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CFA Level II Mock Exam 2
June, 2016
Revision 1
According to our firms policy, nondiscretionary pension accounts and personal trust
accounts have a lower priority on purchase and sale recommendations than discretionary
pension fund accounts. This is why returns have been slightly lower for such accounts.
After the meeting, Wiley proceeded with an analysis of the stocks of two utility firms for
inclusion in his private wealth portfolios. After proper due diligence of each investment,
Wiley e-mailed the recommendation to all his clients for which the investment was
suitable. He then called two of his largest clients to discuss the recommendation in detail.
Wiley is also following The RedNeck Products (RNP), a firm in the electronics industry.
Wiley believes that a bond offered by RNP is suitable for five of his clients. Two of his
clients wish to purchase $40,000 each, and the other three request to purchase $10,000
each. The minimum lot size is established at $5,000 and it is believed that odd-lot
allocations below the minimum would affect the liquidity of the security. Wiley receives
only $65,000 for all the five accounts. He allocates $25,000 each to the first two
accounts, and $5,000 each to the remaining three accounts.
Wiley has been assigned responsibility for managing the accounts of two additional
private wealth clients. As a first step, Wiley developed each clients investment policy
statement (IPS). After six months, Wiley reviewed the IPS of each client. He made the
following additions to the IPS:
Client A: The client has received $80,000 as inheritance from his grandfather.
Client B: The clients brother passed away, and she is now responsible for taking
care of his only child. As such, her income needs have increased, and the
IPS provides for liquid investments only.
After reviewing the IPSs, Wiley increased the proportion of stock investments in client
As account. Realizing that client B needs greater growth in its portfolio due to the
emergence of a dependent, Wiley shortlisted a venture capital fund for her portfolio.
After extensive analysis, Wiley strongly believed that the fund would increase the
portfolios value up by 25% in just three years. He just invests 4% in this fund, investing
96% of the portfolio in highly liquid securities.
After his work for the day was over, Wiley met with one of his clients, Laura Winston,
who is also a portfolio manager at a reputable firm. During their conversation, Winston
told Wiley that she was leaving her current employer to open up her own investment
management firm. She stated that to minimize any conflicts of interest, she was not going
to solicit any current clients of her employers until she has left the firm. She added that
she was not going to take any of her employers property at departure, except the models
she developed on her own personal laptop.
As the conversation continued, Wiley told Winston that he was going to California with
his wife for the weekend. He added that the trip was paid for by one of his clients; the
client had gifted him two tickets to California for achieving above-average returns on his
portfolio.
1. With regards to the trade in APMs stock, has Wiley violated the CFA Institute
Standards of Professional Conduct?
A. Yes.
B. No, because he managed to increase the value of the fund for its
beneficiaries.
C. No, because he protected the beneficiaries by warding off the takeover
attempt.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Wiley has violated the Standards. Wileys duties are to the beneficiaries of the
pension account and not to APM. He should have examined the takeover offer on
its own merits and made an independent decision. The guiding principle is the
appropriateness of the investment decision to the pension plan.
2. Is the firms policy regarding pension accounts, and Wileys actions regarding his
recommendation most likely in accordance with the CFA Institute Standards of
Professional Conduct?
A. No.
B. Only with regards to the pension accounts policy.
C. Only with regards to Wileys treatment of the recommendation.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
The firms policy is not in accordance with the Standards. The policy does not
treat all customers fairly (discretionary accounts are given priority over
nondiscretionary accounts).
Wiley has not violated any Standards, since he widely disseminated the
recommendation and provided the information to all his clients prior to discussing
it with a select few. The largest clients are probably paying higher fees for the
additional service.
3. With respect to his allocation of the bond issued by RNP to his clients accounts,
has Wiley most likely violated the CFA Institute Standards of Professional
Conduct?
A. No.
B. Yes, because he offered preferential treatment to the two larger clients at
the expense of the three smaller clients.
C. Yes, because he failed to communicate his allocation policy to his clients
before allocating the security.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Wiley has not violated any Standards. Even though the distribution is not on a
complete pro rata basis because of the required minimum lot size, the approach
allowed the clients to efficiently sell the bond later if necessary.
4. Are Wileys portfolio modifications for Client A and Client B most likely correct?
A. Yes.
B. Only with respect to Client A.
C. Only with respect to Client B.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Since Client A has just received $80,000, he can probably bear more risk, and a
higher proportion of equities seems appropriate for the portfolio.
5. Has Winston most likely violated Standard IV, Duties to Employers, of the CFA
Institute Standards of Professional Conduct?
A. Yes.
B. No, because she did not solicit any of her employers clients.
C. No, because she did not solicit any of her employers clients, and did not
take with her any of her employers property before leaving.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Winston violated the Standard because she took away with her models that she
developed during her employment at the firm. It does not matter whether she
worked on her personal laptop, home computer, or office computer; the models
are a property of her employer.
6. With regards to his trip to California, has Wiley most likely violated any
Standards?
A. Yes.
B. No, as long as he discloses, in writing, this compensation arrangement to
his employer.
C. No, as long as the trip is of short duration and does not affect his duties at
the firm.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
For his current assignment, Solanki is working alongside Carla Rogers, the chief
investment officer of Motano Enterprises (ME) investment account. Solanki provides
ME with access to research reports, prepared by him, covering global fixed-income
markets.
Rogers has decided to expand MEs investment account to include four sovereign
emerging market bond issues. The companys investment account is presently invested in
developed market equities and bonds. Prior to offering any advice, Solanki believes it is
necessary to evaluate the sustainability of the debt issued in the four emerging market
countries identified by Rogers.
