in the shape of the yield curve.

LOS k
Section 4.1.2 and 4.1.3
Newport Case Scenario

IST Risk Solutions provides institutional financial risk management advisory and
brokerage services. Clients seek IST’s services when evaluating whether to hedge
interest rate, currency, or equity market risks. Simon Weber, senior adviser at IST, is
discussing a new client with analyst Noel Franco.
Weber states: “Newport State College plans a $10 million laboratory renovation
for its science center and has engaged IST to implement options strategies in order
to manage the risk of rising interest rates. The renovation is to be completed in 12
months, in time for the start of the school year. To minimize disruption to its academic
schedule, however, Newport will not begin the work until six months from now. State
funding will not be received until the beginning of the next school year, so a six-month
variable interest rate loan will finance the renovation.”
Franco comments: “I think six-month call options on the six-month forward rate
would probably be the cheapest solution. The price of the European-style option can
be evaluated as the present value of the expected terminal option’s payoffs using the
risk-adjusted periodic rate. Because Newport has indicated that its goal is to pay a
maximum interest rate of 1.25% on the loan, we could also use interest rate put and
call options. I believe the binomial model can be used to value interest rate options.
Exhibit 1 shows the current interest rate information.”
Exhibit 1
Current six-month Libor 1.00%
Six-month forward rate in six months 1.15%
Weber states: “Alternatively, we could consider options on the Eurodollar futures,

which are an actively traded Libor-based derivative contract reflecting the three-month
Libor rate anticipated on the settlement date of the contract. Two consecutive three-
month contracts can be combined to hedge interest rates for a period of six months,
and both American- and European-style options are traded. What valuation model
would you apply to these options?”
Franco replies: “The Black model can be used to value options on the Eurodollar
future. In this model, futures options have two components: a futures component and
a bond component. When hedging against rising interest rates, according to the Black
model, the Eurodollar futures option used can be viewed as the futures component
minus the bond component.”
Weber comments: “We can also consider options on swaps, which the Black model
views as having a bond component and a swap component. The s waption, used to
hedge against rising interest rates, can be evaluated as the swap component minus
the bond component.”
Newport has an endowment that helps support the school financially. The school has
learned the endowment will be receiving a gift of 100,000 shares of Global Industries
(GI) stock in one month. IST recommends the use of a one-month options position
to hedge against a material price decline on the stock during this period. Exhibit 2
lists the relevant GI stock and option characteristics.
Exhibit 2 GI Stock and Option Information

Stock price $77
Call and put options strike price $75
Delta call 0.5952
Delta put –0.4010
37 Franco’s understanding of the valuation of the European style six-month call

option is most likely:
A correct with respect to the payoffs and the discount rate.
B correct with respect to the payoffs but incorrect about the discount rate.
C incorrect with respect to the payoffs but correct about the discount rate.
B is correct. According to the expectations approach of options valuation, option values

are simply the present value of the expected terminal option payoffs (based on risk-
neutral probabilities) discounted at the estimated risk-free interest rate, rather than the
risk-adjusted periodic rate.
A is incorrect. The stated discount rate is correct.
C. is incorrect. The valuation method approach is correct.
Valuation of Contingent Claims

LOS f
Section 3.2
38 Based on the information shown in Exhibit 1 and using a two-step binomial

model to value the current at-the-money interest rate call option, the value of
the underlying instrument at Node 0 would most likely be:
A 1.25%.
B 1.15%.
C 1.00%.
C is correct. When using the two-period binomial model to value interest rate options,
the value of the underlying instrument at Node 0 is the spot rate. The spot rate (and the
at-the-money strike price) is the current Libor rate of 1.00%.
B is incorrect. The value of the underlying instrument is the spot rate, not the forward
rate.
A is incorrect. The value of the underlying instrument is 1.00%; 1.25% is the client’s
upper tolerance bound.

LOS d
Section 3.3
39 Franco’s description of the Black model’s approach to valuation of Eurodollar

futures options used for hedging is:
A correct.
B incorrect, because he is describing a call option.
C incorrect, because he is describing a put option.
B is correct. Franco is incorrect because he describes a long call option, which according
to the Black model can be viewed as the futures component minus the bond component.
Long put options hedge against rising interest rates. The Black model evaluates put
options as the bond component minus the futures component.
A is incorrect. The statement is incorrect.
C is incorrect. The Black model evaluates put options as the bond component minus
the futures component.

