2018 Level II Mock Exam PM

The afternoon session of the 2018 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 Economics 18
13–18 Financial Reporting and Analysis 18
19–24 Financial Reporting and Analysis 18
25–30 Corporate Finance 18
31–36 Equity 18
37–42 Equity 18
43–48 Fixed Income 18
49–54 Fixed Income 18
55–60 Alternative Investments 18
Total: 180

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currently registered CFA candidates. Candidates may view and print the exam for personal exam prepara-
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© 2017 CFA Institute. All rights reserved.
2

2018 LEVEL II MOCK EXAM PM

Theresa LeCompte Case Scenario

Theresa LeCompte, CFA, is an equity analyst for Topaz Group, a full-­service financial
firm that offers insurance, investment banking, brokerage, and investment manage-
ment services through its various divisions. Topaz has adopted the CFA Institute
Research Objectivity Standards to demonstrate their commitment to managing and
fully disclosing conflicts of interest to all investors with access to the firm’s research.
LeCompte’s primary responsibility is to follow the information technology sector
for the firm’s research department that provides the research to Topaz clients and
sells it to outside parties. She is working on two follow-­up reports for NanoMem and
UniFlash. Topaz makes markets in both companies’ securities and LeCompte owns a
small position in NanoMem only.
LeCompte has an excellent relationship with company officials at NanoMem, and
her past research reports made favorable recommendations regarding NanoMem. In
appreciation for her work on NanoMem, last December LeCompte was invited to attend
a company-­sponsored event held at an exclusive beach resort overseas. NanoMem paid
all expenses related to the trip and provided some excellent entertainment activities
for attendees. Prior to participating, LeCompte disclosed the agenda for the trip to
her supervisor at Topaz, but did not mention details concerning expenses since they
were not what she considered material. Shortly after LeCompte returned from this
trip, Topaz was named the lead underwriter for NanoMem’s upcoming secondary
offering. LeCompte believes her excellent relationship with NanoMem played a large
part in securing this business.
LeCompte, however, considers her relationship with UniFlash to be contentious
since company officials appear reluctant to share as much information with her as
they have in the past. She believes this change in behavior is a direct result of the
recent less-­than-­favorable reports she wrote on UniFlash. Prior to publication of her
follow-­up reports on both NanoMem and UniFlash, LeCompte shares her report on
NanoMem in its entirety with top management at NanoMem. UniFlash management
on the other hand is provided only the factual information component of LeCompte’s
UniFlash report.
LeCompte’s compensation at Topaz includes an annual salary plus a bonus based
on both the accuracy of her recommendations over time and the overall profitability
of the group. Topaz makes public disclosure of the extent to which research analyst
compensation in general is dependent upon the firm’s investment banking revenues,
identifying the exact dollar amounts moved from one unit to the other.
Following the release of her reports in early March, LeCompte is invited to appear
on a television program to discuss her recommendations. During her appearance, she
makes the following statements:
Statement 1 My firm makes markets in the securities of both NanoMem and
UniFlash, and I personally own a position in NanoMem.
Statement 2 Although my report on UniFlash issued last quarter reflected
a neutral rating, after meeting with management yesterday,
I now believe a sell rating is more appropriate. I am finaliz-
ing an updated research report for UniFlash that I will release
tomorrow.
When she returns to her office the following day, LeCompte is informed by her
supervisor that a company official at UniFlash called to express his disappointment
and anger regarding the negative remarks she made about UniFlash during her
 3

television appearance. LeCompte states she believes her deteriorating relationship

with UniFlash will make it difficult to eff ectively cov er the com pany in the fut ure.
Privately, she wonders if she should revise her recommendation, ask permission of
her supervisor to discontinue coverage of UniFlash, or request another analyst be
assigned to the company.
1 Before attending the company-sponsored event, which of the following actions
is least appropriate for LeCompte to take to avoid violating any CFA Institute
Standards?
A Disclose the costs of attendance to her immediate supervisor.
B Request her company pay costs related to her attendance.
C Decline the invitation.
2 In sharing her research material with the subject companies, LeCompte most
likely violated CFA Institute Research Objectivity Standards with respect to her
report(s) on:
A Both NanoMem and UniFlash.
B UniFlash.
C NanoMem.
3 Regarding LeCompte’s compensation structure, is Topaz most likely in violation
of the CFA Institute Research Objectivity Standards?
A No.
B Yes, with respect to overall profitability of the group.
C Yes, with respect to accuracy of analyst recommendations.
4 According to the CFA Institute Research Objectivity Standards, does
LeCompte’s first statement made during her television appearance most likely
provide all the recommended disclosures relating to potential conflicts of
interest?
A No, proper disclosures were only made with respect to UniFlash.
B Yes.
C No, proper disclosures were only made with respect to NanoMem.
5 Does LeCompte’s second statement during her TV appearance most likely meet
the CFA Institute Research Objectivity Standards recommendations?
A No, with regards to her inconsistent recommendations.
B Yes.
C No, with regards to the timing of her updated research report.
6 With respect to LeCompte’s coverage of UniFlash, according to the CFA
Institute Standards of Professional Conduct, the least appropriate course of
action for Topaz to take would be to:
A discontinue coverage.
B change assigned analyst.
C upgrade recommendation.

Charles Hollingsworth Case Scenario

Charles Hollingsworth is an investment strategist at Drawbridge Asset Partners
(Drawbridge), an international investment firm. He is meeting with equity analyst
Andrew Gillibrand and fixed-­income analyst Eliana Navarro to discuss new invest-
ment opportunities and the economic factors they should consider as they make their
investment selections.
4

Hollingsworth begins the meeting with the following statement:

“Before we look at new investment opportunities, I want to review some
prior transactions. A few months ago, Drawbridge entered into a carry trade
in a set of currencies. This morning, we were unfortunately forced to close
out the position at a sizable loss as a result of unexpected market volatility.”
Hollingsworth continues:
“Earlier in the year, Drawbridge hedged a long exposure to the Australian
dollar (AUD) by selling AUD 5 million forward against the US dollar (USD);
the all-­in forward price was 0.8940 (USD/AUD). It is now three months prior
to the settlement date, and I want to mark the forward position to market.”
Exhibit 1 provides information about current rates in the foreign exchange markets.