Solanki decides to employ simulation to evaluate the riskiness of the emerging markets.
When asked why he prefers simulation over other techniques, Solanki provides the
following reasons:
Reason 2: Given the unpredictable nature of emerging markets, simulations are best
suited when confronted with new and unpredictable risks.
Solanki then proceeds to initiate the simulation process. He identifies five input variables
inflation, global (US) and local (emerging market) interest rates, foreign exchange
rates, and debt service costs. Using these variables Solanki aims to determine the impact
of a currency crisis, in each of the four markets, on the value of debt issues and project
their likelihood of default.
Solanki proceeds to run the simulation using the input variables and suitable probability
distributions. He summarizes the simulated expected values and standard deviations in
values for the four issues in an exhibit (Exhibit). He has employed local risk-free rate to
calculate expected values for the issues.
Solanki recommends Rogers invest in bond issue A and supports his advice with the
following statement, Out of the two lowest priced issues, A and C, the former has the
lowest variation in simulated values making it the most suitable investment choice. A low
simulated standard deviation in value means that the issue will have the lowest marginal
risk.
Constraint 1: The value of reserves available to pay down debt should not be allowed to
decline below a minimum level, as specified by loan covenants. Should
reserves decline below this level, the government will be denied further
loans on favorable terms.
Constraint 2: Indirect bankruptcy costs can be built into the valuation of each issue by
comparing the total value of available resources for repaying debt to
outstanding claims in all scenarios. This will assist in measuring and
modeling the costs of not meeting debt payments.
A. Reason 1
B. Reason 2
C. Neither of the two reasons.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS d & e
8. In context of the issues surrounding the emerging markets being studied, the most
suitable probability distribution should rely on:
A. historical data.
B. cross-sectional data.
C. statistical distributions and parameters.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS b
9. Based on the steps followed, has Solanki correctly performed the simulations?
A. Yes.
B. No, he has failed to check for correlations across variables.
C. No, some of the variables he has considered may not be predictable.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS c
10. Considering the data in Exhibit 1, Solanki is most likely treating the simulation
process as a:
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS f
A is correct. The data in the exhibit suggests that Solanki is treating the
simulation process as a substitute to risk-adjusted values; this is because cash
flows are being discounted at a risk-free rate to arrive at a value and the standard
deviation in simulated values is being used as a tool to select investments.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS f
12. The constraints being employed by Solanki are most likely, respectively, classified
as:
constraint 1: constraint 2:
A. book value market value.
B. earnings and cash flow market value.
C. earnings and cash flow earnings and cash flow.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS e
Lakeline Associates is an audit firm. Senior auditor Kim Thomas and junior auditor
Gayle Cox are analyzing the financial statements of four corporations operating in
distinct industries. The auditors focus is on disclosures to the companys financial
statements. Based on their analysis, the auditors make four observations with respect to
the information disclosed in the financial statements.
Observation 1: The management of Borough Limited, an oil extractor, has been forced to
revise output prices downwards in response to an unexpected drop in
global oil prices. Weary of being unable to reach its annual operating
earnings target, the management has revised the corporate credit sales
policy at the beginning of the current fiscal year (2014). Under the new
policy customers will enjoy higher purchase discounts with a right to
return current year purchases at the beginning of the following year.
Observation 2: On June 1, 2012 Streak Corp acquired Manson Inc. by issuing 300,000 of
its common stock, which were trading at a market price per share of $50.
On the date of acquisition Manson Inc. had 250,000 shares outstanding
trading at a market price of $45 per share. The fair value of Manson
Inc.s net assets at the time of acquisition was $1.1 million. The goodwill
associated with the purchase is now believed to be overstated due to an
understatement of the identifiable assets at that time. No impairment
charges have been recorded since the date of acquisition and this is
expected to remain the case for the future periods.
Exhibit:
Cash Flows Statement and Net Income Information for
Aerial Limited (2012-2014) in $ Millions
2014 2013 2012
Operating cash flow 45.0 30.3 18.2
Investing cash flow 22.0 15.8 7.0
Financing cash flow 14.8 11.1 9.8
Net income 21.5 16.4 12.5
Operating cash flow variability relative to peers Low Low Low
In a recent conversation with Aerial Limiteds chief executive, Thomas concludes that
the firms operating cash flows are of poor quality.
Observation 4: The management of Grace Manufacturers has switched from the LIFO to
FIFO method of inventory accounting. This shift represents a response to
an unanticipated increase in the global price of a key input component.
In a discussion between the two individuals, Cox shares with Thomas that while the audit
opinion is used as a source of information about a companys risk, it can never be a
financial analysts first source of information.
13. A probable impact of the new sales policy (Observation 1) is that Borough
Limiteds:
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS f
With a revision in credit sales policy, days sales outstanding may increase as
customers are induced to take advantage of purchase discounts and enjoy a
flexible return policy. Furthermore, revenues may increase faster than the
previous years as well as compared to peers in response to an increase in customer
purchases.
14. Using the information in Observation 2 and ignoring the impact of the
overstatement, the amount of goodwill reported on Streak Corps financial
statements on the date of acquisition is closest to:
A. $0.25 million.
B. $3.75 million.
C. $4.00 million.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 6, Reading 18, LOS a
Goodwill = FV of the stock issued fair value of Manson Inc.s net assets
= (300,000 $50) $11,000,000 = $4,000,000
15. Based on the misreporting on the date of acquisition, Streak Corps consolidated
earnings will most likely be distorted in the:
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS d
The consolidated earnings in the current and future periods will most likely be
overstated as depreciation expenses will be understated due to an understatement
of the amount recorded as assets (depreciable base).
