Free Latest CFA Institute CFA Level 2 Exam Questions

1. James Walker is the Chief Financial Officer for Lothar Corporation, a U.S. mining company that specializes in worldwide exploration for and excavation of precious metals. Lothar Corporation generally tries to maintain a debt-to-capital ratio of approximately 45% and has successfully done so for the past seven years. Due to the time lag between the discovery of an extractable vein of metal and the eventual sale of the excavated material, the company frequently must issue short-term debt to fund its operations. Issuing these one to six month notes sometimes pushes Lothar's debt to capital ratio above their long-term target, but the cash provided from the short-term financing is necessary to complete the majority of the company's mining projects.



Walker has estimated that extraction of silver deposits in southern Australia has eight months until project completion. However, funding for the project will run out in approximately six months. In order to cover the funding gap. Walker will have to issue short-term notes with a principal value of $1,275,000 at an unknown future interest rate. To mitigate the interest rate uncertainty, Walker has decided to enter into a forward rate agreement (FRA) based on LIBOR which currently has a term structure as shown in Exhibit 1.







Three months after establishing the position in the forward rate agreement, LIBOR interest rates have shifted causing the value of Lothar's FRA. position to change as well. The new LIBOR term structure is shown in Exhibit 2.



While Walker is estimating the change in the value of the original FRA position, he receives a memo from the Chief Operating Officer of Lochar Corporation, Maria Steiner, informing him of a major delay in one of the company's South African mining projects. In the memo, Stciner states the following: "As usual, the project delay will require a short-term loan to cover funding shortage that will accompany the extra time until project completion. I have estimated that in 210 days, we will require a 90-day project loan in the amount of $2,350,000.1 would like you to establish another FRA position, this time with a contract rate of 6.95%."



Which of the following is closest to the value of the forward rate agreement three months after the inception of the contract (from Walker's perspective)? For this question only, assume that the interest rate at inception was 6.0%.

2. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively.



Which of the following statements about evaluating High Plains financial reporting quality is least accurate?

3. MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRls, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the last decade. The company went public three years ago. Twelve months after their IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds which were putable, but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the last few months. Currently the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.



High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Since MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSofVs bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates:



"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Since the straight value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value."



"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."



Evaluate the portfolio managers' comments regarding the changes in the values of MediSoft's bonds resulting from changes in the volatility of the company's common stock and the volatility of interest rates. The managers were:

4. Michael Robbins, CFA, is analyzing Universal Home Supplies, Inc. (UHS), which has recently gone through some extensive restructuring.



Universal Home Supplies, Inc.



UHS operates nearly 200 department stores and 78 specialty stores in over 30 states. The company offers a wide range of products, including women's, men's, and children's clothing and accessories as well as home furnishings, electronics, and other consumer goods. The company is considering cutting back on or eliminating its electronics business entirely. UHS manufactures many of its own apparel products domestically in a large factory located in Kentucky. This central location permits shipping to distribution points around the country at reasonable costs. The company operates primarily in suburban shopping malls and offers mid- to high-end merchandise mainly under its own private label. At present more than 70% of the company's customers live within a 10-minute drive of one of the company's stores. Web site activity measured in dollar sales volume has increased by over 18% in the past year. Shares of UHS stock are currently priced at $25. Dividends are expected to grow at a rate of 6% over the next eight years and then continue to grow at that same rate indefinitely. The company has a cost of capital of 10.2%, a beta of 0.8, and just paid an annual dividend of $1.25.



UHS has faced serious cash flow problems in recent years as a consequence of its strategy to pursue an upscale clientele in the face of increased competition from several "niche retailers." The firm has been able to issue new debt recently and has also managed to extend its line of credit. The two financing agreements required a pledge of additional assets and a promise to install a super-efficient inventory tracking system in time to meet holiday shopping demand.











Robbins is asked by his supervisor to carefully consider the advantages and drawbacks of using the price-to-sales ratio (P/S) and to determine the appropriate valuation metrics to use when returns follow patterns of persistence or reversals.



Robbins also estimates a cross-sectional model to predict UHS's P/E:

predicted P/E = 5 - (10 x beta) + [3 x 4-year average ROE(%)]

+ [2 X 5-ycar growth forecast(%)]



Is UHS stock, at the end of 2008, best described as overvalued or undervalued according to the:

Trailing PEG ratio? P/S ratio?

5. Delicious Candy Company (Delicious) is a leading manufacturer and distributor of quality confectionery products throughout Europe and Mexico. Delicious is a publicly-traded firm located in Italy and has been in business over 60 years.



Caleb Scott, an equity analyst with a large pension fund, has been asked to complete a comprehensive analysis of Delicious in order to evaluate the possibility of a future investment.



Scott compiles the selected financial data found in Exhibit 1 and learns that Delicious owns a 30% equity interest in a supplier located in the United States. Delicious uses the equity method to account for its investment in the U.S. associate.





Scott reads the Delicious's revenue recognition footnote found in Exhibit 2.



Exhibit 2: Revenue Recognition Footnote

____________________________________________________________________________

in millions___________________________________________________________________

Revenue is recognized, net of returns and allowances, when the goods are shipped to customers and collectability is assured. Several customers remit payment before delivery in order to receive additional discounts. Delicious reports these amounts as unearned revenue until the goods are shipped. Unearned revenue was 7,201 at the end of 2009 and 5,514 at the end of 2008.



Delicious operates two geographic segments: Europe and Mexico. Selected financial information for each segment is found in Exhibit 3.







At the beginning of 2009, Delicious entered into an operating lease for manufacturing equipment. At inception, the present value of the lease payments, discounted at an interest rate of 10%, was 6300 million. The lease term is six years and the annual payment is 669 million. Similar equipment owned by Delicious is depreciated using the straight-line method and no residual values are assumed.



Scott gathers the information in Exhibit 4 to determine the implied "stand-alone" value of Delicious without regard to the value of its U.S. associate.







Using the data found in Exhibit 1 and Exhibit 4, Delicious's implied P/E multiple without regard to its U.S. associate is closest to:

6. Viper Motor Company, a publicly traded automobile manufacturer located in Detroit, Michigan, periodically invests its excess cash in low-risk fixed income securities. At the end of 2009, Viper's investment portfolio consisted of two separate bond investments: Pinto Corporation and Vega Incorporated.



On January 2, 2009, Viper purchased $10 million of Pinto's 4% annual coupon bonds at 92% of par. The bonds were priced to yield 5%. Viper intends to hold the bonds to maturity. At the end of 2009, the bonds had a fair value of $9.6 million.



On July I, 2009, Viper purchased $7 million of Vega's 5% semi-annual coupon mortgage bonds at par. The bonds mature in 20 years. At the end of 2009, the market rate of interest for similar bonds was 4%. Viper intends to sell the securities in the near term in order to profit from expected interest rate declines.



Neither of the bond investments was sold by Viper in 2009.



On January 1,2010, Viper purchased a 60% controlling interest in Gremlin Corporation for $900 million. Viper paid for the acquisition with shares of its common stock.



Exhibit 1 contains Viper's and Gremlin's pre-acquisition balance sheet data.







Exhibit 2 contains selected information from Viper's financial statement footnotes.







The carrying value of Viper's investment portfolio as of December 31, 2009 is closest to:

7. Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U.S. stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U.S. allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.



Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."



Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:



"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."



Which of the following best describes the movement of the futures price on the 240-day equity index futures contract as the contract moves toward the expiration date?

8. Galena Petrovich, CFA, is an analyst in the New York office of TRS Investment Management, Inc. Petrovich is an expert in the industrial electrical equipment sector and is analyzing Fisher Global. Fisher is a global market leader in designing, manufacturing, marketing, and servicing electrical systems and components, including fluid power systems and automotive engine air management systems.



Fisher has generated double-digit growth over the past ten years, primarily as the result of acquisitions, and has reported positive net income in each year. Fisher reports its financial results using International Financial Reporting Standards (IFRS).



Petrovich is particularly interested in a transaction that occurred seven years ago, before the change in accounting standards, in which Fisher used the pooling method to account for a large acquisition of Dartmouth Industries, an industry competitor. She would like to determine the effect of using the purchase method instead of the pooling method on the financial statements of Fisher. Fisher exchanged common stock for all of the outstanding shares of Dartmouth.



Fisher also has a 50% ownership interest in a joint venture with its major distributor, a U.S. company called Hydro Distribution. She determines that Fisher has reported its ownership interest under the proportioned consolidation method, and that the joint venture has been profitable since it was established three years ago. She decides to adjust the financial statements to show how the financial statements would be affected if Fisher had reported its ownership under the equity method. Fisher is also considering acquiring 80% to 100% of Brown and Sons Company. Petrovich must consider the effect of such an acquisition on Fisher's financial statements.



Petrovich determines from the financial statement footnotes that Fisher reported an unrealized gain in its most recent income statement related to debt securities that are designated at fair value. Competitor firms following U.S. GAAP classify similar debt securities as available-for-sale.



Finally, Petrovich finds a reference in Fisher's footnotes regarding a special purpose entity (SPE). Fisher has reported its investment in the SPE using the equity method, but Petrovich believes that the consolidation method more accurately reflects Fisher's true financial position, so she makes the appropriate adjustments to the financial statements.



Had Fisher Global reported its investment in the joint venture under the equity method rather than under the proportionate consolidation method, it is most likely that:

9. Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U.S. stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U.S. allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.



Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."



Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:



"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."



Determine the price of the futures contract on the equity index as of the inception date, January 18.

10. Alertron is a pharmaceutical company with approximately $3.5 billion in annual sales that specializes in the development, manufacturing, and marketing of neurology and oncology drug therapies. The firm is seeking to achieve more rapid growth, and Alertron's executive management team feels that the company can grow faster by making acquisitions than it can by trying to grow organically. As a result, management asks the firm's Director of Strategic Planning, Kanna Ozer, CFA, to analyze potential alternatives. At Alertron's next executive management team meeting, Ozer presents the report shown in Exhibit 1 concerning four potential acquisition targets:





Alertron's executive team agrees that the report is helpful for initiating discussion but decides they need more information concerning the form _of each potential acquisition and the most appropriate method of payment. Alertron's1 management is also concerned whether each potential target would view a takeover attempt as friendly or hostile. Paul Mussara, Alertron's CEO, asks Ozer to prepare a second report that specifically describes the transaction characteristics corresponding to each deal. Ozer's second report is shown in Exhibit 2.





As Alertron was conducting its analysis, Bhavik Kumar, CEO of Dillon Biotech, hears rumors that Alertron may attempt a hostile takeover of his firm. Kumar calls an emergency meeting with Dillon's four executive vice presidents and expresses his concern that Alertron may attempt a bear hug by submitting a merger proposal directly to the board without informing Dillon's management. Kumar concludes the emergency meeting by asking each executive vice president to brainstorm defense mechanisms that Dillon could employ before a takeover attempt is made and also defenses that could be employed after a hostile takeover offer.

After intense discussions, Alertron decides that a takeover offer for Carideo would be most beneficial due to the net present value of cost reduction synergies of $600 million that Ozer estimates would result from the merger. Mussara asks Ozer to evaluate the deal based on a stock offer in which Alertron would exchange 0.75 shares of Alertron stock for each outstanding share of Carideo stock. Ozer compiles the information shown in Exhibit 3 for her analysis.





Ozer, and the rest of the executive management team at Alertron, is extremely confident in the $600 million dollar estimate of cost reduction synergies that are likely to result from the merger and feel that the estimate may actually be conservative. However, when analysts at Carideo review the figures, they have a much different opinion and are less certain that $600 million worth of synergies could be realized. While Carideo believes the net present value of synergies from the deal would still be positive, its estimates are much lower than Alertron's



Carideo's management is also concerned that a merger between Alertron and Carideo could face scrutiny from regulators. Although neither firm is the largest in the pharmaceutical industry, their combined market power could raise antitrust concerns. Phillip Wu, an analyst with Carideo, compiles the following table showing the market share of each of the 12 firms in the pharmaceutical industry to determine whether the concerns were valid. Both Alertron's and Carideo's management teams decide that if regulators are unlikely to challenge the deal, they will proceed with the necessary steps to complete the merger.





Based on each firm's forecasts of the estimated NPV of synergies from a merger between Alertron and Carideo, what payment method is each firm likely to prefer in the deal?

11. William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007-2008 and in developing projections for 2009 and 2010 fiscal years.



Adams Company has been the largest company in the industry but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson but were only 18% above Jefferson in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities.



In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009.



The accompanying table shows financial data for both companies' Form 10-k reports for 2006-2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality.







Based on the financial results of Adams and Jefferson in 2007 and 2008, the company demonstrating the lower earnings quality would be:

12. Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments.



On December 31,2007, Wayland purchased a 35% ownership interest in a strategic new firm called Optimax for $300,000 cash.

The pre-acquisition balance sheets of both firms are found in Exhibit 1.





On the acquisition date, all of Optimax's assets and liabilities were stated on its balance sheet at their fair values except for its property, plant, and equipment (PP&E), which had a fair value of $1.2 million. The remaining useful life of the PP&E is ten years with no salvage value. Both firms use the straight-line depreciation method.



For the year ended 2008, Optimax reported net income of $250,000 and paid dividends of $100,000.



During the first quarter of 2009, Optimax sold goods to Wayland and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Optimax remained in Wayland's inventory.



Wayland currently uses the equity method to account for its investment in Optimax. However, given the potential significance of the investment in the future, Rathbun believes that a proportionate consolidation of Optimax may give a clearer picture of the financial and operating characteristics of Wayland.



Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers the data in Exhibit 2 from Wayland's financial statements. The year-end portfolio value is the market value of all Vanry shares held on December 31. All security transactions occurred on July 1, and the transaction price is the price that Wayland actually paid for the shares acquired. Vanry pays a cash dividend of $1 per share at the end of each year. Wayland expects to sell its investment in Vanry in the near term and accounts for it as held-for-trading.



Wayland owns some publicly traded bonds of the Rotor Corporation that it reports as held-to-maturity securities.



As a result of its investment in Vanry, what amount should Wayland recognize in its income statement for the year ended 2008?

13. The New Growth Era (1991-Today)

Since the Alphian energy crises of the late 1980s, the economy has been in transition. The AEDA goal is to have more than 50% of Alphian GDP coming from what we now call knowledge capital based industries by the year 2020. Given the large and growing population and their constant need for health care, the pharmaceutical industry was Alphia's first knowledge capital based industry. Dr. Satish believes that a focus on knowledge capital will enhance the long term growth prospects of Alphia's economy.



According to the neoclassical growth theory, calculate the contribution to real GDP growth during the period from 1986 to 1990 that came from an increase in capital per hour of labor.

14. Connor Burton, CFA, is the managing partner for United Partners, a small investment advisory firm that employs three investment professionals and currently has approximately $250 million of assets under management. The client base of United Partners is varied, and accounts range in size from small retirement accounts to a $30 million private school endowment. In addition to Burton's administrative responsibilities as the managing partner at United, he also serves as an investment advisor to several clients. Because United Partners is a small firm, the company does not employ any research analysts but instead obtains its investment research products and services from two national brokerage firms, which in turn execute all client trades for United Partners. The arrangement with the two brokers has enabled United to assure its clients that the firm will always seek the best execution for them by having both brokers competitively bid for United's business.



A prospective client, Harold Crossley, has approached Burton about shifting some of his personal assets under management from MoneyCorp to United Partners. Burton provides Crossley with a packet of marketing information that Burton developed himself. The packet contains five years of historical performance data for the private school endowment, Unitcd's largest client. Burton states that the composite's management style and performance results are representative of the management style and returns that United can be expected to achieve for Crossley. Also included in the information packet are brief bios on each of United's three investment professionals. Crossley notices that all three of United's investment professionals are described as "CFA charterholders," but he is not familiar with the designation. In response to Crossley's inquiry. Burton explains the significance of the program by stating that the designation, which is only awarded after passing three rigorous exams and obtaining the requisite years of work experience, represents a commitment to the highest standards of ethical and professional conduct.



As a condition of moving his account to United Partners, Crossley insists that all of his trades be executed through his brother-in-law, a broker for Security Bank. Security Bank is a large, New York-based broker/dealer but is not one of the two brokerage firms with which United currently does business. Burton contacts Crossley's brother-in-law and determines that Security Bank's trade execution is competitive, but Crossley's account alone would not generate enough volume to warrant any soft dollar arrangement for research materials.



However, Crossley'-s brother-in-law does offer for Security Bank to pay a referral fee to Burton for directing any of United's clients to Security Bank's retail banking division. To bring Crossley on as a client, Burton agrees to the arrangement. Going forward. Burton will use Security Bank to execute all of Crossley's trades but will use research materials provided by the other two brokers to assist in the management of Crossley's account.



Several months later, Burton is invited to a road show for an initial public offering (IPO) for Solution Ware, a software company. Security Bank is serving as lead underwriter on SolutionWare's IPO. Burton attends the meeting, which is led by two investment bankers and one software industry research analyst from Security Bank who covers SolutionWare. Burton notes that the bankers from Security Bank have included detailed financial statements for SolutionWare in the offering prospectus and also disclosed that Security Bank provides a warehouse line of credit to SolutionWare. After the meeting, Burton calls Crossley to recommend the purchase of SolutionWare equity. Crossley heeds Burton's advice and tells him to purchase 5,000 shares. Before placing Crossley's order, Burton reads the SolutionWare marketing materials and performs a detailed analysis of expected future earnings and other key factors for the investment decision. Burton determines that the offering would be a suitable investment for his own retirement portfolio in addition to Crossley's portfolio. United Partners, being a small firm, has no formal written policy regarding trade allocation, employee participation in equity offerings, or established blackout periods for employee trading. Burton adds his order to Crossley's order and places a purchase order for the combined number of shares with Security Bank. Burton is later notified that the offering was oversubscribed, and United Partners was only able to obtain roughly 75% of the desired number of shares. To be fair. Burton allocates the shares on a pro rata basis between Crossley's account and his own retirement account. When Burton notifies Crossley of the situation, Crossley is nonetheless pleased to have a position, though smaller than requested, in such a "hot" offering.



According to CFA Standards of Professional Conduct, Burton's participation in the Solution Ware offering most likely:

15. Jenna Stuart is a financial analyst for Deuce Hardware Company, a U.S. company that reports its results in U.S. dollars. Wayward Distributing, Inc., is a foreign subsidiary of Deuce Hardware, which began operations on January 1,2007. Wayward is located in a foreign country and reports its results in the local currency called the Rho. Selected balance sheet information for Wayward is shown in the following table.





Stuart has been asked to analyze how the reported financial results of Wayward will be affected by the choice of the all-current or temporal methods of accounting for foreign operations.

She has gathered the following exchange rate information on the $/Rho exchange rate:

• Spot rate on 1/01/08: $0.35 per Rho

• Spot rate on 12/31/08: $0.45 per Rho

• Average spot rate during 2008: $0.42 per Rho



Will total asset turnover (calculated using end-of-period balance sheet figures) likely be larger when calculated from the Rho financial statements or the financial statements translated into the reporting currency (US$) using the all-current method?

16. Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.



The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000.



The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.



The after-tax operating cash flow for the first year of operations with the new equipment (excluding the initial outlay) is closest to:

17. In 2001, Continental Supply Company was formed to provide drilling equipment and supplies to contractors and oilfield production companies located throughout the United States. At the end of 2005, Continental Supply created a wholly owned foreign subsidiary, International Oilfield Incorporated, to begin servicing customers located in the North Sea. International Oilfield maintains its financial statements in a currency known as the local currency unit (LCU). Continental Supply follows U.S. GAAP and its presentation currency is the U.S. dollar.



For the years 2005 through 2008, the weighted-average and year-end exchange rates, stated in terms of local currency per U.S. dollar, were as follows:





International Oilfield accounts for its inventory using the lower-of-cost-or-rnarlcet valuation method in conjunction with the first-in, first-out, cost flow assumption. All of the inventory on hand at the beginning of the year was sold during 2008. Inventory remaining at the end of 2008 was acquired evenly throughout the year.



At the beginning of 2006, International Oilfield purchased equipment totaling LCU975 million when the exchange rate was LCU 1.00 to SI. During 2007, equipment with an original cost of LCU 108 million was totally destroyed in a fire. At the end of 2007, International Oilfield received a LCU 92 million insurance settlement for the loss. On June 30, 2008, International Oilfield purchased equipment totaling LCU 225 million when the exchange rate was LCU 1.25 to $1.



For the years 2007 and 2008, Continental Supply reported International Oilfield revenues in its consolidated income statement of S375 million and $450 million, respectively. There were no inter-company transactions.

Following are International Oilfield's balance sheets at the end of 2007 and 2008:





At the end of 2008, International Oilfield's retained earnings account was equal to $525 million and, to date, no dividends have been paid. All of International Oilfield's capital stock was issued at the end of 2005.



Assuming that International Oilfield's equipment is depreciated using the straight-line method over ten years with no salvage value, calculate the subsidiary's 2008 depreciation expense under the temporal method.

18. Josh Atwell recently inherited a large sum of money and wants to invest a portion of the inheritance into a real estate investment that provides a tax shelter. Atwell wants to take a limited management role in the real estate investment, and avoid the expense of hiring professional project management. Also, Atwell requires that the real estate investment generate high cash flows. Atwell hired Kellogg Investments to provide him potential real estate investments. Kellogg created Exhibit 1 outlining alternative real estate investments, from which Atwell can make his selection. Atwell's cost for any loan is 8%. The loan would be amortized over 20 years with annual payments. His required rate of return is 11%.





After reviewing the potential real estate investments generated by Kellogg, Atwell decided against all of the choices. Instead, Atwell requested a detailed report on the investment merits of an apartment complex. In Exhibit 2, Kellogg details the operating income of a targeted apartment complex investment. Atwell will make an equity contribution of $1,000,000. The loan-to-value ratio for the apartment complex investment would be 75%.







An adviser from Kellogg states that Atwell should purchase the apartment complex because the net present value of the investment is positive. The adviser also states, however, that the investment's IRR is less than Atwell’s required rate of return. After reviewing the historical financial statements of the potential hotel investment, the advisor notes its erratic net operating income. In fact, the hotel generated several years of growing cash flow followed by two negative years and then a return back to a positive cash flow.



The Kellogg adviser states that the NPV of the apartment complex investment is positive and that the IRR is less than Atwell’s required rate of return. Are the adviser's statements correct?

19. Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.





At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.



As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:

Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.

Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.



Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.







Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.



Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.



If the 5- and 10-year key rates increase by 20 basis points, but the 2- and 20-year key rates remain unchanged:

20. Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.



Ferguson Department Stores, Inc.



FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.



At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.







In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.





In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.



According to FDS's price-to-sales ratio for 2008, based on the post-expansion announcement stock price, FDS is:

21. Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.



Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.







Haas makes the following statements during her YD presentation to the investment committee.



Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.

Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.



During her analysis, Haas came across some estimates of YD's intrinsic value prepared by another analyst. These estimates showed a weighted average cost of capital (WACC) of 12.0%, net operating profit after taxes (NOPAT) of $42 million, and a total adjusted capital base of $200 million. Based on these estimates, YD's residual return on capital (RROC) is closest to:

22. Marsha McDonnell and Frank Lutge are analysts for the private equity firm Thorngate Ventures. Their primary responsibility is to value the equity of private firms in developed global economies. Thorngate’s clients consist of wealthy individuals and institutional investors. The firm invests in and subsequently actively manages its portfolio of private firms.