Exhibit 1  Current Foreign Exchange Data

Spot rate (USD/AUD) 0.9062/0.9066
Three-­month points –36.8/–36.4
Three-­month Libor (AUD) 2.88%
Three-­month Libor (USD) 0.23%

On completion of the agenda items relating to the foreign exchange markets,

Hollingsworth and his team move on to new investment opportunities. They begin
with a discussion about the relationship between economic growth and the perfor-
mance of equity and debt markets.
Gillibrand: “When we consider our equity investments over the long term, our
primary focus should be on the rate of GDP growth. For longer time horizons,
changes in earnings and the price/earnings multiple are relatively less important
in determining appreciation in the stock market.”
Navarro: “When we look at our fixed-­income investments, we should keep in
mind that higher rates of potential GDP growth will translate into higher real
interest rates and higher expected real asset returns.”
Hollingsworth: “Anticipating changes in potential GDP can be quite lucrative
for us because credit rating agencies often use the growth of potential GDP as
an input in evaluating sovereign risk. In general, there is an inverse relationship
between estimated potential GDP growth and credit quality.”
The economic growth projections for two of the countries in which Drawbridge is
considering making new investments are presented in Exhibit 2. Hollingsworth prefers
the Solow growth accounting equation to calculate potential GDP growth rather than
the more simplistic labor productivity growth accounting equation.
2018 Level II Mock Exam PM 5

Exhibit 2  Long-­Term Growth Projections

Growth in
Total Factor Output
Inflation Productivity Elasticity Growth Rate Growth Rate
Country Rate (%) (%) of Capital of Capital (%) of Labor (%)

Country A 1.7 1.5 0.3 3.2 0.4

Country B 1.8 1.3 0.4 3.7 0.5

The conversation then turns to the topic of convergence. Navarro says: “Even
though Country B’s per capita growth is expected to exceed that of Country A for
some time, according to the neoclassical model, eventually both countries will expe-
rience the same growth rate because the model assumes all countries have access to
the same technology.”
Hollingsworth presents the long-­term relative performance of Countries C and
D, shown in Exhibit 3. Although both countries had below-­average levels of per cap-
ita GDP 50 years ago, over time, the per capita GDP growth rate of Country C has
risen rapidly and for nearly 20 years has been well above average. The growth rate
for Country D, however, has risen more slowly. Today, Country C ranks among the
advanced economies whereas Country D remains a developing nation.

Exhibit 3  Real Per Capita GDP Growth

GDP/Capita 50 GDP Growth Rate
Country Years Ago GDP/Capita Today over Past 50 Years

Country C 6,950 35,190 3.30%

Country D 8,240 20,410 1.83%

7 The primary factor that was most likely the cause of Drawbridge's outcome in its
carry trade was:
A stop-­loss orders.
B flight to safety.
C leverage.
8 The mark-­to-­market value for Drawbridge’s forward position is closest to:
A –USD44,774.
B –USD44,800.
C –USD42,576.
9 Which of the statements about economic growth and the performance of equity
and debt markets is the least accurate?
A Navarro’s
B Hollingsworth’s
C Gillibrand’s
10 Based on the data in Exhibit 2, the GDP growth rate in Country A using
Hollingsworth’s preferred method of calculation is closest to:
A 2.74%.
B 2.94%.
6 2018 Level II Mock Exam PM

C 2.86%.
11 Navarro’s statement about the convergence of growth between Country A and
Country B is best described as:
A conditional convergence.
B club convergence.
C absolute convergence.
12 Country D’s current economic status can best be explained by past government
policies that encouraged:
A domestic substitutes.
B foreign investment.
C free trade.

Sunjet Airlines Case Scenario

Sunjet Airlines Ltd. (Sunjet), a US-­based “no frills” carrier, has the following existing
non-­domestic operations.
■ Nanuk Air Inc. (Nanuk) is a Canadian carrier that Sunjet purchased several
years ago. It provides service to remote mining operations in the Canadian
north. The company has been very profitable, and it recently financed a renewal
of its fleet of seaplanes with CAD-­denominated long-­term debt.
■ Sunjet Mexico SA (SunMex) was established on 1 April 2016 to facilitate expan-
sion of the Sunjet network to six Mexican destinations. The company purchased
hangar assets in Mexico that were 100% financed with MXN-­denominated
loans guaranteed by Sunjet, and operations began shortly thereafter. Although
most of SunMex’s revenues are generated in the US vacation travel market, the
company also serves domestic Mexican passengers. These MXN-­denominated
sales amounted to approximately 10% of SunMex’s fiscal 2016–17 revenues, and
they are expected to remain below 15% in the future.
Today is 30 April  2017, one month after Sunjet’s fiscal year end, and the CEO,
Mark Napier, is meeting with the CFO, Lisa Cameron, to discuss the international
operations. Napier mentions that he will be meeting next week with the president
of SunMex to discuss the first year of operations. Cameron pulls out the draft year-­
end results (Exhibit 1) and some exchange rate data (Exhibit 2). She notes that the
SunMex president’s bonus is tied to fixed asset turnover and net income targets. She
reminds Napier that the bonus thresholds are evaluated based on the translated USD-­
denominated financial statements rather than the MXN-­denominated ones, and she
promises to send the translated version once the results are finalized.

Exhibit 1  Summarized Draft Financial Statements for

SunMex, Fiscal 2016–17 (MXN millions)
Cash and accounts receivable 47
Fixed assets (net) 370
Total assets 417

Current liabilities 33
Long-­term debt 224
Common shares 160
Retained earnings 0
2018 Level II Mock Exam PM 7

Exhibit 1  (Continued)

Total liabilities and shareholders’ equity 417

Sales 140
Depreciation expense 20
Other expenses 120
Tax expense 0
Net income 0

Exhibit 2  Selected Exchange Rates

USD per MXN CAD per USD

31 March 2017 0.0513 1.352

Average for fiscal 2016–17 0.0538 1.340
1 June 2016 0.0625 1.300
31 March 2016 0.0625 1.303
Average for fiscal 2015–16 0.0855 1.312

Nanuk, which prepares its translated statements using the current rate method,
is next on the agenda. Cameron reports that annual translated USD-­equivalent sales
are up from 22.3 million last year to 23.7 million this year. Cameron reminds Napier
that one of the performance metrics in the bonus calculation for Nanuk’s president
is Nanuk’s sales growth determined in the local currency. Napier asks Cameron to
calculate that figure for the 2016–17 fiscal year.
Napier also asks Cameron what effect Nanuk’s translated statements will have on
Sunjet’s other comprehensive income for the current year.
Next, they consider the exchange rate exposure on Sunjet’s recent purchase of five
new aircraft. The aircraft were purchased from a British supplier for GBP7 million
each. Payment terms were agreed to as 20% due on order, with the remainder paid one
year after delivery. Sunjet took delivery of the aircraft on 30 June 2016. Final payment
is due on 30 June  2017. Exhibit  3 shows the exchange rates between the USD and
GBP since 30 June 2016.

