Level 2 mock exam question and answers 2008

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 specifi c situations Neither is an

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Level 2 Mock Exam - Part 1_2008

Click here to go to the online version of the Level II Study Guide.

Click here to go to the online version of the latest Candidate Bulletin.

1

Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA

Institute

2008 Modular Level II, Vol 1, pp 70-71, 73, Example 5.

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 specifi c situations

Neither is an acceptable reason for soliciting clients while at Portree The clients belong to Portree and Jun is not permitted to solicit their business until he leaves the fi rm As indicated in the Readings and Standards of Practice Handbook, even though Jun does not receive monetary compensation for his services, he may be considered an employee because as an intern he receives compensation and benefi ts in the form of work experience and knowledge.

2

Institute

2008 Modular Level II, Vol 1, p 70.

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 specifi c situations

Velez has acted appropriately and has not violated her duty of loyalty to Portree According to the Standard relating to Duty to Employer, a departing employee is generally free to make arrangements

or preparations to go into a competitive business before terminating the relationship with her

employer provided that such preparations do not breach the employee’s duty of loyalty Specifi cally, prior to leaving an employer, members must not contact existing clients or potential clients for the purpose of soliciting their business for the new business.

3

Institute

2008 Modular Level II, Vol 1, p 70.

Study Session 1-2-a

applying the Code and Standards to specifi c situations

Jun’s use of Fantine’s methods is acceptable The Standards do not impose a prohibition on the use

of experience or knowledge gained at one employer from being used at another employer According

to the Standards, “Once an employee has left the fi rm, the skills and experience that an employee obtains while employed are not “confi dential” or “privileged” information.”

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Institute

2008 Modular Level II, Vol 1, pp 105-107

Study Session 1-2-a

applying the Code and Standards to specific situations

Jun’s statement about passing the exams on the first try was merely factual, while his business card, which he distributes to prospective clients, prematurely states that he is a CFA charterholder.

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

Standards of Professional Conduct

Priority goes to clients over accounts in which Upsala personnel are beneficial owners.

6

Institute

2008 Modular Level II, Vol 1, pp 69-70, 89

Study Session 1-2-a

applying the Code and Standards to specific situations

Whether or not Upsala’s compliance policy requires disclosure, Jun is obligated to comply with CFA Institute Standards The Standard relating to Loyalty to Employer requires that Jun disclose details of the consulting work and receive written consent from Upsala before rendering service.

discuss the structure of an autoregressive model of order p, calculate one- and two-period-ahead

forecasts given the estimated coefficients, and explain how autocorrelations of the residuals can be used to test whether the autoregressive model fits the time series

Testing for correct specification of an autoregressive (AR) model requires a test to determine if the correlations between the error term and several lagged error terms are statistically different from zero

If the autocorrelations are significantly different from zero, the model is not correctly specified.

explain autoregressive conditional heteroskedasticity (ARCH), and discuss how ARCH models can

be applied to predict the variance of a time series

To examine for the presence of heteroskedasticity, Nordique should test whether the variance of the error in one period depends on the variance of the error in previous periods This is accomplished by regressing the squared residuals from the estimated model on the squared residuals lagged one period.

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“Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel

Study Session 3-13-i, j

discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for them, and demonstrate how a time series with a unit root can be transformed

so that it can be analyzed with an autoregressive model;

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

autoregressive time series models

- (P/E)t-1 = b0 + g1 (P/E)t-1 + εt The null hypothesis (H0: g1 = 0) is that the series has a unit root and is not stationary The alternate hypothesis (H1: g1 ≠ 0) is that the series does not have a unit root and is stationary.

10

Study Session 3-13-i

discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for them, and demonstrate how a time series with a unit root can be transformed

so that it can be analyzed with an autoregressive model

Beloit is concerned that a unit root exists If she is correct, first differencing is a suggested solution, i.e., re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 + b1 [(P/E)t-1 - (P/E)t-2 ] + εt.

11

2008 Modular Level II, Vol 1, p 367

Study Session 3-13-e

explain mean reversion, and calculate a mean-reverting level

If the process is mean reverting, the market P/E will move toward the mean-reverting level over time If it is currently above its mean reversion level, the P/E will tend to fall, suggesting that

underweighting stocks would be appropriate.

The one-month forecast is 0.332 + (0.975 x 22.50) = 22.27 The two-month forecast is 0.332 + (0.975

x 22.27) = 22.04.