During a discussion with junior analysts at the firm, McDonnell compares the characteristics of private firms with that of public firms and makes the following statements:



Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier. Furthermore, the lack of access to

liquid public equity markets can limit a private firm's growth.



Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm, compared to public Firm managers. As a result, the private firm may neglect profitable long-term projects.



Due to its considerable success, Thorngate has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnell and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm's research team is developing a drug that Thomgate's current pharmaceutical firm is also working on. McDonnell estimates that combining research teams would result in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its founders have not advertised the firm's sale publicly.



McDonnell is also examining the prospects of Balanced Metals, a metal fabrication firm. Thorngate currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales at Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm's most valuable assets are its equipment and factory, located in a prime industrial area.



Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although (he sale was not consummated, McDonnell has learned that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnell has obtained the following financial figures from (he Balanced Metals CFO as well as the previously estimated synergistic savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm's incremental revenues.



Current revenues $22,000,000

Revenue growth 7%

Gross profit margin 25%

Depreciation expense as a percent of sales 1%

Working capital as a percent of sales 15%

SG&A expenses $5,400,000

Synergistic cost savings $1,200,000

Tax rate 30%

Lutge is valuing a noncontrolling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years. However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%.



To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen's small size, Lutge obtains a size premium using the smallest size decile of the database. McDonnell examines Lutge's cost of capital calculations and makes the following statements.



Statement 1: I am concerned about the use of this database. The estimation of the size premium may result in an undervaluation of the Jensen equity interest.



Statement 2: The use of betas and the CAPM from the database may be inappropriate, [f so, Lutge should consider using the build-up method where an industry risk premium is used instead of beta.



Which of the following is closest to the FCFF that McDonnell should estimate for Balanced Metals?

23. Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1.





The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides detail about the Alpha Fund with a vintage year of 2006 and committed capital of SI95 million.





The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's new drug pipeline, a company value of $300 million is reasonable in five years. Management at Alpha Fund views Targus Company as a risky investment and is using a discount rate of 40%. After a thorough analysis of Targus's future prospects, Alpha Fund's management believes that there is a possible 15% risk of failure for the company.



Using Exhibit 2 and assuming a 20% carried interest, the Alpha Fund's 2008 dollar amount of carried interest is closest to:

24. MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:



Expected return for Portfolio X =15%

Standard deviation of returns for Portfolio X = 20%

Expected return for Portfolio Y = 7%

Standard deviation of returns for Portfolio Y = 5%



Expected return on Portfolio Z = 5%



Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.



Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:



Expected return on Burk's portfolio = 10%

Standard deviation of returns on Burk's portfolio = 12%

Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of Long Drives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%.



After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.



MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.



MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:



Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.



Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, the Treynor-Black model avoids this problem because it does not consider short positions in securities.



In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast and Elizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.





Kitna has hired MPTA to evaluate the CCT stock and to make a valuation recommendation. In order to determine if the CCT stock is undervalued, overvalued, or properly valued, MPTA must first determine the appropriate value for the CCT beta. Given a CCT beta of 1.5, what is the conclusion that MPTA should make about the value of CCT based on the consensus analyst forecast of CCT returns?

25. Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.



Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to

LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.



Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.



Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.



Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.



Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.

• If a firm anticipates floating rate exposure from issuing floating rate bonds a t some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.

• Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.



If 1-year LIBOR at the end of year 2 is 5.8%, the absolute value of a position (long or short) in the 2-year, 6%, $30 million interest rate floor at the end of year 2 is closest to:

26. Jason Bennett is an analyst for Valley Airlines (Valley), a U.S. firm. Valley owns a stake in Southwest Air Cargo (Southwest), also a U.S. firm. The two firms have had a long-standing relationship. The relationship has become even closer because several of Valley's top executives hold seats on Southwest's Board of Directors.



Valley acquired a 45% ownership stake in Southwest on December 31, 2007. Acquisition of the ownership stake cost $9 million and was paid in cash. Valley's stake in Southwest is such that management can account for the investment using either the equity method or the acquisition method. While Valley's management desires to fairly represent the firm's operating results, they have assigned Bennett to assess the impact of each method on reported financial statements.



Immediately prior to the acquisition. Valley's current asset balance and total equity were $96 million and $80 million, respectively. Southwest's current assets and total equity were $32 million and $16 million, respectively.



While analyzing the use of the equity method versus the acquisition method, Bennett calculates the return on assets (ROA) ratio. He arrives at two conclusions:

Statement 1: Compared to the acquisition method, the equity method results in a higher ROA because of the higher net income under the equity method.

Statement 2: Compared to the acquisition method, the equity method results in a higher ROA because of the smaller level of total assets under the equity method.



In order to get a better picture of Valley's operating condition, Bennett is also considering the use of proportionate consolidation to account for Southwest.



He makes the following statements regarding the acquisition method and a proportionate consolidation:

Statement 3: Both methods are widely accepted under the provisions of U.S. GAAP and International Financial Reporting Standards (IFRS).

Statement 4: Both methods report the same level of assets on the parent's balance sheet.

Statement 5: Both methods report all of Southwest's liabilities on the parent's balance sheet.



In addition. Valley has always wanted to pursue its goal of vertical integration by expanding its scope of operations to include the manufacturing of airline parts for its own airplanes. Therefore, it established a subsidiary, Mountain Air Parts (Mountain), in Switzerland on January 1,2008. Switzerland was chosen as the location for economic and geographical diversification reasons. Mountain will operate as a self-contained, independent subsidiary. Local management in Switzerland will make the majority of operating, financing, and investing decisions.



The Swiss franc (CHF) is the official currency in Switzerland. On January 1, 2008, the USD/CHF exchange rate was 0.77. At December 31, 2008, the exchange rate had changed to 0.85 USD/CHF. The average exchange rate in 2008 was 0.80 USD/CHF. In its first year of operations. Mountain paid no dividends and no taxes. Mountain uses the FIFO assumption for its flow of inventory.







The balance of Valley's current assets as of December 31, 2007, using the acquisition method, is closest to:

27. Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.



Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the "neglected firm effect," in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be "neglected."



Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:



Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei where:

Ri = the rate of return on stock i



COVERAGEi = one if there are three or fewer analysts covering stock i, and equals zero otherwise

LN(SIZEi) = the natural logarithm of the market capitalization (stock price times shares outstanding) for stock i, units in millions



FORECASTi = the 1-year consensus earnings growth rate forecast for stock i



Pilchard derives the following results from her cross-sectional regression:





The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.



Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.





Wilrus asks Pilchard to assess the overall significance of her regression. To address the question, Pilchard calculates the R-square. She also decides to run a test of the significance of the regression as a whole. Determine the appropriate test statistic she should use to test the overall significance of the regression.

28. Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate.

Black notes the following term structure:





Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.



Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department.

Coleman advises Black that:

Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk at the initiation of the swap but the floating rate payer is not.

Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short position in a payer swaption is not.



On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap.

The term structure after 120 days is:





Which position (long or short) should Black take in the payer and receiver swaptions based on his interest rate forecast?

Payer swaption ;Receiver swaption

29. Jenna Stuart is a financial analyst for Deuce Hardware Company, a U.S. company that reports its results in U.S. dollars. Wayward Distributing, Inc., is a foreign subsidiary of Deuce Hardware, which began operations on January 1,2007. Wayward is located in a foreign country and reports its results in the local currency called the Rho. Selected balance sheet information for Wayward is shown in the following table.





Stuart has been asked to analyze how the reported financial results of Wayward will be affected by the choice of the all-current or temporal methods of accounting for foreign operations.

She has gathered the following exchange rate information on the $/Rho exchange rate:

• Spot rate on 1/01/08: $0.35 per Rho

• Spot rate on 12/31/08: $0.45 per Rho

• Average spot rate during 2008: $0.42 per Rho



Will fixed asset turnover (calculated using end-of-period balance sheet figures) likely be lower when calculated using the all-current method or remeasured using the temporal method?

30. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively.



Using only the information found in Exhibit 1 and Exhibit 2, which of the following is most indicative of lower earnings quality?

31. Maria Harris is a CFA® Level 3 candidate and portfolio manager for Islandwide Hedge Fund. Harris is commonly involved in complex trading strategies on behalf of Islandwide and maintains a significant relationship with Quadrangle Brokers, which provides portfolio analysis tools to Harris. Recent market volatility has led Islandwide to incur record-high trading volume and commissions with Quadrangle for the quarter. In appreciation of Islandwide's business, Quadrangle offers Harris an all-expenses-paid week of golf at Pebble Beach for her and her husband. Harris discloses the offer to her supervisor and compliance officer and, based on their approval, accepts the trip.



Harris has lunch that day with C. K. Swamy, CFA, her old college roommate and future sister-in-law. While Harris is sitting in the restaurant waiting for Swamy to arrive, Harris overhears a conversation between the president and chief financial officer (CFO) of Progressive Industries. The president informs the CFO that Progressive's board of directors has just approved dropping the company's cash dividend, despite its record of paying dividends for the past 46 quarters. The company plans to announce this information in about a week. Harris owns Progressive's common stock and immediately calls her broker to sell her shares in anticipation of a price decline.



Swamy recently joined Dillon Associates, an investment advisory firm. Swamy plans to continue serving on the board of directors of Landmark Enterprises, a private company owned by her brother-in-law, for which she receives $2,000 annually. Swamy also serves as an unpaid advisor to the local symphony on investing their large endowment and receives four season tickets to the symphony performances.



After lunch, Alice Adams, a client, offers Harris a 1 -week cruise as a reward for the great performance of her account over the previous quarter. Bert Baker, also a client, has offered Harris two airplane tickets to Hawaii if his account beats its benchmark by more than 2% over the following year.



Juliann Clark, a CFA candidate, is an analyst at Dillon Associates and a colleague of Swamy's. Clark participates in a conference call for several analysts in which the chief executive officer at Dex says his company's board of directors has just accepted a tender offer from Monolith Chemicals to buy Dex at a 40% premium over the market price. Clark contacts a friend and relates the information about Dex and Monolith. The friend promptly contacts her broker and buys 2,000 shares of Dex's stock.



Ed Michaels, CFA, is director of trading at Quadrangle Brokers. Michaels has recently implemented a buy program for a client. This buy program has driven up the price of a small-cap stock, in which Islandwide owns shares, by approximately 5% because the orders were large in relation to the average daily trading volume of the stock. Michaels' firm is about to bring shares of an OTC firm to market in an



IPO. Michaels has publicly announced that, as a market maker in the shares, his trading desk will create additional liquidity in the stock over its first 90 days of trading by committing to minimum bids and offers of 5,000 shares and to a maximum spread of one-eighth.



Carl Park, CFA, is a retail broker with Quadrangle and has been allocated 5,000 shares of an oversubscribed IPO. One of his clients has been complaining about the execution price of a trade Park made for her last month, but Park knows from researching it that the trade received the best possible execution. In order to calm the client down. Park increases her allocation of shares in the IPO above what it would be if he allocated them to all suitable client accounts based on account size. He allocates a pro rata portion of the remaining shares to a trust account held at his firm for which his brother-in-law is the primary beneficiary.

By accepting the trip from Quadrangle, has Harris complied with the CFA Institute Code and Standards?

32. Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.



Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.







Haas makes the following statements during her YD presentation to the investment committee.



Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.

Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.



Haas makes a statement about an assumption concerning residual income (Statement 1) and the residual income model (Statement 2).

Which of the statements is correct?

33. Christopher Robinson, chairman of the board of directors for a private endowment fund, believes that the endowment fund for which he is responsible has diverged too far from its stated objectives. Over several years the board has increased the size of the fund's equity position beyond the stated limits of the investment policy statement. In an effort to realign the fund's investments, Robinson has elected to choose a mortgage-backed security (MBS) for inclusion in the endowment's portfolio. After surveying the MBS market, Robinson has selected four MBS securities to present as potential investments at the next investment committee meeting. Details on the selected MBS securities are presented below:





At the investment committee meeting, a fellow board member raises his concerns over the potential MBS investments stating, "While we all agree that the fixed-income proportion of the endowment is much too small, I am not sure the suggested MBS securities will fulfill the cash flow requirements of the endowment. What risks are we taking on by allocating a portion of the portfolio to these investments? We cannot afford to end up with a timing mismatch between the cash needs of the endowment and the cash provided from its investments. Also, we have given no consideration to commercial mortgage backed securities (CMBS). Isn't our analysis incomplete if we fail to give proper discussion of potential CMBS investment opportunities?"



Robinson responded to his fellow board member by addressing the board member's concerns as follows:



"Since the cash requirements of the endowment fund fluctuate directly with interest rates, the cash flows provided from the MBS will provide adequate protection against cash shortfalls arising from differences in the timing of cash needs and cash sources. In addition, we can further reduce uncertainty surrounding the timing of cash flows by purchasing planned amortization class CMOs, which are securities issued against pools of MBS. CMBS were not presented due to the unacceptable risk profile of the comparable CMBS trading in the marketplace."

Determine the single month mortality rate for MBS-X for Month 20 using 200 PSA.

34. Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.



Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.





After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an

alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.



If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."



To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

Evaluate, in light of the appropriate equity swap strategy for Jacobs's portfolio, Mr. Widby's comments regarding the credit risk and use of swaptions in Jacobs's portfolio.

35. Jenna Stuart is a financial analyst for Deuce Hardware Company, a U.S. company that reports its results in U.S. dollars. Wayward Distributing, Inc., is a foreign subsidiary of Deuce Hardware, which began operations on January 1,2007. Wayward is located in a foreign country and reports its results in the local currency called the Rho. Selected balance sheet information for Wayward is shown in the following table.





Stuart has been asked to analyze how the reported financial results of Wayward will be affected by the choice of the all-current or temporal methods of accounting for foreign operations.

She has gathered the following exchange rate information on the $/Rho exchange rate:

• Spot rate on 1/01/08: $0.35 per Rho

• Spot rate on 12/31/08: $0.45 per Rho

• Average spot rate during 2008: $0.42 per Rho



Suppose for this question only that Stuart has determined that (1) the operating, financing, and investing decisions related to Wayward's operations are typically made by Wayward's local management located in the foreign country; and (2) some of Wayward's accounts receivable are denominated in a different foreign currency called the Del (DI).

Which method is the best to use to translate the Del receivables into Rho, according to U.S. GAAP?

36. Jill Surratt, CFA, and Elizabeth Castillo, CFA, are analysts for Summit Consulting. Summit provides investment advice to hedge funds and actively managed investment funds throughout the United States and Canada.



Surratt and Castillo have a client, Tom Carr, who is interested in increasing his returns from foreign currency positions. Carr currently has a position in Japanese yen (¥) that he wishes to convert to Taiwanese dollars (NTS) because he thinks the Taiwanese currency will appreciate in the near term. He docs not have a quote for yen in terms of the NTS, but has received quotes for both currencies in terms of the U.S. dollar The quotes are $0.008852-56 for the yen and $0.02874-6 for the Taiwanese dollar. He would like to purchase NTS10 million.



Discussing these quotes, Surratt notes that the bid-ask spread is affected by many factors. She states that if an economic crisis were expected in the Asian markets, then the bid-ask spread of the currency quotes should widen. Castillo states that if a dealer wished to unload an excess inventor}' of yen, the typical response would be to lower her ask for the yen, thereby narrowing the bid-ask spread.



In regards to changes in currency values, Surratt states that if the U.S. Federal Reserve unexpectedly restricts the growth of the money supply and foreign interest rates remain constant, then the U.S. interest rate differential should increase, thereby increasing the value of the dollar. She states that this change may occur without a change in the quantity of dollars traded. Surratt also mentions that in addition to monetary policy having an impact on exchange rates, governments sometimes intervene directly into the foreign currency markets. She states that if a country was defending its currency value, it would buy up its currency for as long as needed in the foreign currency markets.



In addition to using monetary policy, Summit Consulting uses anticipated changes in fiscal policy to forecast exchange rates and the balance of payments for a country. Castillo states that if the U.S. Congress were to unexpectedly reduce the budget deficit, then this should have a positive impact on the value of the dollar in the short-run because foreigners would have more confidence in the U.S. economy. Castillo adds that this change would result in changes in the balance of payments components, with the trade deficit and the capital account surplus decreasing.



Another of Summit's clients is Jack Ponder. Ponder would like to investigate the possibility of using covered interest arbitrage to earn risk free profits over the next three months, assuming initial capital of $1 million. He asks Surratt to gather information on the inflation rates, interest rates, spot rates, and forward rates for the U.S. dollar and the Swiss franc (SF). Surratt has also used technical analysis to obtain a projection of the future spot rate for the two countries' currencies.

The information is presented below:





At a training session for new employees, Surratt and Castillo lecture on international trade and finance issues. To illustrate the concept of comparative advantage, Castillo uses two countries, Country A and Country B. Both produce computers and food but have different opportunity costs for producing them. A's opportunity cost of producing another pallet of computers is two bushels of food. B*s opportunity cost of producing another pallet of computers is five bushels of food. The table below provides the output from each country before international trade takes place;





Are Surratt and Castillo correct with regard to their statements concerning the currency bid-ask spreads?

37. Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for Anderson Brothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).



Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.



Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price. Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.



Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.







Williams asks the bank for a GBP/SFr cross rate.

From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:

• 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55

• 60-day forward rate: USD/GBP = USD/GBP = 2.0075 - 85



Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U.S. risk-free rate is 5%.



Is Williams's analysis of the effect of rising nominal Bundovian interest rates on the value and equilibrium quantity of the BU correct?

38. Mary Carr is 62 years old, in good health, and will retire in four years from her position as the CEO and chairman of the board of a large professional services firm, Appleton Professional Services, which is located in the midwestern United States. Carr has approached Tim Houlis, her financial planner, for help in preparing an investment policy statement and accompanying asset allocation. Jack Timmons is Houlis’ assistant.



In a lunch meeting with Houlis and Timmons, Carr reveals that she is thinking of moving this year to be closer to Appleton's largest client. She is concerned about developing an investment plan now given that she will no longer have contact with Houlis if she does move. Houlis reassures her that this is not a problem. He states that a properly constructed investment policy statement can be readily implemented by her new financial advisor. Timmons states that the investment policy statement is a long-term document that should be changed only if the outlook for equities versus bonds and other assets changes.



Carr's parents were successful business people who owned a series of small firms. Their success, however, did not come without challenges. Twice they had to liquidate businesses in which they were the primary shareholders. As a child, Carr became accustomed to the uncertainties of the entrepreneurial world. When she graduated from college, her parents provided her with the funds to purchase Appleton Professional Services. Appleton was a small firm at that point, but Can-has grown it into one of the larger firms in its industry, even though the professional services industry is cyclical and is susceptible to economic recessions. Appleton went public eight years ago and Carr retained a majority shareholder position when it did. Over time she has sold some of the stock but still has a controlling position in the firm.



Despite the business difficulties Carr's parents experienced, they were able to amass a sizeable fortune in their later years. Including her inheritance and holdings in Appleton stock, Carr has a portfolio with a current value of $6,000,000, most of which is invested in Appleton and other domestic and international equities. Carr has instructed Houlis and Timmons to grow her portfolio over time, focusing on capital appreciation and achieving long-term return goals. She would like to leave her children a sizeable inheritance.



Carr is single with two children. Her oldest child, Mark, is 25 years old and financially independent. Her youngest son, John, is a junior in college at a prestigious liberal arts college in New England. The tuition payment for his last year of college of approximately $40,000 is due at the end of this year. She has no mortgage on her house. Carr is an avid bird watcher and gifts $50,000 a year to a local environmental group. She is concerned with the destruction of bird habitat, so she does not want to invest in highly-polluting industries or firms that are involved in real estate development.



When she retires, Carr will receive a lump-sum, after-tax distribution of approximately $500,000 from her firm. She will also begin collecting an annual pension payment equal to her current salary. The pension payment is indexed to inflation. She will be covered under Appleton's health insurance plan in retirement. Carr spends $ 170,000 a year on vacations and living expenses, which is about equal to her current salary at Appleton.



Houlis estimates that Carr is taxed at an effective marginal rate of 30% on capital gains and income. Houlis estimates an inflation rate of 3% for the rest of Carr's life expectancy, which he projects at 20 years or more, given her good health.



With regard to generating adequate liquidity for Carr's portfolio, Timmons states that she need not invest entirely in income-generating assets. Instead, Carr can generate income from stock dividends, bond coupons, and the sale of assets. By being willing to generate income through the sale of assets, Carr would be able to broaden the types of securities available to her for investment. Timmons states that the problem with most assets that produce income (e.g., dividend paying stocks) is that their expected return is usually lower. He states that the advantage of his approach is that Carr could pursue higher return assets, such as small company stocks.



Timmons' approach to generating liquidity can be best characterized as a:

39. Ernie Smith and Jama! Sims are analysts with the firm of Madison Consultants. Madison provides statistical modeling and advice to portfolio managers throughout the United States and Canada.



In an effort to estimate future cash flows and value the Canadian stock market. Smith has been examining* the country's aggregate retail sales. He runs two autoregressive regression models in an attempt to determine whether there are any patterns in the data, utilizing nine years of unadjusted monthly retail sales data. One model uses a lag one variable and the other adds a lag twelve variable. The results of both regressions are shown in Exhibits 1 and 2.









Sims has been assigned the task of valuing the U.S. stock market and uses data similar to the data that Smith uses for Canada. He decides, however, that the data should be transformed. He takes the natural log of the data and uses it in the following model:





Smith and Sims are concerned that the data for Canadian retail sales may be more appropriately modeled with an ARCH process. Smith states, that in order to find out, he would take the residuals from the original autoregressive model for Canadian retail sales and then square them.



Sims states that these residuals would then be regressed against the Canadian retail sales data using the





where e represents the residual terms from the original regression and X represents the Canadian retail sales data. If is statistically different from zero, then the regression model contains an ARCH process.



Smith also examines the quarterly inflation data for an emerging market over the past nine years. He models the data using an autoregressive model with a lag one independent variable which he finds is statistically different from zero. He wonders whether he should also include lag two and lag four terms, given the magnitude of the autocorrelations of the residuals shown in Exhibit 4, assuming a 5% significance level. The critical t-values, assuming a 5% significance level and 35 degrees of freedom, are 2.03 for a two-tail test and 1.69 for a one-tail test.





where: FF is the Federal Funds rate in the United States (US), and BY is the bond yield in the European Union (E) and Great Britain (B).



Before he runs this regression, he investigates the characteristics of the dependent and independent variables. He finds that the Federal Funds rate in the United States and the bond yield in Great Britain have a unit root but that the bond yield in the European Union does not. Furthermore, the Federal Funds rate in the United States and the bond yield in Great Britain are cointegrated but the Federal Funds rate in the United States and the bond yield in the European Union are not.

Which of the following is the appropriate test for cointegration?

40. Ryan Hendricks serves as a security analyst for Investment Management, Inc. (IMI), which employs the Treynor-Black model to evaluate securities and to make portfolio recommendations. IMI uses the capital asset pricing model (CAPM) to determine the degree to which securities may be mispriced relative to IMFs forecasts.



Hendricks evaluates the common shares of Computer Software Associates (CSA), a small company specializing in a unique computer software market niche.