Exhibit 3  USD per GBP Exchange Rates

30 June 2016 1.4746
Average, 1 July 2016–31 March 2017 1.4652
31 March 2017 1.4360
8 2018 Level II Mock Exam PM

Finally, Cameron tells Napier that Sunjet is considering the purchase of 70% of
the shares of Swift Aviation Ltd. (Swift), which operates exclusively in Australia. The
remaining 30% of shares would continue to be listed on the Australian Securities
Exchange. Sunjet intends to have Swift’s existing management team run the company
with little interference.
13 Under which translation method for non-­domestic operations will SunMex’s
fixed asset turnover most likely be higher?
A The temporal method
B The current rate method
C There will be no difference.
14 On translation, SunMex’s USD-­denominated net income most likely includes:
A a re-­measurement gain of $2.526 million.
B a re-­measurement loss of $1.792 million.
C no re-­measurement gains or losses.
15 In the bonus calculation for Nanuk’s president, the sales growth that is to be
used is closest to:
A 10.3%.
B 6.3%.
C 8.5%.
16 The best answer to Napier’s question about the effect of Nanuk on Sunjet’s other
comprehensive income is that Nanuk’s:
A net asset exposure will generate a re-­measurement gain.
B net liability exposure will generate a re-­measurement gain.
C net asset exposure will generate a re-­measurement loss.
17 The exchange gain, in USD thousands, that Sunjet had incurred at year end on
the payment owed to the British aircraft supplier is closest to:
A 1,351.
B 1,081.
C 263.
18 Which translation method will Swift use to convert its financial statements into
USD for inclusion in Sunjet’s consolidated statements?
A The current rate method, because its functional currency is the AUD.
B The current rate method, because its local currency is the AUD.
C The temporal method, because its functional currency is the USD.

Galaxy Electronics Case Scenario

Bogdan Andrei, an independent equity analyst, is working on his analysis of Galaxy
Electronics Ltd. Galaxy is a manufacturer and distributor of foldable smartphones
that focus on security, encryption, and identity protection. The company prepares its
financial statements in accordance with US GAAP. From its inception in 2009, the
company grew rapidly to 2013, but in early 2014 sales growth slowed significantly.
Andrei is reviewing recent changes in the company’s financial reporting to assess the
company’s quality of financial reporting and earnings.
2018 Level II Mock Exam PM 9

Andrei starts with the notes he made following an update issued by Nadeen Bhatty,
Galaxy’s vice president of finance, on financial reporting changes Galaxy implemented
in 2014.
■■ Galaxy produces its smart phones based on orders received. A 25% deposit is
required for all orders, and then Galaxy manufactures and usually ships the
units in two to four weeks. Some orders are placed even further in advance, and
some shipments may not occur for up to two months following an order. Galaxy
had been recording a sale when the product was shipped, but under Bhatty’s
revised policy, the revenue recognition point now occurs when the deposit is
received. “If the products are made to order, then the critical event is the receipt
of the order,” she had explained.
■■ As of 31 August 2014, Galaxy received deposits of $3 million for orders yet to
be shipped.
Andrei compares the descriptions of warranty expenses from the 2013 and 2014
management discussion and analysis (MD&A), shown in Exhibit 1, and observes that
similar information is included among the notes to the financial statements.

Exhibit 1  Excerpts from Galaxy’s MD&A ($ thousands)

2013 Warranties 2014 Warranties

■■ The company provides a one-­year ■■ The company provides a one-­year war-

warranty on its products and records
it as a selling and administrative
expense at the time of sale. The 2013
warranty expense recognized is
$5,000
■■
ranty on its products. After five years of
experience the company has realized that
the actual claims experience has been
less than the amounts accrued and has
revised our warranty estimation rate.
The company also believes its produc-
tion process has become very reliable.
Therefore, in 2014 warranty expense
($2,000) is included in non-­operating
expenses.

Andrei next reviews the comparative financial information for Galaxy in Exhibit 2

Exhibit 2  Galaxy Electronics Ltd. (US$ thousands)

Condensed Income Statement Year Ended 31 August
2014 2013 2012

Sales $100,000 $95,000 $65,000

Gross profit 53,000 47,500 31,200
Operating expenses 32,000 38,000 28,000
Non-­operating expenses 4,400 2,700 3,000
Earnings before taxes 16,600 6,800 200
Net Income $11,122 $4,556 $134
10 2018 Level II Mock Exam PM

Excerpts from Galaxy’s Balance Sheet, 31 August

2014 2013

Assets
Cash and investments $21,122 $25,000
Accounts receivable 25,000 13,500
Inventories 9,000 6,500
Prepaids and deferrals 4,000 2,000
Total current assets $59,122 $47,000
Total Assets $131,122 $127,000

Liabilities
Accounts payable $15,000 $11,000
Unearned revenue 4,000
Warranty provision 2,000 4,000
Current portion of long term debt 5,000 5,000
Total current liabilities $22,000 $24,000
Long term debt 35,000 40,000
Total liabilities $57,000 $64,000

Andrei prepares a Beneish Model analysis, shown in Exhibit 3, to assess the like-
lihood that Galaxy is manipulating its earnings. He recalls that an M-­score of –1.78
corresponds to a probability of earnings manipulation of 3.8%.