16. Which of the following reasons may justify poor cash flow quality?
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS j
Operating cash flows are higher relative to investing cash flow and net income.
The analyst may conclude that cash flows are manipulated and, comparing
operating with investing cash flows, may lead the analyst to conclude that the
company has improperly capitalized expenditures resulting in an overstatement of
operating cash flows and understatement of investing cash flows.
C is incorrect. Low cash flow volatility relative to peers is a sign of high cash
flow volatility.
17. The impact of the policy change (Observation 4) will most likely lead to Aerial
Limiteds financial statements:
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS a
A is correct. The decision to change from the LIFO to FIFO method in the face of
rising inventory prices will result in lower cost of sales being reported and
consequently higher net income. This can be seen as a biased accounting choice
and the underlying objective may be to overstate reported earnings. In addition,
cost of sales reported under the FIFO method comprise older inventory purchases
is a less accurate reflection of economic reality in contrast to the figure reported
by the LIFO method. Biased accounting choices will lower the quality of financial
statements with respect to being decision useful.
18. Based on Thomass view, audit opinions will least likely be the first source of
information about a companys risk because they:
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS m
C is incorrect. The failure to distinguish between generic risks which are relevant
to all company and risks which are specific to an individual company is a
shortcoming of using management commentary as a source of information about a
companys risk exposure.
Equity Planners (EQUIP) is an equity management firm run by a group of ten portfolio
managers, each specializing in a specific sector of the equity market. Due to above-
average returns earned by EQUIP on several invested funds, the firm has managed to
establish a firm standing in the financial community. EQUIP now offers professional
advice to prospective clients even if they do not wish to invest with the firm. Rebecca
Lee is one of the founding portfolio managers at EQUIP. Lee has long used residual
income models in the formulation of appropriate investment strategies. She is now
contemplating the application of momentum indicators to discover possible profitable
trading opportunities. To enhance her understanding of their application, Lee read an
article on Momentum Valuation Indicators, written by Don Levy, a statistical analyst.
The article made the following comments:
1. Earnings surprise is a valuation indicator that reflects the unexpected earnings over a
given time period. When used directly, earnings surprise is often scaled by a measure
reflecting the variability or range in analysts EPS estimates. This is referred to as the
standardized unexpected earnings (SUE).
2. The moving average oscillator or the trading-range break are examples of indicators
that are prone to data snooping and hindsight biases.
Lee decided to gather the earnings surprise history for HotSpot Inc. (HTSP). She
assembled information about the earnings surprise as a percentage of the consensus EPS
forecast, and the values of the standardized unexpected earnings for the past 10 quarters.
After reviewing the data, Lee formulated the following conclusions:
Conclusion 1: The percentage earnings surprise for the quarter ending March 2008 was
significantly negative. This shows that the company had worse results than
anticipated, resulting in an actual EPS that was lower than the consensus
forecast, i.e., a negative earnings surprise.
Conclusion 2: The SUE score for the quarter ending June 2009 was positive. This
indicates that the company outperformed analysts expectations.
Lee is assessing the stock of Cold Rocks Company Ltd. (CRC) for inclusion in EQUIPs
newly introduced equity fund. CRC is a small company with total assets of $5 million
financed with 60% debt at a cost of 8.5%. Even though the company is small in terms of
market capitalization, it managed to earn a return on invested capital of 13% in the most
recent year. The company is taxed at a rate of 25% and has a cost of equity of 11%. After
calculating CRCs residual income, Lee proceeded with estimating the firms enterprise
value added. While reviewing the firms financial statements, Lee decided to make
adjustments for the following items:
Item 1: CRC reports research and development costs in the current year. These costs are
expensed in the period in which they are incurred.
Item 2: The company reports deferred tax assets in excess of deferred tax liabilities.
When preparing her proposal, Lee made the following comment in the report:
As the last assignment of the day, Lee is forecasting the residual income, for the year
ending 2011, of Zephyr Enterprises (ZEPH). Exhibit 1 displays some information
relevant to the analysis.
Exhibit 1
Zephyr Enterprises
Book value per share as of 31 December 2010 $15.68
Earnings estimate for 2011 $3.56
Earnings estimate for 2012 $4.50
Dividends per share forecast for 2011 $1.20
Dividends per share forecast for 2012 $1.35
Required return on equity 10%
A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS p
A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS p
Conclusion 2 is correct. A positive SUE score means that the firm outperformed
expectations and a negative SUE score means the opposite.
21. The residual income for CRC for the most recent year is closest to:
A. $238,750.
B. $251,165.
C. $331,250.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS a
22. Considering each adjustment in isolation, how will adjustments for the items
presented for CRC affect its economic value added?
A. Adjustment for item 1 will increase EVA, and adjustments for items 2 and
3 will have no effect.
B. Adjustment for item 1 will increase EVA, and adjustments for items 2 and
3 will decrease EVA.
C. Adjustment for items 1 and 2 will increase calculated EVA, but
adjustment for item 3 will have no effect.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS a
Research and development costs should be capitalized rather than expensed. This
means that the R&D expense should be added back to earnings to compute
NOPAT. This will increase EVA.
Deferred taxes should be eliminated. Since deferred tax assets are in excess of
deferred tax liabilities, removing them from total capital will have the net effect of
reducing total capital (add DTL back and subtract DTA). This will increase EVA.
Operating leases are treated as capital leases for calculating EVA. Hence, no
adjustment is necessary for item 3.
23. Lees comment in her proposal contrasting the DDM and RI models is most
likely:
A. correct.
B. incorrect, because they will yield equivalent results.
C. incorrect, because the value produced by the dividend discount model can
be higher or lower.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS i
The two models are fundamentally similar; hence, given consistent assumptions,
they both will yield equivalent results.
24. Based on the information provided in Exhibit 1, the per-share residual income for
the year ending 2012 is closest to:
A. $1.992/share.
B. $2.381/share.
C. $2.696/share.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS a
Vincent Oswald, a stock analyst and earnings forecaster, has been asked by his supervisor
to revise the valuation estimates of two firms: Lenora Products Ltd. and Finesse Products
Incorporated. Lenora Products has a current book value per share of $22.89 and a current
market price per share of $120.09. Oswald expects long-term growth to be 9.0% and
long-term return on equity to be 29%. The cost of equity for the firm is 12%. Oswald
plans to use the single-stage RI model for valuation purposes.
Finesse Products operates in an industry that is characterized with high profit margins
and above-average growth. For these reasons, Oswald expects new firms to enter the
industry and erode the firms current market leadership position. He deems it appropriate
to estimate value under the following two scenarios:
Scenario 1: If competitors enter the industry slowly, the firms ROE will decline
gradually towards the required return. In this case, the persistence
parameter would equal 0.80.
Scenario 2: If competition rises more quickly, the firms ROE will decay faster and
the persistence parameter would equal 0.4.
Oswalds forecast horizon is 15 years. He expects earnings per share at the end of the
horizon to be $34.56 and ending and beginning book value to equal $89.05 and 68.15
respectively. The required return on equity is 13% and long-term growth is expected to
be 8%.
When presenting his estimates to his supervisor, Oswald posed the following question:
Oswald has also been asked to value Privico Manufacturing, a private company that is
being acquired by Publico Manufacturing, a large public firm considering expansion in
its industry. After an analysis of guideline public companies, Oswald generated the
estimates displayed in Exhibits 1 and 2.
Exhibit 1
Privico Manufacturing
Equity risk premium 7.5%
Risk-free rate 5.6%
Small stock premium 3.5%
Beta 1.54
Industry risk premium 4.0%
Company-specific premium 1.5%
Current debt to total capital 5%
Optimal debt to total capital 12%
Tax rate 35%
Cost of debt 8.5%
Exhibit 2
Publico Manufacturing
Beta 1.12
Cost of debt 7.0%
Ratio of debt to total capital 30%
While talking to his friend, Audrey Jonas, about it, Oswald stated:
Even though the build-up method makes no beta adjustment, the required rate of return
of Privico calculated using the method is exactly equivalent to the rate of return
calculated using the expanded CAPM.
For valuation concerning the possible sale of Privico, if we use the CAPM to determine
cost of equity, what will be the appropriate estimate of the firms WACC?
Jonas decides to use the guideline public company method to develop a value estimate of
Privico. Oswald stated that, unlike the method Jonas selected, the use of other market
approach methods of private company valuation would not require an estimate of a
control premium. Jonas agreed, and stated that a control premium is most uncertain when
derived from transactions involving the exchange of stock or from transactions that
occurred at a date significantly before the valuation date.
25. With regards to Oswalds estimate of the intrinsic value of Lenora Products
stock, the stock is most likely:
A. fairly valued.
B. overvalued.
C. undervalued.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS f
This estimate is greater than the current market price, and hence, the stock is
undervalued.
26. Relative to scenario 2, Finesse stocks terminal value under scenario 1 will most
likely be:
A. 88.90% higher.
B. 121.20% higher.
C. 135.40% higher.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS h
The ending book value in year 15 will be the beginning book value of year 16.
Hence,
Using the persistence parameter, terminal values under the two scenarios is:
A. yes.
B. no, because if inflation has been high over the years, the estimate under
Tobins q would be lower.
C. no, because if total assets remain constant, but liabilities increase at a high
rate, the estimate under Tobins q would be lower.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS d
The Tobins q is a ratio of the market value of debt and equity to the replacement
cost of total assets. The MVA, if presented as a ratio, will equal the market value
of capital to the book value of capital. If inflation is high, the replacement cost of
assets will be higher than their historical accounting costs, and the Tobins q will
be lower.
28. With respect to his comment about the required rate of return of Privico, Oswald
is most likely:
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOS h
29. The best response to Jonass question is that the WACC will be closest to:
A. 13.662%.
B. 15.755%.
C. 16.569%.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOS d
30. With regards to the control premium, are Oswald and Jonas correct?
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOSd
Walnut Brothers Inc. (WBI) is an asset management firm that operates in the alternative
investments sector of the capital market. Stephanie Blanchet is the chief financial analyst
at WBI, and is responsible for the management of the WBI Real Estate Fund, a fund that
invests exclusively in the private real estate market. Josh Freeze, a real estate research
analyst, is part of the team that manages the fund. Freeze is worried about the funds
investment in commercial real estate located in an emerging economy. At the time the
fund invested in the property, it was still in its developmental stages and the market was
strong and rents were high. But since then, the market has weakened and interest rates
have increased significantly. In addition, due to high vacancy rates and low rents in the
region, new construction is not feasible. When Freeze discussed this changed scenario
with Blanchet, Blanchet stated that this increased the risk of their investment
considerably. She decided to value the investment using the sales comparison approach to
determine the loss that had been incurred on the investment.
Exhibit 1
Sales Comparison Data for the Property
Variable Property Sales Comp 1 Sales Comp 2 Sales Comp 3
Age (years) 15 10 20 25
Condition Good Average Excellent Good
Location Secondary Prime Secondary Prime
Size (square feet) 20,000
Sales price psf $600 $500 $535
Exhibit 2
Adjustments
Adjustments Sales Comp 1 Sales Comp 2 Sales Comp 3
Age (years) 10% 10% 15%
Condition 15% 15% 0%
Location 10% 0% 10%
Although the fund invests exclusively in private real estate, Blanchet is now
contemplating the addition of publicly traded real estate securities to the fund. After a
thorough analysis, Blanchet shortlisted an apartment equity REIT for investment
purposes. She instructed Freeze to obtain a net asset value estimate of the REIT based on
the REITs financials. Exhibit 3 displays the information she provided to Freeze for this
purpose.
Exhibit 3
Net Asset Value Estimate (in thousands)
Pro forma cash NOI for last 12 months $345,349
Assumed cap rate 8.00%
Next 12 months growth in NOI 2.00%
Cash and equivalents $85,039
Land held for future development $56,000
Goodwill $35,000
Deferred taxes $62,193
Other liabilities $145,555
Shares outstanding 65,430
When Freeze presented his estimate of the NAVPS to Blanchet, she stated the following
trading strategies that used this measure as an input:
Strategy 2: If all REITs are trading below NAV, then an investor can benefit by
selling the REIT trading at the smallest discount to NAV.
To confirm the valuation of the REIT, Blanchet decided to use the discounted cash flow
approach to obtain another value estimate. She knew that the REIT distributed a
significant portion of its income to investors and reinvested the free cash flow, hence, the
DCF approach was appropriate. When Freeze inquired about the estimation methodology,
Blanchet stated that estimating the long-term growth rate of the REIT is one of the major
challenges in accurately measuring the intrinsic value. She stated that a number of factors
affected the growth rate of the REIT including:
31. WBI Real Estate Funds investment in commercial real estate is most likely
subject to:
A. long lead time risk, cost of capital risk and unexpected inflation risk.
B. long lead time risk and cost of capital risk but not inflation risk because
real estate values are positively affected by inflation.
C. changing business conditions risk and long lead time risk but not cost of
capital risk because easy access to debt capital will increase real estate
prices.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS c
During the time between conception and the development of the property, market
conditions changed adversely. This reflects the long lead time risk. In addition,
interest rates have increased which will lower real estate prices and their demand.
This reflects the cost and availability of capital risk. Lastly, because of a weak
market with high vacancy rates and low rents, and when new construction is not
feasible, values may not increase with inflation. This introduces inflation risk.
32. With regards to using the sales comparison approach to valuing the commercial
real estate, Blanchet is most likely:
A. correct.
B. incorrect, because the replacement cost approach would be more reliable.
C. incorrect, because the income approach to valuation would be more
reliable.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS i
The market for the commercial real estate property is weak, and hence, would be
characterized by few transactions. Therefore, the sales comparison approach
would be difficult to apply. Since new construction is not feasible, economic
depreciation can be hard to estimate, which makes the replacement cost approach
also difficult to apply. If the property generates income, a value can always be
calculated using the income approach. Thus, in this kind of market, the income
approach is likely to be most reliable.
33. Based on Exhibits 1 and 2, the estimated value of the property using the sales
comparison approach is closest to:
A. $10,143,333.
B. $10,711,667.
C. $11,500,000.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS i
Adjusted prices:
34. The net asset value per share of the apartment equity REIT is closest to:
A. $66.013.
B. $66.812.
C. $67.227.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS e
A. Strategy 1 only.
B. Strategy 2 only.
C. both strategies 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS e
36. Which of the factors mentioned by Blanchet will most likely affect the estimate of
long-term growth in a dividend discount model?
A. Factor 1 only
B. Factors 1 and 3 only
C. Factors 1, 2, and 3
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS h
Factor 1 will increase growth: the return on invested capital is greater for
developmental projects than for acquisitions. Capital structure also has an impact
on growth, particularly in the short term as companies raise or lower their
leverage. High rates of depreciation allowed under tax laws will allow the
retention of enough cash flow without incurring current income taxes. This will
increase growth.
Keith Welch was just hired by Red-Salt Investments (RESA), a firm that invests in the
four major quadrants of the real estate market: private equity, public equity, private debt
and public debt. Welch has been assigned the position of senior analyst at the firm, and is
responsible for the analysis of all four quadrants of the real estate market. Currently,
Welch is evaluating the performance of international commercial real estate REITs.
Welch focused his analysis on a specific sub-sector of an emerging economys real estate
market. He noticed several characteristic activities in the market, including:
After his evaluation, Welch met with the board of WaterSky Enterprises (WASKY), one
of RESAs prospective clients. When discussing publicly traded real estate markets and
their potential growth, Welch presented the board of WALE with information about U.S.
based Residential Equity REIT Incorporated. Exhibit 1 displays this information.
Exhibit 1
Residential Equity REIT incorporated (values in $ thousands)
Gross rental revenue 650,385
Other operating costs 234,309
Depreciation expense 102,500
General and Administrative expenses 85,399
Interest expense 75,450
Non-cash rent 31,675
Leasing commissions 25,000
Adjusted funds from operations 123,052
AFFO per share 2.46
During the meeting, the CEO of the board inquired about how the P/FFO and P/AFFO
multiples could be used as a basis for valuation of REITs and REOCs. While explaining,
Welch made the following comments:
Statement 1: Neither FFO nor AFFO based multiples take into account differences in
leverage among REITs. Hence, their use in relative value analysis should
be used in conjunction with adjustment for leverage levels.
Statement 2: Land does not produce income and hence, does not contribute to FFO or
AFFO. For this reason, land held for development does not affect the
value of FFO or AFFO based multiples.
To further explain relative value analysis based on FFO and AFFO multiples, Welch
displayed information about two equity REITs. Exhibit 3 displays this information.
Exhibit 3
Return on
AFFO Payout Est. annual
P/NAV P/AFFO reinvested
Ratio AFFO growth
cash flow
REIT A 102% 13.5x 85% 5.5% 8.0%
REIT B 98% 14.0x 45% 6.5% 8.0%
Welch then stated the factors that positively affected FFO based multiples, including:
37. Assuming appraisers are using the NAV approach to valuation, which of the
activities in the real estate market that Welch was analyzing are least consistent
with each other?
A. Activities 1 and 2
B. Activities 2 and 3
C. Activities 1, 2 and 3
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOSe
Increased LBO activity, with LBO sponsors buying REITs implies that REITs are
trading at large discounts to NAV. Conversely, when REITs are trading at large
premiums to NAV, IPO activity and stock issuance activity increases because the
public markets are essentially ascribing more value to the real estate than private
markets are. Also, the public markets attracting above-average management teams
also implies that REITs should trade at a premium.
38. Based on the information in Exhibit 1, the REITs funds from operations per share
is closest to:
A. $3.05.
B. $5.10.
C. $7.15.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS f
39. Based on Exhibit 1, the capital expenditure needed to keep the underlying
properties operating smoothly is closest to:
A. $75,500,000.
B. $150,950,000.
C. $178,000,000.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS f & g
A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS g
Statement 1 is correct. Neither FFO nor AFFO take into account differences in
leverage.
Statement 2 is incorrect. Although land may not produce income that contributes
to FFO or AFFO, the land has value and represents a source of greater internal
growth.
41. All else equal, using the information in Exhibit 3, which of the following REITs is
most attractively priced?
A. REIT A
B. REIT B because it is trading at a discount to NAV
C. REIT B because it is trading at a discount to NAV and has a higher growth
in AFFO
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS g
REIT A is cheaper because it is able to generate almost the same growth in AFFO
as REIT B while retaining only 15% of AFFO compared to 55% for REIT B.
Because return on reinvested cash flow is the same, REIT A has much more
growth in returns coming from its existing portfolio.
42. With respect to the factors affecting the P/FFO multiple, Welch is most accurate
with respect to:
A. Factor 1 only.
B. factors 1 and 3 only.
C. factors 1, 2 and 3.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS f
Peter de Silva is a fixed income trader at North Traders, a broker-dealer firm situated in
the United Kingdom. While de Silva has always been aware of the importance of the
arbitrage-free process in valuing fixed-income securities, he has never applied the
approach in practice. To learn more about the technique, he engages in a discussion with
his colleague, Kim Young. During their discussion Young makes the following
comments:
Comment 2: The arbitrage-free valuation framework is based on the notion that two
otherwise identical assets must trade at prices which represents fair value in
their respective markets.
Comment 3: The arbitrage-free valuation free approach, which involves discounting cash
flows using individual spot rates, is restrictive in the sense that the process
cannot be applied to a category of fixed-income securities.
The trader concludes the discussion by inquiring about the conditions, which create the
potential for arbitrage opportunities.
De Silva proceeds to practically apply the techniques learned. He selects three corporate
bonds issued by ARC Manufacturing, a global conglomerate. All three issues mature at
par, are mispriced, trade on the LSE, and differ with respect to credit rating. De Silva has
collected relevant details with respect to the three issues and aims to explore potential
arbitrage opportunities (Exhibit 1).
Next, De Silva would like to explore how interest rate volatility affects the valuation of
fixed-rate option-free bonds. For his analysis the trader selects a four-year, 10%, annual
coupon-paying bond issued by Dutch Inc. He proceeds to calibrate a binomial interest
rate tree (Exhibit 2), which corresponds to the benchmark yield curve. He is particularly
interested in deriving the value of the bond if interest rates follow the designated path:
Dutch Inc. has actively traded mortgage-backed securities. De Silva is exploring which
valuation technique will be most appropriate for this security category.
Exhibit 1:
Option-free Corporate Bonds Issued by ARCManufacturing
Credit rating A-rated BB-rated B-rated
Price per 100 par ()* 99.050 97.145 94.145
Maturity (years) 5 5 5
Coupon (%) 6.0 6.5 7.0
Yield-to-maturity (%) 6.3 7.2 8.1
*Represents current market price
Exhibit 2:
Calibrated Binomial Interest Rate Tree to Match Benchmark Yield Curve
Year 0 Year 1 Year 2 Year 3
1.000% 5.639% 7.546% 9.734%
4.616% 6.178% 7.211%
5.058% 5.904%
4.373%
43. Considering her first two statements, Young is most accurate with regards to:
A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS a
Young is inaccurate with respect to both her statements. The arbitrage free
valuation approach derives security values based on the notion that the value of a
financial asset is equal to the present value of its future cash flows. Stripping and
reconstitution is a process whereby dealers will separate a zero-coupon bond and
trade the individual cash flows in an attempt to earn arbitrage profits.
The arbitrage-free valuation process is based on the law of one price, which
asserts that the two otherwise identical assets must trade at the same price
regardless of the market being represented. The fair value of the asset may differ
from one market to the other and is thus not necessarily equal to the value
suggested by this law.
44. In the context of Statement 3, spot rate discounting is restrictive because the
technique cannot be used to value:
A. corporate bonds.
B. zero-coupon securities.
C. bonds with embedded options.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS a
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS a
In order for a trader to earn arbitrage profits, the value additivity principle must
not hold. In other words, the value of the entire portfolio should not equal to the
sum of its individual cash flows or component securities values. If this is the
case, an investor can buy the overpriced component and sell the underpriced
component.
46. Using the data in Exhibit 1, which of the following bonds will maximize arbitrage
profits?
A. A-rated
B. BB-rated
C. B-rated
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS b
The most mispriced security will maximize arbitrage profits. To determine the
amount of mispricing, the intrinsic value of each security will be calculated and
compared to market value. Note all prices, present values and future values are
stated in per 100 of par value
Securities
A- rated BB-rated B-rated
Market price 99.050 97.145 94.145
(given)
N 5 5 5
I/Y 6.3 7.2 8.1
PMT 6.0 6.5 7.0
FV 100 100 100
PV 98.747 97.145 95.620
Comparing the securities, the B-rated security is the most mispriced and will
maximize arbitrage profits. The trader can purchase the security today at the
current market price and sell it at intrinsic value upon the correction of the price
misalignment.
47. Using Exhibit 3 and information on the Dutch Inc issue, the present value of the
security along the designated path is equal to (in per 100 of par value):
A. 90.568.
B. 109.855.
C. 118.668.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS g
Using the path designated by De Silva, the present value of the Dutch Inc bond
issue is 118.668 per 100 of par value.
The interest rate path followed and the value of the security at each node is
illustrated below. Note that PV does not include the current years coupon
payment.
B is incorrect. The calculated value represents the value of the bond at the
beginning of Year 1 and needs to be discounted back one more period after
including the annual coupon.
48. The most suitable technique for valuing mortgage-backed securities is:
A. pathwise valuation.
B. Monte Carlo simulation.
C. binomial interest rate tree.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS h
While pathwise valuation and binomial interest rate trees can be applied to the
valuation of securities with embedded options Monte Carlo simulation is most
suitable for valuing mortgage-backed securities; this is because the value of these
securities is dependent on the prepayment rate which in turn depends on the path
of interest rates. The Monte Carlo method assists in the valuation of these
securities by simulating a large number of interest rate paths which allows for a
more detailed analysis of the impact of interest rate volatility on security value.
Lyon & Claire (LC) is a portfolio management firm with a specialized fixed-income
department. Based on past in-house analyst forecasts, LC has always preferred callable
bonds to other option embedded bond for its client investment portfolios.
The exhibit below provides details of three callable bond issues currently managed by its
fixed income portfolio managers (Exhibit 1). The bonds are identical with respect to
maturity, credit rating, and are redeemable at par. A 15% volatility assumption is used for
the analysis.
Exhibit 1:
Callable Bond Issues in LCs Investment Portfolio
Annual Z-spread OAS
Coupon Current (basis (basis
Issuer Rate Price First Call Date points) points)
Sans Inc 5.1% 103.00 One month from today 56 25
Harp Limited 4.2% 102.03 Two years from today 65 35
Belle-Monte 6.5% 103.98 Three years from today 69 34
Ali Mehmet is LCs fixed income analyst. He has made the following two forecasts with
respect to interest rates and changes in the yield curve.
Forecast 1: Interest rates will decline from their current level to 4.9%
Forecast 2: With the decline in interest rates the yield curve will invert.
Mehmet is seeking to expand the firms portfolio by including putable bonds. The issue
being evaluating is a four-year, 5.3% annual coupon-paying bond. He is comparing
various duration measures reported for the bond. The exhibit below summarizes the
results of his analysis (Exhibit 2).
Exhibit 2:
Analysis of Putable Bond Issue
Current value of bond 98.50
Effective duration 3.1
One-sided up duration if interests rates
increase by 50 basis points 1.6
Mehmet concludes his analysis by comparing the impact of Forecast 1 on the bonds
under evaluation. He arrives at the following conclusions:
Conclusion 1: The effective duration of the putable bond issue will exceed that reported
for the underlying option-free bond.
Conclusion 2: For a further 1% decline in rates callable bonds will have a relatively lower
price appreciation potential.
49. LCs preference for callable bonds in its investment portfolio reflects a forecast
whereby interest rates are expected to:
A. rise.
B. decline.
C. remain relatively constant.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS a
As an investor of callable bonds, LC would prefer if the issuer (holder of the call
option) does not call the bond. The call option is exercised if interest rates decline
relative to the coupon rate such that the issuer can benefit from the lower market
rate. On the other hand, an investor would prefer constant interest rates over rising
interest rates as the latter will decrease the value of the bond resulting in a capital
loss for the investor.
50. Using the information in Exhibit 1, which of the following bond issues will report
the highest OAS at zero volatility?
A. Sans Inc.
B. Harp Limited
C. Belle-Monte
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS g
The Z-spread corresponds to the OAS at zero volatility. Belle-Monte reports the
highest Z-spread.
51. Considering Forecast 1 and the information in Exhibit 1, the security with the
lowest price appreciation potential will be:
A. Sans Inc.
B. Harp Limited.
C. Belle-Monte.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS l
When interest rates decline the call option moves in the money and the upside
potential of the callable bond is limited. This is because the callable bond exhibits
negative convexity, which results in the securitys price being capped by the call
option particularly if the bond is near the exercise date. Out of the three issues
being analyzed, the Sans Inc. bond will experience the lowest price potential if
interest rates decline. This is because the call option 1) now has value as interest
rates have declined below the coupon rate and 2) is nearest to its exercise date.