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“Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried

2008 Modular Level II, Vol 2, pp 10, 13, 24-26, 33-34

be used and analyze and contrast the earnings effects of using the cost method, equity method,

consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios

The appropriate components of ACI’s net income derived from the equity investments in Exhibit 1 (amounts in millions) are as follows:

Note 1: With a majority owner controlling Marco, there is no indication that ACI exhibits the degree

of control consistent with a 30% stake; the Marco investment has been accounted for by Fanner as an available-for-sale security.

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2008 Modular Level II, Vol 2, p 13-15

as no gains were realized during the year, there would be no change.

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2008 Modular Level II, Vol 2, p 10-24

Study Session 5-21-c

calculate and analyze the mark-to-market investment return on a marketable securities portfolio under SFAS 115

The analyst should track investment performance on a mark-to-market return basis, measuring

the actual investment performance for each period (page 21) ACI has five investments classified under SFAS 115 (marketable securities where the company does not have the ability to exercise significant influence or control): Marco, De Vaca, Viking, Cortez and Da Gama De Vaca does not have a market value and hence is accounted for under the cost method It is not possible to calculate a mark-to-market return for it Calculation of the mark-to-market return includes interest and dividend income plus realized and unrealized gains and losses; see page 21 and 22 for sample calculations and definition The four qualifying securities and calculations of the mark-to-market portfolio return are

as follows: (Note there were no realized gains or losses during the year.) The equity securities were purchased January 1, 2007, their cost basis is therefore equal to the opening market value The debt securities were purchased during the year so their cost basis is also equal to their opening market value.)

Interest or Dividend Income

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2008 Modular Level II, Vol 2, pp 24, 35-36

“Mergers, Acquisitions, and Other Intercorporate Investments,” Thomas R Robinson, Paul Munter, and Julia Grant

2008 Modular Level II, Vol 2, pp 77-78, 88-91

Study Sessions 5-21-d, 5-22-f

distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should

consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios;

identify situations when companies should apply the equity and consolidation methods of accounting for investments

If ACI loses control over Columbus, Columbus will be treated under the equity method instead of under the consolidation method The equity method is one-line consolidation, the net income and common equity are the same but the reported revenues, assets and liabilities would decrease.

17

The litigation will preclude ACI from using the equity method If De Soto is then classified under available-for-sale, book value per share could decrease because equity will not be increased by ACI’s share of De Soto’s income in excess of dividends.

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Study Session 5-21-d

distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should

De Soto must be classified according to the equity method According to the equity method, securities are carried on the balance sheet at cost plus an adjustment for the investor’s share of the investee’s income, less an adjustment for cash dividends received by the investor Thus, $125.0 million cost + (25.5 million income share - 5.0 dividends received) = $145.5 million.

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“Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried

Study Session 6-26-b

distinguish among the local currency, the functional currency, and the reporting currency

The functional currency will be the Euro for Catlette since the all-current method is used and the U.S dollar for Heren (temporal method).

20

Study Session 6-26-c, d

compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of the all-current and temporal methods on the parent company’s balance sheet and income statement

Unrealized non-monetary gains are ignored when the temporal method is used All other gains are reported on the income statement.

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Study Session 6-26-c, d, k

compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of each on the parent company’s balance sheet and income statement; illustrate and analyze alternative accounting methods for subsidiaries operating in hyperinflationary economies

Garrison is using the all-current method for Catlette The all-current method is most appropriate when the subsidiary (Catlette) is a self-contained independent operating entity.

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Study Session 6-26-c, d

compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of each on the parent company’s balance sheet and income statement All gains and losses are reported as a cumulative translation adjustment in equity when the all-current method is used.

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2008 Modular Level II, Vol 2, pp 166, 173

Study Session 6-26-g

translate a subsidiary’s balance sheet and income statement into the parent company’s currency, using the all-current method and the temporal method

Under the all-current method, all assets would be translated at the year-end (current) rate of 0.75:

*Rounded to 1,667

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“Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim

Study Session 9-34-a

explain corporate governance, discuss the objectives and the core attributes of an effective corporate governance system, and evaluate whether a company’s corporate governance has those attributes Directors’ identification with managers’ interest rather than those of the shareholders is a source of conflict, which may call into question the directors’ objectivity.

26

describe the responsibilities of the board of directors, and explain the qualifications and core

competencies that an investment analyst should look for in the board of directors

All three listed board responsibilities are valid components of an effective corporate governance system.

27

Study Session 9-34-g

discuss the valuation implications of corporate governance

Dexter is not concerned about incomplete, misleading, or materially misstated financial statements, i.e., accounting risk.