Exhibit 3  Galaxy 2014 Beneish Model M-­Score Determination

Value Beneish
of Model
Variable Name Variable Variable Coefficient Contribution

Days sales in receivables index DSRI 1.759 0.92 1.619

Gross margin index GMI 0.943 0.528 0.498
Asset quality index AQI 0.814 0.404 0.329
Sales growth index SGI 1.053 0.892 0.939
Depreciation index DEPI 0.932 0.115 0.107
Sales, general, and administra- SGAI 0.95 –0.172 –0.163
tive expenses index
Accruals Accruals 0.107 4.67 0.499
Leverage index LEVI 0.861 –3.270 –2.815

Intercept –4.840
M-­score –3.83
2018 Level II Mock Exam PM 11

Finally, Andrei reviews his notes on Galaxy’s executive compensation. Since 2011,
annual executive compensation has included stock options on the company’s stock.
On 1 September 2014, the company introduced a restricted stock grant program for
all non-executive employees who had worked at the company for three years or more:
■■ The fair value of the company’s stock at the grant date was $4.2 million.
■■ For the shares to vest, it requires a three-­year service period—that is, the
employee has to remain with the company for another three years.
The average volatility of the company’s stock had been in the range of 38%–42%
during 2009–2011, but since 2012, it has declined to the 19%–24% range.
19 Which of the following is most likely a warning sign of deteriorating earnings
quality? The new policy relating to:
A warranty expenses.
B compensation using stock grants.
C revenue recognition.
20 The amount that the new revenue recognition policy contributed to gross profit
in fiscal 2014 ($ millions) is closest to:
A 4.8.
B 1.6.
C 6.4.
21 The best conclusion Andrei can make about the classification of warranty
expenses in 2014 is that Galaxy’s:
A earnings quality is lower.
B financial reporting quality is lower.
C return on sales is improved.
22 Which of the following from Andrei’s Beneish M-­score determination is the
best indicator that Galaxy could be manipulating earnings?
A The total M-­score
B The days sales in receivable index
C The leverage index
23 The fiscal year 2015 stock-­based compensation expense from the stock grant
program will be closest to:
A 1.4 million.
B 4.2 million.
C 0.
24 If the recent changes in the volatility of the company’s stock persist, it will most
likely affect the company’s compensation expense for:
A executives only.
B non-­executive employees only.
C both non-­executive employees and executives.

National Plastics Case Scenario

National Plastics Corp. is a leading manufacturer of high-­quality injection-­molded
plastic packaging materials used by various industries, primarily food and bever-
age processing and packaging firms. In late November 2012, the company received
12 2018 Level II Mock Exam PM

approval for two important patent applications—one providing for improved tamper
protection for plastic containers and another for an improved biodegradable plastic
film that allows for better food preservation.
On 4 January 2013, Haines Foods and Snacks, Inc., launched a hostile takeover
bid for all of the shares of National at $30 per share (a $5 premium in excess of the
pre-­bid price). Haines Foods is a national distributor of deli and dairy products. If its
bid is successful, it plans to continue to operate National as a wholly owned subsidiary.
Zenith ThermoPlastics Inc. produces plastic containers and bags that are used
by the food and beverage industry. Keith Whelan, who is both chief executive officer
and chief financial officer of Zenith, had been in discussions with National to either
purchase or license their newly patented technologies. As a possible alternative, in
view of the Haines bid, Whelan began to consider having Zenith make its own take-
over bid for National.
Whelan provided National’s most recent financial statements, shown in Exhibits
1, 2, and 3, to one of his assistants, Mike Noth, with directions to calculate National’s
free cash flow using the discounted cash flow approach as a first step in determining
the maximum value that Zenith should be willing to pay for National’s shares.

Exhibit 1  National Plastics Corp. Selected Financial Data, for Year Ending 31
December
($ millions) 2012

Revenues 1,614
Cost of goods sold 841
Selling, general, and administrative expense 436
Earnings before interest, taxes, depreciation, and amortization 337
(EBITDA)
Depreciation expense 61
Operating income 276
Interest expense 47
Pretax income 229
Income tax (32%) 73
Net income 156

Share Information

Number of outstanding shares (millions) 60

2012 Earnings per share $2.60
2012 Dividends paid (millions) $37
2012 Dividends per share $0.62

Exhibit 2  National Plastics Corp. Consolidated Balance Sheets ($ millions)

At 31 December 2012 2011

Cash and cash equivalents $8 $5

Other current assets 315 295
Total current assets 323 300
2018 Level II Mock Exam PM 13

Exhibit 2  (Continued)

At 31 December 2012 2011

Fixed assets 1,384 1,250
Less Accumulated depreciation 181 120
Fixed assets, net 1,203 1,130
Total assets $1,526 $1,430

Current liabilities $696 $670

Long-­term debt 562 611
Common stockholders’ equity 268 149
Total liabilities and stockholders’ equity $1,526 $1,430

Exhibit 3  Other Financial Information for National Plastics

Corp. as of 31 December 2012
Effective tax rate 32.00%
Cost of equity 12.00%
Weighted average cost of capital 9.00%

Noth soon returns and points out that the free cash flows from National will
differ in future years as a result of its new patents—he suggests that, just as Zenith
wanted to license the technology, other plastic firms would also be interested. Noth
also suggests that because National has a lower debt-­to-­equity ratio than the rest of
the industry, it could support more debt, so he has adjusted the weighted average
cost of capital (WACC) accordingly. Noth’s projected cash flows and other estimates
are provided in Exhibit 4.

Exhibit 4  Estimates and Assumptions of Mike Noth Used in Valuing

National Plastics as of January 2013 ($ millions except WACC)
2013 2014 2015 2016 Thereafter

End-­of-­year free cash flow 170 165 180 195 Growth at 5% a year
to firm

WACC 10.50%
Total debt immediately 650
following acquisition

After a discussion about the appropriate cash flow estimates and discount rates
to use in determining the value of National to Zenith, Whelan decides that Zenith
should make a mixed offer for all of National’s shares at $35 per share, consisting of
$23 in cash and Zenith common stock with an exchange ratio of 0.24. The details of
the offer are in Exhibit 5.
14 2018 Level II Mock Exam PM

Exhibit 5  Details of Zenith’s Planned Tender Offer for All of National

Plastics’ Common Shares
National Plastics Zenith ThermoPlastics

Pre-­merger price $25/share $50/share

Shares outstanding 60 million 100 million

Tender Offer Zenith will pay $35 per share

for National, consisting of $23
in cash and Zenith common
shares with an exchange ratio
of 0.24.
Post-­merger Following the merger, Zenith’s
shares are expected to be priced
at $53/share.
Synergies from the Zenith believes that most of
merger the synergies arising from
the merger will result from
National’s new patents.