Hendricks obtains the following market model results for CSA, using monthly returns for the past 60 months:





Hendricks uses the adjusted beta method to derive his forecasts for companies' future betas. In deriving his forecast for any company beta, Hendricks uses the following first-order autoregressive formula:

forecast beta = 0.33 + 0.67 x (historical beta) (2)



Hendricks derives required returns for individual securities using the CAPM after making appropriate adjustments using his adjusted beta formula in equation (2).



IMI provides Hendricks with the following capital market forecasts to use as inputs for the CAPM.





IMI asks Hendricks to make decisions to take long and short positions in individual securities for IMl's actively managed portfolio, IMI-Active. Specifically, Hendricks is asked to examine CSA and Millennium Drilling (MD), an oil and gas drilling company specializing in deep sea drilling. After a thorough examination of the prospects for each company, Hendricks derives the following alpha forecasts for CSA and MD.





Hendricks forecasts that the unsystematic variance (the variance of the market model regression error) for MD will be more than double that of CSA.



After determining the appropriate allocations across securities within the IMI-Active portfolio, Hendricks derives the portfolio predictions shown in Exhibit 3.





IMI forecasts that the total standard deviation for the S&P500 returns will equal 20%. After examining the historical forecasting abilities of Hendricks, IMI determines that Hendricks has demonstrated perfect forecasting ability in regards to CSA stock, but imperfect forecasting abilities in regards to MD stock. IMI finds that the correlation between the realized alphas for MD and the forecast MD alphas provided by Hendricks equals 0.50.



Referring to the Treynor-Black model, Hendricks makes the following statements:

Statement 1: All else equal, the Treynor-Black model increases the weight to the active portfolio as its unsystematic risk increases.

Statement 2: The Treynor-Black model is based on the premise that only a limited number of stocks should be included in the actively managed portfolio.



Using the Treynor-Black model along with the alpha and unsystematic variance information for CSA and MD, should CSA or MD receive a larger weight within the IMI-Active portfolio?

41. Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for Anderson Brothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).



Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.



Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price. Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.



Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.







Williams asks the bank for a GBP/SFr cross rate.

From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:

• 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55

• 60-day forward rate: USD/GBP = USD/GBP = 2.0075 - 85



Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U.S. risk-free rate is 5%.



Is Williams correct in his conclusions that Bundovian Semiconductors would benefit from the imposition of a tariff or quota?

42. Lorenz Kummert is a junior equity analyst who is following Schubert, Inc. (Schubert), a small publicly traded company in the United States. His supervisor, Markus Alter, CFA, has advised him to use the residual income model to analyze Schubert.



In his preliminary report to Alter, Kummert makes the following statements:

Statement 1: Residual income models are appropriate when expected free cash flows are negative for the foreseeable future.

Statement 2: Residual income models are not applicable when cash flows are volatile.



Kummert has determined Schubert's cost of equity, cost of debt, and weighted average cost of capital (WACC) to be 12.8%, 8.4%, and 11.9%, respectively. The current price of the stock is $35 per share and there are 130,000 shares outstanding. The relevant tax rate is 30%, and return on equity (ROE) is expected to be 13%.



Summarized financial information about Schubert for 2008 is provided in Exhibits I and II.





Based on his analysis of several years of financial statements, Kummert notes that 2008 was an exceptionally profitable year for Schubert, and that its dividend payouts are usually low because the funds are mainly reinvested in the firm to promote growth. Furthermore, there are very few nonrecurring items on the income statement. Upon review of Kummert's preliminary report, Alter concurs with his analysis of the financial statements but reminds him that Schubert's long-term debt is currently trading at 95% of its book value. He also cautions Kummert that violations of the clean surplus relation can bias the results of the residual income model.



The consensus annual EPS estimate for 2009 is $6.15, and the dividend payout ratio for 2009 is estimated at 5%.



Regarding Alter's caution about violations of the clean surplus relationship, examples of items that can violate this relationship include:

43. Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.





Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.



Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios.

Three of the advantages of P/B ratios that Aims recalls are:

Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.

Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.

Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.



Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)



If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."



Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.



Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.



Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA.

Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.



When Aims investigates the two investment criteria further (the PEG ratio and the comparison between the trailing and leading P/E ratio), should he find his colleague's use of them to be appropriate?

44. Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention―Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.



In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock.

After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:





Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.



Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:



"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."



If the gamma of Put E is equal to 0.081, which of the following correctly interprets the option's gamma?

45. Buying country funds is a better choice than direct investment for most emerging markets.



However, Wong has observed a premium to NAV that is prevalent in closed-end country funds. Wong is curious as to how the observed premiums would affect investments in such instruments.



In contrast to Wong, Greene is more inclined towards individual stocks and has started looking into their financial statements. One firm Greene is analyzing is a German conglomerate. Kaiser Corp. Kaiser has a history of growing by acquiring high-growth firms in niche markets. Exhibit 1 provides key financial information from Greene's analysis of Kaiser Corp.

Exhibit 1: Financial information―Kaiser Corp.







While going through their sample of emerging market stocks, Wong observed that these markets in general have high inflation and that sales for the stocks were extremely seasonal. Wong compensated by adjusting reported sales growth in the emerging market firms by deflating the sales using annual inflation adjustments. Wong also made upward adjustments to reported depreciation figures.



Wong suggested to her colleagues that they add a country risk premium to the discount rate they were using to evaluate emerging market stocks. She further suggested that they estimate country risk premiums by calculating the spread between the yield of U.S. government bonds and that of similar maturity local bonds.



Subsequently they started working on the financial projections for Emerjico, Inc., an emerging market stock. Their assumptions are given in Exhibit 2.

Exhibit 2: Key Assumptions―Emerjico







Based on the spread between local bonds and U.S. Treasuries, is Wong's suggestion of adding a country risk premium to the discount rate being used appropriate or not? Adding a country risk premium is:

46. Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate.

Black notes the following term structure:





Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.



Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department.

Coleman advises Black that:

Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk

at the initiation of the swap but the floating rate payer is not.

Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short position in a payer swaption is not.



On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap.

The term structure after 120 days is:





After 120 days, the value of the fixed rate side and the floating rate side of the swap (based on $1 of notional principal), assuming the annualized swap fixed rate is 3.80%, are closest to:

47. Viper Motor Company, a publicly traded automobile manufacturer located in Detroit, Michigan, periodically invests its excess cash in low-risk fixed income securities. At the end of 2009, Viper's investment portfolio consisted of two separate bond investments: Pinto Corporation and Vega Incorporated.



On January 2, 2009, Viper purchased $10 million of Pinto's 4% annual coupon bonds at 92% of par. The bonds were priced to yield 5%. Viper intends to hold the bonds to maturity. At the end of 2009, the bonds had a fair value of $9.6 million.



On July I, 2009, Viper purchased $7 million of Vega's 5% semi-annual coupon mortgage bonds at par. The bonds mature in 20 years. At the end of 2009, the market rate of interest for similar bonds was 4%. Viper intends to sell the securities in the near term in order to profit from expected interest rate declines.



Neither of the bond investments was sold by Viper in 2009.



On January 1,2010, Viper purchased a 60% controlling interest in Gremlin Corporation for $900 million. Viper paid for the acquisition with shares of its common stock.



Exhibit 1 contains Viper's and Gremlin's pre-acquisition balance sheet data.







Exhibit 2 contains selected information from Viper's financial statement footnotes.







According to U.S. GAAP, Viper's long-term debt-to-equity ratio, calculated immediately after the acquisition, is closest to:

48. Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund's prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.



The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund's exposure as he builds or liquidates positions in his portfolio since Biogene's large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.



The end of the quarter is just a few days away, and Connor is considering three transactions:



Transaction A: Buying Put Options on Stock A



The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A.



The Biogene Fund owns 5% of the outstanding stock of Company B. Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.



Transaction C: Selling the Biogene Fund's Entire Position in .Stock C



Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund's tax expense for the year.



Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene's share to 2%, explaining:



"With Biogene's reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."



Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO. Arnold responded a few hours later with the following message:



"I have just spoken with Ms. D, the CFO of Stock D. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%―you won't be sorry!"



After reviewing Arnold's e-mail, Connor agrees to the 2% offer.



By executing Transaction C, Connor is:

49. Martin Hagemann, CFA, works for a large brokerage firm in Frankfurt, Germany. Hagemann has been hired by Tryssen AG, a global research-based company that is preparing to go public after a long history of operating privately. The need to raise substantial amounts of capital to fund research and development activities is seen as the key motivation for the change in policy. Tryssen is engaged in the discovery, development, manufacture, marketing, and sale of medical products.



Hagemann's first task is to recommend an exchange upon which Tryssen stock can be traded. One possibility is the Deutsche Bourse. The Deutsche Bourse operates primarily as a continuous order-driven system. Another alternative that Tryssen is considering is to list on a different exchange that operates as a price-driven system.



As an alternative, Tryssen may choose to list as an American Depository Receipt (ADR). ADRs are negotiable U.S. securities that usually represent a non-U.S. based company's publicly traded equity. Although typically denominated in U.S. dollars, depository receipts can also be denominated in euros. Depository receipts can be eligible to trade on all U.S. stock exchanges as well as on many European stock exchanges.



The increasing demand for depository receipts is driven by the desire of individual and institutional investors to diversify their portfolios, reduce risk and invest internationally in the most efficient manner possible. While most investors recognize the benefits of global diversification, there are many challenges presented when investing directly in local trading markets. Obstacles can include inefficient trade settlements, uncertain custody services, and costly currency conversions. Depository receipts overcome many of the inherent operational and custodial hurdles inherent in international investing. Tryssen has decided to access the U.S. market by involving itself in an ADR program. Tryssen has decided to save itself a lot of trouble, however, by not complying with SEC registration and reporting requirements.



As an alternative to ADRs, investors interested in increasing their exposure to international investments can choose to acquire exchange traded funds (ETFs). Hagemann researches the advantages and disadvantages of ETFs.



Execution costs are always a concern, and perhaps even more so for international investors. At the present time, Tryssen AG is most concerned with how reliably it can estimate trading costs. As part of the cost estimation process, Hagemann is asked to provide a report on the advantages and disadvantages of techniques used to reduce execution costs.



Trysse AG proceeds to list on the Frankfurt exchange, and a U.S. affiliate of Hagemann's company starts to aggressively promote the stock. A U.S. investor buys 200 shares of Tryssen at a price of 20 per share. At time of purchase, the exchange rate is 1 = $1.15. One month later Tryssen pays a dividend of 0.25 per share, and investors are subject to a withholding tax of 20%. The U.S. investor is eligible to claim a tax credit of $0.06 per share. At the time the dividend was paid, the shares had jumped to 24 each and the U.S. dollar had weakened to 1 = $ 1.20. The shares were sold just after the dividend was paid.



Which of the following alternatives best describes the main benefits of ETFs?

50. William Shears, CFA, has been assigned the task of predicting sales for the specialty retail industry. Shears finds that sales have been increasing at a fairly constant rate over time and decides to estimate the linear trend in sales for the industry using quarterly data over the past 15 years, starting with Quarter 1 of 1994 and ending with Quarter 4 of 2008. On January 1, 2009, Shears estimates the following model:





Shears also estimates an autoregressive model of order one, AR(1), using the changes in quarterly sales data for the industry from the first quarter of 1994 through the fourth quarter of 2008. He obtains the following results for his AR(1) model:





Shears also derives a regression using the residuals from the AR(1) model. He regresses the squared residuals (or estimated errors) against the lagged squared residuals. The results of this regression are reported in Exhibit 4.





Quarterly sales for the Specially Retail Industry during 2008 were:

Shears's supervisor, Sam Kite, expresses concern that equation (1) might be misspecified. Specifically, Kite refers to the finding that "sales have been increasing at a fairly constant rate over time.

Regarding seasonality. Shears should use Exhibit 3 to conclude he should add the following lag 10 his autoregressive model:

51. Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.



The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.



Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, "Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?"



Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:

・ The risk-free rate of return is 2.7%.

・ The expected risk premiums arc:





・ The beta coefficient in the CAPM is estimated to be 0.63.

・ The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.



Trotter also asks Tang about adjusted betas. She says, "We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?"



Trotter has one final question for Tang. Trotter says, "We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes."



Which of the following is the best answer that Tang should give the portfolio manager to the question about adjusted betas?

52. Sharon Foster, 56, is an executive at a large Biotech firm. Foster plans to retire in five years, to travel and spend time with her grandchildren. Foster is in excellent health, although her husband died several years ago. Foster's only significant asset is her employer's 401(k) retirement plan. Her salary is more than adequate to cover her living expenses until she retires, but she does not anticipate that she will accumulate any additional savings beyond her retirement account. The balance in her account currently is $3.2 million, but Foster estimates that by the time she retires the account will have grown to $4.5 million. She expects that her pretax living expenses, including a liberal travel budget, will be $150,000 per year, beginning when she retires. She is willing to take risk to achieve her financial goals. Her retirement account is currently invested 80% in stocks and 20% in bonds. Foster estimates her post-retirement income tax rate to be 35%, which is about the same as her current tax rate.



As she is starting to plan her retirement, Foster has turned to her longtime friend, Don Welch, CFA, who is a portfolio manager at Scientific Investments, LLC. Welch is considering three different mutual funds for Foster's account. All three are well-diversified funds of large capitalization stocks. The expected returns and standard deviations of each fund are shown below in Exhibit 1. Welch assumes a risk-free rate of return of 3.0%.





Welch believes in stock market efficiency, but he also believes that individual securities are mispriced by the market from time to time. He has recently reviewed research related to the Treynor-Black (TB) model of security selection and portfolio optimization. Welch refers to a prospectus from Fund D, which uses the TB framework in developing its portfolios. In discussing their use of the TB model, the prospectus cites an example where an active portfolio of five stocks is combined with a passive, index portfolio. The portfolio weights of the stocks are in Exhibit 2.





Welch further notes that the beta of the active portfolio is 0.90, although the standard deviation of the portfolio's returns is high. Of the five stocks shown in the portfolio, three have positive alphas, and two have negative alphas. A footnote to the sample data states that the sample assumes that the analysts* alpha forecasts are perfect.



Welch is reviewing Foster's account, together with the mutual fund data, in an attempt to develop a long-term investment plan for Foster.



Foster has been reading some investment literature provided by her employer regarding her retirement account. That literature mentions the Sharpe ratio as a meaningful method to compare investment managers' performance results. If Welch were to select a mutual fund from the alternatives shown in Exhibit 1 based solely on the Sharpe ratio, which fund would he most likely select?

53. Joan Fisher and Kim Weatherford are economists responsible for modeling security returns for Quincy Portfolio Managers, which is located in the southwestern United States. Fisher is the firm's chief economist

and Weatherford is her assistant.



Fisher has been busy over the past week modeling the macroeconomic data of an emerging market. The data for the past 24 months is shown in Exhibit 1.





Fisher ponders how she can run a regression that will model the data for this country in the most appropriate way. She decides to regress the macroeconomic values against a time variable. The resulting plot of the residuals is shown in Exhibit 2.





In addition to financial assets, Quincy Portfolio Managers also recommends the use of commodities as a portfolio diversifier. Weatherford has been examining price indices for silver in an attempt to determine whether silver returns are predictable. As an initial step, she uses an autoregressive first-order regression

model on daily price data for silver over the past two years. The plot of the raw data and the results of the regression are shown in Exhibits 3 and 4.









Fisher and Weatherford later discuss fluctuations in gold prices. Although the arithmetic and geometric mean returns for gold were negative for much of the 1980s and 1990s, Fisher and Weatherford believe that gold should perform better in the future due to higher expected inflation. After appropriate transformation of the data, they use an autoregressive first-order regression model to examine the characteristics of gold returns, the results of which are shown in Exhibit 5.





Is the use of the Durbin Watson statistic in Weatherford's silver regression appropriate and, if so, how should it be interpreted?

54. MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRls, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the last decade. The company went public three years ago. Twelve months after their IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds which were putable, but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the last few months. Currently the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.



High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Since MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSofVs bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates:

"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Since the straight value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value."



"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."



Assuming that portfolio managers at Brown & Associates purchased the convertible bonds, how many years would it take to recover the premium per share?

55. Susan Foley, CFA, is Chief Investment Officer of Federated Investment Management Co. (FIMCO), a large investment management firm that includes a family of mutual funds as well as individually managed accounts. The individually managed accounts include individuals, personal trusts, and employee benefit plans. In the past few months, Foley has encountered a couple of problems.



The Tasty IPO



Most portfolio managers of FIMCO have not participated in the initial public offering (IPO) market in recent years. However, recent changes to the compensation calculation at FIMCO have tied manager bonuses to portfolio performance. The changes were outlined in a letter that was sent out to clients and prospects shortly before the new bonus structure took effect. Carl Lee, CFA, is one portfolio manager who believes that investing in IPOs may add to his client's equity performance and, in turn, increase his bonus. While Lee's individual clients have done quite well this year, his employee benefit plans have suffered as a result of limited exposure to the strongest performing sector of the market. Lee has placed an order for all employee benefit plans to receive an allocation of the Tasty Doughnut IPO. Tasty is an over-subscribed IPO that Lee knew would make money for his clients. When he placed the order, Lee's assistant reminded him that one pension plan. Ultra Airlines, was explicitly prohibited from investing in IPOs in its investment policy statement, due to the under-funded status of the pension plan. Lee responded that the Tasty IPO would never actually be owned in Ultra's account, because he would sell the IPO stock before the end of the day and realize a profit before the position ever hit the books.



Another manager, Franz Mason, CFA, who manages accounts for about 150 individuals, is also interested in the Tasty IPO. Mason visits Lee's portfolio assistant and quizzes him about Lee's participation in the Tasty deal. Mason is sure that Lee would not have bought into Tasty unless he had done his homework. Mason places an order for 10,000 shares of the IPO. Mason returns to his desk and begins to allocate the IPO shares among his clients. Mason divides his client base into two groups: clients who are income-oriented and clients who arc capital gains-oriented. Mason believes those clients that are income-oriented are fairly risk averse and could not replace lost capital if the Tasty Doughnut deal lost money. Mason believes the capital gains-oriented accounts arc better able to withstand the potential loss associated with the Tasty IPO. Accordingly, Mason allocates his 10,000 share order of the Tasty IPO strictly to his capital appreciation clients using a pro rata allocation based on the size of the assets under management in each account.



FIMCO Income Fund (FIF)



Over the past three years, the FIF, with $5 billion in assets, has been the company's best performing mutual fund. Jane Ryan, CFA, managed the FIF for seven years, but resigned one year ago to start her own hedge fund. Under Ryan, the FIF invested in large cap stocks with reliable dividends. The fund's prospectus specifies that FIF will invest only in stocks that have paid a dividend for at least two quarters, and have a market capitalization in excess of $2.5 billion. Foley appointed FIMCO's next best manager (based on 5-year performance numbers) Steve Parsons, CFA, to replace Ryan. Parsons had been a very successful manager of the FIMCO Opportunity Fund, which specialized in small capitalization stocks. Six months after Parsons took over the helm at FIF. the portfolio had changed. The average market capitalization of FIF's holdings was $12.8 billion, as opposed to $21 billion a year ago. Over the same period, the average dividend yield on the portfolio had fallen from 3.8% to 3.1%. The performance of the FIF lagged its peer group for the first time in three years. In response to the lagging performance, Parsons purchased five stocks six months ago. Parsons bought all five stocks, none of which paid a dividend at the time of purchase, in anticipation that each company was likely to initiate dividends in the near future. So far, four of the stocks have initiated dividend payments, and their performance has benefited as a result. The fifth stock did not initiate a dividend, and Parsons sold the position last week. Largely due to the addition of the five new stocks, the FIF's performance has led its peer group over the past six months.



Before leaving FIMCO, Ryan had told Foley that above-average returns from both the management and client side could be gained from entering into the risk-arbitrage hedge fund market. Ryan had tried to convince FIMCO management to enter the risk-arbitrage market, but the firm determined that no one had the experience or research capability to run a risk-arbitrage operation. As a result, Ryan started the Plasma Fund LLC one month after leaving FIMCO. Foley remembers seeing Ryan at the annual FIMCO client dinner parly (before she left the firm) discussing the profits to be made from risk-arbitrage investing with several large FIF shareholders. Ryan mentioned that she would be opening the Plasma Fund to these FIMCO clients, several of whom made substantial investments in the first months of Plasma Fund's life. After Ryan resigned and left her office, Foley performed an inventory of firm assets signed out to Ryan. One of the copies of the proprietary stock selection software packages, FIMCO-SelectStock, assigned to Ryan was missing along with several of the SelectStock operating manuals. When Foley contacts Ryan about the missing software and manuals, Ryan states that the reason she took the SelectStock software was that it was an out of date version that FIMCO's information technology staff had urged all managers to discard.



Has there been any violation of CFA Institute Standards of Professional Conduct relating to either the change in the average holdings of the FIF during the first six months of Parsons's leadership, or in Parsons's subsequent investment in the non-dividend paying stocks?

56. De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.



She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.



However, De Jong decides to use residual income analysis instead.

She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.

• The residual income model can be used even when cash flow is difficult to forecast.

• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.

• The residual income model depends on the validity of the clean surplus relation.



She also considers the following assumptions about continuing residual income:

Assumption 1: Residual income is positive and continues at the same level year after year.

Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.

Assumption 3: Residual income growth declines overtime and eventually reaches zero.



De Jong gathers recent financial information data on O'Connor, as shown in Exhibit 1.







De Jong has also determined that at the beginning of 2008, O'Connor had total capital of $324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.



De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.



De Jong discusses her analyses with a colleague, who makes the following general statements:



Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.

Statement 2: When the present value of expected future residual income is

negative, the justified P/B based on fundamentals is less than one.



Which of De Jong's assumptions about continuing residual income is least appropriate?

57. Pat Wilson, CFA, is the chief compliance officer for Excess Investments, a global asset management and investment banking services company. Wilson is reviewing two investment reports written by Peter Holly, CFA, an analyst and portfolio manager who has worked for Excess for four years. Holly's first report under compliance review is a strong buy recommendation for BlueNote Inc., a musical instrument manufacturer. The report states that the buy recommendation is applicable for the next 6 to 12 months with an average level of risk and a sustainable price target of $24 for the entire time period. At the bottom of the report, an e-mail address is given for investors who wish to obtain a complete description of the firm's rating system. Among other reasons supporting the recommendation, Holly's report states that expected increases in profitability as well as increased supply chain efficiency provide compelling support for purchasing BlueNote.



Holly informs Wilson that he determined his conclusions primarily from an intensive review of BlueNote's filings with the SEC but also from a call to one of BlueNote's suppliers who informed Holly that their new inventory processing system would allow for more efficiency in supplying BlueNote with raw materials. Holly explains to Wilson that he is the only analyst covering BlueNote who is aware of this information and that he believes the new inventory processing system will allow BlueNote to reduce costs and increase overall profitability for several years to come.



Wilson must also review Holly's report on BigTirae Inc., a musical promotions and distribution company. In the report, Holly provides a very optimistic analysis of BigTime's fundamentals. The analysis supports a buy recommendation for the company. Wilson finds one problem with Holly's report on BigTime related to Holly's former business relationship with BigTime Inc. Two years before joining Excess, Holly worked as an investment banker and received 1,000 restricted shares of BigTime as a result of his participation in taking the company public. These facts are not disclosed in the report but are disclosed on Excess Investment's Web site. Wilson decides, however, that the timeliness of the information in the report warrants overlooking this issue so that the report can be distributed.



