2012 l2 sample exam v1 2 qa

 Revenues and free cash flows will grow at a constant rate of 5% per year for the foreseeable future  On average, FDF’s operating income EBITDA will be 30% of gross revenues  Required

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Level II Version 1 2012 Sample ExamMcGuinn Case Scenario

Forster investment Advisors (FIA) is an asset management firm managing funds for both retail and institutional clients FIA also undertakes Investment Banking activities including market-making

Recently, FIA’s Finance Director, who acted as the firm’s Compliance Officer, retired The Board decides

to hire a part-time Compliance Officer on a consultancy basis rather than as a full-time employee, to save costs

FIA’s Managing Director asks Terry McGuinn, CFA, if he would be interested in being the Compliance Officer on a part-time basis McGuinn, an independent compliance consultant whose clients mostly include pension funds, agrees to meet the Managing Director to discuss the position At the meeting McGuinn is told, “FIA adopted the CFA Institute Code and Standards ten years ago The outgoing Finance Director assured us at the time we adopted the Code that all of FIA’s policies and procedures met the requirements of the Code and Standards and most of the recommendations as well As a result

we mention compliance with the Code and Standards in all of our marketing material.” After agreeing on terms and conditions, McGuinn accepts the offer to act as FIA’s Compliance Officer on a part-time consultancy basis, with immediate effect As part of the agreement, McGuinn is only required to go into the office once a week, with most of the communication between him and senior management being via e-man or over the phone as needed

McGuinn immediately reviews a Request for Proposal (RFP) to be submitted the next day to a potential pension fund client The proposal is identical to another R.FP sent out two months ago and includes FIA’s organizational structure, an in-depth description of their investment process along with the occasional use of third-party research providers and details a guarantee of a minimum 5% investment return and return of principal through a guaranteed structured savings product, underwritten by a life insurance company

That same day, Colleen Collins, a Research Analyst approaches McGuinn concerned that she may be in possession of insider information The analyst relates how she was at a party the night before and overheard a conversation between two CFOs of competing publicly listed manufacturing companies The CEOs discussed an industry online newsletter, available by subscription only, speculating on the benefits

of a merger between their two companies One of these companies is on F1A’s recommended buy list

Following this conversion, McGuinn feels it necessary to enhance FIA’s rules and procedures when dealing with possible insider information He recommends the following changes to the companys policies and procedures:

 Recommendation 1: Stop market-making activities when in possession of material non-public information

 Recommendation 2: Regularly review employee and proprietary trading

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 Recommendation 3: Require all employees to attend an annual refresher course on how to identify and handle material nonpublic information

After reviewing how FIA chooses and retains its stockbrokers every year McGuinn recommends the following: Stockbroker selection should be based on the following guidelines:

 Guideline 1: Their ability to provide administration services

 Guideline 2: Execute transactions in a timely fashion

 Guideline 3: Obtain best prices

McGuinn undertakes an investigation based on reports citing several FIA fund managers witnessed to have been wined and dined the past few weeks by large brokerage firms trying to get FIA’s business The same employees have not notified him of these dinners, violating FIAs internal policies McGuinn notifies the employees in writing that they have been violating the company policy In the letter of notification, he requires the employees to abide by the policy in the future

1 Did Collins most likely receive insider information as defined by the CFA Standards?

A Yes

B No, because the information is consideration public

C No, because the information is considered nonmaterial

2 Prior to acceptance of FIA’s offer, McGuinn should most likely undertake which of the following to avoid any violation of the CFA institute Code and Standards?

A Because a full-time employee

B Assess the adequacies of existing procedures

C Merge compliance procedures into the firms code

3 Which response in the Request for proposal (RFP) most likely violates Standard I(C) Misrepresentation?

A Guaranteed investment return

B Firm’s organizational structure

C Use of third-party research providers

4 Which of McGuinn’s recommendation is least appropriate to implement as per recommended procedures for compliance of Standard II(A) Material Nonpublic Information?

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6 Regarding fund managers under investigation, the least appropriate further action McGuinn should take is:

A Monitor their future actions

B Report the misconduct up the chain of command

C Require a statement stating the behavior will not be repeated

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Brendan Dennehy Case Scenario

Brendan Dennehy, CFA, works for Transon Investments, Plc., a Dublin-based hedge fund with

significant equity investments in technology companies in Asia North America and Europe Transon is

concerned by the recent poor performance of one of the fund’s Chinese investments, Winston

Communications, an assembler of telecommunications equipment Transon’s chief of information

technology (IT) is Sean Malloy Yesterday, Winston’s IT office sent Malloy data relating to the assembly

process and a printout of an analysis of the number of defective assemblies per hour, Winston’s IT

people believe that the number of defective assemblies per hour is a function of the outside air

temperature and the speed (production rate) of the assembly lines Malloy recalls that Dennehy has had

substantial training in statistics while working on his MBA He asks Dennehy to help him interpret the

regression results supplied by Winston

Exhibit 1

Regression Results D t =b 0 +b 1 Airt+b 2 R t +ε t

Critical t value at 5% significance (two-tail test that coefficient equals zero) 1.96