Because National and Zenith are based in the United States, Whelan also decides
to have Noth calculate the pre- and post-­acquisition Herfindahl–Hirschman Index
(HHI) for the industry. Noth’s HHI calculations are 1,910 pre-­acquisition and 2,000
post-­acquisition. Based on the HHI values, Whelan concludes that (1) the industry
is currently highly concentrated, but (2) under applicable US law, an increase in the
HHI of less than 100 should not generate any governmental challenges to block the
acquisition of National.
When Whelan presents Zenith’s proposed takeover to the board of directors the
following day, one of the directors made the following statements:
1 Although I am certainly in favor of this takeover, I think we would achieve the
greatest value from the acquisition if we offered more stock and less cash.
2 If Zenith does not realize the potential synergies of this acquisition in the next
five years, I suggest a “spin-­off ” as a means to recover some of the money lost in
this venture.
3 A positive initial market reaction will confirm that we did not overpay for
National.

25 If Haines Foods is successful in its attempt to acquire National Plastics, the

business combination is best classified as which type of merger?
A Vertical, backward
B Horizontal, conglomerate
C Vertical, forward
26 National’s free cash flow to the firm (FCFF) for 2012 is closest to (in millions):
A $121.
B $182.
C $104.
27 Based on Noth’s assumptions in Exhibit 4, the most that Zenith should be will-
ing to pay per share of National is closest to:
A $51.
2018 Level II Mock Exam PM 15

B $40.
C $60.
28 Based on Zenith’s proposed tender offer and information in Exhibit 5, the syn-
ergy arising from this merger is closest to (in millions):
A $1,063.
B $643.
C $943.
29 The most accurate interpretation of Whelan’s conclusions concerning the pre-
and post-­acquisition HHI is that they are:
A both correct.
B incorrect in regard to the industry being highly concentrated.
C incorrect in regard to the increase in HHI necessary to trigger a governmen-
tal challenge to the acquisition.
30 Which of the statements made by the member of the Board of Directors is most
accurate?
A Statement 2
B Statement 1
C Statement 3

Valuation Strategies Case Scenario

Valuation Strategies, LLC, is a US-­based manager of equity funds driven by a strict
valuation methodology. Internal analysts determine an intrinsic value target price for
each stock in their respective industry groups using the valuation method assigned
by the company’s director of research, Sara Filo.
Filo judges the integrity and quality of the valuation work and trains the recently
hired analysts. She meets with three such analysts—Pierce Tinker, Frances Evers,
and Jonathan Chance—to discuss residual income valuation. The analysts make the
following statements:
Tinker: Residual income (RI) valuation lacks a focus on economic profitability.
Evers: In a high-­growth company, the RI method is more sensitive to the termi-
nal value estimate than other methods, such as the multi-­stage discounted free
cash flow model.
Chance: The RI method may be most appropriate when near-­term forecasted
free cash flows are negative.
Filo then instructs Evers to use the data in Exhibit 1 and the single-­stage version
of the RI model to determine the intrinsic value per share of Thompson Automation,
Inc. (THA).

Exhibit 1  Inputs for Single-­Stage Residual Income Model,

Thompson Automation, Inc.
Cost of equity 0.105
Return on equity 0.120
Book value per share $49.00
Expected dividend in one year $3.00
Long-­term growth rate of residual income 0.055
16 2018 Level II Mock Exam PM

Filo informs Evers that the current market price of THA is $91 per share. She
asks her to use the data in Exhibit 1 and the single-­stage Gordon growth model to
determine THA’s implied sustainable growth rate at that price.
Tinker’s assignment covers an industry with a wide range of company sizes and
types, although the industry average is similar to the market as a whole. Filo instructs
him to calculate the required return using the Fama–French model for RSTU, one of
the firms in the industry.

Exhibit 2  Selected Data from Tinker’s Industry Coverage

Factor Sensitivities Risk Premiums (%)
Market Size Value Liquidity Market Size Value Liquidity

RSTU 0.9 –0.44 0.7 0.2 4.1 2.0 2.3 0.2

Industry ETF 1.1 0 0 0 4.1 2.0 2.3 0.2

Note: The risk-­free rate is 2.1%.

Chance notes that RSTU, several other firms in the industry, and the industry aver-
age could have different growth rates. He suggests that a P/E-­to-­growth (also known
as the PEG ratio) comparison could help determine relative values. Filo notes that
caution must be taken in applying a PEG ratio analysis correctly. Her analysts respond:
Tinker: The PEG ratio accounts for different rates of growth between two com-
panies but not for different levels of risk.
Evers: Further study of the dividend discount model shows that the relationship
between P/E and growth rates is linear.
Chance: Because PEG ratios can be affected by differences in the duration of
growth, shorter-­term forecasts are preferred because such forecasts are more
reliable.
When reviewing PEG ratios in the industry assigned to him, Chance finds that
Dauvision, Inc. (DAUV) appears to be undervalued. He discusses the stock with
Filo, who notes that DAUV has new, yet-­unproven management. If events unfold in
accordance with the company’s forecasts, Filo expects that the P/E will converge to
the industry average in two years. Using the data in Exhibit 3, Chance estimates the
forecasted annualized return for DAUV from the current market price assuming these
expectations hold true.