Just before the report is issued. Holly mentions to Wilson that BigTime unknowingly disclosed to him and a few other analysts who were wailing for a conference call to begin that the company is planning to restructure both its sales staff and sales strategy and may sell one of its poorly performing business units next year.



Three days after issuing his report on BigTime, which caused a substantial rise in the price of BigTime shares, Holly sells all of the BigTirne shares out of both his performance fee-based accounts and asset-based accounts and then proceeds to sell all of the BigTime shares out of his own account on the following day. Holly obtained approval from Wilson before making the trades.



Just after selling his shares in BigTime, Holly receives a call from the CEO of BlueNote who wants to see if Holly received the desk pen engraved with the BlueNote company logo that he sent last week and also to offer two front row tickets plus limousine service to a sold-out concert for a popular band that uses BlueNote's instruments. Holly confirms that the desk pen arrived and thanks the CEO for the gift and tells him that before he accepts the concert tickets, he will have to check his calendar to see if he will be able to attend. Holly declines the use of the limousine service should he decide to attend the concert.



After speaking with the CEO of BlucNote, Holly constructs a letter that he plans to send by e-mail to all of his clients and prospects with e-mail addresses and by regular mail to all of his clients and prospects without e-mail addresses. The letter details changes to an equity valuation model that Holly and several other analysts at Excess use to analyze potential investment recommendations. Holly's letter explains that the new model, which will be put into use next month, will utilize Monte Carlo simulations to create a distribution of stock values, a sharp contrast to the existing model which uses static valuations combined with sensitivity analysis. Relevant details of the new model are included in the letter, but similar details about the existing model are not included. The letter also explains that management at Excess has decided to exclude alcohol and tobacco company securities from the research coverage universe. Holly's letter concludes by stating that no other significant changes that would affect the investment recommendation process have occurred or are expected to occur in the near future.



According to CFA Institute Research Objectivity Standards (ROS), which of the following statements is most accurate with regard to the rating system used by Holly in his investment report on BlueNote Inc.? The rating system:

58. Martha Gillis, CFA, trades currencies for Trent, LLC. Trent is one of the largest investment firms in the world, and its foreign currency department trades more currency on a daily basis than any other firm. Gillis specializes in currencies of emerging nations.



Gillis received an invitation from the new Finance Minister of Binaria, one of the emerging nations included in Gillis's portfolio. The minister has proposed a number of fiscal reforms that he hopes will help support Binaria's weakening currency. He is asking currency specialists from several of the largest foreign exchange banks to visit Binaria for a conference on the planned reforms. Because of its remote location, Binaria will pay all travel expenses of the attendees, as well as lodging in government-owned facilities in the capital city. As a further inducement, attendees will also receive small bags of uncut emeralds (as emeralds are a principal export of Binaria), with an estimated market value of $500.



Gillis has approximately 25 clients that she deals with regularly, most of whom are large financial institutions interested in trading currencies. One of the services Gillis provides to these clients is a weekly summary of important trends in the emerging market currencies she follows. Gillis talks to local government officials and reads research reports prepared by local analysts, which are paid for by Trent. These inputs, along with Gillis's interpretation, form the basis of most of Gillis's weekly reports.



Gillis decided to attend the conference in Binaria. In anticipation of a favorable reception for the proposed reforms, Gillis purchased a long Binaria currency position in her personal account before leaving on the trip. After hearing the finance minister's proposals in person, however, she decides that the reforms are poorly timed and likely to cause the currency to depreciate. She issues a negative recommendation upon her return. Before issuing the recommendation, she liquidates the long position in her personal account but does not take a short position.



Gillis's supervisor, Steve Howlett, CFA, has been reviewing Gillis's personal trading. Howlett has not seen any details of the Binaria currency trade but has found two other instances in the past year where he believes Gillis has violated Trent's written policies regarding trading in personal accounts.



One of the currency trading strategies employed by Trent is based on interest rate parity. Trent monitors spot exchange rates, forward rates, and short-term government interest rates. On the rare occasions when the forward rates do not accurately reflect the interest differential between two countries, Trent places trades to take advantage of the riskless arbitrage opportunity. Because Trent is such a large player in the exchange markets, its transactions costs are very low, and Trent is often able to take advantage of mispricings that are too small for others to capitalize on. In describing these trading opportunities to clients, Trent suggests that "clients willing to participate in this type of arbitrage strategy are guaranteed riskless profits until the market pricing returns to equilibrium."



Based on the information given, and according to CFA Institute Standards, which of the following statements best describes Trent's compliance procedures relating to personal trading in foreign currencies? The compliance procedures:

59. Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.







Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.



Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.

Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.





The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.



Statement 1: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.



Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.



Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.



Which of the following is NOT an input used to estimate Midwest News's equity risk premium based on the Gordon growth (GGM)?

60. MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical equipment including MRls, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25% growth in sales over the last decade. The company went public three years ago. Twelve months after their IPO, MediSoft made two semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon rate of 7.25%, par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds which were putable, but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, par value of $1,000, and 15 years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility in the price of MediSoft's common stock has been relatively high over the last few months. Currently the stock is priced at $50 on the New York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.



High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue. Since MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the company's bonds. At a meeting to discuss the merits of MediSofVs bonds, the following comments were made by various portfolio managers and analysts at Brown & Associates:



"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the limited downside risk associated with the bond. Since the straight value will provide a floor for the value of the convertible bond, downside risk is limited to the difference between the market price of the bond and the straight value."



"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable purchase."



Subsequent to purchasing one of the putable bonds for his portfolio, one of the managers at Brown & Associates realized that the bond contained a soft put.

Which of the following securities cannot be used to redeem the bond in the event the bond becomes putable?

61. Martha Gillis, CFA, trades currencies for Trent, LLC. Trent is one of the largest investment firms in the world, and its foreign currency department trades more currency on a daily basis than any other firm. Gillis specializes in currencies of emerging nations.



Gillis received an invitation from the new Finance Minister of Binaria, one of the emerging nations included in Gillis's portfolio. The minister has proposed a number of fiscal reforms that he hopes will help support Binaria's weakening currency. He is asking currency specialists from several of the largest foreign exchange banks to visit Binaria for a conference on the planned reforms. Because of its remote location, Binaria will pay all travel expenses of the attendees, as well as lodging in government-owned facilities in the capital city. As a further inducement, attendees will also receive small bags of uncut emeralds (as emeralds are a principal export of Binaria), with an estimated market value of $500.



Gillis has approximately 25 clients that she deals with regularly, most of whom are large financial institutions interested in trading currencies. One of the services Gillis provides to these clients is a weekly summary of important trends in the emerging market currencies she follows. Gillis talks to local government officials and reads research reports prepared by local analysts, which are paid for by Trent. These inputs, along with Gillis's interpretation, form the basis of most of Gillis's weekly reports.



Gillis decided to attend the conference in Binaria. In anticipation of a favorable reception for the proposed reforms, Gillis purchased a long Binaria currency position in her personal account before leaving on the trip. After hearing the finance minister's proposals in person, however, she decides that the reforms are poorly timed and likely to cause the currency to depreciate. She issues a negative recommendation upon her return. Before issuing the recommendation, she liquidates the long position in her personal account but does not take a short position.



Gillis's supervisor, Steve Howlett, CFA, has been reviewing Gillis's personal trading. Howlett has not seen any details of the Binaria currency trade but has found two other instances in the past year where he believes Gillis has violated Trent's written policies regarding trading in personal accounts.



One of the currency trading strategies employed by Trent is based on interest rate parity. Trent monitors spot exchange rates, forward rates, and short-term government interest rates. On the rare occasions when the forward rates do not accurately reflect the interest differential between two countries, Trent places trades to take advantage of the riskless arbitrage opportunity. Because Trent is such a large player in the exchange markets, its transactions costs are very low, and Trent is often able to take advantage of mispricings that are too small for others to capitalize on. In describing these trading opportunities to clients, Trent suggests that "clients willing to participate in this type of arbitrage strategy are guaranteed riskless profits until the market pricing returns to equilibrium."



Trent's arbitrage trading based on interest rate parity is successful mostly due to Trent's large size, which provides it with an advantage relative to smaller, competing currency trading firms. Has Trent violated CFA Institute Standards of Professional Conduct with respect to its trading strategy or its guarantee of results?

62. General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates.

In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:



required real return = country real rate + industry adjustment +company adjustment



Elias Sando, CFA, an analyst with General, estimates the following information for PCC:

Domestic inflation rate = 8.738%

Nominal growth rate = 12.000%

Real country return = 3.000%

Industry adjustmen = 3.000%

Company adjustment = 2.000%



Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).







PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.



Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC.

Consider the following two statements regarding EBITDA:

Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.

Statement 2: EBITDA is also a poor proxy for FCFE.



Suppose that PCC initiates a cash dividend, with a target payout ratio of 25% of net income.

What is the likely magnitude of the effect of the new cash dividend and the net change in the outstanding debt on future FCFE, all else equal?

63. Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers.

One recommendation from a junior analyst is given in Exhibit 1.





This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current £4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"



in a few minutes, Wrang e-mails him back: "The British stock is worth £110.42"



The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for £90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."



Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."



One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."



The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent."

The highlighted phrases are:

Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.

Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.

Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.



Is Wang's description of PVGO most likely correct?

64. Bryan Galloway is a strategist for JS Investments, a small money management firm. His goal is to analyze industries to determine whether there is justification for over- or under-weighting. His supervisor, Robyn Black, CFA, has asked that he document the process he uses to make his recommendations. However, just to be sure that Galloway understands industry analysis. Black asks him to provide examples of supply and demand analysis.

Galloway makes the following two statements to prove that he understands the issue:

Statement 1: In analyzing supply in the tire and rubber industry, it is clear that the sale of each additional automobile will result in the sale of approximately two winter tires.

Statement 2: In analyzing demand for services in the healthcare industry, for every 100 new hospital beds required, 20 additional doctors are needed.



Black is not entirely confident in Galloway's abilities to analyze various industries, but decides to allow him to continue with his analysis.



Four of the largest holdings for JS Investments are a tobacco company, a soda drink company, an oil company, and a cable TV company. Black is worried that government intervention will have a serious impact on future growth for these companies and asks Galloway to further research each of the industries involved. However, just to make sure Galloway can handle this project. Black first asks him to review the basics of industry analysis.



In reviewing the factors affecting pricing considerations, Galloway concludes that all of the following are of direct importance:

Factor 1: Price changes in key supply inputs.

Factor 2: Product segmentation.

Factor 3: Ease of entry into the industry.

Factor 4: Degree of industry concentration.



Galloway also makes the following statements about the characteristics of the phases of the industrial life cycle:

Characteristic 1: Participants compete for market share in a stable industry.

Characteristic 2: Changing tastes have an important impact on the industry.

Characteristic 3: It is not clear that a product will be accepted in the industry.

Characteristic 4: Proper execution of strategy is critical.



Each of the phases is represented by one characteristic.



Excluding external factors, industry analysis is best described as including:

65. Maria Harris is a CFA® Level 3 candidate and portfolio manager for Islandwide Hedge Fund. Harris is commonly involved in complex trading strategies on behalf of Islandwide and maintains a significant relationship with Quadrangle Brokers, which provides portfolio analysis tools to Harris. Recent market volatility has led Islandwide to incur record-high trading volume and commissions with Quadrangle for the quarter. In appreciation of Islandwide's business, Quadrangle offers Harris an all-expenses-paid week of golf at Pebble Beach for her and her husband. Harris discloses the offer to her supervisor and compliance officer and, based on their approval, accepts the trip.



Harris has lunch that day with C. K. Swamy, CFA, her old college roommate and future sister-in-law. While Harris is sitting in the restaurant waiting for Swamy to arrive, Harris overhears a conversation between the president and chief financial officer (CFO) of Progressive Industries. The president informs the CFO that Progressive's board of directors has just approved dropping the company's cash dividend, despite its record of paying dividends for the past 46 quarters. The company plans to announce this information in about a week. Harris owns Progressive's common stock and immediately calls her broker to sell her shares in anticipation of a price decline.



Swamy recently joined Dillon Associates, an investment advisory firm. Swamy plans to continue serving on the board of directors of Landmark Enterprises, a private company owned by her brother-in-law, for which she receives $2,000 annually. Swamy also serves as an unpaid advisor to the local symphony on investing their large endowment and receives four season tickets to the symphony performances.



After lunch, Alice Adams, a client, offers Harris a 1 -week cruise as a reward for the great performance of her account over the previous quarter. Bert Baker, also a client, has offered Harris two airplane tickets to Hawaii if his account beats its benchmark by more than 2% over the following year.



Juliann Clark, a CFA candidate, is an analyst at Dillon Associates and a colleague of Swamy's. Clark participates in a conference call for several analysts in which the chief executive officer at Dex says his company's board of directors has just accepted a tender offer from Monolith Chemicals to buy Dex at a 40% premium over the market price. Clark contacts a friend and relates the information about Dex and Monolith. The friend promptly contacts her broker and buys 2,000 shares of Dex's stock.



Ed Michaels, CFA, is director of trading at Quadrangle Brokers. Michaels has recently implemented a buy program for a client. This buy program has driven up the price of a small-cap stock, in which Islandwide owns shares, by approximately 5% because the orders were large in relation to the average daily trading volume of the stock. Michaels' firm is about to bring shares of an OTC firm to market in an



IPO. Michaels has publicly announced that, as a market maker in the shares, his trading desk will create additional liquidity in the stock over its first 90 days of trading by committing to minimum bids and offers of 5,000 shares and to a maximum spread of one-eighth.



Carl Park, CFA, is a retail broker with Quadrangle and has been allocated 5,000 shares of an oversubscribed IPO. One of his clients has been complaining about the execution price of a trade Park made for her last month, but Park knows from researching it that the trade received the best possible execution. In order to calm the client down. Park increases her allocation of shares in the IPO above what it would be if he allocated them to all suitable client accounts based on account size. He allocates a pro rata portion of the remaining shares to a trust account held at his firm for which his brother-in-law is the primary beneficiary.

According to the Standards of Practice, with respect to the two offers from Adams and Baker, Harris:

66. GigaTech Inc. is a large U.S.-based technology conglomerate. The firm has business units in three primary categories: hardware manufacturing, software development, and consulting services. Because of the rapid pace of technological innovation, GigaTech must make capital investments every two to four years. The company has identified several potential investment opportunities for its hardware manufacturing division. The first of these opportunities, Tera Project, would replace a portion of GigaTech's microprocessor assembly equipment with new machinery expected to last three years. The current machinery has a book value of $120,000 and a market value of $195,000. Tcra Project would require purchasing machinery for $332,000, increasing current assets by 5190,000, and increasing current liabilities by $80,000. GigaTech has a tax rate of 40%.

Additional pro forma information related to the Tera Project is provided in the following table:





Analysts at GigaTech have noted that investment in the Tera Project can be delayed for up to nine months if managers at the company decide this is necessary. However, once the capital investment is made, the project will be necessary to maintain continuing operations. Tera Project can be scaled up with more equipment requiring less capital than the original investment if results are meeting expectations. In addition, the equipment used in Tera Project can be used in shift work if brief excess demand is expected.



GigaTech is also considering expanding its software development operations in India. Software development equipment must be continually replaced to maintain efficiency as newer and faster technology is developed. The company has identified two mutually exclusive potential expansion projects, Zeta and Sigma. Zeta requires investing in equipment with a 3-year life, while Sigma requires investing in equipment with a 2-year life. GigaTech has estimated real capital costs for the two projects at 10.58%. GigaTech expects inflation to be approximately 4.0% for the foreseeable future.

Nominal cash flows and net present values for the Zeta and Sigma projects are provided in the following table:





Recently, GigaTechs board of directors has become concerned with the firm's capital budgeting decisions and has asked management to provide a detailed explanation of the capital budgeting process.

After reviewing the report from management, the board makes the following comments in a memo:

• The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.

• The cash flow projections are flawed since they fail to include costs incurred in the search for projects or the economic consequences of increased competition resulting from highly profitable projects.

• We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.



Determine whether the board of director's memo is correct with regard to its statements about GigaTech's capital rationing system and its method of projecting project cash flows.

67. SIMULATION

Ota L'Abbe, a supervisor at an investment research firm, has asked one of the junior analysts, Andreas Hally, to draft a research report dealing with various accounting issues.



Excerpts from the request are as follows:

• “There's an exciting company that we're starting to follow these days. It's called Snowboards and Skateboards, Inc. They are a multinational company with operations and a head office based in the resort town of Whistler in western Canada. However, they also have a significant subsidiary located in the United States."

• "Look at the subsidiary and deal with some foreign currency issues including the specific differences between the temporal and all-current methods of translation, as well as the effect on financial ratios."

• "The attached file contains the September 30, 2008, financial statements of the U.S. subsidiary. Translate the financial statements into Canadian dollars in a manner consistent with U.S. GAAP."



The following are statements from the research report subsequently written by Hally:

Statement 1: Subsidiaries whose operations are well integrated with the parent will use the all-current method of translation.

Statement 2: Self-contained, independent subsidiaries whose operating, investing, and financing activities are primarily located in the local market will use the temporal method of translation.





Other information to be considered

• Exchange rates (CAD/USD)





• Beginning inventory for fiscal 2008 had been purchased evenly throughout fiscal 2007. The company uses the FIFO inventory value method.

• Dividends of USD 25,000 were paid to the shareholders on June 30, 2008.

• All of the remaining inventory at the end of fiscal 2008 was purchased evenly throughout fiscal 2008.

• All of the PP&E was purchased, and all of the common equity was issued at the inception of the company on October 1, 2004. No new PP&E has been acquired, and no additional common stock has been issued since then. However, they plan to purchase new PP&E starting in fiscal 2009.

• The beginning retained earnings balance for fiscal 2008 was CAD 1,550,000.

• The accounts payable on the fiscal 2008 balance sheet were all incurred on June 30, 2008.

• The U.S. subsidiary's operations are highly integrated with the main operations in Canada.

• The remeasured inventory for 2008 using the temporal method is CAD 810,000.

• All monetary asset and liability balances are the same as they were at the end of the 2007 fiscal year, except that long-term debt was USD 467,700.

• Costs of goods sold under the temporal method in 2008 is CAD 1,667,250.



Suppose the parent uses the all-current method to translate the subsidiary for fiscal 2008. Will return on assets and net profit margin in U.S. dollars before translation be the same as, or different than, the translated Canadian dollar ratios?

68. Chester Brothers, LLC, is an investment management firm with $200 million in assets under management. Chester's equity style is described to clients as a "large cap core" strategy. One year ago, Chester instituted a new compensation plan for its equity portfolio managers. Under this new plan, each portfolio manager receives an annual bonus based upon that manager's quarterly performance relative to the S&P 500 index. For each quarter of aut-performance, the manager receives a bonus in the amount of 20% of his regular annual compensation. Chester has not disclosed this new plan to clients. Portfolio managers at Chester are not bound by non-compete agreements.



Fames Rogers, CFA, and Karen Pierce, CFA, are both portfolio managers affected by the new policy. Rogers out-performed the S&P 500 index in each of the last three quarters, largely because he began investing his clients1 funds in small cap securities. Chester has recently been citing Rogers's performance in local media advertising, including claims that "Chester's star manager, James Rogers, has outperformed the S&P 500 index in each of the last three quarters." The print advertising associated with the media campaign includes a photograph of Rogers, identifying him as James Rogers, CFA. Below his name is a quote apparently attributable to Rogers saying "as a CFA chartcrholdcr I am committed to the highest ethical standards."



A few weeks after the advertising campaign began, Rogers was approached by the Grumpp Foundation, a local charitable endowment with $3 billion in assets, about serving on their investment advisory committee. The committee meets weekly to review the portfolio and make adjustments as needed. The Grumpp trustees were impressed by the favorable mention of Rogers in the marketing campaign. In making their offer, they even suggested that Rogers could mention his position on the advisory committee in future Chester marketing material. Rogers has not informed Chester about the Grumpp offer, but he has not yet accepted the position.



Pierce has not fared as well as Rogers. She also shifted into smaller cap securities, but due to two extremely poor performing large cap stocks, her performance lagged the S&P 500 index for the first three quarters. After an angry confrontation with her supervisor, Pierce resigned. Pierce did not take any client information with her, but when she left she did take a copy of a Pierce has not fared as well as Rogers. She also shifted into smaller cap securities, but due to two extremely poor performing large cap stocks, her performance lagged the S&P 500 index for the first three quarters. After an angry confrontation with her supervisor, Pierce resigned. Pierce did not take any client information with her, but when she left she did take a copy of a computer model she developed while working al Chester, as well as the most recent list of her buy recommendations, which was created from the output of her computer valuation model. Pierce soon accepted a position at a competing firm, Cheeri Group. On her first day at Cheeri, she contacted each of her five largest former clients, informing them of her new employment and asking that they consider moving their accounts from Chester to Cheeri. During both telephone conversations and e-mails with her former clients, Pierce mentioned that Chester had a new compensation program that created incentives for managers to shift into smaller cap securities.



Cheeri has posted Pierce's investment performance for the past five years on its Web site, excluding the three most recent quarters.

The footnotes to the performance information include the following two statements:

Statement 1: Includes large capitalization portfolios only.

Statement 2: Results reflect manager's performance at previous employer.



Assuming Rogers would like to accept the offer to serve on the Grumpp investment advisory committee, Rogers's obligations under the CFA Institute Standards require that he:

69. Glenda Garvey is interning at Samson Securities in the summer to earn money for her last semester of studies for her MBA. She took the Level 3 CFA® exam in June but has not yet received her score. Garvey’s work involves preparing research reports on small companies.



Garvey is at lunch with a group of co-workers. She listens to their conversation about various stocks and takes note of a comment from Tony Topel, a veteran analyst. Topel is talking about Vallo Engineering, a small stock he has tried repeatedly to convince the investment director to add to the monitored list. While the investment director does not like Vallo, Topel has faith in the company and has gradually accumulated 5,000 shares for his own account. Another analyst, Mary Kennedy, tells the group about Koral Koatings, a paint and sealant manufacturer. Kennedy has spent most of the last week at the office doing research on Koral. She has concluded that the stock is undervalued and consensus earnings estimates are conservative.

However, she has not filed a report for Samson, nor does she intend to. She said she has purchased the stock for herself and advises her colleagues to do the same. After she gets back to the office, Garvey purchases 25 shares of Vallo and 50 shares of Koral for herself.



Samson pays its interns very little, and Garvey works as a waitress at a diner in the financial district to supplement her income. The dinner crowd includes many analysts and brokers who work at nearby businesses. While waiting tables that night, Garvey hears two employees of a major brokerage house discussing Metrona, a nanotechnology company. The restaurant patrons say that the broker's star analyst has issued a report with a buy rating on Metrona that morning. The diners plans to buy the stock the next morning. After Garvey finishes her shift, restaurant manager Mandy Jones, a longtime Samson client, asks to speak with her. Jones commends Garvey for her hard work at the restaurant, praising her punctuality and positive attitude, and offers her two tickets to a Yankees game as a bonus.



The next morning, Garvey buys 40 shares of Metrona for her own account at the market open. Soon afterward, she receives a call from Harold Koons, one of Samson's largest money-management clients. Koons says he got Garvey's name from Bertha Witt, who manages the Koons' account. Koons wanted to reward the analyst who discovered Anvil Hammers, a machine-tool company whose stock soared soon after it was added to his portfolio. Garvey prepared the original report on Anvil Hammers. Koons offers Garvey two free round-trip tickets to the city of her choice. Garvey thanks Koons, then asks her immediate supervisor, Karl May, about the gift from Koons but does not mention the gift from Jones. May approves the Koons’ gift.