R square Std Error of the estimate Durbin-Watson F Significance of F

Durbin-Watson critical values (5% significance) 1.63 1.72

Using the data provided in Exhibit 1, Dennehy tests the hypothesis that the coefficients for outside air

temperature and assembly line speed are significantly different from zero, using a significance level of

5%

Next Dennehy would like to confirm that nonstationarity is not a problem To test for this he conducts

Dickey-Fuller tests for a unit root on each of the time series The results are reported in Exhibit 2

Exhibit 2 Results of the Dickey-Fuller tests

Time series Value of the test statistic Std Error t Significance of t

Defective assemblies per

hour

Outside air temperature -0.423 0.0724 -5.846 0.000

Dennehy tells Malloy about the Dickey-Fuller test results, stating:

We can safely use regression to estimate the relationship between the dependent variable and the

independent variables if:

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1 none of the three time series exhibit a unit root, or

2 all three series exhibit a unit root but they are also mutually cointegrated

Malloy disagrees in part with Dennehy’s statement, He agrees with Dennehy about the use of regression

if none of the time series exhibit a unit root But Malloy believes that it is safe to estimate the regression

if only the independent variables exhibit unit roots but are cointegrated, and the dependent variable does not exhibit a unit root

7 Based on Exhibit 1, Dennehy’s tests of the two regression coefficients show a significant different from zero for the coefficient(s) for:

A Assembly line speed （b2） only

B Outside air temperature （b1）only

C Both outside air temperature （b1）and assembly line speed（b2）

8 The results reported in Exhibit 1 suggest:

A The F-statistic of the regression is not significant

B Predictions of defective assemblies per hour made using the regression have only about a 41% chance

B Rejects the null hypothesis of no positive serial correction

C Fails to reject the null hypothesis of no positive serial correction

10 Assuming a 5%level of significance, the Dickey-Fuller results reported in Exhibit 2 show that the:

A Test for a unit root is inconclusive for the dependent variable

B Dependent variable exhibits a unit root but the independent variables do not

C Independent variable exhibits a unit root but the dependent variables do not

11 Dennehys statement about the Dickey-Fuller test is best characterized as:

A Correct

B Incorrect, because only the dependent variable series needs to be tested for the absence of a unit root

C Incorrect, because only the independent variable series needs to be tested for the absence of a unit root

12 Malloy’s reply to Dennehy about the Dickey-Fuller test is best characterized as:

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Nation Resorts Ltd Case Scenario

Nation Resorts Ltd (Nation) is a U.S,-based operator of destination vacation resorts, Resorts are divided

into three types: Winter, which are located at ski mountains; Golf, located on championship courses in

locations such as Arizona; and Seaside located at beaches with ocean, and other activities available, The

three types of resorts generally attract different types of vacationers, and provide different vacation

packages for different vacation budgets, Although the Winter and Golf resorts are somewhat

counter-seasonal, the company still suffers from the risk of the U,S, economy as well as the risk of

unfavorable local weather conditions (lack of snow or sun), To diversify and reduce these risks, Nation

started purchasing properties in other geographic areas including Europe and Central America

Nation made its first foreign investment when it bought a resort in Jamaica on 1 May 2008, Initially

Nation provided managers to assist in operating the resort but then hired local Jamaicans into their

management development program, and one was recently appointed to a senior position at the resort,

Nation invested in building and up grading facilities with the initial expansion financing provided by

Nation’s U,S, bank, Concerned about the high rate of inflation in Jamaica which at the time of purchase

had averaged 20% per annum over the previous three years, Nation kept excess funds in US, dollars,

Vacation packages are sold primarily in the United States and prices reflect competitive conditions in the

U,S, vacation market The resort uses local labor and supplies and is expected to be profitable for the

first time this year Inflation has now declined to 14% per annum, Nation expects to be able to reinvest

any profits in the resort and start using a local bank for ongoing financing needs

On I July 2010 Nation acquired its first European resort, Val Blanc SA, a ski resort in the Alps region of

France, Nation paid €28 million for 100% of the company, The resort attracts skiers primarily from

France and other European countries, The transition has gone very well with Nation leaving the local

managers in place to make all operating and financial decisions, To date the only financial contribution

by Nation has been the initial equity investment, Financial statements for the ski resort at acquisition

and for the six months since then are shown in Exhibit 1

Financial Statements (all figures in thousands)

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Account receivable 6,500 3,000

(1)The 30 June 2010 Statement of Financial Position reflects the fair value of the identifiable assets and liabilities of Val Blanc at acquisition

(2) 31 December 2010 inventory was acquired evenly throughout the period since acquisition

Paul Nakiska, a business analyst with Nation, is meeting with Nation’s Manager of Financial Reporting Max Chara, to discuss how the company should account for the two foreign resorts in the 2010 financial statements, and the impact the resorts will have on Nation’s reported results Nation has a 3 1 December yearend and prepares its financial statements according to U.S GAAP

In preparation for the meeting, Nakiska’s first task was to prepare the purchase price allocation of the Val Blanc acquisition using the acquisition method He has also gathered some exchange rate information related to the two resorts, Exhibit 2