Exhibit 3  Selected Data for Dauvision, Inc. (DAUV)

Per Share Data

Current EPS $2.69

Current trailing P/E 15.1
Expected EPS sustainable growth rate 0.077
Dividends 0
Forecasted industry average forward P/E 17.4

31 In the discussion of residual income valuation, which analyst makes the most
accurate statement?
2018 Level II Mock Exam PM 17

A Tinker
B Chance
C Evers
32 Using the data in Exhibit 1 and the single-­stage residual income model, the
intrinsic value per share for THA is closest to:
A.$49.00.
$60.00.
$63.70.
33 Based on Exhibit 1 and the Gordon growth model, THA’s sustainable dividend
growth rate is closest to:
A 0.072.
B 0.087.
C 0.084.
34 Based on Exhibit 2 and the Fama–French model, the required return for RSTU
is closest to:
A 4.42%.
B 6.56%.
C 6.52%.
35 Following Filo’s cautionary remark about the PEG ratio, the analyst who makes
the most accurate statement about it is:
A Evers.
B Tinker.
C Chance.
36 Based on Exhibit 3 and Filo’s expectations for DAUV, the annualized percentage
return for DAUV is closest to:
A 20.0.
B 15.6.
C 22.0.

Wadgett Manufacturing Case Scenario

Tom Baker, director of equity investments at Private Wealth Fund, instructs his recently
hired junior equity analysts Ida Paschel and Lyle Covey to review and evaluate oppor-
tunities in the automotive parts industry for a possible addition to the equity portfolio.
Baker encourages Paschel to consider the onboard information systems subsegment,
which is growing rapidly as new mobile technologies are developed.
Baker mentions that he has heard that Wadgett Manufacturing Inc. projects rapid
growth of what it calls “smart mirrors.” Baker states that Wadgett’s stock price had
been decreasing recently and that he was not certain of an appropriate valuation for
Wadgett. The analysts make the following statements:
Covey: The decline in price was the result of a recent failed acquisition of
Wadgett; Wadgett’s price is moving back to an appropriate value as it no longer
appears to be a takeover target.
Paschel: We could compare the value to that of the value of a subsidiary of a
large technology conglomerate that also works on “smart mirrors.” However, the
value of a subsidiary tends to be higher than if it were a stand-­alone entity.
Baker: Pairs trading analysis would help determine whether Wadgett’s market
price seemed to be below its intrinsic value
18 2018 Level II Mock Exam PM

Since Wadgett has no plan to begin paying a dividend, Baker asks the analysts to
calculate the free cash flow to the firm (FCFF). The two analysts discuss how to go
about it, and they make the following comments:
Paschel: If we begin with cash flow from operations (CFO), we do not have to
make adjustments for working capital.
Covey: We should begin with earnings before interest, taxes, depreciation, and
amortization (EBITDA) but will have to add in all the non-­cash charges on the
income statement.
Paschel: Regardless of whether we start with net income, CFO, or EBITDA, we
will have to add in net borrowing.
Wadgett’s ambitious growth projections will likely require a substantial investment
in manufacturing facilities. In order to finance the project, Wadgett expects to borrow
substantially more than it has in the past and intends to retire the debt within the
next 10 years. During a discussion of how this debt may influence the valuation, the
analysts make the following statements:
Statement 1 Because the capital structure seems very likely to change signifi-
cantly, it would be best to use free cash flow to equity (FCFE)
because the value to equity is more direct.
Statement 2 I would select FCFF over FCFE. When we look forward, the
required return on equity may be more sensitive to changes in
financial leverage than just the changes in weighted average cost
of capital (WACC).
Statement 3 With either model, we should discount future cash flows by the
required return on equity because we are considering buying the
stock.
Baker asks his team to determine how sensitive the value of Wadgett’s common
shares is to model parameters by using the single-­stage FCFE growth model for val-
uation. Baker instructs Paschel to calculate the current intrinsic value of the shares
using the base case information. The valuation is shown in Exhibit 1.

Exhibit 1  Valuation of Wadgett’s Common Shares

Normalized FCFE $1.38
FCFE growth rate 0.08
Equity risk premium 0.075
Beta 1.40
Risk-­free rate 1.2%

Baker informs Covey that the highest and lowest reasonable alternative estimates
of the valuation model parameters are as follows: 15% for beta, 20% for equity risk
premium, and 25% for growth rate. He asks Covey to perform a sensitivity analysis for
each of these parameters while keeping all other inputs at the base case level. Covey’s
results are shown in Exhibit 2.
2018 Level II Mock Exam PM 19

Exhibit 2  Sensitivity Analysis to Model Parameters in Valuation of

Wadgett’s Common Shares
Per-­Share Valuation with Per-­Share Valuation with
Parameter Low Estimate High Estimate

FCFE growth rate $25.67 $89.29

Equity risk premium $93.15 $25.70
Beta $70.14 $28.25

Note: The risk-­free rate is 1.2% in all cases.

Covey mentions that another auto parts competitor, Daklan PLC, always seems
to trade at a significant discount to its peers. Baker and his analysts meet to discuss
Daklan's valuation and make the following statements:
Covey: The current market price is $28 per share, which is well below the value
calculated using a two-­stage dividend discount model.
Paschel: We should use both the method of comparables and the method of
forecasted fundamentals to evaluate whether Daklan truly trades at a P/E well
below the market multiple.
Baker: If Daklan spins off its unrelated paper products division, the valuation
discount will decline.

37 Who makes the most accurate statement in regard to Wadgett’s current

valuation?
A Baker
B Paschel
C Covey
38 In regard to calculating Wadgett’s FCFF, the comment that is most appropriate
is the one dealing with:
A working capital adjustments.
B treatment of all non-­cash charges.
C treatment of net borrowing.
39 In discussing Wadgett’s growth projections and the influence they may have on
the FCFE and FCFF valuation process, which of the analysts’ statements is most
accurate?
A Statement 1
B Statement 3
C Statement 2
40 Using only the data for the base case in Exhibit 1, the intrinsic value that
Paschel calculates is closest to:
A $37.30.
B $73.78.
C $40.28.
41 Using the data in Exhibit 2, the parameter that causes the greatest sensitivity in
valuing Wadgett’s common shares is the:
A beta.
B growth rate.
20 2018 Level II Mock Exam PM

C equity risk premium.

42 In the discussion of Daklan’s valuation, whose statement best describes a sum-­
of-­the-­parts approach?
A Paschel’s
B Baker’s
C Covey’s

Wingaersheek Arbitrage Opportunities Case

Scenario
Sandy Annisquam is the head of trading at Wingaersheek Arbitrage Opportunities, LLP,
a hedge fund specializing in fixed-­income strategies. The firm’s investment approach
is to exploit small price differences across similar or identical securities. Annisquam
has asked Choate Hake to develop a comprehensive automated trading system that
will allow traders to identify opportunities in the market. Annisquam and Hake are
discussing several applications that need to be developed for the traders.
Hake begins development on an algorithm that will evaluate government bonds that
have been stripped. He tests his logic by evaluating a dollar-­denominated Tangoran
government bond with a 3.20%, annual pay coupon maturing in three years, using
data in Exhibit 1. The bond is quoted in the market at $103.50.