LOS j
Section 5.1
40 Is Weber’s description of the swaption used for the hedge most likely correct?
A No, because it would be correctly evaluated as the bond component minus
the swap component
B No, because he is describing a receiver swaption
C Yes
C is correct. A payer swaption would hedge against rising interest rates. According to the
Black model, the value of a payer swaption can be described as the swap component
minus the bond component.
B is incorrect. A receiver swaption hedges against falling interest rates and Weber is
describing a payer swaption.
A is incorrect. The receiver swaption is evaluated as the bond component minus the
swap component.

LOS k
Section 5.2
41 Assuming one option per share, an appropriate delta hedge for the GI stock
would most likely be to:
A sell 168,010 calls.
B sell 148,428 calls.
C buy 40,100 puts.
A is correct. The call delta is 0.5952. The number of calls to hedge 100,000 shares is
calculated as 1/0.5952 = 168,010. An appropriate hedge for 100,000 shares of stock with
a delta of 1 would be to sell 168,010 calls.
B is incorrect. This assumes DeltaH (used when selling calls against 100,000 short
puts) should be used. The portfolio delta is 1 and the put delta is –0.4010 and DeltaH
= –0.6737 (or –0.4010/0.5952), which would be used when hedging a short position of
puts on 100,000 shares of stock. Using calls, the number of hedging units is 1/–0.6737;
1/0.6737 = 148,428.
C is incorrect. The correct number of puts to purchase is calculated as 1/Delta put
or 249,376 puts.

LOS m
Section 6.1
42 If the price of GI stock approaches $75 over the next 30 days, which of the fol-
lowing changes in option parameter measures will most likely be observed?
A Decreases in vega and the absolute value of theta
B Increases in vega and the absolute value of theta
C A decrease in vega and an increase in the absolute value of theta
B is correct. Typically, theta is negative for options. The speed of the option value decline
increases, however, as time to expiration decreases. Vega is high when options are at
or near the money. During the next 30 days, the options will approach expiration and
approach being at the money.
A is incorrect.
C is incorrect. Vega increases as the options become closer to at-the-money.

LOS l
Yushan Capital Partners Case Scenario

Yushan Capital Partners is a global private equity firm with offices in Taipei, Hong
Kong, and London. It has built a strong reputation with institutional investors, offer-
ing venture capital, leveraged buyout, and special situation funds to pension funds,
endowments, and insurance companies. Pai-han Chen is a generalist analyst at Yushan.
Chen’s responsibilities include completing research projects assigned by the portfolio
teams and responding to questions from institutional consultants.
Anant Madan works as an alternative investment analyst for a consulting firm that
is advising a large pension plan that seeks to expand its private equity exposure. A
member of that plan’s investment committee asks Madan to evaluate Yushan’s current
UK Fund IX offering (Fund IX) for potential investment in the plan. As part of his
analysis, Madan reviews the offering document for Fund IX, as well as the results of
a previously offered fund with similar objectives, YCP UK Fund VI (Fund VI).
As part of his review of Fund IX, Madan has a discussion with Chen. Madan has
noticed from the offering document that Fund IX is subject to an annual reconcilia-
tion or “true-up” to address the event of a highly profitable transaction followed by
unprofitable transactions. The GP pays back capital contributions, fees, and expenses
subsequently to the LPs to ensure the profit split is in line with the terms outlined in
the prospectus. He asks Chen to explain this concept in more detail.
Chen goes on to discuss a number of other fund provisions with Madan. He
explains that the no-fault divorce clause, tag-along rights, and hurdle rate all represent
benefits to the LP investors, whereas the co-investment provision and placement fees
primarily benefit the GP.
Madan reviews the most recent annual report for Fund VI (shown in Exhibit 1)
to evaluate Yushan’s prior track record. The £300 million fund has a vintage of 2011,
management fees of 2%, carried interest of 20%, a hurdle rate of 7%, and a term of 2018.
Exhibit 1 YCP UK VI—Operating Results (£ millions) as of 31 Dec. 2016

2011 2012 2013 2014 2015 2016
Called Down 120 40 25 60 25 10

Realized Results 0 0 25 80 100 195
Unrealized –15 –35 35 25 35 60
Results
Distributions 60 110 175
Following his meeting with Madan, Chen is asked by a portfolio manager at Yushan
to do an initial review of Robologistix LTD, a potential investment opportunity. After
reviewing the company’s operating history, Chen notes the following characteristics
regarding Robologistix:
■■ limited operating history;
■■ significant product breakthrough in development, with outcome uncertain;
■■ difficult-to-forecast cash flows;
■■ weak asset base; and
■■ newly formed management team.
The portfolio manager asks Chen to determine the pre-money valuation for the
potential investment in Robologistix, using the following assumptions:
■■ Time to exit event = 6 years.
■■ Terminal value = £32 million.