After talking with May, Garvey starts a research project on Zenith Enterprises, a frozen-juice maker. Garvey's gathers quarterly data on the company's sales and profits over the past two years. Garvey uses a simple linear regression to estimate the relationship between GDP growth and Zenith's sales growth. Next she uses a consensus GDP estimate from a well-known economic data reporting service and her regression model to extrapolate growth rates for the next three years.



Later that afternoon, Garvey attends a company meeting on the ethics of money management. She listens to a lecture in which John Bloomquist, a veteran portfolio manager, talks about his job responsibilities. Garvey takes notes that include the following three statements made by Bloomquist:



Statement 1: I’m not a bond expert, and I’ve turned to a colleague for advice on how to manage the fixed-income portion of client portfolios.



Statement 2: I strive not to favor either the remaindermen or the current-income beneficiaries, instead I work to serve both of their interests.



Statement 3: All of my portfolios have target growth rates sufficient to keep ahead of inflation.



Garvey is not working at the diner that night, so she goes home to work on her biography for an online placement service.

In it she makes the following two statements:



Statement 1: I'm a CFA Level 3 candidate, and I expect to receive my charter this fall. The CFA program is a grueling, 3-part, graduate-level course, and passage requires an expertise in a variety of financial instruments as well as knowledge of the forces that drive our economy and financial markets.

Statement 1: I expect to graduate with my MBA from Braxton College at the end of the fall semester.

As both an MBA and a CFA, I'll be in high demand. Hire me now while you still have the chance.

Did the two statements in Garvey's biography violate Standard VII(B) Reference to CFA Institute, the CFA designation, and the CFA program?

70. Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which arc being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share.

Financial information for BioTLab for the most recent 12 months is provided below:

• Net working capita! excluding cash increased from $7,460,000 to $9,985,000;

• Book value increased from $81,250,000 to $101,250,000.

• BioTLab currently has no debt.

• Research facilities and production equipment were purchased for $8,450,000.

• BioTLab held non-operating assets in the amount of $875,000.

• Net income for the 12 months was $20,000,000.

• BioTLab has a marginal tax rate of 40%.

• Noncash charges for depreciation and restructuring for the 12 months were $1,250,000.



BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt.



Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year.



Which model would be most appropriate in valuing the Groh Group?

71. Bryan Galloway is a strategist for JS Investments, a small money management firm. His goal is to analyze industries to determine whether there is justification for over- or under-weighting. His supervisor, Robyn Black, CFA, has asked that he document the process he uses to make his recommendations. However, just to be sure that Galloway understands industry analysis. Black asks him to provide examples of supply and demand analysis.

Galloway makes the following two statements to prove that he understands the issue:

Statement 1: In analyzing supply in the tire and rubber industry, it is clear that the sale of each additional automobile will result in the sale of approximately two winter tires.

Statement 2: In analyzing demand for services in the healthcare industry, for every 100 new hospital beds required, 20 additional doctors are needed.



Black is not entirely confident in Galloway's abilities to analyze various industries, but decides to allow him to continue with his analysis.



Four of the largest holdings for JS Investments are a tobacco company, a soda drink company, an oil company, and a cable TV company. Black is worried that government intervention will have a serious impact on future growth for these companies and asks Galloway to further research each of the industries involved. However, just to make sure Galloway can handle this project. Black first asks him to review the basics of industry analysis.



In reviewing the factors affecting pricing considerations, Galloway concludes that all of the following are of direct importance:

Factor 1: Price changes in key supply inputs.

Factor 2: Product segmentation.

Factor 3: Ease of entry into the industry.

Factor 4: Degree of industry concentration.



Galloway also makes the following statements about the characteristics of the phases of the industrial life cycle:

Characteristic 1: Participants compete for market share in a stable industry.

Characteristic 2: Changing tastes have an important impact on the industry.

Characteristic 3: It is not clear that a product will be accepted in the industry.

Characteristic 4: Proper execution of strategy is critical.



Each of the phases is represented by one characteristic.



Which of the following choices best describes all the elements that Galloway should consider in doing an analysis of external factors in an industry analysis?

72. Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers.

One recommendation from a junior analyst is given in Exhibit 1.





This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current £4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"



in a few minutes, Wrang e-mails him back: "The British stock is worth £110.42"



The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for £90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."



Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."



One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."



The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent."

The highlighted phrases are:

Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.

Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.

Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.



Upon review, should Wang accept the estimated intrinsic value and investment recommendation for Aussie Shipping?

73. Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1.





The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides detail about the Alpha Fund with a vintage year of 2006 and committed capital of SI95 million.





The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's new drug pipeline, a company value of $300 million is reasonable in five years. Management at Alpha Fund views Targus Company as a risky investment and is using a discount rate of 40%. After a thorough analysis of Targus's future prospects, Alpha Fund's management believes that there is a possible 15% risk of failure for the company.



Using Exhibit 2, calculate the 2008 percentage management fee of the Alpha Fund.

74. A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.





In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the hedge fund index.



As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.



Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in illiquid bonds if the opportunity presents itself.



in reviewing the correlation matrix (Exhibit 2), Nash concluded that the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure that the fund's returns will be positive when the returns of the index are negative.



After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective

statistical measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition, Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future risk.



Rather than comparing hedge funds against the S&P 500 index, Nash believes a hedge fund index may be more appropriate.

Which of the following is least likely to be a problem with the hedge fund index constructed by Nash?

75. The government has approved a new method of extending the shelf life of fruits and vegetables.



Chiraq's concerns about new entrants into Rogert's business is least likely correct regarding:

76. Marsha McDonnell and Frank Lutge are analysts for the private equity firm Thorngate Ventures. Their

primary responsibility is to value the equity of private firms in developed global economies. Thorngate’s clients consist of wealthy individuals and institutional investors. The firm invests in and subsequently actively manages its portfolio of private firms.



During a discussion with junior analysts at the firm, McDonnell compares the characteristics of private firms with that of public firms and makes the following statements:



Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier. Furthermore, the lack of access to liquid public equity markets can limit a private firm's growth.



Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm, compared to public Firm managers. As a result, the private firm may neglect profitable long-term projects.



Due to its considerable success, Thorngate has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnell and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm's research team is developing a drug that Thomgate's current pharmaceutical firm is also working on. McDonnell estimates that combining research teams would result in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its founders have not advertised the firm's sale publicly.



McDonnell is also examining the prospects of Balanced Metals, a metal fabrication firm. Thorngate currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales at Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm's most valuable assets are its equipment and factory, located in a prime industrial area.



Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although (he sale was not consummated, McDonnell has learned that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnell has obtained the following financial figures from (he Balanced Metals CFO as well as the previously estimated synergistic savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm's incremental revenues.



Current revenues $22,000,000

Revenue growth 7%

Gross profit margin 25%

Depreciation expense as a percent of sales 1%

Working capital as a percent of sales 15%

SG&A expenses $5,400,000

Synergistic cost savings $1,200,000

Tax rate 30%

Lutge is valuing a noncontrolling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years. However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%.



To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen's small size, Lutge obtains a size premium using the smallest size decile of the database. McDonnell examines Lutge's cost of capital calculations and makes the following statements.



Statement 1: I am concerned about the use of this database. The estimation of the size premium may result in an undervaluation of the Jensen equity interest.

Statement 2: The use of betas and the CAPM from the database may be inappropriate, [f so, Lutge should consider using the build-up method where an industry risk premium is used instead of beta.



Regarding the statements made by McDonnell on Lutge's cost of capital calculations for Jensen, arc both statements correct?

77. Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.





Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.



Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios.

Three of the advantages of P/B ratios that Aims recalls are:

Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.

Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.

Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.



Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)



If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."



Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.



Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.



Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA.

Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.



Which one of the three advantages recalled by Aims most likely represents a good reason to consider using a P/B ratio?

78. Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.





Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.



Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios.

Three of the advantages of P/B ratios that Aims recalls are:

Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.

Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.

Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.



Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)



If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."



Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.



Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.



Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA.

Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.



Are Aims's two comments about the dividend yield and EBITDA ratios correct?

79. Tobin Yoakam, CFA, is analyzing the financial performance of Konker Industries, a U.S. company which is publicly traded under the ticker KONK. Yoakam is particularly concerned about the quality of Konker's financial statements and its choices of accounting methodologies.



Below is a summary of Konker's financial statements prepared by Yoakam.





Konker has an operating lease for several of its large machining tools. The lease term expires in five years, and the annual lease payments are $2 million. The applicable interest rate on the operating lease is 9%. Yoakam believes that the operating lease should be capitalized and treated as a finance lease. For purposes of adjusting the financial statements, Yoakam believes that the machining tools should be depreciated using straight-line depreciation with a salvage value of $3 million.



At the beginning of 20X8, Konker formed a qualified special purposes entity (QSPE) and sold a portion of its accounts receivables to the QSPE. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) is considering the elimination of qualified special purposes entities.



Konker has three major operating divisions: Konker Industrial, Konker Defense, and Konker Capital. Yoakam has computed the EBIT margin for each division over the last three years as well as the ratio of the percentage of total capital expenditures to the percentage of total assets for each division.





Since Yoakam is concerned about the quality of Konker's earnings, he decides to analyze the accrual ratios using the balance sheet approach. The table below contains the last three years of accrual ratios for Konker and the industry average.



An analyst is considering the effects of income reported under the equity method on certain financial ratios.

For a firm that reports equity income as non-operating income (not included in EBIT), removing equity income from the financial statements would most likely result in:

80. Fashion Inc. is a major U.S. distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.



Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.



Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.





Using the comparable transaction approach based on the four recently acquired companies, Smith determines an estimated takeover value based on equally weighted key valuation variables. The estimated takeover value would be closest to:

81. “Rerun the analysis assuming straight-line depreciation for tax purposes. The NPV will be higher, and we'll be more likely to get the project funded."



Cummings has two other projects under consideration that would affect the production of storage lockers. Project 1 relates to changing the production process, and Project 2 relates to expanding the distribution facility. Holbrook estimates the NPV of the expected cash flows for Project 1 at negative $7 million. An additional investment of $3 million would allow management to more rapidly adjust to the demand for a certain type of locker. The value of this flexibility is estimated at $9 million. He estimates that the NPV of the expected cash flows for Project 2 at $3 million. An expansion option would require an additional investment of $2 million. At this time, Cummings does not have any capital rationing restrictions.



Holbrook emails the lead analyst for the budgeting group and indicates that he cannot make a decision on Project 2 without knowing the value the expansion option will provide.



Holbrook calls a capital budgeting meeting with CEI's production manager and quality control manager. Holbrook opens the meeting by stating: "I think we should accept this project based solely on the fact that it provides great operating margins. Nevertheless, I think we should conduct net present value (NPV) analysis to confirm my opinion." Holbrook then receives the following comments:



Comment 1:

It is important that interest is included in the discounted cash flows used with NPV analysis because interest is a real and very significant expense.



Comment 2:

If applied correctly, the NPV of this project will be higher if we discount economic profits instead of net after-tax operating cash flows in our analysis. I suggest we calculate economic profit as net operating profit after tax minus the dollar cost of capital.



Are Mans' recommendations regarding the robotic project correct or incorrect?

82. Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.







Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.



Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.

Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.





The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.



Statement 1: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.



Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.



Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.



The required return estimate of Freedom Corporation is closest to:

83. Sara Robinson and Marvin Gardner are considering an opportunity to start their own money management firm. Their conversation leads them to a discussion on establishing a portfolio management process and investment policy statements. Robinson makes the following statements:

Statement 1;

Our only real objective as portfolio managers is to maximize the returns to our clients.

Statement 2:

If we are managing only a fraction of a client's total wealth, it is the client's responsibility, not ours, to determine how their investments are allocated among asset classes.

Statement 3: When developing a client's strategic asset allocation, portfolio managers have to consider capital market expectations. In response, Gardner makes the following statements:

Statement 4: While return maximization is important for a given level of risk, we also need to consider the client's tolerance for risk.

Statement 5: We'll let our clients worry about the tax implications of their investments; our time is better spent on finding undervalued assets.

Statement 6: Since we expect our investor's objectives to be constantly changing, we will need to evaluate their investment policy statements on an annual basis at a minimum.



Robinson wants to focus on younger clientele with the expectation that the new firm will be able to retain the clients for a long time and create long-term profitable relationships. While Gardner felt it was important to develop long-term relationships, he wants to go after older, high-net-worth clients.



Are Statements 2 and 3 correct when considering asset allocation?

84. Gary Smith, CFA, has been hired lo analyze a specialty tool and machinery manufacturer, Whitmore Corporation (WMC). WMC is a leading producer of specialty machinery in the United States. At the end of 2006, WMC purchased York Tool Company (YTC), an Australian firm in a similar line of business. YTC has partially integrated its marketing functions within WMC but still maintains control of its operations and secures its own financing. Following is a summary of the income statement and balance sheet for YTC (in millions of Australian dollars - AUD) for the past three years as well as exchange rate data over the same period.







Smith has discovered that WMC has a small subsidiary in Ukraine. The Subsidiary follows IAS accounting rules and uses FIFO inventory accounting. The Ukrainian subsidiary was acquired ten years ago and has been fully integrated into WMC's operations. WMC obtains funding for the subsidiary whenever the company finds profitable investments within Ukraine or surrounding countries. According to forecasts from economists, the Ukrainian currency is expected to depreciate relative to the U.S. dollar over the next few years. Local currency prices are forecasted to remain stable, however.



One of the managers at WMC asks Smith to analyze a third subsidiary located in India. The manager has explained that real interest rates in India over the last three years have been 2.00%, 2.50%, and 3.00%, respectively, while nominal interest rates have been 34.64%, 29.15%, and 25.66%, respectively. Smith requests more time to analyze the Indian subsidiary.



Determine whether the translation method appropriate for consolidating the Ukrainian subsidiary's financial statements would allow WMC to recognize unrealized and realized gains in nonmonetary assets owned by the subsidiary.

85. Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corp, a competitor of Hardin's, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes that the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%).





Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively.



Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton Bonds―one that uses the current spot rate curve and another that uses the interest rate tree given above.



For the next step in his analysis, Diffle has decided to calculate the value of the Hardin bonds using the interest rate tree. His assumption is that the bond will be called ai any node of the tree where the calculated value exceeds the call price. Diffle summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Diffle makes the following statements:

Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds.

Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds.



After reviewing Diffle's analysis, Puldo notes that Diffle has not included any information on the option adjusted spread (OAS) for the Hardin bonds. Puldo suggests that Diffle should evaluate the OAS in order to get an idea of the liquidity risk of the Hardin bonds. Diffle counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption.



To finish his analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle has shocked interest rates by 25 basis points throughout the interest rate tree he has been using to value the two bond issues. Using the new rates, Diffle has calculated values for the bonds assuming a 25-basis-point increase or decrease in rates. He plans to use these values as inputs into the following formulas for duration and convexity:







Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity?

86. Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.



Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.







In his report, Wayne makes the following statements regarding the CMO:

Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.



Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.



Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.



Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.



Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.



Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.



Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:



Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.



Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.



Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.



Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.



How many of Wayne's observations related to CDOs (Statement 3, Statement 4, and Statement 5) are correct?

87. Frank Hoskins and Paul Lanning are economists for a large U.S. investment advisory firm. Platinum Advisors. Hoskins and Lanning use their independent research on U.S. stocks and international stocks to provide advice for the firm's network of advisors. As the senior economist at Platinum, Hoskins is a partner in the firm and is Lanning's supervisor. Lanning has worked for Platinum for the past four years. At a lunch meeting, the two economists discuss the usefulness of economic theory, economic data, and the resulting forecasts of the global economic and stock market activity.



Hoskins is investigating the growth prospects of the country of Maldavia. Maldavia is a formerly communist country with a population of 3 million located in Eastern Europe. The Maldavian government had been aggressive in instituting political reform and encouraging the growth of financial markets. However, due to a recent insider trading scandal and resulting stock market volatility, the Maldavian government is considering restrictions on further stock market growth and the establishment of a national securities regulator. Hoskins states that these developments are not encouraging for future economic growth.



Lanning is examining the country of Petra. Petra is a country of 25 million located in South America and rich with natural resources including oil. The recently elected president of Petra, Carlos Basile, has announced that he would like to diversify the country's economy away from natural resources while nationalizing the oil industry. Lanning states that these changes would not be beneficial for the future growth of the Petrian economy.



One of the many items they study when examining an economy or stock market is the economic information released by governments and private organizations. Hoskins and Lanning use this information to determine the effects on economic growth and the appropriate portfolio allocations to the bond and stock markets. Examining information for Maldavia, Hoskins has learned that the Maldavian private sector has embarked on an ambitious plan to increase labor productivity by purchasing more machinery for its factories. The private sector feels compelled to do this because Maldavia has historically relied too heavily on labor as the main input into production. Plotting the productivity curve for Maldavia, Hoskins states that labor productivity should increase because the productivity curve will shift upward and to the right.



Lanning is examining the historical record of economic growth in Petra. He has gathered the data in Exhibit 1 to determine potential economic growth.





Hoskins is also examining data for the country of Semeria. Semeria is an emerging country that has benefited from recent changes in the political environment as well as technological advances. Its economy is growing rapidly, and changes in the Semerian economy and society have resulted in more opportunities for women. The Semerian economy has experienced 17 consecutive quarters of positive growth in GDP, which is unprecedented in Semerian history. Interest rates have increased over time because businesses have been borrowing heavily to invest in new machinery and technologies. Most economists are forecasting further increases in interest rates in Semeria.



It has long been Platinum's policy that its economists use long-term economic growth trends to forecast future economic growth, stock returns, and dividends in a country. Lanning is examining the economy of Tiberia. Tiberia has a population of 11 million and is located in northern Africa. Its economy is diversified, and its main exports are agricultural products and heavy machinery. The country's economy has been growing at an annual rate of 6.2% for the past ten years, in part because of technological advances in the manufacture of heavy equipment. These advances involve the use of computer-operated welding machines that have made the manufacture of heavy equipment less expensive. Lanning is worried, however, that the 6.2% GDP growth rate may not be sustainable and is considering advising Platinum's portfolio managers to decrease their portfolio allocations in the country. Before doing so, he will consult with Hoskins.



Which of the following choices is closest to Petra's growth in real labor productivity from 2001 to 2007 and the portion that is due to technology?

Growth in real labor productivity ;Portion due to technology A. 5.14% ;1.71%

B. 5.14% ;3.43%

C. 7.50% ;5.79%

88. Sampson Aerospace is a publicly-traded U.S. manufacturer. Sampson supplies communication and navigation control systems to manufacturers of airplanes for commercial and government use. The company operates two divisions: Commercial Operations and Government Operations. Revenues from the Government Operations division comprise 80% of Sampson's total company revenues. Revenues for other companies in the industry are also driven primarily by sales to the U.S. government.



Sampson has gained a reputation for offering unique products and services. Sampson's market share has been increasing, and its net profit margin is among the highest in its industry.



As part of its business strategy, Sampson seeks out opportunities to enhance internal growth by acquiring smaller companies that possess new technologies that would allow Sampson to offer unique products and services. To this end, Sampson CEO, Drew Smith, recently asked his acquisitions team to consider the purchase of a controlling interest in either NavTech or Aerospace Communications, both software applications firms. Smith provides his acquisitions team with an aerospace analyst's industry report that addresses many key issues within the industry. Selected passages from the report are reproduced below:



Sales in the aerospace electronics industry depend primarily on government military spending, which, in turn, depends on defense budgets. Sales depend on commercial travel to a much lesser extent. The government defense spending budget outlook is fairly bleak as the current administration is looking for ways to reduce the budget deficit. We feel the commercial airline segment has more upside than downside, especially as the global economy improves, so we might see a gradual shift in industry focus toward the commercial airline sector. Companies that already have a foothold in the commercial sector are well-positioned to grow during the global recovery. Even so, companies in this industry will remain highly sensitive to government spending for their revenues. Research and development costs are high and the industry is highly capital intense. While there are only a few companies in this industry, good opportunities exist, especially for companies that have developed sustainable profits through wise acquisitions, cost containment, and the ability to secure long-term government contracts.



Sampson Aerospace recently announced that it is reducing its investment return assumption on its pension assets from 6% to 5%, and that it has entered negotiations to possibly acquire controlling equity interests in communications software firms, NavTech and Aerospace Communications. NavTech recently has decided to capitalize a significant portion of its research and development expense, and Aerospace Communications has restructured and reclassified many of its leases from operating to financial leases. Sampson CEO Drew Smith recently announced that Sampson had dropped out of negotiations with Knowledge Technologies, claiming it was likely not a sustainable business model.



Consensus forecasts for NavTech and Aerospace Communications are presented in Exhibit 1.







Which of the following is most likely a negative factor in assessing the profitability of Sampson over the medium to long term?

89. Lauren Jacobs, CFA, is an equity analyst for DF Investments. She is evaluating Iron Parts Inc. Iron Parts is a manufacturer of interior systems and components for automobiles. The company is the world's second largest original equipment auto parts supplier, with a market capitalization of $1.8 billion. Based on Iron Parts's low price-to-book value ratio of 0.9* and low price-to-sales ratio of 0.15x, Jacobs believes the stock could be an interesting investment. However, she wants to review the disclosures found in the company's financial footnotes. In particular, Jacobs is concerned about Iron Parts's defined benefit pension plan. The following information for 2007 and 2008 is provided.







Iron Parts has adopted SFAS No. 158, Employers' Accounting for Defined Benefit Pensions and Other Postretirement Plans.



Jacobs wants to fully understand the impact of changing pension assumptions on Iron Parts's balance sheet and income statement. In addition, she would like to compute Iron Parts's economic pension expense.



If, instead of following U.S. GAAP, Iron Parts followed International Financial Reporting Standards, its pension liability reported on the balance sheet would be:

90. Engineered Packaging Inc. (EPI) is a manufacturer of industrial and consumer packaging products. The company's products include composite and plastic rigid packaging, flexible packaging, as well as metal and plastic ends and closures. In January 2008, EPI entered into a joint venture with BMI Enterprises. EPI contributed ownership of five plants, while BMI contributed a new manufacturing technology. The joint venture is known as EP/BM LLC. EPI owns 50% of EP/BM LLC and uses the equity method to account for its investment.

The following information for 2008 is provided:





In January 2009, EPI decides to sell its interest in EP/BM LLC. This is the fifth divesture in the last five years.

Which of the following statements is least likely regarding this sale? The divestiture:

91. The Wyroman International Pension Fund includes a $65 million fixed-income portfolio managed by Susan Evermore, CFA, of Brighton Investors. Evermore is in the process of constructing a binomial interest-rate tree that generates arbitrage-free values for on-the-run Treasury securities. She plans to use the tree to value more complex bonds with embedded options. She starts out by observing that the yield on a one-year Treasury security is 4.0%. She determines in her initial attempt to price the two-year Treasury security that the value derived from the model is higher than the Treasury security's current market price.



After several iterations Evermore determines that the interest rate tree that correctly values the one and two-year Treasury securities has a rate of 5.0% in the lower node at the end of the first year and a rate of 7.5% in the upper node at the end of the first year. She uses this tree to value a two-year 6% coupon bond with annual coupon payments that is callable in one year at 99.50. She determines that the present value at the end of the first year of the expected value of the bond's remaining cash flows is $98.60 if the interest rate is 7.5% and $100.95 if the interest rate is 5.0%.



