CFA Level II Mock Exam 2 Questions (PM)

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CFA Level II Mock Exam 2
June, 2017

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 CFA Level II Mock Exam 2 Questions (PM)

FinQuiz.com 2nd Mock Exam 2017 (PM Session)

Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Financial Reporting and Analysis 18
19-30 Equity Investments 36
31-42 Alternative Investments 36
43-54 Fixed Income 36
55-60 Portfolio Management 18
Total 180

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 1 through 6 relate to Ethical and Professional Standards

Investopia Associates (INVEA) Case Scenario

Investopia Associates (INVEA) is a capital management firm in Miami, USA. Josh

Wiley is the chief investment officer (CIO) at the firm who heads the institutional wing
of INVEA. INVEA serves as the trustee for Alpha Manufacturings (APM) pension plan.
Walter White, the CEO of APM, recently called a meeting with Wiley to discuss a
takeover attempt by XLS Manufacturing. White advised Wiley to purchase APMs stock
in the open market for its pension plan to ward off XLS. Wiley believes that the stock is
undervalued and purchases a considerable amount of the stock for the pension fund. As a
result of the heavy stock purchases, APMs stock price rises significantly. This not only
increases the value of the pension fund, but also wards of the takeover attempt.

As a result of above-average performance of the pension funds that Wiley manages,

INVEA has managed to attract the pension accounts of a number of firms. One such firm
is Tick Enterprises (TICK), with a pension fund worth $25 million. During their first
client-advisor meeting, Wiley presented the performance of INVEAs existing pension
funds over the past ten years. Noticing a slight variation in the total returns of the funds,
the CFO at TICK inquired about the reasons. Wiley made the following comment:

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

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.

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.

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.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 7 to 12 relate to Quantitative Methods

Hector Solanki Case Scenario

Hector Solanki is a fixed-income analyst at Pratt Associates, a global research house.

Solanki is the firms most prized analyst having considerable experience in fixed-income
securities issued in both developed and emerging markets.

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 1: Simulations generate risk-adjusted expected values and consider the

probability of all possible outcomes.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

After specifying the variables, Solanki moves on to generate probability distributions of

expected bond values. Given the volatility in the foreign exchange markets and frequent
shifts in monetary policy, Solanki is unsure of the type of data he should use to generate a
probability distribution. In addition, the lack of depth in the fixed-income segment of
these markets means that Solanki will have few comparable bonds available for the
simulation.

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 the local risk-free rate
to calculate expected values for the issues.

Exhibit: Results of Simulation

Simulated
Simulated Standard
Risk-free Rate Expected Deviation in
Bond Issue (%) Value* Value
A 2 $150 18%
B 3 $170 25%
C 3 $150 22%
D 4 $190 30%
*Price per 100 of par value

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.

Solanki concludes his analysis by demonstrating how simulation can be used as an

effective risk hedging tool. He explains to Rogers how he plans to introduce two
constraints into the analysis of the emerging market issues in order to judge the
effectiveness of this tool.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

7. Which of the following reasons, provided by Solanki, accurately characterizes the

benefits of simulation over other risk assessment tools?

A. Reason 1
B. Reason 2
C. Neither of the two reasons.

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.

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.

10. Considering the data in Exhibit 1, Solanki is most likely treating the simulation
process as a:

A. substitute for risk-adjusted values.

B. complement to risk-adjusted values.
C. tool for calculating risk-adjusted values.

11. The simulation technique used by Solanki to derive bond values:

A. ignores total portfolio risk.

B. considers non-diversifiable risk only.
C. fails to distinguish between non-diversifiable and asset-specific risk.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 13 through 18 relate to Financial Reporting and Analysis

Lakeline Associates Case Scenario

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 in 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 100% of Manson Inc.s

outstanding shares 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 $11 million. The goodwill associated with the purchase is
now believed to be overstated due to an understatement of the identifiable
assets at that time, which were depreciable. No impairment charges have
been recorded since the date of acquisition and this is expected to remain
the case for the future periods.