■■ Amount of investment = £3.0 million.
■■ Discount return used by investors = 40%.
■■ Number of shares issued and outstanding to current shareholders = 500,000.
43 The language in the offering document that Madan asks Chen to explain most
likely describes:
A a clawback provision.
B carried interest.
C a ratchet clause.
A is correct. A clawback provision requires the GP to return capital to LPs in excess of

the agreed profit split between the LPs and GPs. This provision ensures that when a
private equity firm exits a highly profitable investment early in the life of the fund but
subsequent exits are less profitable, the GP pays back capital contributions, fees, and
expenses to LPs to ensure that the profit split is in line with the terms outlined in the
fund’s prospectus. Carried interest represents the GP’s share of profits generated by the
fund. A ratchet clause is a mechanism that determines the allocation of equity between
shareholders and the management team of the private equity controlled company.
B is incorrect. Carried interest represents the GP’s share of profits generated by the fund.
C is incorrect. A ratchet clause is a mechanism that determines the allocation of
equity between shareholders and the management team of the private equity controlled
company.
Private Equity Valuation

LOS f
Section 3.1
44 Is Chen most likely accurate regarding provisions that benefit LPs versus those
that benefit GPs?
A Yes
B No, with regard to items that benefit the LPs
C No, with regard to items that benefit the GPs
C is correct. The co-investment provision is generally favorable for LP investors. With this
provision, LPs generally have a first right of co-investing along with the GP. This can be
advantageous for the LPs because fees and profit share are likely to be lower (or zero)
on co-invested capital. The GP and affiliated parties are also typically restricted in their
co-investments to prevent conflicts of interest with their LPs. Placement fees are paid
to the fundraiser, either up front or as a trailer fee, corresponding to a fraction of the
amount invested by the limited partners.
A is incorrect. The co-investment provision is generally favorable for LP, not GP,
investors.
B is incorrect. The items Chen lists as benefits for LP investors are accurate.

LOS f, g
Section Appendix 1.3
45 The DPI value Madan calculates for Fund VI is closest to:

A 2.35×.
B 1.12×.
C 1.23×.
C is correct. DPI (distributed to paid in) is the cumulative distributions paid out to LPs as
a proportion of the cumulative invested capital. In this case, DPI = £345 (Total distribu-
tions)/£280 (Total call downs) = 1.23×.
A is incorrect; 2.35 represents the value for TVPI (DPI + RVPI) = 1.23 + 1.12.
B is incorrect; 1.12 reflects the value for RVPI = £312.6/£280.

LOS i
Section 4
46 The carried interest Yushan received in 2016 is closest to:

A £53.0 million.
B £27.4 million.
C £12.5 million.
B is correct. The solution table was constructed using the information provided
in Exhibit 1. The carried interest is shown in column 7 and is calculated as 20% times
the increase in net asset value (NAV) before distributions: 0.2 × (£545.1 – £408.3) =
£27.4 million. Note that for carried interest to apply, NAV before distribution must exceed
committed capital.
Called Mgmt. Operating Carried NAV

Down PLC Fee Results NAV Interest Distribution Post-Dist.
2011 120 120 2.4 –15 102.6 102.6

2012 40 160 3.2 –35 104.4 104.4
2013 25 185 3.7 60 185.7 0.1 185.6
2014 60 245 4.9 105 345.7 32.0 60 253.7
2015 25 270 5.4 135 408.3 12.5 110 285.7
2016 10 280 5.6 255 545.1 27.4 175 342.8
A is incorrect. It reflects the NAV in 2016 minus the total paid in capital times 20%:
0.2 × (£545.1 – £280) = £53.0 million.
C is incorrect. It reflects the carried interest amount in 2015.

LOS i
Section 4
47 Which of the following valuation methods is Chen least likely to use for
Robologistix?
A Real option method
B Discounted cash flow

C Replacement cost
B is correct. From the information provided (limited market history, weak asset base,
low cash predictability, new management team), Robologistix is most likely a venture-
stage company. Early-stage companies are best evaluated using the replacement cost
or real option methods. Discounted cash flow (DCF) valuation is more appropriate for
companies that have a longer operating history and is least appropriate for Robologistix.
A and C are incorrect. Early-stage companies are best evaluated using the replacement
cost, venture capital, or real option approaches.