Note: Assume Evermore's calculations regarding the two-year 6% callable bond are correct



Evermore also uses the same interest rate tree to price a 2-year 6% coupon bond that is putable in one year, and value the embedded put option. She concludes that if the yield volatility decreases unexpectedly, the value of the putable bond will increase and the value of the embedded put option will also increase, assuming all other inputs are unchanged.



Evermore also uses the interest rate tree to estimate the option-adjusted spreads of two additional callable corporate bonds, as shown in the following figure.





Evermore concludes, based on this information, that the A A-rated issue is undervalued, and the BB-rated issue is overvalued.



At a subsequent meeting with the trustees of the fund. Evermore is asked to explain what a binomial interest rate model is and how it was used to estimate effective duration and effective convexity. Evermore is uncertain of the exact methodology because the actual calculations were done by a junior analyst, but she tries to provide the trustees with a reasonably accurate step-by-stcp description of the process:

Step 1: Given the bond's current market price, the on-the-run Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree.

Step 2: Add 100 basis points to each of the 1-year rates in the interest rate tree to derive a "modified" tree.

Step 3: Compute the price of the bond if yield increases by 100 basis points using this new tree.

Step 4: Repeat Steps 1 through 3 to determine the bond price that results from a 100 basis point decrease in rates.

Step 5: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.



Lucas Davenport, a trustee and university finance professor, immediately speaks up to disagree with Evermore. He claims that a more accurate description of the process is as follows:

Step 1: Given the bond's current market price, the Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree and calculate the bond's option-adjusted spread (OAS) using the model.

Step 2: Impose a parallel upward shift in the on-the-run Treasury yield curve of 100 basis points.

Step 3: Build a new binomial interest rate tree using the new Treasury yield curve and the original rate volatility assumption.

Step 4: Add the OAS from Step I to each of the 1-year rates on the tree to derive a "modified" tree.

Step 5: Compute the price of the bond using this new tree.

Step 6: Repeat Steps 1 through 5 to determine the bond price that results from a 100 basis point decrease in rates.

Step 7: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.



At the meeting with the trustees. Evermore also presents the results of her analysis of the effect of changing market volatilities on a 1-year convertible bond issued by Highfour Corporation. Each bond is convertible into 25 shares of Highfour common stock. The bond is also callable at 110 at any time prior to maturity. She concludes that the value of the bond will decrease if either (1) the volatility of returns on'Highfour common stock decreases or (2) yield volatility decreases.



Davenport immediately disagrees with her by saying "changes in the volatility of common stock returns will have no effect on the value of the convertible bond, and a decrease in yield volatility will result in an increase in the value of the bond."



For this question, analyze each effect separately. Is Davenport correct in disagreeing with Evermore's conclusions regarding the effect on the value of the convertible bond resulting from a change in volatility?

92. Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.



Ferguson Department Stores, Inc.



FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.



At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.







In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.





In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.



The value of one share of FDS using the H-model is closest to:

93. The Wyroman International Pension Fund includes a $65 million fixed-income portfolio managed by Susan Evermore, CFA, of Brighton Investors. Evermore is in the process of constructing a binomial interest-rate tree that generates arbitrage-free values for on-the-run Treasury securities. She plans to use the tree to value more complex bonds with embedded options. She starts out by observing that the yield on a one-year Treasury security is 4.0%. She determines in her initial attempt to price the two-year Treasury security that the value derived from the model is higher than the Treasury security's current market price.



After several iterations Evermore determines that the interest rate tree that correctly values the one and two-year Treasury securities has a rate of 5.0% in the lower node at the end of the first year and a rate of 7.5% in the upper node at the end of the first year. She uses this tree to value a two-year 6% coupon bond with annual coupon payments that is callable in one year at 99.50. She determines that the present value at the end of the first year of the expected value of the bond's remaining cash flows is $98.60 if the interest rate is 7.5% and $100.95 if the interest rate is 5.0%.



Note: Assume Evermore's calculations regarding the two-year 6% callable bond are correct



Evermore also uses the same interest rate tree to price a 2-year 6% coupon bond that is putable in one year, and value the embedded put option. She concludes that if the yield volatility decreases unexpectedly, the value of the putable bond will increase and the value of the embedded put option will also increase, assuming all other inputs are unchanged.



Evermore also uses the interest rate tree to estimate the option-adjusted spreads of two additional callable corporate bonds, as shown in the following figure.





Evermore concludes, based on this information, that the A A-rated issue is undervalued, and the BB-rated issue is overvalued.



At a subsequent meeting with the trustees of the fund. Evermore is asked to explain what a binomial interest rate model is and how it was used to estimate effective duration and effective convexity. Evermore is uncertain of the exact methodology because the actual calculations were done by a junior analyst, but she tries to provide the trustees with a reasonably accurate step-by-stcp description of the process:

Step 1: Given the bond's current market price, the on-the-run Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree.

Step 2: Add 100 basis points to each of the 1-year rates in the interest rate tree to derive a "modified" tree.

Step 3: Compute the price of the bond if yield increases by 100 basis points using this new tree.

Step 4: Repeat Steps 1 through 3 to determine the bond price that results from a 100 basis point decrease in rates.

Step 5: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.



Lucas Davenport, a trustee and university finance professor, immediately speaks up to disagree with Evermore. He claims that a more accurate description of the process is as follows:

Step 1: Given the bond's current market price, the Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree and calculate the bond's option-adjusted spread (OAS) using the model.

Step 2: Impose a parallel upward shift in the on-the-run Treasury yield curve of 100 basis points.

Step 3: Build a new binomial interest rate tree using the new Treasury yield curve and the original rate volatility assumption.

Step 4: Add the OAS from Step I to each of the 1-year rates on the tree to derive a "modified" tree.

Step 5: Compute the price of the bond using this new tree.

Step 6: Repeat Steps 1 through 5 to determine the bond price that results from a 100 basis point decrease in rates.

Step 7: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.



At the meeting with the trustees. Evermore also presents the results of her analysis of the effect of changing market volatilities on a 1-year convertible bond issued by Highfour Corporation. Each bond is convertible into 25 shares of Highfour common stock. The bond is also callable at 110 at any time prior to maturity. She concludes that the value of the bond will decrease if either (1) the volatility of returns on'Highfour common stock decreases or (2) yield volatility decreases.



Davenport immediately disagrees with her by saying "changes in the volatility of common stock returns will have no effect on the value of the convertible bond, and a decrease in yield volatility will result in an increase in the value of the bond."



The value of the 2-year 6% callable bond today using the interest rate tree is closest to:

94. Alertron is a pharmaceutical company with approximately $3.5 billion in annual sales that specializes in the development, manufacturing, and marketing of neurology and oncology drug therapies. The firm is seeking to achieve more rapid growth, and Alertron's executive management team feels that the company can grow faster by making acquisitions than it can by trying to grow organically. As a result, management asks the firm's Director of Strategic Planning, Kanna Ozer, CFA, to analyze potential alternatives. At Alertron's next executive management team meeting, Ozer presents the report shown in Exhibit 1 concerning four potential acquisition targets:





Alertron's executive team agrees that the report is helpful for initiating discussion but decides they need more information concerning the form _of each potential acquisition and the most appropriate method of payment. Alertron's1 management is also concerned whether each potential target would view a takeover attempt as friendly or hostile. Paul Mussara, Alertron's CEO, asks Ozer to prepare a second report that specifically describes the transaction characteristics corresponding to each deal. Ozer's second report is shown in Exhibit 2.





As Alertron was conducting its analysis, Bhavik Kumar, CEO of Dillon Biotech, hears rumors that Alertron may attempt a hostile takeover of his firm. Kumar calls an emergency meeting with Dillon's four executive vice presidents and expresses his concern that Alertron may attempt a bear hug by submitting a merger proposal directly to the board without informing Dillon's management. Kumar concludes the emergency meeting by asking each executive vice president to brainstorm defense mechanisms that Dillon could employ before a takeover attempt is made and also defenses that could be employed after a hostile takeover offer.

After intense discussions, Alertron decides that a takeover offer for Carideo would be most beneficial due to the net present value of cost reduction synergies of $600 million that Ozer estimates would result from the merger. Mussara asks Ozer to evaluate the deal based on a stock offer in which Alertron would exchange 0.75 shares of Alertron stock for each outstanding share of Carideo stock. Ozer compiles the information shown in Exhibit 3 for her analysis.







Ozer, and the rest of the executive management team at Alertron, is extremely confident in the $600 million dollar estimate of cost reduction synergies that are likely to result from the merger and feel that the estimate may actually be conservative. However, when analysts at Carideo review the figures, they have a much different opinion and are less certain that $600 million worth of synergies could be realized. While Carideo believes the net present value of synergies from the deal would still be positive, its estimates are much lower than Alertron's



Carideo's management is also concerned that a merger between Alertron and Carideo could face scrutiny from regulators. Although neither firm is the largest in the pharmaceutical industry, their combined market power could raise antitrust concerns. Phillip Wu, an analyst with Carideo, compiles the following table showing the market share of each of the 12 firms in the pharmaceutical industry to determine whether the concerns were valid. Both Alertron's and Carideo's management teams decide that if regulators are unlikely to challenge the deal, they will proceed with the necessary steps to complete the merger.





Using Ozer's estimates of the cost reduction synergies, the gain that would accrue to Carideo's shareholders as a result of the merger with Alcrtron is closest to:

95. Marie Williams, CFA, and David Pacious, CFA, are portfolio managers for Stillwell Managers. Williams and Pacious are attending a conference held by Henri Financial Education on the fundamentals of valuation for common stock, preferred stock, and other assets.



During the conference, the presenter uses an example of four different companies to illustrate the valuation of common stock from the perspective of a minority shareholder.



During the conference, the presenter uses an example of four different companies to illustrate the valuation of common stock from the perspective of a minority shareholder.

• Firm A is a noncyclical consumer products firm with a 50 year history. The firm pays a $1.80 dividend per share and attempts to increase dividends by 4% a year. Earnings and dividends have steadily increased for the past

20 years.

• Firm B is a technology firm. It has never paid a dividend and does not expect to in the near future. Furthermore, due to large investments in new factories and equipment, the firm is not expected to generate positive free cash flow in the foreseeable future.

• Firm C is an industrial firm with currently very little competition and a dividend growth rate of 9% a year. However, the profits in its product market have started to attract competitors and it is expected that Firm C's profits will slowly decline such that the dividend growth steadily falls each year until it reaches a growth rate of 4% a year.

• Firm D is a pharmaceutical firm that is currently enjoying high profits and paying dividends. However, the firm's strongest selling drug is coming off patent in three years. With no other drugs in the pipeline, the firm's dividend growth rate is expected to drop abruptly in three years and settle at a lower growth rate.



The next day, Pacious decides to put what he learned into practice. The stock he is valuing, Maple Goods and Services, currently pays a dividend of $3.00. The dividend growth rate is 25% and is expected to steadily decline over the next 8 years to a stable rate of 7% thereafter. Given its risk, Pacious estimates that the required return is 5%.



Williams analyzes the value of Mataka Plastics stock. Its dividend is expected to grow at a rate of 18% for the next four years, after which it will grow at 4%. This year's dividend is $5.00 and Williams estimates the required return at 15%.



From the seminar, Pacious learned that a firm's health can be gauged by the present value of its future investment opportunities (PVGO).

Tackling a calculation, he uses the following example for Wood Athletic Supplies:

Stock price $90.00

Current earnings $5.50

Expected earnings $6.00

Required return on stock 15%



Pacious and Williams discuss the characteristics of firms in various stages of growth, where firms experience an initial growth phase, a transitional phase, and a maturity phase in their life. They both agree that the Gordon Growth Model is not always appropriate. Pacious makes the following statements.



Statement 1: For firms in the initial growth phase, earnings are rapidly increasing, there are little or no dividends, and there is heavy reinvestment. The return on equity is, however, higher than the required return on the stock, the free cash flows to equity are positive, and the profit margin is high.

Statement 2: When estimating the terminal value in the three-stage dividend growth model, it can be estimated using the Gordon Growth Model or a price-multiple approach.



Which of the following is closest to the current value for Mataka Plastics stock?

96. Debbie Angle and Craig Hohlman arc analysts for a large commercial bank, Arbutus National Bank. Arbutus lias extensive dealings in both the spot and forward foreign exchange markets. Angle and Hohlman are providing a refresher course on foreign exchange relations for its traders. Unless indicated otherwise, Angle tells the traders to assume that real interest rates arc equivalent throughout the world.



Angle uses a three country example from North America to illustrate foreign exchange parity relations. In it, the Canadian dollar is expected to depreciate relative to the U.S. dollar and the Mexican peso. Nominal, one year interest rates in the United States are 7% and are 13% in Mexico. From this data and using the uncovered interest rate parity relationship, Angle forecasts future spot rates.



During their presentation, Hohlman discusses the effect of monetary and fiscal policies on exchange rates. He cites a historical example from the United States, where the Federal Reserve shifted to an expansionary-monetary policy to stimulate economic growth. This shift was largely unanticipated by the financial markets because the markets thought the Federal Reserve was more concerned with inflationary pressures. Hohlman states that the effect of this policy was an increase in economic growth and an increase in inflation. The cumulative effect on the dollar was unchanged, however, because, according to Hohlman, an increase in U.S. economic growth would strengthen the dollar whereas an increase in inflation would weaken the dollar.



Regarding U.S. fiscal policies, Hohlman states that if these were unexpectedly expansionary, real interest rates would increase, which would produce an appreciation of the dollar. But, Hohlman adds, an increase in the federal budget would encourage imports such that the overall short-run effect would be for a decrease in the value of the dollar.



Using this same historical example, Angle discusses capital flows and the effect on the balance-of-payments components. Angle makes the following statements:

Statement 1; Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to the currencies of countries whose available real rates of return are low.

Statement 2: The flow of foreign capital into U.S. investments, net of outflows of U.S. capital, is measured by the financial account. In the case of an expansionary fiscal policy, the financial account will increase and move towards a surplus.



Angle next discusses the foreign exchange expectation relation. She states that, examining Great Britain and Japan, it appears that the four year forward rate, which is currently ¥200/£, is an accurate predictor of the expected future spot rate. Furthermore, she states that uncovered interest rate parity and relative purchasing power parity hold. In the example for her presentation, she uses the following figures for the two countries.







As a follow-up to Angle's example, Hohlman discusses the use and evidence for purchasing power parity. He makes the following statements.



Statement 3: Absolute purchasing power parity is based on the law of one price, which states that a good should have the same price throughout the world. Absolute purchasing power parity is not widely used in practice to forecast interest rates.



Statement 4: Although relative purchasing power parity is useful as an input for long-run exchange rate forecasts, it is not useful for predicting short-run currency values.



Regarding the statements made by Angle on capital flows and the effect of fiscal policy on the balance-of­payments components, are both statements correct?

97. Carl Warner, CFA, has been asked to review the financial information of Global Drug World (GDW) in preparation for a possible takeover bid by rival competitor Consolidated Drugstores International (Consolidated). GDW has produced impressive results since going public via an initial public offering in 1998. Through a program of aggressive growth by acquisition, GDW is currently seen as a major player and a threat to Consolidated^ own plans for growth and profitability.

In preparation for his analysis, Warner has gathered the following financial data from GDW's year-end statements:













As part of his analysis, Warner needs to forecast the free cash flow to the firm (FCFF) for 2009. The best information he has points to an increase in sales of 6%. The earnings before interest and tax (EBIT) margin is not expected to change from the rate of 6.4% achieved in 2008. Additional fixed capital spending is expected to be $36,470. Investment in net working capital is expected to be $24,313. Moreover, Warner notes that the only noncash charge is depreciation, which he estimates will be $60,000.

Warner has been asked to analyze the effect each of the following corporate events, if taken during 2009, would have on GDW's free cash flow to equity (FCFE):

• 20% increase in dividends per share.

• Repurchase of 25% of the firm's outstanding shares using cash.

• New common share offering that would increase shares outstanding by 30%.

• New issue of convertible bonds that are not callable for fie years and would increase the level of debt by 10%.



The 2009 estimate of FCFF is closest to:

98. Jane Bowman, CFA, and Frank Shrum, CFA, are analysts for Brookstonc Advisors. Brookstone recommends investments in United States and global markets. Bowman and Shrum are responsible for analyzing investments and conducting cyclical analysis in developed and emerging markets.



Bowman is examining the country of Waltonia for a possible investment. Currently, the country's economy is beginning to recover from a recession. Businesses have increasing confidence in the economy, inflation is falling, the government is stimulating the economy, and the economy has just started to expand. Bowman identifies this is as the recovery stage of the business cycle and states that since inflation is falling, investors should put their money in bonds.



In terms of the business cycle, Waltonia has grown slower than its neighboring country of Bergamo, where the economy is in the early stages of an upswing. Bergamese businesses are confident and inventories are increasing. Bowman states that an investment in commodities or stocks would be advised because when the economy grows, these assets will rise in price.



Shrum is examining the value of a company in the United States using the franchise value model. In it, he will generate an intrinsic P/E ratio that can be multiplied against the firm's projected earnings to derive a value for the company. The intrinsic P/E value consists of the tangible P/E value, which represents the firm's static value, and a franchise P/E value which represents the firm's growth value. The franchise P/E value then consists of the franchise factor, which incorporates the required return on new investments, and the growth factor, which factors in the present value of the excess return from new investments.

He applies this analysis to the firm of Salisbury Materials, which has the following characteristics:

Return on Equity 20%

Dividend Payout Ratio 40%

Required Return on Equity 16%



In light of the increased inflation in the United States due to increased commodity prices. Bowman is examining the effect of inflation on the P/E ratio. She states that when there is not full-flow-through of inflation, a firm in a low inflation country will have a higher P/E ratio than one in a high inflation country. She provides the following example of inflation flow-through. If the real required return is 9%, inflation is 4%, and the inflation flow-through rate is 80%, then the P/E ratio will be 10.2.



Shrum states that when valuing an emerging market, an investor should adjust their projections for the higher inflation risk. He states that the analyst should adjust the cash flows rather than the discount rate for the increased risks from emerging markets, such as political risk and macroeconomic risk. Bowman adds that there are several arguments that can be made and makes the following statements.



Statement 1: One argument is that companies respond differently to the risk in their country. For example, exporters would benefit from a weaker local currency but importers would be hurt by a depreciating local currency. Adjusting the discount rate by the same amount for all companies within a country would misstate the influence of country risk on each company.



Statement 2: Additionally, country risk is one-sided and asymmetric in that the country risk to foreign investors is much greater than that to local investors. So if a single discount rate were used to discount cash flows, then the valuations would be inaccurate for either the foreign investors or the local investors.



Shrum follows up with Bowman's analysis. He states that an alternative to adjusting the cash flows is to calculate a weighted average cost of capital for the emerging country firm and add a country risk premium to it. This discount rate would then be applied against unadjusted cash flows to value the emerging market firm. Regarding this analysis, he makes the following statements.



Statement 3: When estimating the percent of debt and equity in the capital structure, the market value of the firm's debt and equity should be used, not the book value.



Statement 4: The beta will be needed to obtain the cost of equity capital in the CAPM. The beta should be estimated for the company by regressing the company's returns against a well diversified global index, not the local market index.



Regarding Bowman's justifications for adjusting emerging market country risk by the cash flows, are both Statements 1 and 2 correct?

99. Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund's prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.



The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund's exposure as he builds or liquidates positions in his portfolio since Biogene's large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.



The end of the quarter is just a few days away, and Connor is considering three transactions:



Transaction A: Buying Put Options on Stock A



The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A.



The Biogene Fund owns 5% of the outstanding stock of Company B. Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.



Transaction C: Selling the Biogene Fund's Entire Position in .Stock C



Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund's tax expense for the year.



Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene's share to 2%, explaining:



"With Biogene's reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."



Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO. Arnold responded a few hours later with the following message:



"I have just spoken with Ms. D, the CFO of Stock D. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%―you won't be sorry!"



After reviewing Arnold's e-mail, Connor agrees to the 2% offer.



By executing Transaction B, Connor is:

100. Jenna Stuart is a financial analyst for Deuce Hardware Company, a U.S. company that reports its results in U.S. dollars. Wayward Distributing, Inc., is a foreign subsidiary of Deuce Hardware, which began operations on January 1,2007. Wayward is located in a foreign country and reports its results in the local currency called the Rho. Selected balance sheet information for Wayward is shown in the following table.





Stuart has been asked to analyze how the reported financial results of Wayward will be affected by the choice of the all-current or temporal methods of accounting for foreign operations.

She has gathered the following exchange rate information on the $/Rho exchange rate:

• Spot rate on 1/01/08: $0.35 per Rho

• Spot rate on 12/31/08: $0.45 per Rho

• Average spot rate during 2008: $0.42 per Rho



Suppose for this question only that Stuart decides to use the all-current method to translate Wayward's results into U.S. dollars. Is it likely that the quick ratio and the interest coverage ratio will be the same or different in Rho before translation and in U.S. dollars after translation?

101. Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.



The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the

end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.



The initial outlay for the project is closest to:

102. Ernie Smith and Jama! Sims are analysts with the firm of Madison Consultants. Madison provides statistical modeling and advice to portfolio managers throughout the United States and Canada.



In an effort to estimate future cash flows and value the Canadian stock market. Smith has been examining* the country's aggregate retail sales. He runs two autoregressive regression models in an attempt to determine whether there are any patterns in the data, utilizing nine years of unadjusted monthly retail sales data. One model uses a lag one variable and the other adds a lag twelve variable. The results of both regressions are shown in Exhibits 1 and 2.







Sims has been assigned the task of valuing the U.S. stock market and uses data similar to the data that Smith uses for Canada. He decides, however, that the data should be transformed. He takes the natural log of the data and uses it in the following model:





Smith and Sims are concerned that the data for Canadian retail sales may be more appropriately modeled with an ARCH process. Smith states, that in order to find out, he would take the residuals from the original autoregressive model for Canadian retail sales and then square them.

Sims states that these residuals would then be regressed against the Canadian retail sales data using the



where e represents the residual terms from the



original regression and X represents the Canadian retail sales data. If is statistically different from zero, then the regression model contains an ARCH process.



Smith also examines the quarterly inflation data for an emerging market over the past nine years. He models the data using an autoregressive model with a lag one independent variable which he finds is statistically different from zero. He wonders whether he should also include lag two and lag four terms, given the magnitude of the autocorrelations of the residuals shown in Exhibit 4, assuming a 5% significance level. The critical t-values, assuming a 5% significance level and 35 degrees of freedom, are 2.03 for a two-tail test and 1.69 for a one-tail test.





where: FF is the Federal Funds rate in the United States (US), and BY is the bond yield in the European Union (E) and Great Britain (B).



Before he runs this regression, he investigates the characteristics of the dependent and independent variables. He finds that the Federal Funds rate in the United States and the bond yield in Great Britain have a unit root but that the bond yield in the European Union does not. Furthermore, the Federal Funds rate in the United States and the bond yield in Great Britain are cointegrated but the Federal Funds rate in the United States and the bond yield in the European Union are not.

Will Sims' regressions of European and British bond yields on the U.S. Federal Funds rate produce valid results?

103. Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U.S. dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annua! payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.