Exhibit 2 Selected Exchange Rates

Nakiska started the meeting:

I suggest we use the current rate method for both of our foreign subsidiaries because that will simplify our financial reporting The current rate method also allows the key metrics we use to valuate performance; the current ratio, fixed asset turnover and operating margin, to be the same after translation as before

Chara replied:

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I am not so concerned about the translated metrics, because we evaluate the performance of each resort

in its local currency; however, I am concerned about the effect on Nation’s consolidated net income and return on equity

If we use the temporal method for the resort in France, we can take advantage of the strengthening Euro and report the translation gain on the income statement

I am also not so concerned about using the same method for all subsidiaries, if using different methods will help increase our net income

Nakiska agreed to calculate the effects of the various translation methods and of the Val Blanc acquisition on the financial statements and send the report to Chara

13 In 2008 Nation most likely used which of the following translation methods for the Jamaican resort? The:

A temporal method, due to the high rate of inflation

B temporal method, because the US dollar was the functional currency

C current rate method, because the Jamaican dollar was the functional currency

14 Nakiska’s allocation of the purchase price of the acquisition of Val Blanc will most likely result in which of the following for Nation, in €, before translation of the subsidiary’s financial statements?

A Again of 1,500

B Goodwill of 8,000

C An increase in retained earnings of 9,500

15 The net income (in $ US) from the Val Blanc subsidiary that will be included in Nations income for

C Fixed asset turnover

18 Is Chara correct in his assessment of the effect of using the temporal method on the Val Blanc resort?

A No ,because it would result in a translation loss on the income statement

B Yes, because it would result in a translation gain on the income statement

C No, because the translation gain or loss would not be reported in net income

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Fargo Durum Farms (FDF) Case Scenario

Minneapolis Viking Arbitrageurs, LLC (MVA), is a fledgling U.S-based hedge fund having slightly over $

50 million under its management MVA specializes in owning and managing small-sized properties in agriculture, forestry, and mining Its average investment is about $8 million

Jim Hester, MVA’s Managing Partner and Chief Investment Strategist is examining the financial statements and other pertinent information about Fargo Durum Farms, Inc (FDF), as a potential investment opportunity

FDF is jointly owned by two brothers, John and Man, of the Mahoney family With all their children graduated from North Dakota State University and currently living in Minneapolis, the brothers have decided to sell the property Hester believes that commodity prices will continue their uptrend for extended periods and investing in a North Dakota farming operation where farm lands are still attractively priced will produce high returns for the hedge fund Its tangible assets including working capital comprise approximately 1,500 acres of fertile and well-irrigated land, farm buildings, machinery, residential quarters, livestock, cattle feed, seeds, gain, and so forth FDF also carries significant intangible assets that include biological assets, patented hybrid seeds, and milk quotas

Select data from FDF’s income statement for the year ended December 2010 are presented in Exhibit 1 Exhibit 2 contains additional estimates compiled by Hester

Exhibit 1 FDF’s Selected Financial Data for the year ended December 2010

Gross Revenues from crops, livestock, feed, etc $2,500,000

Selling, general, and administrative expenses (SG&A) 900,000

Exhibit 2 Additional data and Hester’s estimates for normalization

1 The cost of goods sold ratio should be higher at 45%

2 SG&.A includes 5400,000 in owners’ compensation According to Hester’s research, owners’ compensation expense for similar sized farms is 5200,000

3 A ranch and living quarters are not required for the farm’s core operations, A total of

5125,000 in expenses (525,000 in depreciation and 5100,000 in operating expenses included in SG&A) relate to those properties The ranch and living quarters will be kept by the current owners and are not a part of FDFs farming operations being considered for purchase by the hedge fund

4 For pro forma purposes, depreciation and amortization will be 10% of gross revenues and the

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current tax rate of 30% is considered reasonable

First, Hester assesses FDFs normalized operating income after tax Next, he values FDF’s equity using the free cash flow to the firm (FCFF) approach under the following additional assumptions

 Revenues and free cash flows will grow at a constant rate of 5% per year for the foreseeable future

 On average, FDF’s operating income (EBITDA) will be 30% of gross revenues

 Required capital expenditures will equal the projected depreciation & amortization expense plus 10% of the incremental revenue

 Additional working capital (other than cash) equal to l5°/ of the incremental revenue is required

 The cost of equity and weighted average cost of capital (WACC) are 14% and 11.5%, respectively

Hester presents his initial assessment and valuation of FOF to MVA’s Investment Committee, The comments and suggestions from some members on the Committee are as follows:

Xavier Moreno, Commodities Analyst, suggests the use of excess earnings method (EEM) for valuing FDF and makes the following three statements in support of his preference:

1 EEM involves estimating the earnings remaining before deducting amounts that reflect the required returns to the tangible assets

2 It is a widely used method for pricing entire private businesses such as FDF

3 EEM is especially useful for valuing FDF as it allows for valuing working capital, fixed assets, and intangibles using different discount rates