Exhibit 1  Spot, Par, and Forward Rates

Year 1 Year 2 Year 3

Spot Rate 1.10% 1.50% 2.01%

Par Rate 1.10% 1.50% 2.00%
Forward Rate 1.10% 1.91% 3.04%

Hake develops a framework for valuing bonds using a binomial interest rate tree.
He understands that there are several factors used in developing the tree and asks
Annisquam for counsel on the correct data to use. Annisquam makes the following
comments to Hake:
Comment 1 In the valuation process, the interest rate tree generates cash
flows that are interest rate dependent but does not provide the
interest rates used to discount those cash flows.
Comment 2 Two assumptions must be made to create a binomial tree. The
first is an interest rate model such as a lognormal model of inter-
est rates. The second is a volatility of interest rates.
Comment 3 Volatility can be measured relative to the current level of rates.
By using a lognormal distribution, interest rate movements are
proportional to the level of rates and are bounded at the low end
by zero.
Annisquam asks Hake to use a binomial interest rate tree to calculate the value of
a bond. He tests the module using a three-­year, $100 par value, 4% annual pay coupon
bond and the data in Exhibit 2.
2018 Level II Mock Exam PM 21

Exhibit 2  Three-­Year Binomial Rate Tree

4.50%
3.60%

2.90% 3.25%

2.60%

2.35%

Time 0 Year 1 Year 2

Annisquam tells Hake that he needs to calibrate the binomial interest rate tree to
match a term structure of interest rates. Hake wants to better understand this process
and asks Annisquam to describe it. Annisquam says, “Calibrating an interest rate tree
requires an iterative process that ensures that the upper and lower rates are consistent
with the volatility assumption, the interest rate model, and the observed market value
of the benchmark bond. The cash flows of the bond are discounted using the interest
rate tree, and if this doesn’t produce the correct price, another pair of forward rates
is selected and the process is repeated.”
Annisquam then develops a model that compares the value of a bond determined
using a binomial interest rate tree to its value determined using spot rates. The bond
he selects for the comparison is non-­benchmark, option-­free, and has five years to
maturity and an annual-­pay coupon rate of 3%. The coupon rate is below the coupon
rate of the benchmark bond. The yield curve is currently downward sloping. The output
of Annisquam’s model shows that the spot rates generate a value equal to the market
price of the bond, but the interest rate tree methodology produces a higher value.
Annisquam wants Hake to develop a program for pricing securities that are interest
rate path dependent, such as mortgage-­backed securities (MBS). He believes that using
the Monte Carlo method and employing 2,000 simulations will provide an average
present value across all scenarios equal to the actual market value of the securities.
Hake runs a simulation and uses it to value a benchmark bond. He finds that the value
generated does not equal the market price of the bond.
43 Based on the market price of the Tangoran government bond and the interest
rates in Exhibit 1, what profitable arbitrage opportunity should Hake’s algo-
rithm most likely identify?
A Buying the strips and selling the bond
B Buying the Year 1 and Year 2 strips and selling the Year 3 strip
C Buying the bond and selling the strips
44 Which of Annisquam’s comments regarding binomial interest rate trees is least
likely correct?
A Comment 2
B Comment 3
C Comment 1
45 Using the backward induction method and the data in Exhibit 2, the value of
the bond Hake has been asked to value is closest to:
A 101.069
B 101.584
C 102.532
22 2018 Level II Mock Exam PM

46 Is Annisquam most likely correct in regard to his comments on calibrating a

binomial interest rate tree?
A No, he incorrectly describes the iterative process.
B Yes.
C No, he is incorrect regarding the interest rate used.
47 Assuming Annisquam’s spot rate valuation is correct, why does his model most
likely produce a different result?
A He is valuing a non-­benchmark bond.
B The model is incorrect because both methodologies should value the bonds
equally.
C The yield curve is downward sloping.
48 To correct the problem Hake encounters when using a Monte Carlo simulation,
he would most likely:
A adjust the volatility assumption.
B increase the number of simulations.
C add a constant to all interest rates on all paths.

Bay Corporation Case Scenario

Charles Marlin is the research director at Seacrest Associates, a fixed-­income asset
manager that uses a quantitative process. Cedric Betta is an analyst focused on devel-
oping in-­depth credit analyses of the firm’s credit investments using quantitative tools.
Marlin asks Betta to prepare a comprehensive credit report on Bay Corporation (Bay
Corp) for presentation to Seacrest’s credit committee.
Using the data in Exhibit 1, Betta begins his credit risk assessment by calculating
the maximum price an investor is willing to currently pay for a Bay Corp bond when
considering credit risk. He assumes continuous compounding and that US govern-
ment bonds are risk free.

Exhibit 1  Bond Data for Bay Corporation

Par value $5,000,000
Maturity 4.0 years
Risk-­free rate; zero-­coupon yields 1.25%
Bay Corp credit spread 0.75%
Bond type Zero coupon

Betta reviews the use of traditional credit models to assess the risk of Bay Corp.
He makes the following statements to Marlin regarding two traditional approaches
to credit risk analysis, credit scoring, and credit ratings.
Statement 1 A credit-­scoring model would not be applicable for Bay Corp
because it is most often used for retail borrowers. In addition, it
only provides an ordinal ranking and does not provide an esti-
mate of the borrower’s probability of default.
Statement 2 Credit ratings do not provide an estimate of the borrower’s prob-
ability of default. They provide an ordinal ranking of borrowers
by riskiness that is helpful in portfolio construction and the risk
management process.
2018 Level II Mock Exam PM 23

Statement 3 Both credit scores and credit ratings reflect current economic
considerations in assessing a borrower.
Marlin instructs Betta to also consider structural models of credit risk and makes
the following points: (1) A structural model is based on the balance sheet of a company
and views the equity as a European call option on the company’s assets with a specific
maturity and strike price, and (2) the probability of default for the debt is equal to the
probability that the company’s asset value falls below the face value of the debt and
the loss given default is given by this shortfall.
Betta tells Marlin that he believes that, compared with structural models, reduced
form models better match actual market conditions in assessing credit. In developing
a reduced form model, Betta considers the inputs provided in Exhibit 2.

Exhibit 2  Inputs for Reduced-­Form Model

Input Variable

1 Bay Corp zero-­coupon bond maturing in 2025

2 Bay Corp 4% coupon bond maturing in 2037
3 Inflation rate, growth rate of GDP
4 Riskless interest rate, level of unemployment
5 Market value of Bay Corp assets
6 Bay Corp privately held equity value

Marlin asks Betta if reduced form models of corporate credit risk provide advantages
over structural models. Betta responds that reduced form models have less restrictive
assumptions than structural models because of the one critical assumption that cannot
be relaxed. He notes two weaknesses with regard to reduced form models: (1) The use
of past observations to predict the future requires that it be formulated and back tested
properly, and (2) credit risk measures are biased by implicit estimation procedures.
Finally, Betta would like to examine the term structure of credit spreads for Bay
Corp. The company has a number of coupon bonds outstanding across the maturity
spectrum that should facilitate his analysis. He notices the market prices of the bonds
are lower than would be implied by results of either a structural or reduced form model.
Betta is confident he has correctly estimated the price of the zero-­coupon bonds implied
by the coupon bond prices, which in this case rank equally in the capital structure.
49 Based on the data in Exhibit 1, Betta’s calculation would show that the maxi-
mum price an investor is willing to pay for Bay Corp bonds is closest to:
A $4,615,580.
B $4,852,228.
C $4,619,227.
50 Betta is least likely correct with regard to which statement regarding traditional
credit models?
A Statement 2
B Statement 1
C Statement 3
51 Are Marlin’s points regarding structural models of credit risk most likely
correct?
A Yes.
24 2018 Level II Mock Exam PM

B No, he is incorrect with regard to Point 1.

C No, he is incorrect with regard to Point 2.
52 Which inputs listed in Exhibit 2 are most likely required in Betta’s development
of a reduced form model?
A Inputs 2, 3, and 4
B Inputs 1, 5, and 6
C Inputs 2, 3, and 6
53 Which comment made by Betta is least likely correct with regard to reduced
form models relative to structural models?
A His comment regarding assumptions
B His comment regarding the first weakness
C His comment regarding the second weakness
54 The lower market prices Betta observes for Bay Corp bonds is most likely
explained by:
A a liquidity risk premium.
B the need to estimate implied bond prices.
C differences in priority in case of default.

Eric Silverman Case Scenario

Eric Silverman is a senior portfolio manager for the endowment of Sawyer University
based in California. Sawyer’s investment policy currently only allows allocations to
domestic equity and corporate bonds. The investment committee has tasked Silverman
with assessing the endowment’s foray into real estate investments. He is meeting with
two of his team members to discuss the assignment: Jenny Lin, a senior associate, and
Rohan Dua, a senior financial analyst.
The endowment’s investment committee has asked Silverman to consider the impli-
cations of direct real estate investments in the endowment portfolio. The committee’s
view is that such investments will likely generate income and capital appreciation but
have no significant impact on portfolio risk because of their high correlations with
the existing investments.
Silverman has asked Dua to carry out some preliminary research on commercial
real estate and to report on his findings. Dua reports that commercial real estate
property types include office properties, industrial and warehouse space, and retail
space. Dua indicates that demand for office space depends on employment growth,
whereas a strong economy drives demand for warehouse space. Demand for retail
space depends on the level of import and export activity.
Silverman and his team are evaluating an investment in an office property. They
propose to use three valuation methods: the discounted cash flow method (DCF), the
cost approach, and the sales comparison approach. There are four years remaining in
the property lease, and annual net operating income (NOI) from lease payments is
$750,000. When the lease rolls over in Year 5, there is expected to be a one-­time 15%
increase in NOI. Information about the evaluation is provided in Exhibits 1 and 2.

Exhibit 1  Selected Information to Evaluate Subject Property

Discount rate 7.50%
Terminal cap rate 5.50%
Market value of land $2,500,000
2018 Level II Mock Exam PM 25

Exhibit 1  (Continued)

Replacement building costs $20,000,000

Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000

Exhibit 2  Sales Comparison Information to Evaluate Subject Property

Size Price
(square Age (per square
feet) (years) Condition foot)

Subject office property 12,000 7 Excellent

Comparable office property 1 8,000 10 Average $1,150
Comparable office property 2 14,000 4 Average $1,325

To adjust for age, the price per square foot (PSF) of the comparable property is
adjusted by 3% per year of age difference. The adjustment for the condition of the
office property is 14% for properties in average condition.
Silverman asks the group to provide some characteristics of the three valuation
methods. Lin responds, “the DCF method takes into account cash flows that are
relevant to investors and incorporates the cyclical nature of the real estate market.
The cost approach works best for newer properties, whereas the sales comparison
approach provides reliable value estimates in an active real estate market in which
there are numerous transactions.”
55 The investment committee’s view on direct real estate investment is least likely
correct with regard to:
A income.
B portfolio risk.
C capital appreciation.
56 Is Dua most likely correct with regard to the factors that drive demand for dif-
ferent commercial real estate property types?
A No, he is incorrect about retail space.
B Yes.
C No, he is incorrect about industrial and warehouse space.
57 Based on the information provided and Exhibit 1, the value of the office prop-
erty based on the DCF approach is closest to:
A $14,254,549
B $16,265,226
C $18,193,813
58 Using the cost approach, the estimated value of the office property based on
Exhibit 1 and other information provided is closest to:
A $14,800,000.
B $15,300,000.
26 2018 Level II Mock Exam PM

C $17,300,000.
59 Based on Exhibit 2 and other information provided, the value of the office prop-
erty using the sales comparison approach is closest to:
A $16,834,500.
B $17,023,500.
C $13,875,000.
60 In her response to Silverman regarding the characteristics of the three valuation
approaches, Lin is least likely correct with respect to the:
A DCF approach.
B sales comparison approach.
C cost approach.