Observation 3: Aerial Limited prepares and presents its financial statements in

accordance with the IFRS. The operating, investing and financing
sections of the cash flows statement as well as net income reported for
the fiscal years 2012 to 2014 are presented in the exhibit below:

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 CFA Level II Mock Exam 2 Questions (PM)

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:

A. revenues may increase faster than receivables.

B. accounts receivables turnover may be overstated.
C. number of days sales outstanding may increase each year.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

15. Based on the misreporting on the date of acquisition, Streak Corps consolidated
earnings will most likely be distorted in the:

A. current period only.

B. future periods only.
C. both current and future periods.

16. Using the data in the Exhibit, which of the following reasons may justify poor
cash flow quality?

A. Accelerating payments to payables

B. Improper capitalization of expenditures
C. Low cash flow volatility relative to peers

17. The impact of the policy change (Observation 4) will most likely lead to Aerial
Limiteds financial statements:

A. not being decision useful.

B. being non-GAAP compliant.
C. reflecting conservative accounting choices.

18. Based on Thomass view, audit opinions will least likely be the first source of
information about a companys risk because they:

A. focus solely on historical information.

B. fail to consider a firms going concern status.
C. do not distinguish between generic and company-specific risks.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 19 through 24 relate to Equity Investments

Equity Planners (EQUIP) Case Scenario

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. 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:

Comment 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).

Comment 2: The moving average oscillator and 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.

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 CFA Level II Mock Exam 2 Questions (PM)

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 pre-tax 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.
Neither are expected to reverse in future.

Item 3: The company reports all operating leases as capital leases.

When preparing her proposal, Lee made the following comment in the report:

Relative to the DDM model, recognition of value typically occurs earlier in residual
income models. Hence, when calculating value using similar assumptions, the RI model
will yield a larger value estimate than the DDM due to the time value of money concept.

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%

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 CFA Level II Mock Exam 2 Questions (PM)

19. The article is most accurate with respect to:

A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.

20. Lee is most accurate with respect to:

A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.

21. The residual income for CRC for the most recent year is closest to:

A. $238,750.
B. $251,165.
C. $331,250.

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.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 25 through 30 relate to Equity Investments

Lenora and Finesse Products Case Scenario

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:

If market value added is presented as a ratio, will it be equivalent to the Tobins q?

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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%
Pre-tax 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.

Jonas then posed the following question to Oswald:

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?

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 CFA Level II Mock Exam 2 Questions (PM)

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 less useful 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.

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.

27. The most appropriate response to Oswalds question 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.

28. With respect to his comment about the required rate of return of Privico, Oswald
is most likely:

A. correct, because both methods yield a required return of approximately

22%.
B. incorrect, because the expanded CAPM yields a required rate of return that
is 4% higher.
C. incorrect, because the build-up method yields a required rate of return that
is 4% higher.

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 CFA Level II Mock Exam 2 Questions (PM)

29. The best response to Jonass question is that the WACC will be closest to:

A. 13.662%.
B. 15.755%.
C. 16.569%.

30. With regards to the control premium, are Oswald and Jonas correct?

A. Only Oswald is correct

B. Only Jonas is correct
C. Both Oswald and Jonas are correct

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Questions 31 through 37 relate to Alternative Investments

Walnut Brothers Inc. (WBI) Case Scenario

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, which currently generates
modest income.

Blanchet advised Freeze to invest a portion of the fund in an investment property in

Illinois, USA. Freeze decided to use the sales comparison approach to value the property.
For this purpose, he gathered relevant data about comparables. Exhibits 1 and 2 display
this information.

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

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 CFA Level II Mock Exam 2 Questions (PM)

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. 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 1: The NAV estimate can be used as a relative valuation measure. An

investor can benefit by purchasing a REIT that trades at a discount to
NAV and selling those trading at a premium to NAV, since the NAV can
be viewed as the intrinsic value of the security.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

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:

Factor 1: A focus on developmental projects rather than acquisitions

Factor 2: An increased use of financial leverage

Factor 3: A higher rate of depreciation allowed under tax laws

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.

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.

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.

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 CFA Level II Mock Exam 2 Questions (PM)

34. The net asset value per share of the apartment equity REIT is closest to:

A. $66.013.
B. $66.812.
C. $67.227.

35. Blanchet is most accurate with respect to:

A. Strategy 1 only.
B. Strategy 2 only.
C. both strategies 1 and 2.

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

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 37 through 42 relate to Alternative Investments

Red-Salt Investments Case Scenario

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:

Activity 1: Significant leveraged buyout activity with LBO sponsors attempting to

buy REITs
Activity 2: An increase in IPO activity and stock issuance.
Activity 3: The public markets attracting above-average management teams because
of an increase in the size of organizations.

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

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 CFA Level II Mock Exam 2 Questions (PM)

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 2 displays this information.