If the forecast materializes, the difference between the coupon rate and interest
rates level will be the greatest for the Belle-Monte issue. However, the upside
potential will not be as significantly restricted as the Sans Inc. issue because the
call option is not exercisable for another two years; this reduces the impact of the
interest rate decline on upside potential.
The option embedded in the Harp Limited issue will continue to remain out of the
money as the coupon rate is higher relative to the forecasted interest rate. The
price appreciation potential of this issue will be the least severely affected by the
forecast.
52. Which of the following observations is most likely consistent with Forecast 2
(using the information in Exhibit 1)? There is an increased likelihood that the
issues will:
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS e & l
An inverted yield curve will result in the decline in forward rates, which are a
component of the binomial interest rate tree used to value bonds with embedded
options. Lower rates will increase the probability of the issues being called. As a
result, there is a higher likelihood of the issues moving closer to being in the
money.
53. Based on the information in Exhibit 2, relative to the one-sided up duration, the
one-sided down duration will indicate that the price sensitivity of the putable bond
to interest rate changes is:
A. lower.
B. higher.
C. the same in absolute terms only.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS k
When interest rates decline, the put option is unlikely to be called and the putable
bond behaves similarly to a straight bond with respect to the impact of rate
changes on price. Therefore, the duration will be higher indicating greater price
sensitivity to interest rate changes.
A. 1 only.
B. 2 only.
C. 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS j & l
Linda Harris is a portfolio manager at South Solutions (SS), a wealth management firm,
which caters to individual and institutional clients. Freight Foundation is Harriss newest
client. Harris is selecting fixed-income and equity securities to include in the portfolio.
The exhibit below summarizes details of the fixed-income investments being considered
for FFs portfolio (Exhibit 1).
Scott Trance is a junior portfolio manager who has recently joined SS. Trance is working
alongside Harris and is assisting her in the evaluation of the potential securities. Upon a
careful study of the data presented in Exhibit 1, Harris makes the following statements:
Statement 1: Assuming the bond issues are comparable, risk-neutral investors would
expect the yield on a 12-year default-free bond to equal 7.00%.
Next, Harris combines the fixed-income data collected with economic growth forecasts.
Based on the current slope of the yield curve, she learns that economic analysts have
forecasted that a recession is highly anticipated. She would like to determine what this
implies for business credit demand and expected inflation.
Harris then moves on to evaluate potential equity securities for FFs portfolio.
Information concerning these securities is outlined in the exhibit below (Exhibit 2).
Harris concludes her analysis by extending the recessionary forecast to the identified
equity securities. She anticipates that a recession will lead to a decline in the P/E ratios of
the identified stocks.
Statement 1: Statement 2:
A. Yes No
B. No Yes
C. Yes Yes
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS f
Where investors are risk-neutral, the expected return on a government bond will
equal to the loss-adjusted expected return on a comparable corporate bond with
the same maturity. Therefore, the expected return on a 12-year default-free bond
will equal to 7.00% (which is equal to the expected loss on a 12-year corporate
bond).
56. Which of the following factors most likely supports the economic forecast?
Correct Answer: C
Reference: CFA Level II, Volume 6, Study Session 18, Reading 55, LOS d
C is correct. When the yield curve is inverted, there is often a diminished business
credit demand for long-term bonds.
57. In light of the economic forecast, when allocating the fixed-income securities
(Exhibit 1) to FFs portfolio, Harris will:
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS g
During economic recessions, the credit spreads quoted on bonds tend to rise.
However, certain sectors of the bond market are more sensitive to changes in
spread than others.
B is incorrect. Due to higher credit risks, non-investment grade issues quote larger
spreads compared to investment-grade issues. Therefore, the spread of a non-
investment grade issue is expected to rise more leading to a larger decline in
price. In this scenario, an investment in the non-investment grade issue is
inappropriate.
C is incorrect. Only when credit spreads are narrowing will investors be less
discerning among issuers with weak and strong credit credentials.
58. Considering the data in Exhibit 1 and the economic forecast, which of the
following issues will provide the best hedge against poor consumption outcomes?
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS d
A is correct. A 5-year default-free issue is the best hedge against bad consumption
outcomes. This is because of the relative certainty about the real payoff from a 1-
year default-free issue and thus the certainty about the amount of consumption
that an investor will be able to undertake with the payoff. The issues payoff has a
low, probably zero, correlation with bad consumption outcomes and is thus the
most effective hedge.
B is incorrect. The payoff from a long-term default free issue will be less certain
compared to the 1-year default-free issue. This is because investors will have less
confidence in their ability to form views about inflation over the term of the issue.
Therefore, the greater uncertainty in payoff of the issue will result in this issue
being a less effective hedge against poor consumption outcomes.
59. Using the data in Exhibit 2, which of the following stocks can most likely be
classified as a value stock?
A. A
B. B
C. C
Correct Answer: B
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS j
60. Which of the following factors will most likely contribute to a decline in the P/E
ratios, as forecasted by Harris?
Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 18, Reading 55, LOS j
Based on the formula below, the P/E ratio will decline with a rise in:
Pit
=
[
Et CF i t + s ]
E
s
E
( i i
s =1 1 + lt + s + t , s + t , s + t , s + t , s )