Jamal Bahrami, the External Consultant on the Committee differs from Hester and prefers the use of free cash flow to equity (FCFE) model Further, he develops his own estimates for valuing FDF’s equity

 Owing to the continued strength in the global demand for wheat, FDF will experience a higher annual growth rate of 10% over the next two years, 2011 and 2012; thereafter, it will grow at a constant rate of 6% per year

 Next year (201 1)FDF will realize $1,000,000 in cash flow from operations

 To support its high growth needs, FDF will require $400, 000 in new capital investment next year

 The company would need additional borrowing in the amount of $250,000 at an interest cost of 8%

 Because of illiquidity and small-firm risk premiums the appropriate WACC and required return on equity respectively, will be higher at 12.9% and 16%

Hester made a cash offer of $ 9 million to the Mahoney brothers, However, they decided to make a counteroffer and approached Joselyn Olsen, a reputable agriculture industry analyst at the Red River Valley Consultants, LLP, for her assessment of FDF’s value

Olsen prefers the guideline transactions method (GTM) using next year’s expected EBITDA to value FDF and she estimates the following from the company data, market information, and her own assessments

 FDF’s expected 2011 gross revenue = $ 2,800,000

 2011 cost of goods sold =42% of gross revenue

 2011 SG&A = 25% of gross revenue

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 Three recent purchase transactions of similar farms in North Dakota indicate an average MVIC (Market Value of Invested Capital) to EBITDA multiple of 9.0

 FDF commands a 30% control premium

 FDF need not incur any additional capital expenditures or borrowing

Olsen justifies her choice of the GTM approach in the following three statements:

1 The GTM approach works well for valuing FDF as it uses a multiple that specially relates to sales of entire companies SFAS No.157 presents a fair value hierarchy that gives the highest priority to market based evidence Further, tax courts in U.S assessing private company valuations have generally stated a preference for valuation based on market transactions

2 Most appraisers readily accept the valuation from GTM approach because of the reliability of transactions data

3 The market approach to determine the value of equity is appropriate even for companies with highly leveraged financial conditions or significant volatility expected future financial performance

Satisfied with Olsen’s valuation and her methodological choice, the Mahoney brothers move ahead with their counteroffer to Hester

19 The normalized operating income after taxes for the year 2010 for FDF using the company’s data and Hester’s assessments and estimates in Exhibits 1 and 2 is closet to:

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Martin Investment Management Inc Case Scenario

Jennifer Martin, CFA, is the owner of Martin Investment Management mc, a boutique company that specializes in managing money for high-net-worth individuals The firm specializes in real estate and private equity investments, Martin has three client meetings today

The first meeting is with Larry Smith, Smith is interested in investing in real estate but is not sure what type of real estate would be most appropriate for him, Smith is an executive with a major management consulting firm He has a high income, so his main goal is to use real estate investments as a tax shelter

Martin uses the internal rate of return (IRR) method to evaluate real estate investments She is aware of problems with this method, and makes the following statement to Smith:

“Using the IRR method can be problematic For example if project cash flows change from positive to negative, you can end up with more than one IRR You can also end up ranking projects incorrectly using the IRR method if they are substantially different in size.”

Martins second meeting is with Andre Metcalfe, Metcalfe is interested in investing in apartment buildings, Martin tells Metcalfe about three apartment buildings that may be suitable, The details are shown in Exhibit 1

Exhibit 1 Apartment Buildings-selected Information

Apartment 1 Apartment 2 Apartment 3

Exhibit 2 Venture Capital Deal — Investment Information

Terminal value (at time of exit) $1,000,000

Discount rate used by investor 40%

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Wolfe is also interested in investing in private equity funds, but is not familiar with how their management compensation systems work He wants to make sure that management stays motivated and

is focused on maximizing profits Martin tells Wolfe that most private equity funds have a mechanism in place that enables the management team to increase its equity allocation depending on the companys’ actual performance and the return achieved by the private equity firm

25 Given Smith’s real estate investment goal, the least suitable investment for him is:

B incorrect about the size of projects

C incorrect about the change in the sign of cash flows

27 Based on the information in Exhibit 1, the after-tax cash flow for Apartment 1 is closet to:

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Aubrey Yacht Manufacturers Case Scenario

Jack Aubrey and his brother Charles are co-founders of Aubrey Yacht Manufacturers of Miami, Florida, The company specializes in the production of yachts in the $ 200,000 to $ 800,000 price range, The Aubrey brothers took the company public in 1998 and its shares are now traded on NASDAQ under the symbol AYM

Jack is the President and Charles is the CEO and Chairman of the Board, The demand for yachts in AYM’s price range had been quite strong going into the recent recession, which began at the end of 2007, Unfortunately, production at AYM had been curtailed during that time because of a strike that had started in early June of that year, The company had been able to reduce its finished goods inventory substantially by the time the strike ended in January 2008, Throughout 2008, the company carried little inventory and reduced its debt from its long run average of 25% debt to equity, Finally in 2009, it repaid all of its outstanding debt, The result was that the company emerged from the recession much stronger than other yacht manufacturers

Earnings and dividends had been growing strongly until the strike occurred The company paid its first dividend in 2002 but discontinued it soon after the strike began Exhibit I shows the history of the company’s earnings per share (EPS) and dividends per share (DPS) since 2002

Exhibit 1 Aubrey Yacht Manufacturers Earnings and Dividend history for years ending

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Steve Maturin is a director of AYIVI and has been a close friend of Charles since childhood, Maturin is the CEO of Standard Marine Containers, a manufacturer of plastic pallets and crates used in marine shipping, Jack Aubrey is a director of Standard Marine Containers

Charles, Maturin and their families had just returned from a two-week cruise to Bermuda on the company’s best yacht, Maturin informed lack that the weather on this year’s trip was much better than last year, that he was well rested and ready to tackle some thorny issues in their first board meeting of the year, “In particular, “ said Maturin, “alternatives to paying dividends, moving to a staggered board of directors, and the company’s financing mix are items of great interest to me.”

Maturin reminded Aubrey that the results of a survey that had been conducted last year on a large sample of the company’s investors indicated that on average the investors tax rate on capital gains was 23%, but their tax rates on dividends varied widely across the sample, Maturin also said that on reviewing the company’s share price behavior during the 2002 to 2007 period, he found that it normally fell on average by about 68% of the dividend amount when the shares went ex’-dividend

Maturin said: “I’ve been thinking that our current annual election of the board is not in the best interests

of our shareholders, and we should be moving to a staggered board for the following reasons:

1 the company would be less likely to resist hostile takeover attempts with a staggered board

2 it would ensure the continuity of the knowledge and experience in the company that is so essential for good corporate governance, and,

3 it would provide board members more time in getting to understand the needs of shareholders and be

in a better position to align their interests with them.”

Exhibit 2 shows selected information about the company’s current Board of Directors taken from its website and regulatory filings

Exhibit 2 Aubrey Yacht Manufacturers Composition of the Board of Directors 2011

Director Director Status Director Since Current Position

Charles Aubrey Executive 1998 CEO.AYM Chairman of the Board

Bill Babbington Independent 2000 Dean of Engineering, Florida Maritime

College Molly Harte Independent 2000 Director of Equity Research, First

Marine Bank of Miami Steve Metunrin Independent 1998 CEO Standard Marine Containers

Thomas Pullings Independent 2010 Retired managing partner, Price,

Lybrand and Waterways, LIP Sophie Williams Independent 1998 Professor and Chairman, Grand Banks

Nautical Industrial Institute of Technology

Among the directors, only the Aubreys have ever had an employment relationship with the company

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Maturin concluded his remarks by saying, “I would like to see the company use debt again, It should issue debt and repurchase shares to return to its historical level 0.25 debt-to-equity We should be able

to issue debt at a cost of 5%, and this should not materially increase the costs of financial distress, agency costs, or asymmetric information With our current cost of equity at 12% and a 30% tax rate, our weighted average cost of capital should drop, enhancing shareholder value.”

31 The dividend policy that was used by Aubrey Yacht until the strike occurred is best described as a:

A stable dividend policy

B residual dividend policy

C constant dividend payout ratio policy

32 If Aubrey’s earnings and dividend estimates for 2012 and 2013 are correct, and the company adopts his suggested dividend policy, the company’s 2013 dividends per share will be closed to:

A Maturin’s employment history with the company

B Personal relationships between Maturin and Charles

C Jack’s membership on the board of Standard Maturin Containers

36 Using Maturin’s assumptions, the company’s weighted average cost of capital under his proposed financing plan would be closet to:

A 9.8%

B 10.3%

C 11.3%

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Level II Version 1_v10 2012 Sample Exam

Click here to to go to MyCFA

1

“Guidance for Standards I-VII,” CFA Institute

2012 Modular Level II, Vol 1, pp 101-103

Study Session 1-2-b

Recommend practices and procedures designed to prevent violations of the Code of Ethics and

Standards of Professional Conduct

B is correct McGuinn should make an assessment on whether he would be able to clearly discharge his supervisory responsibilities as a Compliance Officer before accepting the offer FIA’s adoption of the CFA Institute Code and Standards does not necessarily imply they have in place proper policies and procedures to ensure compliance with the Code and Standards Especially since the adoption occurred ten years ago and it was at that time an assessment of the adequacy of the policies and procedures was last made According to Standard IV (C) Responsibilities of Supervisors, in the absence of a compliance system or an inadequate one, a member should not accept supervisory responsibility until such time that the firm adopts reasonable procedures to allow adequate exercise of supervisory responsibilities.

2

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations

B is correct The RFP was done on the basis of the old organizational structure Standard I (C) requires members not to misrepresent the qualifications of a firm With a senior professional leaving the firm, the organizational structure should have been updated prior to submitting an RFP for a potential client’s consideration.

3

Study Session 1-2-a

C is correct When determining whether information is considered “insider,” the source of the

information must be assessed An industry or trade newsletter that speculates on the benefits of a merger between two companies does not necessarily mean the two companies are actually merging The two CEOs are overheard discussing the newsletter but never provide their perspectives on the article, so the information is related only to the newsletter Hence the information would not be considered material.

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Study Session 1-2-b

A is correct When a firm acts as a market maker, a prohibition on proprietary trading may be

counterproductive to the goals of maintaining the confidentiality of information and market liquidity

In some cases a withdrawal by the firm from market-making activities would be a clear tip to outsiders Firms that continue market-making activity while in the possession of material nonpublic information should, however, instruct their market makers to remain passive to the market: i.e., take only the contra side of unsolicited customer trades.

5

2012 Modular Level II, Vol 1, p 66

Study Session 1-2-a

A is correct Standard III (A) Loyalty, Prudence, and Care requires an investment manager to use client brokerage to the benefit of the client and not the firm When members or candidates use client brokerage

to purchase goods or services that do not benefit the client (“soft dollars” or “soft commissions”), such

as administration services, a disclosure regarding how the firm addresses the potential conflict of interest must be made to the client.

6

Study Session 1-2-b

C is correct As a supervisor (Standard IV (C) Responsibilities of Supervisors), McGuinn has the

responsibility after he notices and investigates the violation to report the violation up the chain of

command as well as to monitor the employee to ensure the errant behavior has changed and conforms

to the Code and Standards A statement from the errant employees stating they will cease the activity in violation is not enough.

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“Correlation and Regression,” Richard A Defusco, CFA, Dennis W McLeavey, CFA, Jerald E Pinto, CFA, and David E Runkle, CFA

“Multiple Regression and Issues in Regression Analysis,” Richard A Defusco, CFA, Dennis W

McLeavey, CFA, Jerald E Pinto, CFA, and David E Runkle, CFA

Study Sessions 3-11-e, g; 3-12-b

Explain the assumptions underlying linear regression, and interpret the regression coefficients

Formulate a null and alternative hypothesis about a population value of a regression coefficient, select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance

Formulate a null and an alternative hypothesis about the population value of a regression coefficient, calculate the value of the test statistic, determine whether to reject the null hypothesis at a given level of significance by using a one-tailed or two-tailed test, and interpret the results of the test

The null hypotheses are that the coefficients equal zero The alternative hypotheses are that the

coefficients do not equal zero (two-tailed tests) The appropriate test statistics, t, are calculated by

dividing the estimates of the coefficients by their respective standard error

tb1 = 0.0006 / 0.0010 = 0.60

tb2 = 0.5984 / 0.30 = 1.9947

The test statistic for outside air temperature is less than the critical value of 1.96 The test statistic for assembly line speed exceeds the critical value of 1.96 We cannot reject the null hypothesis that the population regression coefficient for outside air temperature, b1, is zero We can reject the null hypothesis that b2 is zero at the 5% level of significance.

8

“Correlation and Regression,” Richard A Defusco, CFA, Dennis W McLeavey, CFA, Jerald E Pinto, CFA, and David E Runkle, CFA

2012 Modular Level II, Vol 1, pp 308-310, 319-322

Study Sessions 3-11-f, I; 3-12-g

Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient

Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and

calculate and interpret an F-statistic

Evaluate how well a regression model explains the dependent variable by analyzing the output of the regression equation and an ANOVA table

The R2 indicates that variations in the independent variables explain approximately 41% of the variation

in the dependent variable The F-statistic is highly significant R2 does not inform us regarding the

probability of a dependent variable prediction being correct.

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Study Session 3-12-i

Explain the types of heteroskedasticity and the effects of heteroskedasticity and serial correlation on statistical inference

The value of the Durbin-Watson statistic is given in Exhibit 1 as 1.890 The critical values are given as 1.63 and 1.72 As the value (1.89) exceeds the upper critical value (1.72), the D-W test fails to reject the null hypothesis of no positive serial correlation.

be analyzed with an AR model

Describe the steps of the unit root test for nonstationarity, and explain the relation of the test to

autoregressive time-series models

Explain how time-series variables should be analyzed for nonstationarity and/or cointegration before use

Based on the t ratios and their significance levels in Exhibit 2, we reject the null hypothesis that the

coefficient is zero for both outside air temperature and assembly line speed (i.e., the independent

variables) We do not reject the null for the dependent variable, defective assemblies per hour.

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Another possibility is that each time series, including the dependent variable and each of the

independent variables, has a unit root If this is the case, we need to establish whether the time series are cointegrated.”

When all series used in a regression display unit roots, but they are also mutually cointegrated, we can safely use regression analysis.

“Multinational Operations,” Timothy S Doupnik

2012 Modular Level II, Vol 2, pp 272-274, 278

Study Session 6-24-a, f

Distinguish among presentation currency, functional currency, and local currency

Analyze the effect of alternative translation methods for subsidiaries operating in hyperinflationary economies

Based on the facts described, the U.S dollar was the functional currency of the resort in 2008 The U.S economy and the U.S dollar are the factors that influence the prices of the vacation packages The operations were financed from the United States and excess funds were also invested there Nation also supplied onsite management Therefore, the temporal method would be the most appropriate method to use Although inflation was high at 20% per year over the past three years, that would not meet FASB’s definition of hyperinflation, which requires the temporal method be used for subsidiaries normally using the current rate method.

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“Intercorporate Investments,” Susan Perry Williams

Study Session 6-22-a, c

Describe the classification, measurement, and disclosure under International Financial Reporting

Standards (IFRS) for: (1) investments in financial assets, (2) investments in associates, (3) joint ventures, (4) business combinations, and (5) special purpose and variable interest entities

Analyze effects on financial statements and ratios of different methods used to account for intercorporate investments

The acquisition was a bargain purchase for Nation:

Fair value of the net assets (Exhibit 1)

Negative goodwill is recognized immediately as a gain in profit or loss.

15

2012 Modular Level II, Vol 2, pp 275, 277, 280-283

Study Session 6-24-c, d

Compare and contrast the current rate method and the temporal method, evaluate the effects of each on the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios

Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s currency, and analyze the different effects of the current rate

method and the temporal method on the subsidiary’s financial ratios

The functional currency for the Val Blanc subsidiary is the Euro; it operates independently and attracts European tourists, and the prices are set in Euros It is also financed in Euros Therefore the financial statements would be translated using the current rate method Under the current rate method, the net earnings (loss) is calculated using the average rate for the period (from July – December) (€725) ×

$1.3198 / 1 € = ($957)

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2012 Modular Level II, Vol 2, pp 274, 276-277, 282-283

Study Session 6-24-d

Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s currency, and analyze the different effects of the current rate method and the temporal method on the subsidiary’s financial ratios

Total shareholders’ equity as at 31 December 2010 consists of Share capital, Retained earnings, and the Cumulative foreign exchange gain or loss since acquisition The total amount can be calculated either

as the sum of the individual components or as the difference between assets and liabilities Using the current rate method, all assets and liabilities are translated at the closing rate

Using the difference between assets and liabilities:

Alternatively: 1.3261 x [67,000 – (12,225 + 26,000)] = 38,159

Using the translation of individual items and calculation of the foreign exchange gain:

(1) In the current rate method the share capital and opening retained earnings use the rate at the

date of acquisition (1 July) and the change in retained earnings is equal to the net earnings (loss)

for the period at the average rate (July – Dec).

(2) Foreign Translation gain/loss calculation:

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2012 Modular Level II, Vol 2, pp 277, 284-286

translated at the average rate for the year; therefore, ratios involving only income statement numbers, like the operating margin, will be unaffected by translation.

all ratios involving only asset and liability numbers, like the current ratio, will also be unaffected by translation.

With both income

statement & balance

Study Session 6-24-c, e

Compare and contrast the current rate method and the temporal method, evaluate the effects of each on the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios

Analyze the effect on a parent company’s financial ratios of the currency translation method used

The euro strengthened against the U.S dollar in the July – December period (1.225 to 1.3261) Under the temporal method the exposure is limited to monetary assets less monetary liabilities, which normally results in a net liability position (and does for the Val Blanc subsidiary) When the foreign currency strengthens, a net liability position results in a negative translation adjustment (loss) Hence use of the temporal method would result in a translation loss being reported on the income statement and Chara’s statement in incorrect.

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“Private Company Valuation,” Raymond D Rath, ASA, CFA

Study Session 12-43-e

Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings.

FDF’s financial performance for the year ended December 2010 As reported

$

Normalized

$

Selling, general, and administrative expenses (SG&A): reflects $200,000

reduction in owner’s compensation and $100,000 reduction in operating

expenses related to the ranch.

20

“Free Cash Flow Valuation,” Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson, CFA, and John Stowe, CFA

2012 Modular Level I, Vol 4, pp 307-312

Study Sessions 12-40-j; 12-43-f

Estimate a company’s value using the appropriate free cash flow model(s)

Demonstrate the free cash flow, capitalized cash flow, and excess earnings methods of private company valuation.

Calculation of next year’s FCFF, value of the firm, and value of equity $

- Required capital expenditures

(depreciation + 10% incremental revenues)

- Increase in working capital

(15% of incremental working capital)

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Study Session 12-43-e, f

Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings

Demonstrate the free cash flow, capitalized cash flow, and excess earnings methods of private company valuation

Statement 3 is correct The excess earnings method (EEM) allows for valuing working capital, fixed assets, and intangible assets using different discount rates (p 549).

22

“Free Cash Flow Valuation,” Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson, CFA, and John Stowe, CFA

2012 Modular Level I, Vol 4, pp 292-297, 315-320

Study Sessions 12-40-c, j; 12-43-g

Explain the appropriate adjustments to net income; earnings before interest and taxes (EBIT); earnings before interest, taxes, depreciation, and amortization (EBITDA); and cash flow from operations (CFO)

to calculate FCFF and FCFE

Estimate a company’s value using the appropriate free cash flow model(s)

Explain factors that require adjustment when estimating the discount rate for private companies.

Calculation of next year’s (2011) FCFE and value of equity at the end of 2010

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“Market-Based Valuation: Price and Enterprise Multiples,” Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson, CFA, and John Stowe, CFA

Study Sessions 12-41-n; 12-43-i, k

Calculate and interpret enterprise value multiples, and evaluate the use of EV/EBITDA

Demonstrate the market approaches to private company valuation (for example, guideline public

company method, guideline transaction method, and prior transaction method), and describe advantages and disadvantages of each

Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability.

24

Study Session 12-43-i

Demonstrate the market approaches to private company valuation (for example, guideline public

company method, guideline transaction method, and prior transaction method), and describe advantages and disadvantages of each

The GTM approach uses a multiple that specifically relates to sales of entire companies, and SFAS

No 157 also presents a fair value hierarchy that gives the highest priority to market-based evidence Additionally, in the United States, tax courts assessing private company valuations have generally stated

a preference for valuation based on market transactions, although they often accept valuations based on the income approach.

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“Investment Analysis,” James D Shilling

Study Session 13-44-a

Explain, for each type of real property investment, the main value determinants, investment

characteristics, principal risks, and most likely investors

B is correct Vacant or raw land is least suitable for Smith because he has a high income and his main goal is to use real estate as a tax shelter Raw land provides no depreciation benefits.

26

Study Session 13-44-d

Explain potential problems associated with using IRR as a measurement tool in real estate investments

A is correct Martin is correct about the problems with the IRR method when project cash flows change signs and when the sizes of the projects being evaluated are significantly different.

27

Study Session 13-44-c

Calculate the after-tax cash flow and the after-tax equity reversion from real estate properties

A is correct 80,000 – 25,000 – ((80,000 – 7,000 – 22,000) × 35%) = $37,150

28

“Income Property Analysis and Appraisal,” James D Shilling

Explain the relation between a real estate capitalization rate and a discount rate

B is correct Apartment 2 is expected to appreciate in value since the discount rate is larger than the capitalization rate The capitalization rate is equal to the discount rate minus the growth rate Thus, Apartment 2 has an implied growth rate of 11% – 9% = 3%, which is higher than the growth rates for the other two apartment buildings.

29

“Private Equity Valuation,” Yves Courtois, CFA, and Tim Jenkinson

Study Session 13-46-j

Calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method (1) with single and multiple financing rounds and (2) in terms of IRR

A is correct 1,000,000 / (1 + 0.4)3 – 200,000 = 164,431

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“Private Equity Valuation,” Yves Courtois, CFA, and Tim Jenkinson

Study Session 13-46-f

Explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis

of private equity fund returns

A is correct A ratchet enables the management team to increase its equity allocation depending on the company’s actual performance, and the return achieved by the private equity firm.

31

“Dividends and Share Repurchases: Analysis,” Gregory Noronha, CFA, and George H Troughton, CFA

Compare stable dividend, target payout, and residual dividend payout policies, and calculate the

dividend under each policy

Each year, from 2002 to 2007, the company paid out approximately 51% to 52% of earnings – indicating

a constant dividend payout ratio policy.

Compare stable dividend, target payout, and residual dividend payout policies, and calculate the

dividend under each policy

Aubrey is proposing a stable dividend policy – one that reflects long-run expected earnings

The adjustment factor = 1 / number of years over which the adjustment in dividends is to occur = 1 / 5 = 0.20

Expected Dividend = Last dividend + Increase in earnings × Target payout ratio × Adjustment factor For 2013: Expected Div = 3.42 + (8.05 – 6.60) × 0.35 × 0.20 = $3.52

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Study Session 8-30-c

Explain how clientele effects and agency issues may affect a company’s payout policy

The change in price when the stock goes ex-dividend can be described as:

PW is the share price with the dividend attached

PX is the share price ex-dividend

D is the dividend

And TD and TCG are the marginal tax rates on

dividends and capital gains

If the dividend is assumed to be $1, and the price

change is 68% of the dividend 0.68 = 1 × (1 – T (1 – 0.23)D)

TD = 47.6%

34

“Corporate Governance,” Rebecca Todd McEnally, CFA, and Kenneth Kim

Study Session 9-31-e

Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice

Staggered boards do allow for continuity of the knowledge and experience in the company, which is essential for good corporate governance.

35

“Corporate Governance,” Rebecca Todd McEnally, CFA, and Kenneth Kim

Study Session 9-31-d, e

Describe responsibilities of the board of directors, and explain qualifications and core competencies that

an investment analyst should look for in the board of directors

Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company’s corporate governance practice

As indicated in Exhibit 2, among the current board members, only the Aubreys are/were past employees

of the firm Maturin was a childhood friend of Charles and recently returned from a long trip (for the second year in a row); Maturin and Jack have interlocking directorships on their respective boards.

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“Capital Structure,” Raj Aggarwal, CFA, Pamela Peterson Drake, CFA, Adam Kobor, CFA, and Gregory Noronha, CFA

Explain the Modigliani-Miller propositions concerning capital structure, including the impact of

leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure.

According to MM Proposition II, in the presence of taxes

re = Marginal cost of equity capital for levered firm

r0 = Cost of equity capital for unlevered firm

D, E, V = market value of debt, equity, and value of firm respectively

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