Exhibit 2
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:

Factor 1: An increase in the concentration of properties in primary locations

Factor 2: A decrease in recurring maintenance-related capital expenditures
Factor 3: An increase in gains on sale of properties

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

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 CFA Level II Mock Exam 2 Questions (PM)

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.

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.

40. Welch is most accurate with respect to:

A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.

41. All else equal, using the information in Exhibit 2, 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

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.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 43 through 48 relate to Fixed Income

Peter de Silva Case Scenario

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 1: The arbitrage-free valuation approach derives security values using a

process known as stripping and reconstitution.

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:

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 CFA Level II Mock Exam 2 Questions (PM)

Year 1 Path: Highest interest path

Year 2 Path: Middle interest rate path
Year 3 Path: Second highest interest rate 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 ARC Manufacturing
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
Required return (%) 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 comments, Young is most accurate with regards to:

A. Comment 1 only.
B. Comment 2 only.
C. neither Comment 1 nor Comment 2.

44. In the context of Comment 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.

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 CFA Level II Mock Exam 2 Questions (PM)

45. The most appropriate response to De Silvas query is that:

A. the value additivity principle must not hold.

B. a financial asset with a risk-free payoff must trade at a neutral price today.
C. traders are required to commit a net amount equal to a fraction of the asset
value.

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

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.

48. The most suitable technique for valuing mortgage-backed securities is:

A. pathwise valuation.
B. Monte Carlo simulation.
C. binomial interest rate tree.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 49 through 54 relate to Fixed Income

Lyon & Claire Case Scenario

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 bonds for its client investment portfolios.
The exhibit below provides details of three callable bond issues currently included in its
fixed income portfolios (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

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 CFA Level II Mock Exam 2 Questions (PM)

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 an otherwise identical but option-free bond.
Conclusion 2: For a further 1% decline in rates callable bonds will have a relatively lower
price appreciation potential than putable bonds.

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.

50. Using the information in Exhibit 1, OAS at zero volatility is highest for which of
the following bond issues?

A. Sans Inc.
B. Harp Limited
C. Belle-Monte

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.

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:

A. exhibit positive convexity.

B. move closer to being in the money.
C. respond similarly to the change in rates as otherwise identical but option-
free bonds.

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 CFA Level II Mock Exam 2 Questions (PM)

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.

54. Mehmet is most accurate with respect to Conclusion (s):

A. 1 only.
B. 2 only.
C. 1 and 2.

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 CFA Level II Mock Exam 2 Questions (PM)

Questions 55 through 60 relate to Portfolio Management

Linda Harris Case Scenario

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.

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. Harris
makes the following statements:

Statement 1: Expectations play a very important role in asset valuations. Industry vide
default and recovery rates that are well anticipated can be used to generate
holding period returns in corporate bonds

Statement 2: If I were to construct a portfolio solely comprising of corporate

issues, I can be reasonably assured that the portfolio will be well-
diversified across industrial sectors, maturities, and investment grades.
Investors opting to invest in this portfolio can minimize their exposure to
market risk.

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).

Exhibit 1: Potential Equity Securities for FFs Portfolio

Forecasted
Dividend Yield Current Price Per Earnings Growth
Stock (%) Share ($) (%)
A 0.2 45 20
B 3.0 50 2
C 0.8 60 2

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 CFA Level II Mock Exam 2 Questions (PM)

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.

55. Is Trance correct with respect to statements 1 and 2?

Statement 1? Statement 2?
A. Yes No
B. No Yes
C. No No

56. Which of the following factors most likely supports the economic forecast?

A. Upward sloping yield curve

B. Higher inflationary pressures
C. Diminished business credit demand for long-term bonds

57. In light of the economic forecast, when allocating the fixed-income securities to
FFs portfolio, Harris will:

A. prefer non-cyclical and investment grade issues.

B. prefer non-investment grade and cyclical issues.
C. be cyclical and investment grade classification.

58. Considering the economic forecast, which of the following issues will provide the
best hedge against poor consumption outcomes?

A. 1-year default-free issue

B. 15-year default-free issue
C. 20-year corporate issue

59. Using the data in Exhibit 1, which of the following stocks can most likely be
classified as a value stock?

A. A
B. B
C. C

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 CFA Level II Mock Exam 2 Questions (PM)

60. Which of the following factors will most likely contribute to a decline in the P/E
ratios, as forecasted by Harris?

A. Rise in real interest rates

B. Fall in unexpected inflation
C. Decline in GDP growth volatility

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