The current term structure of interest rates for both countries is given in the following table:





Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI.

In addition to the terms of the swap, Torrey includes the following information in the report:

• Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U.S. Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

• In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

• Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.



Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso.

The new term structure of interest rates is as follows:





Which of the following statements correctly assesses the excerpt from Torrey's report regarding the swap spread on the currency swap under consideration? Torrey's statement is:

104. Ron Natin heads a committee that oversees the USA Insurance portfolio with total assets of $25 billion. The portfolio has 15% of total assets allocated to foreign investments, which include both international stocks and bonds. The committee has adopted a position that the domestic markets are efficient and thus, has indexed the domestic portion of the portfolio. Each unique asset class in the domestic portfolio has been benchmarked individually. The committee believes that foreign markets are less efficient and utilizes active managers for this asset class. The foreign allocation is 60% stocks and 40% bonds. The committee has divided the foreign stock portfolio equally among three different managers. The committee closely monitors the risk level of these managers by reviewing their portfolio betas (current betas: 1.1, 0.95, and 1.3).



As part of his committee responsibilities, Natin is required to review all reports and speeches prepared by other members of the committee before they are presented to the public. One of the committee members, Mclanie Henley, has submitted a speech on the subject of international diversification and the international capital asset pricing model (ICAPM) that she will give to a group of MBA students at a local university. Following are excerpts from her proposed speech:



International investment and diversification is an important concern in money management and, of the many relevant issues to discuss, there are two key insights that I will Take time to explain. First of all, it is essential to realize that the currency exposure of a foreign stock investment is the sensitivity of the stock price to a change in the value of the local currency and that a positive correlation between stock prices and the local currency would mean that the local stock price increases as a result of a depreciation of the local currency. Second, as future asset managers you should realize that improvements in a foreign nation's economic activity that result in an increase in real interest rates will decrease bond prices, but will be offset by an appreciation of the home currency.



The ICAPM is similar to the domestic CAPM in several ways. For example, both models assume that investors are risk-averse, preferring lower levels of risk and greater expected returns, that all investors have the same expectations for the risk and return of every asset, and that all investors should hold some combination of a risk-free asset and the market portfolio.



The IGAPM is a useful construct to determine asset prices in a global context. Strategies that depend explicitly on asset prices derived from the ICAPM can rely on these asset prices even if currency hedging is inhibited in certain markets by legal restrictions on such activities.



The committee monitors the investments of its equity managers by modeling the expected returns of each individual stock. The model used is (he ICAPM. One such stock, a Swiss medical equipment manufacturer, has a world beta of 1.2. The world market risk premium is 4%, and the Swiss franc offers a risk premium of 0.5%. The currency exposure is 0.5, and the applicable risk-free rate is 5%. The expected return on this stock according to the ICAPM model is closest to:

105. Sara Robinson and Marvin Gardner are considering an opportunity to start their own money management firm. Their conversation leads them to a discussion on establishing a portfolio management process and investment policy statements. Robinson makes the following statements:

Statement 1;

Our only real objective as portfolio managers is to maximize the returns to our clients.

Statement 2:

If we are managing only a fraction of a client's total wealth, it is the client's responsibility, not ours, to determine how their investments are allocated among asset classes.

Statement 3: When developing a client's strategic asset allocation, portfolio managers have to consider capital market expectations. In response, Gardner makes the following statements:

Statement 4: While return maximization is important for a given level of risk, we also need to consider the client's tolerance for risk.

Statement 5: We'll let our clients worry about the tax implications of their investments; our time is better spent on finding undervalued assets.

Statement 6: Since we expect our investor's objectives to be constantly changing, we will need to evaluate their investment policy statements on an annual basis at a minimum.



Robinson wants to focus on younger clientele with the expectation that the new firm will be able to retain the clients for a long time and create long-term profitable relationships. While Gardner felt it was important to develop long-term relationships, he wants to go after older, high-net-worth clients.



In addition to Statement 6, an appropriately developed investment policy statement is least likely to address which of the following elements?

106. Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:



Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).



Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. Oneof the advantages is comparability between the two methods since both calculate return

relative to systematic risk.



Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.



The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:



• One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.

• The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.

• Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.

• Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.



Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.



The least appropriate limitation of Value at Risk (VaR) is that:

107. Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corp, a competitor of Hardin's, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes that the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%).





Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively.



Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton Bonds―one that uses the current spot rate curve and another that uses the interest rate tree given above.



For the next step in his analysis, Diffle has decided to calculate the value of the Hardin bonds using the interest rate tree. His assumption is that the bond will be called ai any node of the tree where the calculated value exceeds the call price. Diffle summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Diffle makes the following statements:

Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds.

Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds.



After reviewing Diffle's analysis, Puldo notes that Diffle has not included any information on the option adjusted spread (OAS) for the Hardin bonds. Puldo suggests that Diffle should evaluate the OAS in order to get an idea of the liquidity risk of the Hardin bonds. Diffle counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption.



To finish his analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle has shocked interest rates by 25 basis points throughout the interest rate tree he has been using to value the two bond issues. Using the new rates, Diffle has calculated values for the bonds assuming a 25-basis-point increase or decrease in rates. He plans to use these values as inputs into the following formulas for duration and convexity:







Calculate the value of the Bratton bonds using the interest rate tree.

108. Jerry Sanders, CFA, has been asked to analyze the 20-year bonds of Marietta Tech, Inc., which are currently being held in a corporate bond portfolio managed by a colleague, and to recommend whether the bonds should be sold or held. The bonds currently have a yield spread of 1.55% over Treasuries.



Marietta Tech, Inc. designs, manufactures, and markets specialty trucks and truck bodies mounted on new truck chassis produced by others, including concrete mixers, refuse bodies, fire and emergency vehicles, defense trucks, cut-away and dry freight van bodies, refrigerated units, stake bodies, and other specialized trucks. Marietta also manufactures fiberglass wind deflectors, armored trucks, shuttle buses, and cargo vans. Marietta's customers are located in the United States and Canada.



Exhibit 1: Selected Financial Data for Marietta Tech, Inc. (in thousands of $)









At lunch Sanders discusses the credit analysis of various types of bonds with Elizabeth Yan, who was just hired as a bond analyst. Yan makes the following statements:

Statement 1: An analysis of the issuer's business and operating risks is important to the analysis of corporate bond credit risk but not important for the credit analysis of asset backed securities (ABS).

Statement 2: The unique bond covenants in a municipal bond's trust indenture require an additional level of credit analysis not necessary in a corporate credit analysis.



Compare the 2008 long-term obligations to capitalization ratio benchmarks to Marietta's ratio. Marietta is between the:

109. In 2001, Continental Supply Company was formed to provide drilling equipment and supplies to contractors and oilfield production companies located throughout the United States. At the end of 2005, Continental Supply created a wholly owned foreign subsidiary, International Oilfield Incorporated, to begin servicing customers located in the North Sea. International Oilfield maintains its financial statements in a currency known as the local currency unit (LCU). Continental Supply follows U.S. GAAP and its presentation currency is the U.S. dollar.



For the years 2005 through 2008, the weighted-average and year-end exchange rates, stated in terms of local currency per U.S. dollar, were as follows:





International Oilfield accounts for its inventory using the lower-of-cost-or-rnarlcet valuation method in conjunction with the first-in, first-out, cost flow assumption. All of the inventory on hand at the beginning of the year was sold during 2008. Inventory remaining at the end of 2008 was acquired evenly throughout the year.



At the beginning of 2006, International Oilfield purchased equipment totaling LCU975 million when the exchange rate was LCU 1.00 to SI. During 2007, equipment with an original cost of LCU 108 million was totally destroyed in a fire. At the end of 2007, International Oilfield received a LCU 92 million insurance settlement for the loss. On June 30, 2008, International Oilfield purchased equipment totaling LCU 225 million when the exchange rate was LCU 1.25 to $1.



For the years 2007 and 2008, Continental Supply reported International Oilfield revenues in its consolidated income statement of S375 million and $450 million, respectively. There were no inter-company transactions.

Following are International Oilfield's balance sheets at the end of 2007 and 2008:





At the end of 2008, International Oilfield's retained earnings account was equal to $525 million and, to date, no dividends have been paid. All of International Oilfield's capital stock was issued at the end of 2005.



Assume the country where International Oilfield is operating has been experiencing 30% annual inflation over the past three years.

Which of the following best describes the effect on Continental's consolidated financial statements for the year ended 2008?

110. Tom Vadney, CFA, is president and CEO of Vadney Research and Advisors (VRA), a large equity research firm that specializes in providing international investment and advisory services to global portfolio managers. He has a staff of five junior analysts and three senior analysts covering industries and firms across the Americas, Europe, and Asia-Pacific regions.



In a recent meeting with an institutional portfolio manager, Vadney is asked to review the differences between U.S. GAAP and International Financial Reporting Standards (IFRS) as well as provide a comprehensive industry analysis for the telecommunications sector in Europe and the Asia-Pacific region. Vadney asks Maria Mnoyan, a senior analyst covering the sector, to research the requested information for the client meeting.



Prior to the meeting, Vadney and Mnoyan meet to prepare for the client presentation. They first discuss differences between U.S. GAAP and IFRS. Mnoyan states that although there will be increasing convergence between the two accounting standards, one major difference currently is that IFRS permits either the "partial goodwill" or "full goodwill" method to value the goodwill and the noncontrolling interest under the acquisition method. U.S. GAAP requires the full goodwill method. Vadney adds that U.S. GAAP requires equity method accounting for joint ventures, while under IFRS, proportionate consolidation is preferred, but the equity method is permitted.



Vadney then asks Mnoyan to share her findings on the telecommunications sector. Mnoyan first presents an overview of the competitive forces that characterize the sector in the two regions. In particular, she notes that the sector in both regions is characterized by high switching costs. Vadney asks how high switching costs would affect the bargaining power of buyers and suppliers.



Mnoyan firmly believes that investing in companies located in developing countries provides strong growth potential through technological change and increases in capital, labor, and savings that contribute to higher dividend levels, even if the dividend growth rate is unaffected.



In her research report Mnoyan identifies several countries and industries with attractive investment potential. She notices that the telecommunications sector in one of the countries is characterized by a duopoly. The $50 billion telecom industry in another country in her analysis is dominated by he firms with market shares of $10 billion each.



Finally, Vadney and Mnoyan discuss investment opportunities in specific firms. Mnoyan values firms using both the discounted cash flow model and the franchise value method.

She makes the following statements on the franchise value method:

Statement 1: A higher asset turnover ratio increases the franchise P/E ratio, one of the components of the intrinsic P/E value.

Statement 2: When firms pay out profits as dividends at a higher rate, a firm's intrinsic P/E value decreases.



Mnoyan's best response to Vadney on how high switching costs affect the bargaining power of buyers and suppliers, respectively, should be:

111. Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.



The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.



Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, "Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?"



Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:

・ The risk-free rate of return is 2.7%.

・ The expected risk premiums arc:





・ The beta coefficient in the CAPM is estimated to be 0.63.

・ The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.



Trotter also asks Tang about adjusted betas. She says, "We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?"



Trotter has one final question for Tang. Trotter says, "We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes."



The best response to Trotter's question about survivorship bias is:

112. MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:



Expected return for Portfolio X =15%

Standard deviation of returns for Portfolio X = 20%

Expected return for Portfolio Y = 7%

Standard deviation of returns for Portfolio Y = 5%



Expected return on Portfolio Z = 5%



Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.



Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:



Expected return on Burk's portfolio = 10%

Standard deviation of returns on Burk's portfolio = 12%



Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of Long Drives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%.

After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.



MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.



MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:



Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.



Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, the Treynor-Black model avoids this problem because it does not consider short positions in securities.



In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast and Elizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.





Assume that there are two stocks in the active portfolio, one recommended by Nasi and the other by Tackacs. Using the Treynor-Black model and alphas adjusted for each analyst's forecast accuracy, what is the optimal allocation of the stock recommended by Nast to the active portfolio?

113. Glenda Garvey is interning at Samson Securities in the summer to earn money for her last semester of studies for her MBA. She took the Level 3 CFA® exam in June but has not yet received her score. Garvey’s work involves preparing research reports on small companies.



Garvey is at lunch with a group of co-workers. She listens to their conversation about various stocks and takes note of a comment from Tony Topel, a veteran analyst. Topel is talking about Vallo Engineering, a small stock he has tried repeatedly to convince the investment director to add to the monitored list. While the investment director does not like Vallo, Topel has faith in the company and has gradually accumulated 5,000 shares for his own account. Another analyst, Mary Kennedy, tells the group about Koral Koatings, a paint and sealant manufacturer. Kennedy has spent most of the last week at the office doing research on Koral. She has concluded that the stock is undervalued and consensus earnings estimates are conservative.

However, she has not filed a report for Samson, nor does she intend to. She said she has purchased the stock for herself and advises her colleagues to do the same. After she gets back to the office, Garvey purchases 25 shares of Vallo and 50 shares of Koral for herself.



Samson pays its interns very little, and Garvey works as a waitress at a diner in the financial district to supplement her income. The dinner crowd includes many analysts and brokers who work at nearby businesses. While waiting tables that night, Garvey hears two employees of a major brokerage house discussing Metrona, a nanotechnology company. The restaurant patrons say that the broker's star analyst has issued a report with a buy rating on Metrona that morning. The diners plans to buy the stock the next morning. After Garvey finishes her shift, restaurant manager Mandy Jones, a longtime Samson client, asks to speak with her. Jones commends Garvey for her hard work at the restaurant, praising her punctuality and positive attitude, and offers her two tickets to a Yankees game as a bonus.



The next morning, Garvey buys 40 shares of Metrona for her own account at the market open. Soon afterward, she receives a call from Harold Koons, one of Samson's largest money-management clients. Koons says he got Garvey's name from Bertha Witt, who manages the Koons' account. Koons wanted to reward the analyst who discovered Anvil Hammers, a machine-tool company whose stock soared soon after it was added to his portfolio. Garvey prepared the original report on Anvil Hammers. Koons offers Garvey two free round-trip tickets to the city of her choice. Garvey thanks Koons, then asks her immediate supervisor, Karl May, about the gift from Koons but does not mention the gift from Jones. May approves the Koons’ gift.



After talking with May, Garvey starts a research project on Zenith Enterprises, a frozen-juice maker. Garvey's gathers quarterly data on the company's sales and profits over the past two years. Garvey uses a simple linear regression to estimate the relationship between GDP growth and Zenith's sales growth. Next she uses a consensus GDP estimate from a well-known economic data reporting service and her regression model to extrapolate growth rates for the next three years.



Later that afternoon, Garvey attends a company meeting on the ethics of money management. She listens to a lecture in which John Bloomquist, a veteran portfolio manager, talks about his job responsibilities. Garvey takes notes that include the following three statements made by Bloomquist:



Statement 1: I’m not a bond expert, and I’ve turned to a colleague for advice on how to manage the fixed-income portion of client portfolios.



Statement 2: I strive not to favor either the remaindermen or the current-income beneficiaries, instead I work to serve both of their interests.



Statement 3: All of my portfolios have target growth rates sufficient to keep ahead of inflation.



Garvey is not working at the diner that night, so she goes home to work on her biography for an online placement service.

In it she makes the following two statements:



Statement 1: I'm a CFA Level 3 candidate, and I expect to receive my charter this fall. The CFA program is a grueling, 3-part, graduate-level course, and passage requires an expertise in a variety of financial instruments as well as knowledge of the forces that drive our economy and financial markets.

Statement 1: I expect to graduate with my MBA from Braxton College at the end of the fall semester.

As both an MBA and a CFA, I'll be in high demand. Hire me now while you still have the chance.

In her estimation of Zenith's future growth rate, what standard did Garvey violate?

114. Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U.S. dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annual payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.



The current term structure of interest rates for both countries is given in the following table:





Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI.

In addition to the terms of the swap, Torrey includes the following information in the report:• Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U.S. Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

• In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

• Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.



Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso.

The new term structure of interest rates is as follows:





Evaluate Torrey's statements regarding IRPs ability to mitigate the credit risk inherent in currency swaps and interest rate swaps. Torrey is only correct regarding:

115. Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.



Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.







Haas makes the following statements during her YD presentation to the investment committee.



Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.

Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.



Haas notes that the multi-stage residual equity income model captures more detail in calculating YD's intrinsic value. An assumption of the model is that ROE fades to the cost of equity over time, which is known as a persistence factor (varying from 0 to 1). Identify which characteristic indicates a higher persistence of abnormal earnings.

116. Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate.

Black notes the following term structure:





Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.



Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department.

Coleman advises Black that:

Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk at the initiation of the swap but the floating rate payer is not.

Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short position in a payer swaption is not.



On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap.

The term structure after 120 days is:







Ignore your answer to Question 115 and assume the annualized fixed rate on the swap is 3.80%.

The amount of the first fixed payment due on this swap is closest to:

117. Lorenz Kummert is a junior equity analyst who is following Schubert, Inc. (Schubert), a small publicly traded company in the United States. His supervisor, Markus Alter, CFA, has advised him to use the residual income model to analyze Schubert.



In his preliminary report to Alter, Kummert makes the following statements:

Statement 1: Residual income models are appropriate when expected free cash flows are negative for the foreseeable future.

Statement 2: Residual income models are not applicable when cash flows are volatile.



Kummert has determined Schubert's cost of equity, cost of debt, and weighted average cost of capital (WACC) to be 12.8%, 8.4%, and 11.9%, respectively. The current price of the stock is $35 per share and there are 130,000 shares outstanding. The relevant tax rate is 30%, and return on equity (ROE) is expected to be 13%.



Summarized financial information about Schubert for 2008 is provided in Exhibits I and II.





Based on his analysis of several years of financial statements, Kummert notes that 2008 was an exceptionally profitable year for Schubert, and that its dividend payouts are usually low because the funds are mainly reinvested in the firm to promote growth. Furthermore, there are very few nonrecurring items on the income statement. Upon review of Kummert's preliminary report, Alter concurs with his analysis of the financial statements but reminds him that Schubert's long-term debt is currently trading at 95% of its book value. He also cautions Kummert that violations of the clean surplus relation can bias the results of the residual income model.



The consensus annual EPS estimate for 2009 is $6.15, and the dividend payout ratio for 2009 is estimated at 5%.



Which of the following amounts are closest to the economic value added (EVA) and market value added (MVA) of Schubert, respectively?

EVA; MVA

118. Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund's prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.



The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund's exposure as he builds or liquidates positions in his portfolio since Biogene's large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.



The end of the quarter is just a few days away, and Connor is considering three transactions:



Transaction A: Buying Put Options on Stock A



The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A.



The Biogene Fund owns 5% of the outstanding stock of Company B. Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.



Transaction C: Selling the Biogene Fund's Entire Position in .Stock C



Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund's tax expense for the year.



Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene's share to 2%, explaining:



"With Biogene's reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."



Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO. Arnold responded a few hours later with the following message:



"I have just spoken with Ms. D, the CFO of Stock D. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%―you won't be sorry!"



After reviewing Arnold's e-mail, Connor agrees to the 2% offer.



Based upon Connor's acceptance of the 2% limitation after receiving the e-mail from Arnold:

119. For the past 15 years, Susan Luna, CFA, Kyle Lawson, CFA, and Matt Miller. CFA, have worked together as equity analysts and then equity portfolio managers in the investment management division (BIMCO) of the Broadway Life Insurance Company. For the past five years, the three associates have worked together managing the BIMCO Aggressive Growth Fund (BAGF). During their management tenure the BAGF had excellent performance and was well recognized in the financial press.



Just over one year ago, Broadway Life was acquired by a larger company, Gobble Insurance, and as part of the consolidation process BIMCO was closed. The closure allowed Luna, Lawson and Miller to start their own investment management firm, Trio Investment Management LLC (TIM). TIM focuses on the small capitalization growth equities area. This is the same investment focus as the BAGF, but TIM will have individually managed accounts. Several cases have arisen calling for interpretation as to consistency with CFA Institute Standards of Professional Conduct.



Case 1

TIM markets its investment management services by contracting with small, local bank trust departments. One of the newest bank trust clients for TIM is Shadow Mountain Bank and Trust. Judy Sampson, CFA, the trust officer for Shadow Mountain, has scheduled a meeting with a potential client. When Lawson arrives for the client meeting, he finds that all of the TIM marketing material, including biographies of TIM portfolio managers, has been relabeled by Sampson as the Shadow Mountain Wealth Management Team. Sampson has also added the performance of BAGF into the current TIM Equity Composite Index portfolio and relabeled the resultant combined graph, the Shadow Mountain Equity Composite Index. Sampson states that making such changes would probably please clients and improve the chances of acquiring additional trust management accounts for Shadow Mountain and TIM. Lawson goes along and makes the presentation to the potential client using the Shadow Mountain marketing material and the relabeled BAGF/TIM equity performance record.



Case 2

Susan Luna of TIM is meeting with Sol Wurtzel, an institutional salesman for Turn Byer, a large national brokerage firm. Luna complains that TIM*s technology costs are too high, especially their outside software services costs. TIM currently subscribes to two investment-related software services. The first software vendor is StockCal Software Services (StockCal), which provides valuation and stock charting capabilities TIM uses in their equity research and selection process. The other vendor is Add-Invest Software (Add-Invest), a software program providing account management and performance evaluation reporting which TIM uses in developing monthly reports for all clients. In response to Luna, Wurtzel suggests that Turn Byer has an excellent soft dollar trading desk and would be willing to offer to cover TIM's StockCal and Add-Invest expenses through soft dollar commissions. Luna then reviews TIM's projected commission dollars for the year and decides there are more than enough soft dollars to pay the StockCal, AGF and Add-Invest Software bills combined. Luna believes she can be assured of excellent trade execution from Turn Byer and improved profitability for TIM because of the increased use of soft dollars. Luna then directs that the StockCal and Add-Invest software services be paid for with soft dollar or client brokerage dollars.



Case 3

Sol Wurtzel, the equity salesman for Turn Byer, has referred several clients to TIM over the past year. In fact, Wurtzel referrals currently account for almost 20% of the assets managed by TIM. The principals of TIM decide to reward Wurtzel, either by doubling the commissions paid on trades executed through Turn Byer on Wurtzel's referral accounts, or by paying Wurtzel a cash referral fee for each additional TIM account opened by a Wurtzel referral. The principals agree that any cash referral fee would need to be disclosed to clients in advance.



Case 4

Luna notes that her clients have become increasingly aware of the directed client brokerage / soft dollar commissions issue. At a recent meeting with one of her large pension clients. Service Workers Union Local #1418, the subject of directed commissions came up. Upon learning of the commission dollars available to their account, the Union trustees directed Luna to use their client brokerage of approximately $25,000 to donate to a think lank called the Hoover Study Center of Unions at Samford University. Service Workers trustees believed the Hoover study will increase the public awareness of the benefits unions offer to their members and increase union membership. Luna concurs with the trustee's judgment on increasing union enrollment as a great goal, and follows the client's instructions and makes the $25,000 contribution to the Hoover Study Center. Another client, Rosa Lutz, has asked Luna to credit the soft dollar client brokerage proceeds from her personal retirement accounts to Roswell Academy, to update their computer lab. Luna agrees that a new computer lab for Roswell Academy is greatly needed and she allocates 510,000 of Lutz's commission dollars to Roswell Academy.



Would either of the compensation arrangements to reward Wurtzel for client referrals be in violation of the CFA Institute Standards of Professional Conduct?