28

“Capital Structure and Leverage,” Raj Aggarawal, Cynthia Harrington, Adam Kobor and Pamela P Peterson

Study Session 8-32-i, k, l

discuss the effect of taxes on the MM propositions, the cost of capital, and the value of a company; explain and diagram the static trade-off theory of the optimal capital structure;

compare the implications of the MM propositions, the pecking order theory of capital structure, and the static trade-off theory of capital structure

Assuming static trade-off theory of capital structure holds the value of a levered firm is maximized

at its optimal debt-to-equity ratio which is the case when the weighted average cost of capital are

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“Dividends and Dividend Policy,” George H Troughton and Catherine E Clark

Study Session 8-33-j

compare and contrast the following dividend policies: residual dividend, longer-term residual

dividend, dividend stability, and target payout ratio

A longer-term residual approach as used by TML S.A is defined to pay out a (more) stable cash dividend to shareholders and allocate a (more) flexible amount to share repurchases (see p 168) Hence, TML S.A already experiences stable cash dividends (based on sustainable earnings) and additional share repurchases (as a mean to distribute temporary earnings), and the management is most likely to keep everything as it is.

30

“Dividends and Dividend Policy,” George H Troughton and Catherine E Clark

Study Session 8-33-k

calculate a company’s expected dividend using the variables in the target payout approach

Formula to be applied is: Expected dividend = Last dividend + (Expected increase in earnings x Target payout ratio x Adjustment factor) where

Adjustment factor = 1 / period to adjust dividend

The expected dividend = €0.50 + (€3.0 - €2.5) x 0.40 x 1 / 5 = €0.54

31

“Competitive Strategy: The Core Concepts,” Michael E Porter

Study Session 11-41-a, b

analyze the competitive advantage and competitive strategy of a company and the competitive forces that affect the profitability of a company and discuss the two fundamental questions determining the choice of competitive strategy;

explain how competitive forces determine industry profitability

Industry rivalries have increased the cost of doing business and reduced profits industry-wide Porter (p 169) says “the first fundamental determinant of a firm’s profitability is industry attractiveness,” which is evaluated using the five forces (p 170) of industry rivalry, buyer power, supplier power, threat of substitutes and threat of new entry The vignette says that new entry and substitute

products are not a concern However, competition for customers and suppliers has reduced industry profitability (customers are paying less and costs for programming are rising) The vignette also indicates that revenues are cyclical in nature With regard to its position within the industry,

Svensoft’s previous strategy of focusing on the financial services industry has been rendered invalid

by the entry of major competitors into this segment.

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Study Session 11-41-a, c

analyze the competitive advantage and competitive strategy of a company and the competitive forces that affect the profitability of a company and discuss the two fundamental questions determining the choice of competitive strategy;

analyze basic types of competitive advantage that a company can possess and the generic strategies for achieving a competitive advantage, the risks associated with each of the generic strategies, the difficulties and risks of simultaneously using more than one of the generic strategies, and the difficulties in sustaining a competitive advantage with any generic strategy

Svensoft’s plan to increase reliability constitutes a differentiation strategy.

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“Industry Analysis,” Jeffrey C Hooke

discuss the key components that should be included in an industry analysis model

External factors such as technology, government, social changes, demographics and foreign

influences are not discussed.

34

Study Session 11-42-b, c

illustrate the life cycle of a typical industry;

analyze the effects of business cycles on industry classification (i.e., growth, defensive, cyclical) The high customer penetration, along with slowing growth prospects, indicate that the industry is mature That revenue declines and expands at greater-than-GDP rates indicates that it is a cyclical industry.

35

Study Session 11-42-f

explain factors that affect industry pricing practices

The entry of broader based competitors into the financial services market, with the ability to

differentiate on both features and cost, is reducing segmentation However, the increased competition

is raising wages and reducing revenue for existing players and makes it difficult for new players to emerge.

36

“A Note on Asset Valuation,” George H Troughton

“International Asset Pricing,” Bruno Solnik and Dennis McLeavey

Most valuation models are based on discounting future cash flows, as Kennant realizes On p 5, Troughton refers to the stock valuation process espoused in Graham and Dodd and states, “That epic work stressed a philosophy of investing centered on the concept of ‘intrinsic value’.” Another work by John Burr Williams proposes estimating the intrinsic value of common stock by calculating the present value of all future dividends per share (p 7) Contrary to Kennant’s belief, the modern portfolio theory applies to portfolios as well as for valuing individual stocks in the framework of CAPM (pp 434-436).

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“Discounted Dividend Valuation,” John D Stowe, Thomas R Robinson, Jerald E Pinto, and Dennis

W McLeavey

“Equity: Concepts and Techniques,” Bruno Solnik and Dennis McLeavey

Study Sessions 12-46-u, 11-40-g

estimate, using the DuPont model, a forecast for return on equity that can be used to estimate a company’s sustainable growth rate;

evaluate two common approaches of equity analysis (ratio analysis and discounted cash flow models including the franchise value model) and demonstrate how to find attractively priced stocks by using either of these methods

The higher asset turnover is the primary reason for Fast Food’s higher ROE See calculation of

DuPont analysis below.

analyze the competitive advantage and competitive strategy of a company and the competitive forces that affect the profitability of a company and discuss the two fundamental questions determining the choice of competitive strategy

Given that Belle Cuisine can source its ingredients from many suppliers, the effect of their bargaining power is low (because they hardly have bargaining power), and confronted with few important

customers (selling 75% to five customers), the effect of its buyers’ bargaining power is high.

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explain how competitive forces determine industry profitability

Buyer propensity to substitute increases intensity of rivalry.

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explain the role of a generic strategy in the strategic planning process

Belle Cuisine exploits the special needs of a niche market, i.e., high quality food for clients at private hospitals, by differentiating through branded quality products.

42

illustrate the life cycle of a typical industry

A pioneering stage is characterized by many business failures.

43

“General Principles of Credit Analysis,” Frank J Fabozzi

distinguish among default risk, credit spread risk, and downgrade risk

Credit spread risk is correct because the major risk is expressed as the concern that the downgrade is not fully reflected in the price of the bonds, which indicates the price will decline due to an increase

in the credit spread from the anticipated downgrade.

44

calculate, critique, and interpret the key financial ratios used by credit analysts

Solvency ratios are a function of the nature of a company’s business Therefore, it is inappropriate to make direct comparisons between Barr and Park because they are in different industries.

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Total debt to capitalization equals current liabilities plus long-term debt, divided by long-term debt plus current liabilities plus shareholders’ equity:

(5,199 + 7,436) / (7,436 + 5,199 + 2,449) = 12,635 / 15,084 = 83.8%

The EBIT interest coverage ratio equals net income plus interest expense plus taxes, divided by the interest expense: (1,221 + 580 + 263) / 580 = 2064 / 580 = 3.6.

46

Funds from operations/total debt ratio is found by adding the non-cash items (depreciation and amortization) to net income and dividing the sum by total debt (current liabilities plus long-term liabilities), i.e., (1,841 + 1,320) / (8,314 + 12,013) = 3,161 / 20,327 = 15.6%.

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identify, explain, and interpret the typical elements of the corporate structure and debt structure of a high-yield issuer and the impact of these elements on the risk position of the lender

Statement 1 is incorrect and Statement 2 is correct The Tadd Group is more vulnerable to a rise

in short-term interest rates because they have a higher percentage of bank debt compared to Arc Holdings’ bank debt and reset notes combined and because bank debt has a higher priority of claims status than senior bonds.

48

identify, explain, and interpret the typical elements of the corporate structure and debt structure of a high-yield issuer and the impact of these elements on the risk position of the lender

The presence of zero (deferred) coupon bonds in the debt structure can impair the company’s ability

to improve its credit quality in the future as a burden is placed on future cash flows to meet the

deferred interest obligation.

49

“Option Markets and Contracts,” Don M Chance

explain how an option price, as represented by the Black-Scholes-Merton model, is affected by each

of the input values (the option Greeks);

As time to expiration increases the value of the call price also increases.

50

explain the gamma effect on an option’s price and delta and how gamma can affect a delta hedge Statement #1 is incorrect Gamma is larger when there is more uncertainty about whether the option will expire in- or out-of-the-money Statement #2 is correct Gamma measures the sensitivity of delta

to a change in the underlying When gamma is large, delta changes rapidly and cannot provide a good approximation of how much the option moves for each unit of movement in the underlying.

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calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic bond, and synthetic underlying stock and infer why an investor would want to create such instruments

The synthetic call (long put, long underlying and short bond) is more expensive than the market price, thus the call is under-priced in the market Using put-call parity, Baloo should buy the call in the market and sell the synthetic call Thus the correct arbitrage transaction (see put-call parity formula below) is to buy the call and sell the put, short the equity, and buy the bond

Put-call parity: co + X / (1 + r)T = po + So

co current price of call option with exercise price X, expiring in T years

X exercise price

r risk-free rate

po current price of put option with exercise price X, expiring in T years

So current equity price

52

“Swap Markets and Contracts,” Don M Chance

calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of the different types of equity swaps during their lives

Fixed rate on swap = 4.99% (Given in vignette)

Market value of a swap:

=((723.86 / 757.09) - 0.9209 - 0.0499 x (0.9691+ 0.9209)) x 100,000,000 = -$5,910,000.

54

“Swap Markets and Contracts,” Don M Chance

calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of the different types of equity swaps during their lives

This is the value of a swap as defined in the reference material.

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“Portfolio Concepts,” Richard A Defusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel

Study Session 18-68-i, l

discuss and compare macroeconomic factor models, fundamental factor models, and statistical factor models;

discuss the arbitrage pricing theory (APT), including its underlying assumptions and its relation to the multifactor models, calculate the expected return on an asset given an asset’s factor sensitivities and the factor risk premiums, and determine whether an arbitrage opportunity exists, including how to exploit the opportunity

The model estimated in Exhibit 1 is a macroeconomic factor model In macroeconomic factor models, the factors are surprises in macroeconomic variables that significantly explain equity returns.

The expected return on Portfolio P is:

The expected return on an equal combination of Portfolios Q and R is:

explain the sources of active risk, and define and interpret tracking error, tracking risk, and the

information ratio, and explain factor portfolio and tracking portfolio

Portfolio T tracking risk = 400.5 = 6.3%.

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CFA Institute 2008 Mock Exam 01 Q

Q1-6

Sang-Gyung Jun Case Scenario

Sang-Gyung Jun is enrolled in an MBA program and serves as an unpaid intern for Portree Investment Services During his internship, Jun's supervisor at Portree, Barbara Fantine, teaches him several stock valuation

techniques Jun hopes his unpaid internship will eventually result in full-time employment with Portree, and he enthusiastically recruits a number of wealthy clients, most of whom are family members Fantine praises his efforts, remarking that "these clients are the foundation on which you can build your career at Portree."

Despite his success, Jun's internship remains unpaid even after he receives his MBA degree and passes the CFA® Level III examination Jun seeks full-time employment with Upsala Financial Corp., which specializes in serving high-net-worth individuals

When interviewing for the position at Upsala, Jun informs his interviewer that "I need to obtain only one more year of work experience before I will receive the CFA charter I passed all three CFA examinations on the first try." After the interview, Jun considers contacting the clients he has recruited at Portree to ask if they would become his clients at Upsala

When Fantine learns of Jun's plans to leave Portree, she informs Jun, "You are not permitted to use any of the valuation techniques I have taught you because they belong to me."

Jun subsequently accepts the position at Upsala and informs Fantine On the same day, Fantine receives news about the departure of another Portree employee, Jasmine Velez, CFA Velez is leaving to start an investment firm that will directly compete with Portree Velez has not contacted any potential clients, but during non-work hours she has incorporated the new firm and obtained the necessary licenses

On Jun's first day of work at Upsala, he receives and reviews a copy of the firm's compliance policy, excerpts of which appear in Exhibit 1

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Exhibit 1 Upsala Financial Corp

Compliance Policy

Independent Practice

Employees of Upsala may enter into independent practice only in business segments not already targeted by Upsala, and only in roles clearly leading to improvements in employee skill and expertise that can be used beneficially by Upsala

Priority of trades

The interests of outside clients must be given priority over accounts registered in the name of Upsala itself Moreover, all personal trades by employees of Upsala firm will be pre-cleared in accordance with the firm's compliance policies

Several months later, Jun receives an offer of part-time consulting work from a family friend who needs

assistance marketing investment services to high-net-worth individuals in Korea Jun reviews the firm's policy on independent practice and confirms that Upsala does not conduct business in Korea Jun is convinced that the consulting work will improve his skills and thus benefit Upsala He accepts the consulting work, which requires approximately three hours of late-night work on Mondays and Wednesdays Jun then sends an email to his supervisor informing him of the consulting offer, its requirements, duration, compensation, and the skills he expects to develop from the work

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B No, because he owes a duty of loyalty to Portree

C No, because he has not yet received an official offer from Upsala

D No, because he has not received written permission from either Upsala or Portree

B Yes, because she plans to compete directly with Portree

C Yes, because she incorporated the firm before leaving Portree

D Yes, because she uses the knowledge and skills acquired at Portree to develop a competing

business

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B Yes, because he does not have Fantine's permission

C Yes, because he does not have Portree's permission

D Yes, because he does not inform his supervisor of the source of the methods

Question

Does Jun violate CFA Institute Standards of Professional Conduct with respect to his:

exams on the first try?

use of the business card?

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Question

To make Upsala's statement on Priority of Trades consistent with CFA Institute Standards, Jun's most

appropriate recommendation is to replace the first sentence with:

Select exactly 1 answer(s) from the following:

A The interests of clients must be given priority over accounts in which Upsala's employees are beneficial owners

B The interests of outside clients must be given priority over family client accounts and accounts

registered in the name of Upsala itself

Question

When accepting the part-time consulting position, does Jun violate any CFA Institute Standards?

A No

B Yes, because he does not have consent

C Yes, because he does not provide adequate disclosure to Upsala

D Yes, because the work requirements will interfere with his duties to Upsala

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Q7-12

Jacques Nordique Case Scenario

Jacques Nordique is a quantitative analyst at Brimford Investment Management One of the firm's managing partners asks Nordique to collect and analyze data as part of a project to explain and to forecast the behavior of price/earnings (P/E) ratios Nordique wants to examine time-series models of P/E behavior and begins by collecting 15 years of monthly data on market P/E ratios

After considering several different time-series models, Nordique estimates a regression equation of the form:

(P/E)t = b0 + b1 (P/E)t-1 + εt

and obtains the results shown in Exhibit 1 Nordique believes the time series is mean reverting and given the estimated coefficients, he calculates the mean-reverting level of the market P/E ratio to be 13.3

Exhibit 1 Regression Results Dependent Variable is the Market Price/Earnings (P/E) Ratio

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Exhibit 2 Critical Values of Selected Test Statistics

2 120+

2.92 1.66

4.30

dL = 1.65, dU = 1.69

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B R-squared value and F-statistic

C autocorrelations between the error terms

D correlation between the squared error terms and the independent variable

Question

To determine whether Beloit's first concern is valid, Nordique's most appropriate action would be to:

A perform the Dickey-Fuller test

B re-estimate the model using a moving average

C regress the squared residuals from the equation estimated in Exhibit 1 on the squared

residuals lagged one period

D test whether the variance of the error in one period depends on the variance of the

error in successive time periods

Question

Which of the following models is most appropriate to determine if Beloit's second concern is justified?

A (P/E)t – (P/E)t–1 = b0 + g1 (P/E)t + εt

B (P/E)t - (P/E)t-1 = b0 + g1 (P/E)t-1 + εt

C (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t - (P/E)t-1] + εt

D (P/E)t - (P/E)t-1 = b0 + g1 [(P/E)t-1 - (P/E)t-2] + εt

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C re-estimate the regression using the form: (P/E)t = b0 + b1 (P/E)t-1 + b2 (P/E)t-2 + εt

D re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 +b1 [(P/E)t-1 - (P/E)t-2 ] +εt

Question

If Nordique's claim about mean reversion is correct, which of the following recommendations is most appropriate? Select exactly 1 answer(s) from the following:

A Overweight stocks if the P/E is above its mean reversion level

B Underweight stocks if the P/E is above its mean reversion level

C Overweight stocks if the stock market is falling and underweight stocks if the stock market is rising

D Overweight stocks if the P/E is below its historical average, underweight stocks if the P/E is above

its historical average

Question

If the model estimated in Exhibit 1 is correctly specified, and the market P/E ratio is 22.50 in June 2007, the

estimate of the market P/E ratio for August 2007 is closest to:

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Q13-18

Gregory Fanner (ACI) Case Scenario

Gregory Fanner, CFA, is a financial analyst with Alchemy Consolidated Industries, Inc (ACI) ACI is a U.S corporation involved in several industry sectors and, in addition, has a significant portfolio of intercorporate investments Fanner's supervisor, Charles Wilmington, has requested that Fanner provide an update on ACI's newest equity and debt investments (all purchased 1 January 2007) Wilmington is especially interested in three

of the investments, Marco, Inc., Cortez, Inc., and Da Gama, Inc., because they have declined in value Fanner has developed Exhibit 1, containing information about the companies requested by Wilmington

Exhibit 1 ACI, Inc Portfolio A Newest Acquisitions (amounts in millions)

Percentage

Cost Basis ($U.S.)

Market Value

31 December

2007

Reported Net Income 2007

Dividends Received by ACI in 2007

Investment

Cost Basis (Purchased at Par Value)

Market Value

31 December 2007

Interest Received

by ACI in

2007

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Wilmington has asked for Fanner's opinion about reclassifying the two debt securities to available-for-sale securities After investigating, Fanner discovers significant negative changes in the economic circumstances regarding these securities, and indicates to Wilmington that reclassification should not create a problem As a separate issue, Fanner also discovered that the possibility exists for De Soto to be involved in future litigation such that ACI's influence could be challenged Currently, ACI's degree of influence over De Soto has not been compromised

Fanner has gathered the following additional information:

• ACI controls 7 of 12 seats on the Columbus board of directors, 3 of 10 seats on the De Soto board of directors, and 3 of 16 seats on the Marco board of directors

• Marco has a majority holder that exercises control over Marco's operations

• ACI does not classify equity securities as trading account securities

• De Vaca is the only security from Exhibits 1 or 2 that is not publicly traded

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Question

If, after year end, ACI loses majority control of Columbus through loss of some board seats, the most likely result

is that ACI's:

A net income will decrease

B total revenues will decrease

C net working capital will increase

D return on common equity will decrease

Question

If Wilmington announces that the litigation involving De Soto has materialized and that Fanner should make any necessary reclassifications, the most likely result is that ACI's:

A debt-to-equity ratio will be lower

B book value per share will be lower

C income for tax reporting will be greater

D cash received from investees will be greater

Question

The year-end 2007 balance sheet carrying value of De Soto was closest to:

A $120.0 million

B $145.5 million

C $150.5 million

D $160.0 million

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Q19-24

Erika Wong Case Scenario

Erika Wong, an analyst with Montreal Investments, is forecasting 2008 results for Garrison Inc Garrison has two wholly-owned European subsidiaries: Catlette and Heren Wong has prepared individual forecasts for the parent company (before consolidating the subsidiaries) in U.S dollars and for the two subsidiaries in their local currency (the Euro) She wants to determine how the translation of subsidiary results will affect the consolidated results

of operations, using the following additional information:

• Both Catlette and Heren use the FIFO method for inventory

• Catlette's results will be translated into dollars using the all-current method

• Heren's results will be remeasured into dollars using the temporal method

Wong's forecasted exchange rates for the U.S dollar and Euro are shown in Exhibit 1 along with historical rates Her forecasted financial data for Catlette Company are presented in Exhibits 2 and 3

Wong is particularly concerned about whether the choice of translation methods will distort Garrison's financial ratios relative to the ratios in local currencies She plans to translate the forecasted financial statements for the subsidiaries into U.S dollars using the methods which Garrison is expected to use

Exhibit 1 Exchange Rates

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Exhibit 2 Catlette Company Forecasted Balance Sheet

31 December 2008 (in millions of Euro)

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C both Heren and Catlette

D neither Heren nor Catlette

Question

When it consolidates Heren's results, Garrison will ignore the exchange rate holding effects of:

A realized monetary gains

B unrealized monetary gains

C realized nonmonetary gains

D unrealized nonmonetary gains

Question

The translation method used by Garrison for Catlette is best justified if:

A Catlette is a sales outlet for the parent's products

B Catlette operates in a highly inflationary economy

C Catlette is a self-contained independent operating entity

D Garrison's reporting currency is used as the functional currency for Catlette

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Question

When Garrison consolidates Catlette's results, unrealized exchange rate holding gains on monetary assets will be: Select exactly 1 answer(s) from the following:

B reported in operating earnings

C reported in non-operating earnings

D reported in equity as a cumulative translation adjustment

When Wong converts her forecasted income statement data for Catlette into U.S dollars, gross profit margin for

2008 will be closest to:

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Q25-30

MFT Plc Case Scenario

MFT Plc is a money management firm based in the U.K One of MFT's funds invests in companies with effective corporate governance and conservative capital structures Rollo Martin, a newly hired analyst, prepares a presentation for the MFT investment committee

Before screening potential investment opportunities, Martin asks his supervisor Hugh Crabbin how to identify effective corporate governance structures/systems Crabbin states that Martin should look for the following corporate governance attributes:

• Transparency in disclosures;

• Measurable performance accountabilities;

• Strong directors identification with managers' interest;

• Clearly defined governance responsibilities to stakeholders

Martin gathers information regarding several enterprises and finds on France-based TML S.A.'s website details on its corporate governance which are presented in Exhibit 1

Exhibit 1 Extract from TML S.A.'s Corporate Governance Information

Board Responsibilities

1 Acquire adequate training so that members are able to adequately perform their duties

2 Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance

3 Establish corporate values and governance structures for the company to ensure that the business is conducted

in an ethical, competent, fair, and professional manner

Martin discusses TML S.A.'s corporate governance structure and the valuation implications with his colleague Buck Dexter Dexter is concerned about management's ability to receive excessive compensation, to take on unwarranted off-balance-sheet obligations, and to enter into transactions harming shareholders' long-term interest

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In addition to TML S.A.'s corporate governance, Martin analyzes the company's capital structure He observes that it has a low debt-to-equity ratio relative to its peers Martin determines the unlevered value for TML S.A to

be €2,000,000,000 He makes the estimates shown in Exhibit 2 to assess the impact of leverage on TML S.A.'s capital structure

Exhibit 2 Selected Leverage Scenarios for TML S.A

Despite Dexter's concerns with regard to TML S.A.'s corporate governance, Martin includes the company in his presentation as an investment opportunity During the investment committee meeting J G Carey, one of MFT's senior members, noted that TML S.A has a debt-to-equity ratio lower than its peers and has shorter maturity debt

Carol Reed, MFT's chief investment officer, is interested in TML S.A.'s dividend policy TML uses a longer-term residual dividend approach and currently earnings are near the cyclical high Martin explains that in the past the company has kept its cash dividend stable despite rising earnings Moreover, he believes that the recent increase

in earnings is only temporary In addition to paying cash dividends, the company has a share repurchase program

Reed does not agree that much of the increase in TML S.A.'s earnings is temporary She wants to know from Martin what the expected dividend of TML S.A would be if the company used a 5-year period to adjust the dividend towards a target payout ratio of 40% Martin uses TML S.A.'s regular dividend per share of €0.50, last year's earnings of €2.50 per share, and current year's anticipated earnings of €3.0 per share to calculate the expected dividend

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B No, because Item 1 is not a component of an effective corporate governance system

C No, because Item 2 is not a component of an effective corporate governance system

D No, because Item 3 is not a component of an effective corporate governance system

Question

Dexter's concern regarding TML's management reflects each of the following risk areas except:

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Question

Assuming static trade-off theory holds and using the information in Exhibit 2, TML S.A.'s value is:

A unaffected by capital structure

B highest under the low leverage scenario

C highest under the high leverage scenario

D highest under the medium leverage scenario

Question

Given TML's dividend policy and Martin's assessment of its earnings, TML's most likely course of action would be to: Select exactly 1 answer(s) from the following:

A reduce share repurchases

B increase the cash dividend

C introduce a stock dividend

D maintain the current cash dividend

Question

If TML S.A were applying the proposed target payout ratio, its expected dividend would be closest to:

A €0.54

B €0.58

C €0.70

D €0.74

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Q31-36

Faye Kennant Case Scenario

Faye Kennant, an equity analyst, is preparing a research report on Svensoft Oyj, which sells application software

to large financial services firms and is based in Helsinki, Finland Kennant plans to conduct an industry analysis, consider several valuation alternatives, and select an appropriate valuation tool

Her first step is to consider whether Svensoft is in an attractive industry and to gauge whether Svensoft has a strong position within the industry She prepares the following industry analysis:

• Industry structure and rivalry: The application software industry is dominated by two companies: Waldoware and Meteor The founders of Waldoware and Meteor are long-term rivals and the two firms compete brutally for every customer Svensoft has historically avoided competition with the two by focusing on the needs of large financial services providers However, Waldoware recently acquired a small financial services software firm and has provided significant resources for it to compete more effectively Further, Meteor has developed its own offering, which many customers consider superior to Svensoft's offering

• Threat of new entry: The dominant positions enjoyed by existing players have resulted in significant barriers

to entry

• Threat of substitutes: substitute products are not currently available

• Customer power: Since most financial services firms already have some sort of application software, the

recent increase in available offerings is allowing them to negotiate much better deals for renewals or new licenses

• Supplier power: Labor is the primary input to application software The increased rivalry has created demand

for programmers and elevated salaries, particularly for experienced programmers

• Demand: Application software has largely penetrated its target customer base and industry revenue growth

has slowed Over the business cycle revenues are now expected to rise and fall at approximately 1.25 times the rate of overall economic growth

• Supply: There are few limitations to the quantity of application software that can be provided

• Svensoft has decided to respond to these pressures by further focusing on the reliability of its applications Financial services customers have cited reliability as their key consideration in purchase decisions Svensoft currently lags Waldoware in this regard but intends to become the most reliable

Kennant believes in using appropriate valuation models grounded in traditional intrinsic value and discounting concepts She believes that modern portfolio theory (MPT) applies to portfolios but it is not useful in valuing an individual stock

Given the consolidation that has already taken place in the industry, Kennant believes Svensoft could be acquired She considers several potential valuation models to determine Svensoft's potential takeover value

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Svensoft's competitive strategy is best described as:

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Question

The industry analysis model for Svensoft pays least attention to:

Which life cycle phase and business cycle reaction best describe the application software industry?

Business Cycle Reaction

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