LOS c, d
Section 2
48 Based on the assumptions Chen has for Robologistix, the estimated value per
share is closest to:
A £3.54.
B £4.29.
C £2.50.
C is correct. Using the basic VC method, the price per share can be calculated for the
general case in a five-step procedure (from Appendix 1.1, 1.2):
Step 1. POST = V/(1 + r): £32/[(1.4)6] = £32/7.5295 = £4.2499

Step 2. PRE = POST – I: £4.2499 – £3.00 = £1.2499 million
Step 3. F = I/POST: £3.0/£4.2499 = 70.5899%
Step 4. y = x[F/(1 – F)]: 500,000[0.7059/(1 – 0.7059] = 1,200,000
Step 5. p1 = I/y: £3,000,000/1,200,000 = £2.50
A is incorrect. A incorrectly uses POST instead of I in Step 5.

B is incorrect. B incorrectly uses 1,200,000 as the total share count, not the share count
for Yushan for its investment. After backing out the initial 500,000 shares, the price per
share is £3,000,000/700,000 = £4.2857.

LOS j
Section Appendix 1.1
Halimah Yusuf Case Scenario

Halimah Yusuf is a portfolio manager at VSL Asset Management (VSLAM), based
in Singapore. VSLAM provides customized portfolio management and investment
consulting services to institutional clients. Yusuf is meeting with new analysts, John
Cerra, Eunice Quek, and Inderjit Singh, to review the firm’s portfolio management
models and techniques.
Yusuf welcomes everyone to the meeting and begins by stating, “We use multi-
factor models for portfolio construction as well as return and risk attribution.” She
asks, “Can anyone tell me how arbitrage pricing theory (APT) is related to these
multifactor models?”
Quek responds, “APT helps us determine the appropriate number of factors to
use in a multifactor model; however, it does not specify the identity of those factors.”
Yusuf continues, “Multifactor models fall into one of three categories: macroeco-
nomic factor models, fundamental factor models, and statistical factor models. For
macroeconomic factor models, the factors are the value, or level, of selected macro-
economic variables. For fundamental factor models, the factors are company share
attributes, such as price-to-earnings ratio and market capitalization. Finally, when
using statistical factor models, we apply statistical techniques, such as factor analysis
or principal component analysis, to derive factors that are portfolios of securities that
best explain historical return covariances and variances.”
To explain the use of multifactor models for portfolio return attribution, Yusuf
presents the group with portfolio and benchmark information in Exhibit 1. She also
notes the risk-free rate of return is 1.3%.
Exhibit 1 Multifactor Model Data

Factor Sensitivity Factor
Factor Portfolio Benchmark Return
Market 1.05 1 3.5%

Small-Cap 0.5 0.3 4.7%
Value –0.6 0.2 –4.5%
Momentum 0.5 0.1 5.1%
Yusuf asks the group to use Exhibit 1 to characterize the portfolio manager’s invest-
ment style. Cerra responds, “This manager has a large-cap orientation and follows a
contrarian strategy with a growth bias.”
Yusuf continues, “Based on your review of the information in Exhibit 1 and given
that the portfolio manager’s active return from security selection is 1.5%, I would like
each of you to identify the factor that contributes the most to the manager’s active
return.” The analysts respond as follows:
Cerra says, “My calculations suggest that it is the Value factor.”
Quek responds, “I disagree. In my view, it is the Momentum factor.”
Singh states, “No, my analysis indicates that it is the Market factor.”
Finally, Yusuf provides the group with the information in Exhibit 2 and states, “As I
previously stated, multifactor models can also be used to identify a portfolio manager’s
risk exposures. Please use the information in Exhibit 2 to identify the portfolio with
the highest active factor risk related to style factors, relative to active risk.”
Exhibit 2 Active Risk Squared Analysis for Selected Portfolios (Entries Are
in Percentage Squared)
Active Factor
Industry Style Total Active Active Risk
Portfolio Factor Factor Factor Specific Squared
X 12 28 40 24 64
Y 7.2 14.4 21.6 14.4 36
Z 4 10 14 2 16
49 Is Quek’s response to Yusuf most likely correct?

A Yes.
B No, she is incorrect regarding the number of factors.
C No, she is incorrect regarding the identity of the factors.
B is correct. Quek is incorrect in stating that APT specifies the number of factors in a mul-
tifactor model but is correct in stating that APT does not specify the identity of factors
in a multifactor model. APT does not indicate the number of factors or their identity.
A is incorrect. Quek is incorrect in stating that APT specifies the number of factors in a
multifactor model but correct in stating that APT does not specify the identity of factors
C is incorrect. Quek is correct in stating that APT does not specify the identity of factors
An Introduction to Multifactor Models

LOS a
Section 3
50 In her statement about the three types of multifactor models, Yusuf is least
likely correct with respect to:
A statistical factor models.
B fundamental factor models.
C macroeconomic factor models.
C is correct. In macroeconomic models, the factors are “surprises” (how much higher or
lower than what was expected) in macroeconomic variables, not the level or value of
macroeconomic variables.
A is incorrect. Statistical models are described accurately. Statistical factor models
use factor analysis to produce factors that are portfolios of securities that best explain
historical return covariances. Alternatively, they use principal component analysis to
derive factors that are portfolios of securities that best explain historical return variances.
B is incorrect. Fundamental factor models are described correctly; the factors are
company share attributes, such as price-to-earnings ratio and market capitalization.

LOS d
Section 4
51 Based on Exhibit 1 and other information provided by Yusuf, the expected

return on the portfolio is closest to:
A 8.90%.
B 11.28%.
C 12.58%.
C is correct.
E(Rp) = RF + βp,1Market + βp,2Small-Cap + βp,3Value + βp,4Momentum

= 0.013 + 1.05 × 0.035 + 0.5 × 0.047 + (–0.6) × (–0.045) + 0.5 × 0.051
= 0.12575, or 12.58%.
A is incorrect. This calculation incorrectly neglects to add the Market factor:
0.0890 = 0.013 + 0.5 × 0.047 + (–0.6) × (–0.045) + 0.5 × 0.051
B is incorrect. This calculation incorrectly neglects to add the risk-free rate (1.3%):
0.1128 = 1.05 × 0.035 + 0.5 × 0.047 + (–0.6) × (–0.045) + 0.5 × 0.051

LOS c
Section 3
52 In his response to Yusuf, Cerra’s characterization of the portfolio manager’s

investment style, using Exhibit 1, is most likely correct with respect to having a:
A growth bias.
B contrarian strategy.
C large-cap orientation.
A is correct. Cerra is correct regarding the growth bias. The factor sensitivity for the
Value factor is –0.6, which signifies a growth bias. Cerra is incorrect regarding a large-cap
orientation and a contrarian strategy. The portfolio factor sensitivity for the Small-Cap
factor is 0.5, indicating a small-cap orientation. For the Momentum factor, the factor
sensitivity of 0.5 indicates a momentum bias, not a contrarian strategy, which would be
true if the factor sensitivity for the Momentum factor were negative and not close to zero.
B is incorrect. Cerra is incorrect with regard to the contrarian strategy. For the
Momentum factor, the factor sensitivity is 0.5, which indicates a momentum bias.
C is incorrect. Cerra is incorrect with regard to a large-cap orientation. The portfolio

factor sensitivity for the Small-Cap factor is 0.5, indicating a small-cap orientation.

LOS f
Section 5.1
53 Which of the following analysts most likely provides the correct answer to
Yusuf ’s question on the contribution to active return?
A Quek
B Cerra
C Singh
B is correct. Cerra is correct. To determine which factor contributes most to active return,
note the following:
Active return = 6.755% + 1.5% = 8.255%

= ∑[(Portfolio sensitivity) − (Benchmark sensitiv-
ity)] × (Factor return) + Security selection
Return from factor tilts = Sum of the absolute contribution to active
return
= ∑[(Portfolio sensitivity) − (Benchmark sensitiv-
ity)] × (Factor return)
= 6.755%
The proportional contribution to active return for each factor = Return from factor
tilts ÷ Active return.
The table below shows that the Value factor had the highest contribution to active
return, 43.61% (3.6% ÷ 8.255%).
Contribution to Active
Factor Sensitivity (1) – (2) Factor Return
Factor Portfolio Benchmark Difference Return Absolute Proportion
(1) (2) (3) (4) (3) × (4)
Market 1.05 1 0.05 3.5% 0.175% 2.12%

Small-Cap 0.5 0.3 0.2 4.7% 0.940% 11.39%
Value –0.6 0.2 –0.8 –4.5% 3.600% 43.61%
Momentum 0.5 0.1 0.4 5.1% 2.040% 24.71%
Return from factor tilts 6.755% 81.83%
Security selection 1.500% 18.17%
Active return 8.255% 100.00%
A is incorrect. Quek is incorrect. The Value factor has the highest contribution to
active return.
C is incorrect. Singh is incorrect. The Value factor has the highest contribution to
active return.

LOS f
Section 5.1
54 In response to Yusuf, based on the information in Exhibit 2, the portfolio with

the highest active factor risk exposure to the style factor is:
A Portfolio X.
B Portfolio Y.
C Portfolio Z.
C is correct. Portfolio Z has the highest active factor risk exposures to the style factor.
Portfolio Z active style risk squared ÷ Active risk squared = 10 ÷ 16 = 62.5%.
Portfolio X active style risk squared ÷ Active risk squared = 28 ÷ 64 =
43.75%.
Portfolio Y active style risk squared ÷ Active risk squared = 14.4 ÷ 36 = 40%.
A is incorrect. Portfolio X active style risk squared ÷ Active risk squared = 28 ÷ 64 =
43.75%.
B is incorrect. Portfolio Y active style risk squared ÷ Active risk squared = 14.4 ÷ 36 =
40%.

LOS e
Section 5.2
Trans-Capital Case Scenario

Trans-Capital Asset Management (TCAM) is a multifamily office offering investment
management services to wealthy families. In the initial stages of a client engagement,
TCAM focuses on crafting an investment policy statement tailored to the client’s
specific circumstances.
Witold Schenke, a TCAM wealth adviser, has scheduled a new client meeting
with Joachim Arndt, a successful entrepreneur who founded and owns Arndt Equity
Partners (AEP), an Austrian commercial real estate management and development
firm now valued at EUR100 million. AEP has recently decided to start paying an
annual dividend of EUR8.5 million to its owners, and Arndt is arranging the sale of
40% of AEP to a consortium of new partners for cash, which will result in the largest
amount of investable funds he has ever had available.
Arndt has completed TCAM’s client questionnaire, which Schenke has summa-
rized below.
Exhibit 1 Arndt Client Summary

Personal: Joachim Arndt, age 58; wife, Helle Arndt, age 53. Both in good
health. Helle is a successful commercial real estate broker. Two finan-
cially independent adult sons.
Income and Both Joachim and Helle enjoy their work and plan to remain active
expenses: in business and work for approximately another 12 years. Joachim’s
salary from AEP alone exceeds the couple’s annual spending needs,
and Helle earns almost as much. Income tax rate of 40%.
Exhibit 1 (Continued)
Assets: Assets consist of the remaining ownership share of AEP, a EUR5 mil-

lion bond portfolio, and their personal residence. Both have limited
experience investing in equities and as a result are uncomfortable
investing in the asset class. Dividends and capital gains are taxed at a
rate of 20%.
Estate plan: AEP shares are to be left to their two sons. The sons are employed
by AEP, and they plan to take over day-to-day management of the
company in the next five to seven years. The Arndt Family Dynasty
Trust is to be set up and funded for the benefit of grandchildren and
later generations.
At their meeting, Arndt discusses with Schenke the intended use of the funds and
explains that the AEP sales proceeds will not be needed to supplement the Arndts’
present and future spending needs. EUR12 million of the funds will be invested in
a commercial real estate partnership in the United States, and TCAM is to manage
EUR20 million. In the next eight months, ownership of these investments will be
transferred to the Arndt Family Dynasty Trust.
In preparation for the meeting with Schenke, Arndt has prepared an investment
policy statement, shown in Exhibit 2.
Exhibit 2 Investment Policy Statement for Joachim Arndt

Goal 1: The investment return goal of the portfolio managed by TCAM
should match the return goal of the US commercial real estate
partnership, which is approximately 1% monthly.
Goal 2: Under normal circumstances, the maximum loss on the TCAM
portfolio should not exceed 5% in any given year.
Constraint 1: No more than EUR5 million of the TCAM portfolio is to be
invested in a diversified mix of equities. The remainder should be
in a diversified mix of intermediate-term bonds generating stable
cash flows.
Constraint 2: Capital gains taxes will be due in eight months. Arndt’s tax cost
basis in AEP was essentially zero.
Constraint 3: Funds will not be drawn from the portfolio until the Arndts’ infant
grandchildren need to supplement post-university education and
living expenses.
Schenke points out that TCAM adopts a portfolio perspective when approaching
investment management and views portfolio management as a process consisting
of three steps: a planning step, an execution step, and a feedback step. Shenke also
presents the information provided in Exhibit 3.
Exhibit 3 Long-Run Capital Market Expectations

Standard
Asset Class Expected Returns Deviation
European fixed income 3.5% 6%

European equities 7% 12%
US real estate 4% 12%
55 Based on Exhibit 1, Arndt’s risk tolerance and liquidity constraints should most
likely be described as combining a high:
A ability to take risk with high liquidity risk.
B ability to take risk with low liquidity risk.
C willingness to take risk with low liquidity risk.
B is correct. Arndt has above average ability to take risk and low liquidity risk. The multi-
generational time horizon allows for an above average ability to take risk, and liquidity is
not required from the investments for spending needs. Capital gains taxes of EUR8 million
(20% tax rate of EUR40 million total proceeds) are only a portion of the sales proceeds
and are not at risk of being uncovered. The amount of income from the couple’s salaries
plus the AEP dividends will prevent investment portfolio volatility from affecting their
financial abilities. Current income and savings cover all current liquidity needs.
A is incorrect. Arndt has low liquidity risk. Spending needs are covered through earned
income and dividend payments.
C is incorrect. Arndt has a low willingness to take risk. The Ardnts do not wish to have
more than a EUR5 million invested in equities and want to avoid annual drawdowns
greater than 5%.
The Portfolio Management Process and the Investment Policy Statement

LOS e
56 Based on Exhibit 2, which of Arndt’s goals and constraints are least likely con-
sistent with each other?
A Goal 2 and Constraint 1
B Goal 1 and Constraint 3
C Goal 2 and Constraint 3
C is correct. Goal 2, which defines the maximum annual loss of 5% under normal circum-
stances, and Constraint 3, which defines the long time horizon before funds will first
be needed, are least consistent with each other. The long time horizon would normally
indicate a higher-than-average ability to take risk, making Goal 2—which limits the
annual unrealized loss—inconsistent with Constraint 3.
A is incorrect. The low maximum annual loss defined in Goal 2 is consistent with the
low allocation in equities defined in Constraint 1.
B is incorrect. The high return objective of Goal 1 is consistent with the long time
horizon of Constraint 3

LOS e, f
Section 6.2
57 Based on Exhibits 1 and 2, the time horizon for Arndt’s TCAM portfolio can be
best described as:
A a single-stage long-term time horizon.
B a multistage time horizon—the first lasting eight months, followed by an
indefinite long-term time horizon.
C a multistage time horizon—the first lasting approximately 12 years, followed
by an indefinite long-term time horizon.
A is correct. Arndt’s TCAM portfolio has a single-stage long-term time horizon. The
portfolio will be held in a trust for the grandchildren, from which funds will probably
not be required for at least 20 years and will continue to be managed for subsequent
generations. These funds are not needed for the Arndts’ spending needs.
B is incorrect. In the next eight months, the real estate investment will be made and
taxes will be due. These will not change the long-term time horizon of the portfolio for
the benefit of the grandchildren and later family generations.
C is incorrect. The Arndts may retire in 12 years, but they have sufficient financial
resources from other sources. The time horizon of this portfolio is not affected by
retirement needs.

LOS f
Section 6.2
58 Which of Arndt’s planned investment asset allocations most likely violates

TCAM’s portfolio perspective approach to investment management?
A Diversified equities
B US commercial real estate
C Diversified intermediate- to long-term bonds
B is correct. Arndt has ignored the importance of diversification (and a portfolio perspec-
tive) in his decision to add to his commercial real estate investments. Commercial real
estate already represented more than 90% of the Arndts’ assets before the sale. Equities
and intermediate-term bonds would offer a diversifying benefit to the entire portfolio.
A is incorrect. Equities could serve as a diversifier to commercial real estate.
C is incorrect. Bonds could serve as a diversifier to commercial real estate.

LOS a
Section 3
59 In the context of the portfolio management process, Schenke’s responses to

Arndt in their meeting are most likely intended to serve as components of the:
A feedback step.
B execution step.
C planning step.
C is correct. Schenke and Arndt are discussing the Arndts’ objectives and constraints in
order to create an investment policy statement (IPS). These are all parts of the planning
step of the portfolio management process. The feedback step of the portfolio manage-
ment process does not refer to Schenke’s responses to Arndt’s comments and questions.
A is incorrect. Feedback refers to monitoring, rebalancing, and portfolio evaluation.
B is incorrect. Preparing an IPS is part of the planning step.

LOS b
Section 5
60 In order to create Arndt’s strategic asset allocation, Shenke will most likely use
information from:
A Exhibits 2 and 3.
B Exhibit 2 only.
C Exhibit 3 only.
A is correct. In order to create a strategic asset allocation for Arndt, Schenke combines
information from the IPS (Exhibit 2) and capital market expectations (Exhibit 3). The
strategic asset allocation will include target asset class weights and maximum and min-
imum permissible asset class weights, which are specified as risk control mechanisms.
B is incorrect. Information from Exhibits 2 and 3 is required.
C is incorrect. Information from Exhibits 2 and 3 is required.

LOS d
Section 5.1

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1–6 Ethical and Professional Standards 18

2019 LEVEL II MOCK EXAM AM

Lucas Thorpe Case Scenario

1 As a result of Thorpe’s admission he traded in Savanna shares, which CFA

Guidance for Standards I–VII

A is correct. It is not necessary for Thorpe to revise the information he submitted to

Guidance for Standards I–VII

3 Did Thorpe most likely violate CFA Institute Standard I: Professionalism by

Guidance for Standards I–VII

4 Which of Thorpe’s information-­gathering techniques described to the Hearing

Guidance for Standards I–VII

5 Which of the draft policies concerning Standard II(A): Material Nonpublic

Guidance for Standards I–VII

C is correct. Thorpe violated Standard IV(A): Loyalty by establishing a new disciplinary

Guidance for Standards I–VII

Litvenko Consulting Case Scenario

Rt+1 = the expected return on the security in the next period

Exhibit 1 Selected Regression Data for Storcon, Inc.

Intercept (b0) 0.040

List of Variables to Be Used in Machine Learning Trial

B is correct. Epstein estimates the next-­period return as

Rt+1 = b0 + b1 × (Rmt – Rft) + b2 × SMBt + b3 × HMLt + b4 × Dt + b5 ×

Rt+1 = the expected return on the security in the next period

Rt+1 = b1 × (Rmt – Rft) + b2 × SMBt + b3 × HMLt + b4 × Dt + b5 × RIt

Rt+1 = b0 + b1 × (Rmt – Rft) + b2 × SMBt + b3 × (–HMLt) + b4 × Dt + b5 ×

Multiple Regression and Machine Learning

Multiple Regression and Machine Learning

9 The most appropriate way to address the outperformance issue discussed by

Multiple Regression and Machine Learning

B is correct. Supervised learning is a form of machine learning where labeled or tagged

Multiple Regression and Machine Learning

Multiple Regression and Machine Learning

Multiple Regression and Machine Learning

Trana Case Scenario

Exhibit 1 Trana AB Income Statements for the Years Ended 31 December

Sales 30,200 26,892 4,700 4,653

Exhibit 2 Exchange Rates

Beginning 2014 8.43 6.32

Exhibit 3 Number of Stores by Region

2014 340 99 80 519

Calculations SEK (millions)

Number of stores in the United States 80

Number of stores in the United States 80

C is incorrect. It uses year-­end rates instead of average rates to convert sales

Number of stores in United States 80

European sales (given) (in SEK18,394 SEK21,640

A is incorrect. This does not adjust for the FX.

European sales (in millions) SEK18,394 SEK21,640

16 Which of the following is Lars’s most appropriate answer to Eriksson’s question

Tax Effect Under

Swedish earnings SEK338 74.4 55.8 SEK18.6

B is incorrect. It is only the EBT in Sweden: 338 × (0.22 – 0.165) = 18.6.

Barbara Carlyle Case Scenario

Exhibit 1 Avignon Corporation Earnings and Dividend

EPS C$1.38 C$1.39 C$1.37 C$1.44

Exhibit 2 SpeedyPro, Inc. Selected Financial Information

Exhibit 3 Avignon Corporation Selected Financial

19 Based on Exhibit 1, Avignon’s current dividend policy is best described as a:

B constant dividend payout ratio policy.

C is correct. Avignon’s current dividend policy would be classified as stable because

Dividends and Share Repurchases: Analysis

Dividends and Share Repurchases: Analysis

21 Which of Lee’s statements to Carlyle about share repurchases is least accurate?

4 Which of Thorpe’s information-gathering techniques described to the Hearing

Exhibit 1 Selected Regression Data for Storcon, Inc.

B is correct. Epstein estimates the next-period return as

Exhibit 1 Trana AB Income Statements for the Years Ended 31 December

Exhibit 2 Exchange Rates

Exhibit 3 Number of Stores by Region

C is incorrect. It uses year-end rates instead of average rates to convert sales

Exhibit 1 Avignon Corporation Earnings and Dividend

Exhibit 2 SpeedyPro, Inc. Selected Financial Information

Exhibit 3 Avignon Corporation Selected Financial

Exhibit 1 Cratt Ltd. Press Release Core EPS Announcement

* Core EPS is a non-GAAP measure that excludes acquisition charges of $0.18

Exhibit 2 Partial Results of Market Screen of Companies in

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Exhibit 1 Bond Price Information

Exhibit 2 GI Stock and Option Information

37 Franco’s understanding of the valuation of the European style six-month call

38 Based on the information shown in Exhibit 1 and using a two-step binomial

Exhibit 1 YCP UK VI—Operating Results (£ millions) as of 31 Dec. 2016