120. Stanley Bostwick, CFA, is a business services industry analyst with Morton world Financial. Currently, his attention is focused on the 2008 financial statements of Global Oilfield Supply, particularly the footnote disclosures related to the company's employee benefit plans. Bostwick would like to adjust the financial statements to reflect the actual economic status of the pension plans and analyze the effect on the reported results of changes in assumptions the company used to estimate the projected benefit obligation (PBO) and net pension cost. But first, Bostwick must familiarize himself with the differences in the accounting for defined contribution and defined benefit pension plans.



Global Oilfield's financial statements are prepared in accordance with International Financial Reporting Standards (IFRS). Excerpts from the company's annual report are shown in the following exhibits.











Which of the following best describes the effects of a decrease in the rate of compensation growth during 2009 all else equal? Global Oilfield's:

121. Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.





Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is 26.50.



Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios.

Three of the advantages of P/B ratios that Aims recalls are:

Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.

Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.

Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.



Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)



If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."



Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.



Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.



Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA.

Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.



Using the information in Exhibit 1, estimate the 2008 P/E ratio for Flavia Stores using the method of average return on equity. The P/E ratio is closest to:

122. Valentine notes that a share of Trailblazer's stock is currently priced at $32. Moreover, she expects the dividend for next year to be $1.47 and forecasts that the price of one share of Trailblazer stock at the end of the year wilt be $35.



In her report, Valentine makes the following statements about Trailblazer dividends:

Statement 1: Trailblazer is expected to pay a dividend next year and will continue to do so for the foreseeable future.

Statement 2: The required rate of return for Trailblazer stock will likely exceed the growth rate of its dividends.

Statement 3: Trailblazer is in a mature sector of its industry, and accordingly,

I expect dividends to decline to a constant rate of 4% indefinitely.



In speaking to a colleague at her firm, Valentine makes the following additional statements after her report is released:

Statement 4: Trailblazer has a 10-year history of paying regular quarterly dividends.

Statement 5: Over a recent 10-year period, Trailblazer has experienced one 3-year period of consecutive losses and another period of two annual losses in a row but has been extremely profitable in the remaining five years.



Valentine is concerned about the theoretical validity of using the APT to obtain an estimate of the required rate of return on equity. She decides to attend a conference dealing specifically with estimation techniques that analysts can employ.

At one of the conference seminars, the following points are made:

Statement 6: The APT is a better approach than the CAPM because even though the factor risk premiums are difficult to estimate, the CAPM is more problematic because it relies on a single market risk premium estimate, which in turn leads to greater input uncertainty.

Statement 7: Model uncertainty is a problem with the APT but not with the CAPM.



Valentine is also analyzing the stock of Farwell, Inc. Farwell shares are currently trading at $48 based on current earnings of $4 and a current dividend of $2.60. Dividends are expected to grow at 5% per year indefinitely. The risk-free rate is 3.5%, the market risk premium is 4.5%, and Farwell's beta is estimated to be 1.2.



The justified leading and justified trailing P/E ratios of Farwell are closest to:

Justified leading P/E ;Justified trailing P/E

123. Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.



Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.



Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.



Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.



Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.



Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.

• If a firm anticipates floating rate exposure from issuing floating rate bonds a t some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.• Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.



What would be the most appropriate way for Reichmann to construct an interest rate collar to hedge the fixed-rate portion of the portfolio using the 2-year 6% floor and a 2-year 12% cap?

124. Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.



Ferguson Department Stores, Inc.



FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.



At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.







In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.





In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.



Assuming a tax rate of 34%, the underlying earnings per share (EPS) for FDS in 2008 is closest to:

125. Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.





At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.



As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:

Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.

Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.



Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.







Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.



Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.



Is Berg correct about the specified change in yield needed to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model?

126. Austin Clark, CFA, has been asked to analyze White Goods Corporation, a $9 billion company that owns a nationwide chain of stores selling appliances and other electronic goods. As part of his analysis of the White Goods Corporation, Clark's supervisor, David Horvath, asks Clark to forecast White Goods' 2009 sales using multiple regression analysis.

The following model was developed:



sales = 20.1 + 0.001 GDP+ 1,000.6 TR + 0.1 CC -3.2 PC -40.3 UR

t-values: (1.1) (2.3) (1.75) (3.2) (-0.48) (-0.9) Number of observations: 76

Standard error estimate: 15.67

Unadjusted R2: 0.96

Regression sum of squares: 412,522

Error sum of squares: 17,188



Independent Variable Descriptions



GDP = gross domestic product

TR = average coupon rate on 5-year U.S. Treasury securities

CC = most recent quarter end consumer confidence index value

PC = previous year's sales of personal computers

UR = most recent quarter end unemployment rate



Variable Estimates for 2009



GDP =8,000

TR = 0.05

CC =97

PC = 60,000



UR = 0.055



Critical Values For Student's t-Distribution





Clark's supervisor asks him to prepare a report explaining the implications of the regression analysis results. Clark writes the following conclusions concerning regression analysis in his report: Interpreting the results of regression analysis can be problematic if certain assumptions of the ordinary least squares framework are violated.

The regression output for White Goods Corporation is unreliable for the following reasons:

Finding 1: The correlation between regression errors across time is very close to 1.

Finding 2: There is a strong relationship between the regression error variance and the regression independent variables.



Using his multiple linear regression, Clark's sales forecast for 2009 is closest to:

127. Michael Thomas, CFA, is a fixed-income portfolio manager for TFC Investments. As part of his portfolio strategy for the Prosperity Fund, Thomas searches for companies that he expects to be upgraded or downgraded. Those potential upgrades he finds are added to the portfolio or if already in the portfolio are increased in proportion to other holdings before the upgrade takes place. Potential downgrades are sold from the portfolio before the downgrade takes place. Thomas is evaluating his portfolio's current holdings which include several bonds issued by companies in the oil and gas exploration and refining industries. Year-end rating updates are expected to occur in a few days and Thomas is preparing to adjust his portfolio based on expected changes in credit ratings.

He has assembled the following annual data on four of the oil and gas stocks in the portfolio:

Exhibit: 1







Thomas has been discussing his fixed-income strategies with a fellow portfolio manager, Shawna Reese. Reese has indicated that while his initial approach is good, the overall credit analysis strategy could be improved and has made the following suggestions to Thomas for both the Prosperity Fund and other fixed-income funds he manages:

- The current methodology does not consider special issues related to high-yield debt which makes up approximately 5% of the Prosperity Fund. Because most high-yield issuers have such a heavy dependence on short-term debt financing, analysis of the firm's debt structure will be extremely important to determine the priority of claims on the firm's assets as well as what source(s) of funds will be used to repay the principal. In addition, the corporate structure of high-yield issuers must be examined to determine the issuer's access to cash flows generated by its subsidiaries. A simple analysis of the parent's financial ratios will not reveal complicated corporate structures and indebtedness of subsidiaries that may restrict the issuer's ability to obtain the cash flows necessary to service its debt.

- The current methodology as applied to the Municipal Opportunities Fund does not include the necessary specialized analysis for municipal securities. Among other items, tax-backed munis must be scrutinized as to the issuer's ability to maintain balanced budgets as well as to ensure that the issue has first priority of claims to revenue from public works projects. Revenue-backed munis require an assessment of the sufficiency of rate covenants to cover expenses and debt servicing of the underlying project as well as the ability for other government entities to access the revenues generated by the enterprise before they are passed on to revenue bondholders.



As part of his portfolio analysis, Thomas also examines yield volatility.

Thomas makes the following statements:

Statement 1: Implied yield volatility estimates are based on the assumptions that the option pricing model is correct and that volatility is constant.

Statement 2: Yield volatility has been observed to follow patterns over time that can be modeled and used to forecast future volatility.



He concludes his analysis by comparing the swap rate curve to a government bond yield curve as a benchmark.



Which of the following statements regarding the choice between government bond yield curves and swap rate curves as benchmark yields is most likely correct?

128. Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.



Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.







In his report, Wayne makes the following statements regarding the CMO:

Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.



Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.



Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.



Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.



Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.



Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.



Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:



Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.



Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.



Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.



Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.



Based on the material he has read concerning ABS, Wayne disagrees with Freed's Statement 6 but agrees with Statement 7. In fact:

129. Sara Robinson and Marvin Gardner are considering an opportunity to start their own money management firm. Their conversation leads them to a discussion on establishing a portfolio management process and investment policy statements. Robinson makes the following statements:

Statement 1;

Our only real objective as portfolio managers is to maximize the returns to our clients.

Statement 2:

If we are managing only a fraction of a client's total wealth, it is the client's responsibility, not ours, to determine how their investments are allocated among asset classes.

Statement 3: When developing a client's strategic asset allocation, portfolio managers have to consider capital market expectations. In response, Gardner makes the following statements:

Statement 4: While return maximization is important for a given level of risk, we also need to consider the client's tolerance for risk.

Statement 5: We'll let our clients worry about the tax implications of their investments; our time is better spent on finding undervalued assets.

Statement 6: Since we expect our investor's objectives to be constantly changing, we will need to evaluate their investment policy statements on an annual basis at a minimum.



Robinson wants to focus on younger clientele with the expectation that the new firm will be able to retain the clients for a long time and create long-term profitable relationships. While Gardner felt it was important to develop long-term relationships, he wants to go after older, high-net-worth clients.



Are Statements 1 and 4 consistent with the appropriate method of developing portfolio objectives?

130. Fashion Inc. is a major U.S. distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.



Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.



Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.





To justify his use of the comparable transaction approach to establish a fair acquisition for Flavoring, Smith would like to conclude his report with the most important reason for choosing this approach.

Which of the following rationales would Smith most likely use?



• The fair acquisition price developed for Flavoring reflects a market based valuation approach, an advantage compared to discounted cash flow valuations, which are based on assumptions that do not incorporate market valuations.



• The acquisition prices for recently acquired companies provide a reasonable approximation of their realistic intrinsic values.

• The fair acquisition price developed for Flavoring is a realistic estimate of potential value to Fashion given that forecasts of future performance are unavailable.

131. Galena Petrovich, CFA, is an analyst in the New York office of TRS Investment Management, Inc. Petrovich is an expert in the industrial electrical equipment sector and is analyzing Fisher Global. Fisher is a global market leader in designing, manufacturing, marketing, and servicing electrical systems and components, including fluid power systems and automotive engine air management systems.



Fisher has generated double-digit growth over the past ten years, primarily as the result of acquisitions, and has reported positive net income in each year. Fisher reports its financial results using International Financial Reporting Standards (IFRS).



Petrovich is particularly interested in a transaction that occurred seven years ago, before the change in accounting standards, in which Fisher used the pooling method to account for a large acquisition of Dartmouth Industries, an industry competitor. She would like to determine the effect of using the purchase method instead of the pooling method on the financial statements of Fisher. Fisher exchanged common stock for all of the outstanding shares of Dartmouth.



Fisher also has a 50% ownership interest in a joint venture with its major distributor, a U.S. company called Hydro Distribution. She determines that Fisher has reported its ownership interest under the proportioned consolidation method, and that the joint venture has been profitable since it was established three years ago. She decides to adjust the financial statements to show how the financial statements would be affected if Fisher had reported its ownership under the equity method. Fisher is also considering acquiring 80% to 100% of Brown and Sons Company. Petrovich must consider the effect of such an acquisition on Fisher's financial statements.



Petrovich determines from the financial statement footnotes that Fisher reported an unrealized gain in its most recent income statement related to debt securities that are designated at fair value. Competitor firms following U.S. GAAP classify similar debt securities as available-for-sale.



Finally, Petrovich finds a reference in Fisher's footnotes regarding a special purpose entity (SPE). Fisher has reported its investment in the SPE using the equity method, but Petrovich believes that the consolidation method more accurately reflects Fisher's true financial position, so she makes the appropriate adjustments to the financial statements.



Regarding the prior purchase that was accounted for under the pooling of interests method, had Fisher Global reported this purchase under the acquisition method:

132. Martin Hagemann, CFA, works for a large brokerage firm in Frankfurt, Germany. Hagemann has been hired by Tryssen AG, a global research-based company that is preparing to go public after a long history of operating privately. The need to raise substantial amounts of capital to fund research and development activities is seen as the key motivation for the change in policy. Tryssen is engaged in the discovery, development, manufacture, marketing, and sale of medical products.



Hagemann's first task is to recommend an exchange upon which Tryssen stock can be traded. One possibility is the Deutsche Bourse. The Deutsche Bourse operates primarily as a continuous order-driven system. Another alternative that Tryssen is considering is to list on a different exchange that operates as a price-driven system.



As an alternative, Tryssen may choose to list as an American Depository Receipt (ADR). ADRs are negotiable U.S. securities that usually represent a non-U.S. based company's publicly traded equity. Although typically denominated in U.S. dollars, depository receipts can also be denominated in euros. Depository receipts can be eligible to trade on all U.S. stock exchanges as well as on many European stock exchanges.



The increasing demand for depository receipts is driven by the desire of individual and institutional investors to diversify their portfolios, reduce risk and invest internationally in the most efficient manner possible. While most investors recognize the benefits of global diversification, there are many challenges presented when investing directly in local trading markets. Obstacles can include inefficient trade settlements, uncertain custody services, and costly currency conversions. Depository receipts overcome many of the inherent operational and custodial hurdles inherent in international investing. Tryssen has decided to access the U.S. market by involving itself in an ADR program. Tryssen has decided to save itself a lot of trouble, however, by not complying with SEC registration and reporting requirements.



As an alternative to ADRs, investors interested in increasing their exposure to international investments can choose to acquire exchange traded funds (ETFs). Hagemann researches the advantages and disadvantages of ETFs.



Execution costs are always a concern, and perhaps even more so for international investors. At the present time, Tryssen AG is most concerned with how reliably it can estimate trading costs. As part of the cost estimation process, Hagemann is asked to provide a report on the advantages and disadvantages of techniques used to reduce execution costs.



Trysse AG proceeds to list on the Frankfurt exchange, and a U.S. affiliate of Hagemann's company starts to aggressively promote the stock. A U.S. investor buys 200 shares of Tryssen at a price of 20 per share. At time of purchase, the exchange rate is 1 = $1.15. One month later Tryssen pays a dividend of 0.25 per share, and investors are subject to a withholding tax of 20%. The U.S. investor is eligible to claim a tax credit of $0.06 per share. At the time the dividend was paid, the shares had jumped to 24 each and the U.S. dollar had weakened to 1 = $ 1.20. The shares were sold just after the dividend was paid.



Which of the following represents a correct advantage and a correct disadvantage for the indicated approach that is aimed at reducing execution costs?

133. Jonathan Adams, CFA, is doing some scenario analysis on forward contracts. The process involves pricing the forward contracts and then estimating their values based on likely scenarios provided by the firm's forecasting and strategy departments. The forward contracts with which Adams is most concerned are those on fixed income securities, interest rates, and currencies.



The first contract he needs to price is a 270-day forward on a $1 million Treasury bond with ten years remaining to maturity. The bond has a 5% coupon rate, has just made a coupon payment, and will make its next two coupon payments in 182 days and in 365 days. It is currently selling for 98.25. The effective annual risk-free rate is 4%. Adams is also analyzing forward rate agreements (FRAs).



The LIBOR spot curve is as follows:





Finally, Adams wants to price and value a currency forward on euros. The euro spot rate is $1.1854. The dollar risk-free rate is 3%, and the euro risk-free rate is 4%.



After 30 days, Adams wants to value a $10 million short position in the 2x5 FRA. The 90-day forward rate in 30 days is now 4.14%, and the original price of the FRA was 4.30%. 120-day LIBOR has changed to 3.92%. The current value of the $10 million FRA to the short position under this scenario is closest to:

134. Russell Larson, CFA, is an investment analyst for Sentry Properties, Inc., a group of wealthy investors that is currently interested in purchasing Riviera Terrace, a 60- unit apartment complex in Southeastern Florida. The current owners of Riviera Terrace have agreed to sell the property for $40,000,000. Larson estimates that Rivjera Terrace's net operating income for the first year after the sale is finalized will be $4,200,000, and it is expected to maintain its historic annual growth rate of 5%.



At Sentry's request, Larson will evaluate the investment in Riviera Terrace over a 5-year horizon using selling prices of $45,000,000 and S60,000,000.



During the due diligence process, Larson has determined that the average selling price for apartment complexes similar to Riviera Terrace is $1,250,000 per unit, with annual net operating income equal to $ 135,000 per unit. Larson has also determined that net operating income is typically 80% of gross income.

Larson has collected the following information to aid in his evaluation of Riviera Terrace.



• The property will be fully depreciated at a rate of S 1,250,000 per year over 32 years.

• Rental contracts are expected to be reissued on the date the sale is completed.

• Sentry has arranged to finance the investment with a 30-ycar, 7% interest-only loan, with monthly payments and a face value equal to 80% of the initial investment.

• Selling expenses will be 7% of the gross selling price.

• The capital gains tax rate is 15%, the tax on recaptured depreciation is 28%, and the tax rate on ordinary income is 40%.

• Sentry Properties' required return on equity is 20%.

• The interest rate on U.S. government bonds after adjustments for real estate based tax savings = 5.0%.

• The premium investors require for the illiquidity of real estate investments = 2.5%.

• The average real estate return net of appreciation = 1.25%.

• The real estate investment risk premium = 3.0%.

• The average internal rate of return for properties that are comparable to Riviera Terrace is 22%.

As part of the diligence process, Larson deems it to be appropriate to estimate the.market value of Riviera Terrace using capitalization rates based on the market extraction and built-up methods. One of the partners in Sentry Properties has also asked Larson to estimate the market value of Riviera Terrace using:



(1) the direct income capitalization approach and (2) the gross income multiplier approach.



There are several indicators that the Florida real estate market may take a downward turn over the next five years. With this in mind, Larson determines that there is a reasonable chance that Sentry will have to terminate its investment in Riviera Terrace at the end of year 3 at the initial purchase price of $40,000,000. Under this scenario, he estimates the equity reversion after tax (ERAT) in year 3 to be $4,934,000. Cash flow after tax in years 1 and 2 are $1,676,000 and $1,802,000, respectively.



In the scenario in which Sentry will sell Riviera Terrace for $60,000,000 at the end of the investment horizon, the total tax liability is closest to:



• $1,750,000.



• $2,370,000.



• $4,120,000.

135. Jerry Sanders, CFA, has been asked to analyze the 20-year bonds of Marietta Tech, Inc., which are currently being held in a corporate bond portfolio managed by a colleague, and to recommend whether the bonds should be sold or held. The bonds currently have a yield spread of 1.55% over Treasuries.



Marietta Tech, Inc. designs, manufactures, and markets specialty trucks and truck bodies mounted on new truck chassis produced by others, including concrete mixers, refuse bodies, fire and emergency vehicles, defense trucks, cut-away and dry freight van bodies, refrigerated units, stake bodies, and other specialized trucks. Marietta also manufactures fiberglass wind deflectors, armored trucks, shuttle buses, and cargo vans. Marietta's customers are located in the United States and Canada.



Exhibit 1: Selected Financial Data for Marietta Tech, Inc. (in thousands of $)









At lunch Sanders discusses the credit analysis of various types of bonds with Elizabeth Yan, who was just hired as a bond analyst. Yan makes the following statements:

Statement 1: An analysis of the issuer's business and operating risks is important to the analysis of corporate bond credit risk but not important for the credit analysis of asset backed securities (ABS).

Statement 2: The unique bond covenants in a municipal bond's trust indenture require an additional level of credit analysis not necessary in a corporate credit analysis.



Based on the available information, Sanders should:

136. Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund's prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.



The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund's exposure as he builds or liquidates positions in his portfolio since Biogene's large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.



The end of the quarter is just a few days away, and Connor is considering three transactions:



Transaction A: Buying Put Options on Stock A



The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A.



The Biogene Fund owns 5% of the outstanding stock of Company B. Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.



Transaction C: Selling the Biogene Fund's Entire Position in .Stock C



Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund's tax expense for the year.



Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene's share to 2%, explaining:



"With Biogene's reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."



Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO. Arnold responded a few hours later with the following message:



"I have just spoken with Ms. D, the CFO of Stock D. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%―you won't be sorry!"



After reviewing Arnold's e-mail, Connor agrees to the 2% offer.



Arnold's arguments for limiting Biogene's share to 2% suggest that Apple:

137. Ernie Smith and Jama! Sims are analysts with the firm of Madison Consultants. Madison provides statistical modeling and advice to portfolio managers throughout the United States and Canada.



In an effort to estimate future cash flows and value the Canadian stock market. Smith has been examining* the country's aggregate retail sales. He runs two autoregressive regression models in an attempt to determine whether there are any patterns in the data, utilizing nine years of unadjusted monthly retail sales data. One model uses a lag one variable and the other adds a lag twelve variable. The results of both regressions are shown in Exhibits 1 and 2.









Sims has been assigned the task of valuing the U.S. stock market and uses data similar to the data that Smith uses for Canada. He decides, however, that the data should be transformed. He takes the natural log of the data and uses it in the following model:







Smith and Sims are concerned that the data for Canadian retail sales may be more appropriately modeled with an ARCH process. Smith states, that in order to find out, he would take the residuals from the original autoregressive model for Canadian retail sales and then square them.

Sims states that these residuals would then be regressed against the Canadian retail sales data using the

where e represents the residual terms from the



original regression and X represents the Canadian retail sales data. If is statistically different from zero, then the regression model contains an ARCH process.



Smith also examines the quarterly inflation data for an emerging market over the past nine years. He models the data using an autoregressive model with a lag one independent variable which he finds is statistically different from zero. He wonders whether he should also include lag two and lag four terms, given the magnitude of the autocorrelations of the residuals shown in Exhibit 4, assuming a 5% significance level. The critical t-values, assuming a 5% significance level and 35 degrees of freedom, are 2.03 for a two-tail test and 1.69 for a one-tail test.





where: FF is the Federal Funds rate in the United States (US), and BY is the bond yield in the European Union (E) and Great Britain (B).



Before he runs this regression, he investigates the characteristics of the dependent and independent variables. He finds that the Federal Funds rate in the United States and the bond yield in Great Britain have a unit root but that the bond yield in the European Union does not. Furthermore, the Federal Funds rate in the United States and the bond yield in Great Britain are cointegrated but the Federal Funds rate in the United States and the bond yield in the European Union are not.

Are the comments of Smith and Sims on the construction of an ARCH model correct?

138. Trent Black is a government fixed-income portfolio manager and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate.

Black notes the following term structure:





Black is also evaluating receiver and payer swaptions on the same $30 million interest rate swap. The swaptions are European-style swaptions that mature in 240 days. Black anticipates a decline in interest rates and would like to use the swaptions to profit from his interest rate forecast.



Black is also concerned about the potential credit risk inherent in both interest rate swaps and swaptions, so he consults Marcus Coleman, a contract specialist in the legal department.

Coleman advises Black that:

Statement 1: The fixed rate payer in any plain vanilla interest rate swap is exposed to potential credit risk at the initiation of the swap but the floating rate payer is not.

Statement 2: The long position is exposed to potential credit risk in a payer swaption at initiation but the short position in a payer swaption is not.



On May I after 120 days. Black is asked to determine the value of the 2-year, $30 million swap.

The term structure after 120 days is:





After 120 days, the value of the fixed rate side and the floating rate side of the swap (based on $1 of notional principal), assuming the annualized swap fixed rate is 3.80%, are closest to: