DA4387 Level II CFA Mock Exam 2018 Afternoon A

2018
CFA® EXAM REVIEW

AFTERNOON
SESSION
LEVEL II CFA
®
MOCK EXAM 1
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Mock Exam 4 – Afternoon Session – Questions
Questions 61 to 66 relate to Ethical and Professional Standards
Milos Veshny, CFA, is a senior analyst at Donner Chapman and Partners (DCP), a large financial services
firm specializing in cross-border transactions and pan-European company research. Veshny has more than
20 years’ experience as a stock analyst and has recently taken over the agricultural equity division.
At an institutional investor briefing hosted by DCP, Veshny has been asked to present his latest
recommendations for MJ Zwol (MJZ), a large seed exporter based in Amsterdam. He details his research
methodology and describes to the audience how he has come to a “Strong buy” recommendation for
MJZ stock. Veshny currently owns MJZ stock in a family account, which is not disclosed during the
presentation, but which is clearly disclosed in his full research report. This report is available to audience
members who are clients of DCP.
Prior to Veshny’s report on MJZ, DCP analysts had not reviewed the seed exporter for more than 5 years.
At the time, it was decided that coverage of the company was to be discontinued indefinitely and DCP
released a research report explaining why it had decided to stop following MJZ. Now that Veshny
has begun researching the company again, he intends to update his recommendation when material
information regarding the company is released.
Adam Knight, CFA, is the head of DCP’s mergers and acquisitions (M&A) department. He is currently
working on the valuation of Mon Diante Foods (MDF), a Spanish grain and rice grower, as part of a
potential takeover bid by a UK agricultural firm and DCP client, Eversure (EVS). EVS is engaged with
DCP to undertake the valuation and to underwrite a secondary issue to help raise capital for the potential
takeover. Knight also sits on DCP’s research review committee, which is responsible for reviewing DCP
research reports before they are published. Veshny’s team currently has a “Buy” recommendation for
EVS and is soon to release a “Hold” recommendation for MDF.
After the new MDF report is released, Knight contacts Veshny to access the full research report so that
his team can verify factual information on MDF. In their discussions, which are conducted through the
DCP legal department, Knight mentions to Veshny that he believes the MDF stock recommendation is too
generous, and that he might want to consider reviewing the research report. Veshny is reluctant to do so,
especially as Knight has let him know that MDF is a potential takeover target.
Veshny recently visited the headquarters of Baldacci Family Estate Vineyards (BFE), a producer of
grapes, wine, and vinegar across southern Europe. The company invited a number of analysts to view its
operations, and Veshny spent much time discussing the outlook for the company with Adrian Baldacci,
company CEO and grandson of the company’s founder.
As a result of concerns over water rights in Spain and France, Veshny is looking to downgrade the
recommendation on BFE from “Buy” to “Hold.” Out of courtesy, Veshny sends Baldacci a spreadsheet
with revenue projections to highlight why he intends to change the company’s rating. Baldacci asks for
Veshny to delay his report for 2 weeks, as he is in discussions with a private equity firm that is looking
to purchase some of the affected vineyards. The result of this potential transaction, which has now been
publicly disclosed, may affect Veshny’s projections, and he therefore decides to delay his report until
© Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
35
further information regarding the transaction is made available. Three weeks later, Veshny publishes a
research report for BFE with a “Buy” recommendation.
The BFE report also indicates a high level of risk for the stock due to commodity price fluctuations and
climate change effects. The recommendation and risk categories form the two-dimensional framework for
all of DCP’s research reports. As this is proprietary information, a complete description of DCP’s rating
system is not available to clients or other report users.
61. In complying with the CFA Institute Research Objectivity Standards (ROS), which of the
following statements is least accurate in regard to Veshny’s MJZ presentation? Veshny should:
A. not have made a recommendation on MJZ stock.

B. have, if possible, disclosed his holding in MJZ to the audience.
C. have made sure his research report was available to all audience members at a reasonable
price.
62. Regarding the coverage of MJZ, which of the following is most accurate?
A. The coverage is in line with CFA Institute Research Objectivity Standards (ROS)
recommendations.
B. The coverage is not in line with CFA Institute Research Objectivity Standards (ROS)
recommendations, as Veshny should be reviewing the company on a regular basis.
C. The coverage is not in line with CFA Institute Research Objectivity Standards (ROS)
recommendations, as DCP did not provide adequate disclosures upon discontinuing coverage
of MJZ.
63. According to CFA Institute Research Objectivity Standards (ROS), which of the following
statements is least accurate regarding DCP’s M&A department and its engagement with EVS?
A. A quiet period should be implemented for EVS stock.

B. Knight should be removed from DCP’s research review committee.
C. DCP should not participate in underwriting the EVS secondary offering.
64. Regarding discussions between Veshny and Knight, which of the following is most likely to be a
contravention of CFA Institute Research Objectivity Standards (ROS)?
A. Knight’s comment regarding the MDF recommendation

B. Knight’s request to the research team for the MDF research report
C. Conducting discussions between Veshny and Knight through the legal department
36
65. According to CFA Institute Research Objectivity Standards (ROS), which of the following
statements is most accurate regarding Veshny’s research report on BFE? Veshny should not have:
A. delayed his report.

B. sent projections to Baldacci.
C. changed his recommendation.
66. To comply with CFA Institute Research Objectivity Standards (ROS) recommendations, which of
the following is least accurate in regard to DCP’s rating system? DCP should:
A. amend the two-dimensional framework.

B. provide absolute and relative recommendations.
C. provide clients with a complete description of the firm’s rating system upon request.
37
Questions 67 to 72 relate to Quantitative Methods
Tommy Kaw, CFA, works as a business analyst for a high-end furniture design and manufacturing
company, Sims Ergonomics Corporation (SEC). With its main manufacturing arm situated in Malaysia,
the business has been able to grow earnings over the past few years through a focus on productivity and
cost efficiency.
Kaw believes that as a result of ongoing technological advancements, the company can continue to
improve overall productivity, which he measures as units per labor hour, indefinitely. Using the past
40 quarters of data, Kaw runs a log-linear regression, which produces the following trend results:
Regression statistics
Multiple R 0.7652
R-squared 0.5855
Durbin-Watson 2.09
Observations 40
Coefficients P-value
Intercept 0.2149 0.1017
Time 0.0187 0.0000
Using these results, Kaw forecasts the level of productivity (units per labor hour) for the next eight
quarters (t = 41 to t = 48).
Kaw’s manager, Michael Sun, is also interested in the likely cost of labor over the coming few years and
asks Kaw to analyze quarterly wages growth data in Malaysia. After doing a preliminary review of the
data, Kaw decides that an autoregressive (AR) model would be most appropriate.
Kaw: I have used the Durbin-Watson test and found the errors of the AR model to be uncorrelated;
therefore, as long as the data is covariance stationary, we can estimate the model using ordinary least
squares.
Sun: For the wages growth time series to be covariance stationary, the variance must be constant and
finite in all periods and the mean must be equal to zero.
Following on from these discussions, Kaw completes his analysis of the wages growth data and produces
the following data, regression, autocorrelation, and t-distribution figures:
Previous 4 quarters Quarterly wages growth

Q1 20X0 1.64%
Q2 20X0 2.27%
Q3 20X0 0.80%
Q4 20X0 1.98%
38
Regression statistics
Multiple R 0.6603
R-squared 0.4360
Durbin-Watson 1.88
Observations 40
Coefficients t-Stat
Intercept 0.0035 3.876
Lag 1 0.7208 5.078
Autocorrelation
Lag 1 0.0457
Lag 2 –0.1451
Lag 3 –0.0895
Lag 4 0.7698
Two-tailed t-test values

Df 0.1 0.05 0.01
38 1.686 2.024 2.712
39 1.685 2.023 2.708
40 1.684 2.021 2.704
Kaw also decides to test other autoregressive models to help forecast quarterly wages growth. The
second-order AR model based on the same data set is represented as:
x t = 0.0022 + 0.6893x t −1 − 0.1187x t − 2 + ε t
On reviewing the work carried out by Kaw, Sun makes the following statements:
Statement 1: To determine which model would be the best fit for the wages growth data, the model with
the smallest standard error should be used. This would be a measure of the size of in-sample forecast
errors.
Statement 2: Alternatively, you can determine more appropriate models by comparing measures of out-
of-sample forecast errors. This is usually done by looking at the error between future forecasts and actual
observations.
39
67. Kaw’s estimate for the level of productivity in Quarter 45 (t = 45) is closest to which of the
following?
A. 0.8415 units per labor hour

B. 1.0564 units per labor hour
C. 2.8756 units per labor hour
68. Regarding Kaw’s and Sun’s comments in regard to the use of the autoregressive model, which of
the following statements is most accurate?
A. Both statements are incorrect.

B. Only Sun’s statement is correct.
C. Only Kaw’s statement is correct.
69. According to Kaw’s AR model regression analysis, the mean-reverting level of the wages growth
level is closest to which of the following?
A. 0.005
B. 0.013
C. 0.723
70. Regarding the regression and autocorrelation analysis of the wages growth data, which of the
following statements is least accurate?
A. The model should be adjusted for seasonality.

B. The regression coefficients are statistically significant.
C. There is no evidence that the lag correlations are significantly different from zero.
71. The forecast for Q2 20X1 is closest to which of the following?
A. 1.01%
B. 1.49%
C. 1.58%
72. Which of the following is most correct in regard to Sun’s statements about comparing the
autoregression models for wages growth?
A. Both statements are correct.

B. Only Statement 1 is correct.
C. Only Statement 2 is correct.
40
Questions 73 to 78 relate to Financial Reporting and Analysis
Alberta Smith Mining (ASM) is a large Canadian resources company specializing in the extraction
and processing of bulk materials. The company has its headquarters in Toronto, and has a number of
subsidiaries around the world. The majority of ASM’s sales are denominated in USD, as is a large portion
of its operational costs. Most of ASM’s financing is in USD; however, ASM is listed on the Toronto Stock
Exchange and prepares its financials in CAD.
Ferros Brasilia (FB), ASM’s largest subsidiary, is an iron ore mining operation located in Brazil. FB
accounts for about 40% of the ASM group’s iron ore sales. In order to expand operations at one of its
sites, FB plans to buy a fleet of automated trucks from a supplier in Germany. The trucks cost EUR 18.2
million and are purchased and received on February 18, 20X0, when the EUR/BRL spot rate is 3.6541.
Payment is made for the trucks 45 days later on April 4, 20X0, when spot rates have moved to 3.9220. FB
prepares quarterly financials in BRL, and the EUR/BRL spot rate on March 31, 20X0, is 3.5714.
ASM’s Canadian operations have seen an increase in purchases of coal from an energy consortium in
Japan. They have recently agreed to a 5-year agreement to sell 80,000 tons of coal per quarter to the
Japanese company at a fixed and discounted price of JPY 5,900 per ton. In return, the Japanese firm
has agreed to invest in a new ASM mine in Western Canada. Throughout the year, the value of account
receivables related to this contract fluctuate due to currency movements. For the year ending December
31, 20X0, ASM recognizes a foreign exchange loss of CAD 1.780 million as a nonoperating expense on
the income statement.
Kim Waleed, CFA, a member of the ASM finance department, is currently working on converting several
of the subsidiary accounts into their presentation currencies. ASM follows International Financial
Reporting Standards (IFRS), and Waleed has received the accounts for the following subsidiaries:
• ASM Greater West, a U.S.-based logistics business, which reports in USD

• Cape Iron, a South African mining business, which reports in ZAR
41
She has also received the following financial information for ASM Pekat, a raw materials mining
subsidiary situated in Indonesia:
Income and dividend statement

for the year ending December 31, 20X0
USD CAD/USD relevant
’000s historical rates
Sales 12,765
Cost of sales 3,628 0.8126
Depreciation 2,008 0.8509
Interest 870
Other nontax expenses 4,687
Tax 470
Net income after tax 1,102
Dividends 600 0.8143
Balance sheet
as at December 31, 20X0
USD CAD/USD relevant
’000s historical rates
Assets
Cash and cash equivalents 380
Accounts receivable 2,490
Inventory 7,705 0.8126
Property, plant, and equipment 24,990 0.8509
Accumulated depreciation –11,789 0.8496
Liabilities
Accounts payable 1,007
Short-term debt 1,267
Long-term debt 9,760
Equity Capital 9,080 0.8636
Retained earnings 2,662
Note:
• Average CAD/USD rate for the period = 0.8250

• CAD/USD as at December 31, 20X0 = 0.8003
• Retained earnings at the beginning of the year = CAD 2.577 million
42
Owing to government debt concerns in various Eastern European countries, Waleed is concerned
about the effects of large currency movements in some of the subsidiaries. She discusses this with her
supervisor and makes the following statements:
Statement 1: Under hyperinflationary conditions, it might be appropriate to adjust the property values for
inflation.
Statement 2: Also, in a hyperinflationary environment, we should assume that the foreign subsidiary’s
functional currency is the same as our presentation currency and use the temporal method to translate
financial statements.
73. Regarding Ferros Brasilia’s machinery purchase, which of the following statements is least correct?
A. Ferros Brasilia should recognize a foreign exchange gain on April 4, 20X0.

B. Ferros Brasilia should recognize a foreign exchange loss on March 31, 20X0.
C. Ferros Brasilia should revalue the machinery and accounts payable on March 31, 20X0.
74. Regarding ASM’s 5-year coal contract in JPY, which of the following is most accurate?
A. The loss could also have been recorded as an operating expense.

B. The JPY has likely appreciated against the CAD throughout the year.
C. The foreign exchange loss should not have been included on the income statement.
75. In regard to the U.S. and South African subsidiaries, which of the following is most correct?
A. Both ASM Greater West’s accounts and Cape Iron’s accounts should be translated using the
temporal method.
B. Cape Iron’s accounts should be translated using the temporal method, but ASM Greater
West’s accounts do not need translation.
C. ASM Greater West’s accounts should be translated using the current rate method, and Cape
Iron’s accounts should be translated using both the current rate method and the temporal
method.
76. Using the current rate method to translate the accounts for ASM Pekat, the cumulative translation
adjustment as at December 31, 20X0, is closest to which of the following?
A. –CAD 172,869
B. CAD 598,928
C. CAD 981,943
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77. Regarding the translation of ASM Pekat’s accounts, which of the following is most correct?
A. The return on assets would be greater using the current rate method as compared to using the
temporal method.
B. The net profit margin would be greater using the current rate method as compared to using
the temporal method.
C. The gross profit margin would be greater using the current rate method as compared to using
the temporal method.
78. Regarding Waleed’s statements about the effect of hyperinflation on foreign entity account
translation, which of the following is most accurate?

44
Questions 79 to 84 relate to Corporate Finance
Vince Cowley-Smith, CFA, Mansi Singh, CFA, and Tania Parker, CFA, are equity analysts for the
Woolett Family Office Fund (WFOF). The family office and fund are domiciled in the United Kingdom,
and manage more than GBP 950 million in investments, properties, and business ventures.
Cowley-Smith is currently reviewing two companies that are listed on the Frankfurt stock exchange. EK
PharmaGen (EKPG) is a well-established biotechnology firm with global annual revenue of more than
EUR 40 billion. Munich Rubber (MR) is a large supplier of tires and fittings to the global automotive
industry, and has a similar level of revenues. Both companies are currently trading at EUR 70 per share
and paid a dividend of EUR 2.50 per share in the previous year.
EKPG is in a fast-changing industry and has a strong pipeline of promising R&D projects that are nearing
the end of their pilot phases. EKPG issues an announcement to the market advising of a cut in dividends
of EUR 0.50 in order to have the capital to bring some of its more successful innovations to market.
MR is a mature company that has proven to the market over the previous decades its excellent
management of investor capital in providing steadily growing earnings and dividends. For the second year
in a row, MR announces to investors that dividends will be maintained at EUR 2.50 per share.
Based on analysis of each company’s investor base, Cowley-Smith has determined the following investor
characteristics:
• EKPG’s marginal investor is middle-aged with a marginal tax rate on dividends of 36% and a flat
tax rate of 24% on capital gains.
• MR’s marginal investor is retired with a flat tax rate on dividends and capital gains of 12%.
Cowley-Smith has been asked by Singh to help her research Labrador Security Systems (LSS), a
provider of security infrastructure to airports and other transport hubs. The company, situated in the small
European country of Regenwalde, is due to announce its final dividend for the year, and the analysts
make the following observations:
Singh: I would expect LSS to maintain its dividends over the next few years. Reliability of earnings has
become a real worry, and I think that the company would be inclined to be conservative with how
much it pays out.
Cowley-Smith: Also, there seems to be a lack of investment opportunities on the horizon, which is
another good reason to be conservative with how much of the earnings is paid out as dividends.
The Regenwalde tax jurisdiction employs an imputation system for dividends to mitigate the double
taxation of company profits. LSS announces a final dividend of EUR 1.20 per share, which equates
to a payout ratio of 100%. The corporate tax rate in Regenwalde is 25%, and WFOF pays tax on all
investment income at 15%.
Parker has been asked to prepare a report by the WFOF trustees on Petergate Original Lager (POL),
a medium-sized brewer from the sub-Saharan country of Taurland. POL’s earnings per share for the
previous year was $3.00, and this is expected to increase to $3.20 in the current year. Parker has focused
her attention on a recent director’s statement from POL that highlighted board discussions regarding the
45
brewer’s dividend policy. Over the past few years, POL has followed a dividend policy of paying out a
constant amount of 80% of earnings. The directors believe that the payout level might need to be a little
more conservative over the medium term and are considering the following:
1. Reducing the constant dividend payout ratio to 76%

2. Moving to a stable dividend policy based on the current payout level, but with an adjustment
factor of 5 years
In her report to the WFOF trustees, Parker makes the following statements:
Statement 1: In the case of POL, dividends in Taurland are taxed at a higher rate than capital gains.
Thus, investors would likely prefer POL to engage in share repurchases as a way to return capital to
shareholders. This also has the added benefit of improving managerial flexibility, as repurchases are not
expected to be as consistent as dividends.
Statement 2: POL has a lot of employee stock options expiring in this year, so it might not be a
good idea for the company to conduct share repurchases at the same time. However, POL is quite
underleveraged at the moment, so a share repurchase might be a good way to increase financial leverage.
79. Which of the following statements regarding the dividend announcements by EK PharmaGen and
Munich Rubber is least accurate?
A. The market might view both MR’s and EKPG’s announcements as positive.
B. The market might view both MR’s and EKPG’s announcements as negative.
C. The market might view EKPG’s announcement as positive and MR’s dividend announcement
as negative.
80. In regard to the investor bases of EK PharmaGen and Munich Rubber, the expected decrease in
share prices is closest to which of the following?
A. EKPG share price drop of EUR 1.68; MR price drop of EUR 2.50
B. EKPG share price drop of EUR 2.11; MR price drop of EUR 2.20
C. EKPG share price drop of EUR 2.38; MR price drop of EUR 2.50
81. Regarding the analysts’ statements about Labrador Security Systems, which of the following is
most accurate?

B. Only Singh’s statement is correct.
C. Only Cowley-Smith’s statement is correct.
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82. The tax payable by WFOF per share on dividends received from Labrador Security Systems is
closest to which of the following?
A. –EUR 0.16
B. –EUR 0.12
C. EUR 0.18
83. In regard to the two dividend policies under consideration by the directors of POL, which of the
following statements is most correct?
A. The policies will give the same expected dividend this year.
B. The stable dividend policy will give a higher expected dividend this year.
C. The constant payout ratio dividend policy will give a higher expected dividend this year.
84. In regard to statements made by Parker in her report, which of the following is most accurate?

47
Questions 85 to 90 relate to Equity
Emily Fontaine, CFA, is the head of corporate finance at Walter Monroe Biggs (WMB), a U.S.-based
financial services firm. She has more than 25 years’ experience in the industry in areas such as
project finance, mergers and acquisitions, and business valuation. Fontaine is responsible for a
team of 15 analysts, accountants, and business appraisers, and the company specializes in the retail,
entertainment, and consumer discretionary sectors.
Fontaine is reviewing the work of one of her team, who has prepared a statement of work for Rowntree
Adventure Goods (RAG), a small chain of outdoor gear supplies stores located in Pennsylvania. RAG
is wholly owned by the estate of Harry Rowntree, who recently passed away, leaving his three children
to run the business. They, however, have little interest in being shop owners and are looking to sell
the business as a whole or in parts. The statement of work lists the different approaches that could be
undertaken in preparing a valuation for the business, and makes the following statement:
We propose that we undertake two separate valuations: (1) as a going concern and (2) as a
liquidation. Based on our preliminary analysis of accounts, it is evident that profitability has been
falling over the past few years; hence, a liquidation value may be appropriate. It is unclear whether
there is value added to the assets through the current operations; hence, there might not be any
material difference between a liquidation value and a going-concern value. However, the gap
between liquidation and going-concern valuations of RAG might be even lower, should you require
a quick sale.
There is also evidence of poor accounting practices, which may have an impact on the assessment of
RAG’s value. The statement of work lists the following areas of concern, which it states have likely led to
an inflation in business earnings:
• Capitalization of product development costs

• Reduction in depreciable lives of some of the business equipment
• Sharp increase in credit sales, but a reduction in bad-debt allowances
WMB has been engaged to provide a valuation report relating to an ongoing court case involving
Fahrenheit Luxury Luggage (FLL), a small public company listed on the New York Stock Exchange. The
business was the target of a takeover, which was rejected by shareholders after directors produced an
independent valuation showing the bid to be below fair market value. After the takeover bid was removed,
the stock price fell sharply and has remained well below the price indicated in the independent valuation
report.
After researching the business and industry, Fontaine prepares a preliminary report that highlights the
following:
Statement 1: The original valuation report has incorrectly applied a control premium, which is
inappropriate in this situation. This resulted in an inflated valuation.
Statement 2: The original valuation failed to take into account a discount for illiquidity. FLL is thinly
traded, and the valuation of the company should have taken this into account.
48
Fontaine has also been reviewing some of the inputs into many of WMB’s valuation models. In particular,
she is testing a number of their required rate of equity return models to ensure that the internally
developed models are valid and reliable.
For public company valuation, WMB generates betas for several factors. The factors, along with their
respective historical annual premiums, are as shown:
Market premium 4.90%

Size premium 3.60%
Value premium 2.10%
Momentum premium 0.90%
Liquidity premium 1.40%
The risk-free rate used in all the models is currently set at 3.10% p.a. WMB uses some or all of these
factors across a number of common industry models. To test the models used, Fontaine generates the
betas for three random public companies:
Company A Company B Company C

Market beta 0.7 1.5 0.9
Size beta 0.3 0.8 –0.6
Value beta 0.7 –0.4 0.5
Momentum beta 0.4 0.7 –0.1
Liquidity beta –0.2 0.3 –0.4
85. Regarding Rowntree Adventure Goods’s statement of work, the statement is least correct
regarding which of the following?
A. The use of a liquidation valuation

B. The valuation differences under a quick sale
C. The valuation differences due to value added from operations
86. Regarding the issues of earnings quality raised by the statement of work for the valuation of
Rowntree Adventure Goods, the statement is least correct with regard to which of the following?
A. Depreciable lives
B. Bad-debt allowances
C. Capitalization of costs
49
87. In regard to the preliminary report of the valuation of Fahrenheit Luxury Luggage, which of the
following is most accurate?

88. Using the betas and premiums provided, the required rate of return for Company A under the
Pastor-Stambaugh model is closest to which of the following?
A. 6.1%
B. 8.3%
C. 8.8%
89. In regard to the required rate of returns for Company B and Company C, which of the following
is least accurate?
A. Company C is a large-cap value company.

B. Company B is a small-cap company, and Company C has relatively low liquidity.
C. Company B has a relatively high sensitivity to the market and relatively low liquidity.
90. In regard to valuation models used reviewed by Fontaine, which of the following statements is
most accurate?
A. The models used by WMB are macroeconomic multifactor models.

B. WMB should generate different factor values for each different model used.
C. Adding more factors to the models will increase the forecasting power of the model, while
decreasing its complexity and cost.
50
Questions 91 to 96 relate to Equity
Victor Caretta, CFA, and Melanie Bambrough, CFA, are sell-side equity analysts at Elephant and Moore
Stockbroking (EMS). Caretta has more than 25 years of experience in stock market research, while
Bambrough is a recent graduate with limited experience. EMS is situated in San Francisco and has
predominantly dealt in U.S.-listed equities. However, due to client demand, EMS now also offers services
relating to some of the larger non-U.S. public companies.
Caretta has developed most of the EMS valuation models over the past two decades, and he uses different
models depending upon sector and firm age. He is currently researching a small manufacturing firm,
Jacksonville Piping, and has prepared the following financial information for the previous financial year:
For the year ending December 31, 20X1

$ ’000s
Sales 26,870
Cost of sales 18,901
Gross profit 7,969
Other expenses* 5,072
Net profit before tax and interest 2,897
Interest expense 190
Tax expense 677
Net income 2,030
Other financial information:
Tax rate 25%
Capital expenditure 923
Proceeds from sale of long-term assets 120
Change in cash 55
Change in account receivables 38
Change in inventories –25
Change in short-term debt 24
Change in account payables 35
*Includes depreciation and amortization of $530,000.
Caretta prefers to calculate free cash flow to the firm and free cash flow to equity using net income
figures. Bambrough is more accustomed to calculating free cash flow figures by adjusting operating
cash flows. While discussing new valuation models for non-U.S. companies, they make the following
observations:
Bambrough: Under U.S. GAAP, as interest received and dividends received are recognized as operating
cash flows, they need to be subtracted from operating cash flow, on an after-tax basis, in determining
free cash flow to the firm.
Caretta: We need to be careful with calculations for companies that use IFRS. As such companies might
recognize dividends received as financing cash flow, these should be added onto operating cash flow
to calculate free cash flow to the firm.
51
Bambrough has recently completed a valuation report for Mighty Strong Scaffolding and has calculated
free cash flow to equity. After reviewing the following information and Bambrough’s 20X1 calculations,
Caretta advises that her work will need to be amended.
For the year ending December 31

20X1 20X0
$ ’000s $ ’000s
EBITDA 34,127
Depreciation expense 9,109
Amortization expense 872
Interest expense 7,886
Other financial information:
Tax rate 25%
Capital expenditure 3,890
Proceeds from sale of long-term assets 5,809
As at December 31
20X1 20X0
$ ’000s $ ’000s
Cash 9,729 9,984
Account receivables 1,209 1,112
Inventories 13,772 13,582
Short-term debt 3,308 3,450
Account payables 18,263 18,177
Long-term debt 49,039 47,751
Bambrough is also preparing a valuation report for Oasis Human Capitalista (OHC), a human resources
company located in Canada. In so doing, Bambrough reviews a report by Caretta of a peer company
located in the United States. In his report, Caretta makes the following statement:
In completing this valuation, I have forecasted future operating cash flows based on current
operating cash flows and applying a steady rate of growth. I have discounted these forecasts at an
appropriate cost of equity in order to calculate the value of the firm. I have used operating cash
flows instead of free cash flow to equity as this is an appropriate proxy given the relatively low
need for capital expenditures and steady debt levels.
52
Bambrough has produced the following information for OHC, which she uses to calculate an equity
valuation.
CAD ’000s
Current FCFF 14,625
Current FCFE 11,277
Current debt value 57,987
Other valuation assumptions: 1.
Cost of debt (pre-tax) 7.30%
Cost of equity 19.30%
Tax rate 30%
Target debt-to-equity ratio 50%
Growth rate of FCFF 4.20%
Growth rate of FCFE 4.50%
After reviewing her work, Caretta recommends that she amend her cost of equity by adding 0.5% to
adjust for country return and adjust her growth figures as follows:
• FCFE growth for years 0–5 of 7.5% p.a.

• FCFE growth for year 6 onward of 4.5% p.a.
91. Jacksonville Piping’s free cash flow to the firm in 20X1 is closest to which of the following?
A. $1.85 million
B. $1.87 million
C. $1.92 million
92. In regard to Caretta’s and Bambrough’s statements regarding operating cash flows, which of the
following statements is most correct?
A. Both statements are incorrect.

B. Only Caretta’s statement is correct.
C. Only Bambrough’s statement is correct.
93. Mighty Strong Scaffolding’s free cash flow to equity in 20X1 is closest to which of the following?
A. $23.9 million
B. $25.0 million
C. $29.8 million
53
94. Regarding the statement made by Caretta in his report, which of the following is most accurate?
Caretta’s statement is incorrect in regard to:
A. calculating firm value.

B. forecasting operating cash flows.
C. the use of operating cash flows as a proxy for free cash flow to equity.
95. Bambrough’s original equity value of Oasis Human Capitalista based on free cash flow to the
firm is closest to which of the following?
A. CAD 79.6 million

B. CAD 89.0 million
C. CAD 132.4 million
96. After applying Caretta’s adjustments, the present value of the year 5 terminal value of OHC using
a two-stage FCFE model is closest to which of the following?
A. CAD 39.5 million

B. CAD 40.7 million
C. CAD 42.5 million
54
Questions 97 to 102 relate to Fixed Income
Jay Maddison, CFA, is a senior trade and settlement analyst for Leith Walk Asset Management (LWAM),
a boutique fund manager specializing in fixed-income assets. He has more than 15 years’ experience on
dealing desks with a focus on fixed-income futures and swaps.
Maddison is currently reviewing rates and prices for U.S. Treasuries, and has been given the current spot
rates as follows:
Term (years) 1 2 3 5 7 10 20 30
Spot (% p.a.) 3.59 3.43 3.21 3.09 2.89 2.78 2.84 3.37
One of LWAM’s relative value strategy funds is looking to increase exposure to medium-term yields on U.S.
Treasuries. The fund manager has been quoted a forward price of 0.9610 for a 2-year forward 5 years from
today. He is concerned that the price might be too high and has asked that Maddison review the offer price.
Maddison is putting together a report for his team on the current state of the U.S. Treasury market and his
outlook for rates. He is expecting the yield curve to flatten over the next year, and he makes the following
statements:
Statement 1: The current yield curve indicates that forward rates should be lower than corresponding
spot rates over the medium term.
Statement 2: As the curve flattens, we should see 1-year forward rates converging toward the yield curve.
Simone O’Connell, CFA, a member of Maddison’s team, is critical of his focus on the government bond
yield curve. She sends him an e-mail with the following paragraph:
The swap curve should be used as our benchmark interest rate curve for each country. This is more
appropriate for LWAM due to our high use of swap contracts to gain desired exposures. Also, many
countries have limited government bond maturities, while most swap curves have yield quotes at
many maturities. As the swap market is highly regulated, we can be confident that the swap rate
curve will accurately reflect market sentiment.
Nine months later, Maddison has been asked to assist with a transaction involving swaps. The yield curve
for near-dated maturities has flattened to some degree, and the Libor spot rates are as follows:
Term (years) 1 2 3
Spot (% p.a.) 2.50 2.55 3.20
A few months later, Maddison has noticed that the yield curve has flattened further, while various spread
measures employed by LWAM have widened. Maddison sends a memo to his team, highlighting some of
the changes to the fixed-income market over the past 3 months:
Statement 3: The I spread across most of our short-term securities has widened significantly. This
highlights the deterioration in conditions in the corporate bond space.
Statement 4: The TED spread has also widened. This indicates that market trust in sovereign debt has fallen.
55
97. Based on the initial spot rates, the forward rate for a 1-year forward 2 years on is closest to which
of the following?
A. 2.77%
B. 3.02%
C. 3.21%
98. Regarding the forward price quoted to the relative value strategy fund manager, which of the
following statements is most accurate?
A. The forward is overpriced.

B. The forward is underpriced.
C. The forward is priced fairly.
99. In regard to the statements made by Maddison in his report, which of the following is most
accurate?
A. Only Statement 1 is correct.

C. Both Statements 1 and 2 are correct.
100. Regarding O’Connell’s recommendation to change interest rate benchmarks, which of the
following is most accurate? O’Connell’s statement is incorrect in regard to:
A. LWAM’s high use of swap contracts.

B. government bond maturities.
C. swap market regulation.
101. Based on the spot rates given after 9 months had passed, the 3-year swap rate is closest to which
of the following?
A. 3.15%
B. 3.18%
C. 3.20%
102. In relation to the memo sent by Maddison, which of the following is most correct?
A. Only statement 3 is correct.

B. Only statement 4 is correct.
C. Both Statements 3 and 4 are correct.
56
Questions 103 to 108 relate to Derivatives
Nancy Van Hewson, CFA, and Albert Chung, CFA, work as derivatives traders in the treasury department
of a large investment bank, OSB Bank, situated in Switzerland. The bank trades in most financial and
derivatives markets around the world and specializes in deal structuring for large pension funds.
Van Hewson has more than 10 years’ experience dealing with forwards on various underlying
instruments, including indexes, interest rates, commodities, and currencies. One of the trades that she is
looking at involves a EUR forward rate agreement (FRA) with OSB Bank taking the short position. The
details of the deal are as follows:
• Notional value of EUR 30,000,000

• 2 × 4 FRA
• 360 day count convention
• Current Euribor rates:
Term (days) % p.a.

30 2.78
60 2.85
90 2.97
120 3.10
150 3.15
180 3.22
210 3.78
It is now the end of the quarter, and Van Hewson is valuing a number of derivative positions. The bank’s
largest equity exposure is a short equity forward exposure over the S&P 500 index. The forward contract
was entered during the past quarter at a forward price of $2,240.28, and it matures in 127 days. The
following rates and prices are current at the end of the quarter:
• S&P 500 index at 2,231.72

• Continuously compounded risk-free rate of 4.87% p.a.
• Continuously compounded dividend yield on the S&P 500 of 3.08% p.a.
Chung is well-known for his options trading expertise and heads up the options trading team at OSB
Bank. He also is a key consultant on the bank’s structured products team, which is the main source for
most of the bank’s option exposures.
The structured products team is looking at putting together a product using a range of stock options
across a basket of companies listed on the London Stock Exchange. One of the underlying exposures
of interest is Priory Automotives and Autofinance (PAA), a large car dealership company in the United
Kingdom and Spain. Chung has been asked to value the 1-year put and call options for PAA, exercisable
at 49 with the underlying trading at GBP 49.25. Based on current estimates, in 1 year the stock price is
expected to either move up by 15% or move down by 20%. The current risk-free rate for 30 days is
3.3% p.a.
Chung is also looking at pricing an option for Great Continental Wireless (GCW), an Internet provider
based in Amsterdam, which doesn’t currently pay any dividends. GCW is currently trading at EUR
57
173.77, and the price is expected to move as shown in the following diagram and information over the
next 2 years:
Chung is looking at valuing a 2-year American put option with a strike price of EUR 180 using a two-
period binomial calculation. The risk-free rate is currently 4.2% p.a.
A colleague of Chung values the same put option using the Black-Scholes-Merton (BSM) model, with
a stock price volatility of 19% p.a. and a continuously compounded risk-free rate of 4.2% p.a. The
premium for the put option is substantially lower under his calculation, and he raises concerns about
Chung’s calculation. In response, Tsang makes the following statement:
Values between options pricing models might be different for a number of reasons, and the lower
premium price is likely to be the result of the following:
1. The BSM calculation might not have accurately accounted for the exercise premium
available to American-style options in certain circumstances.
2. The volatility level might have been too high, thus reducing the value of the premium
under the BSM model.
OSB Bank sells put options on 25,000 shares of GCW stock at 1:1 (i.e., 25,000 put options). Three
months later, the share price of GCW has risen to $180 and Chung decides it is a good idea to delta hedge
the position using call options. The call options he chooses as the hedge instrument have an exercise price
of $160 and are nearing maturity in the next few months.
58
103. The annualized rate of the EUR forward rate agreement at initiation is closest to which of the
following?
A. 3.10%
B. 3.33%
C. 3.39%
104. The end-of-quarter value of the S&P 500 equity forward to OSB Bank is closest to which of the
following?
A. –$8.56
B. –$5.29
C. $8.56
105. Using a one-period binomial model, the values of PAA’s options are closest to which of the
following?
A. Call option premium of GBP 2.55; put option premium of GBP 5.13
B. Call option premium of GBP 4.58; put option premium of GBP 3.25
C. Call option premium of GBP 4.92; put option premium of GBP 3.11
106. Using the two-period binomial model, the value of the GCW put option is closed to which of the
following?
A. EUR 16.87
B. EUR 20.30
C. EUR 24.86
107. Regarding Chung’s response to his colleague, which of the following statements is most
accurate?
A. Only his first point is valid.

B. Only his second point is valid.
C. Both of his points are valid.
108. Regarding the likely hedging transaction for the GCW option exposure, which of the following
statements is least correct?
A. Chung will sell call options.

B. The gamma of the exposure is likely to be high.
C. Chung will likely trade roughly 25,000 call options.
59
Questions 109 to 114 relate to Alternative Investments
Meryl Cahill, CFA, works as an investment analyst for The Hamilton Group (THG), a large family office
located in Austin, Texas. She has worked for THG and other family offices for the past 5 years, having
started her career as a research assistant in a boutique hedge fund. The THG portfolio consists of a
diverse pool of global investments with more than $800 million in assets under management.
Following a recent investment committee meeting, Cahill has been researching several property
investments to be considered as potential investments. These include:
• Albion Medical Centre Fund, an investment trust listed on the London Stock Exchange invested
in health-related properties
• Berliner Haus Mortgage Fund, a mortgage fund with security over residential property in Berlin
• Co-founder House, Cable Street, San Francisco, a two-story office building
Excerpt from investment committee meeting minutes:
As per changes to the tactical asset allocation, the fund requires an increase to property exposures.
The additional property investments that will blend best with the existing portfolio would likely be
a public investment with minimal exposure to property price fluctuations.
The THG fund has received an offer for an existing warehouse it owns in Atlanta, Georgia. Cahill has
been asked to assess the offer, but is having difficulty in finalizing a recommendation for the committee.
Some of the committee members, who are unfamiliar with direct property valuations, are concerned with
the progress of the assessment and, as a result, Cahill sends the committee an e-mail with the following
paragraph:
There are a number of complications with direct property investments that make them more
difficult to value when compared to shares or other financial securities. First, each property is
different and thus you can’t simply compare prices with other properties. Also, cash flows are
very uncertain, which make it difficult to forecast with any great reliability. Last, due to relatively
infrequent transactions, determining price is hindered as the most recent comparable property
transaction price might not be representative of the current fair value.
Cahill has gathered the following initial information for the warehouse to help her with her overall
assessment:
Tenanted units 11
Vacant units 1
Monthly rent per unit $2,150
Advertising signage income p.a. $70,000
Annual operating expenses per unit $9,120
Mortgage interest p.m. $105,000
Management fee on effective gross income 2.5%
Cahill presents her initial valuation to the committee, who recommend that she reduce the advertising
income and increase the management fee. After plugging the new figures into her model, she determines
60
that the warehouse would have net operating income of $152,000, which is expected to remain flat for the
next 3 years before growing at 2.5% annually thereafter. Based on market data, the cap rate for such an
investment is 9.0% p.a.
Cahill has also been asked by the investment committee chair, Seb Leadenhall, to investigate a new
opportunity to invest into Main Street J Fund (MSJF), a private equity (PE) fund based in Chicago.
MSJF is seeking initial capital from investors with its primary strategy to invest in established companies
operating in the retail and consumer goods space. At the following meeting, a concern is raised about
the risks of PE funds, particularly manager risk. Cahill and Leadenhall both respond to this concern by
highlighting the benefits a PE firm can bring to the management of a company.
Cahill: Through effective structuring of investments terms, PE firms can ensure that managers are
incentivized to maximize the exit value of a company. They can also include earn-out provisions to
help limit downside risks to capital.
Leadenhall: PE firms can include provisions to the investment that give them certain board control and
veto rights. They might also have clauses that restrict employees from taking part in trade union or
other organized labor activity.
In the MSJF investment pack, the fund provides a recent example of a leveraged buyout of Short’n’Tall
Homewares (STH) by another PE fund, Main Street E Fund (MSEF). The transaction details are as
follows:
Price 22,500,000
Debt to equity 200%
MSEF preference shares to equity 50%
Preference shares dividends 13%
MSEF ordinary shares to equity 40%
STH management ordinary shares to equity 10%
Exit time frame 3 years
Exit price 34,000,000
Debt repaid by exit 40%
109. In regard to the property investments presented by Cahill, which of the following statements is
most correct?
A. Only the Albion Medical Centre Fund is in line with the investment committee’s stated
preference.
B. Only the Berliner Haus Mortgage Fund is in line with the investment committee’s stated
preference.
C. Only the Co-founder House, Cable Street, San Francisco, property is in line with the
investment committee’s stated preference.
61
110. Regarding Cahill’s e-mail in response to committee members’ concerns, which of the following
is most accurate? Cahill is incorrect regarding the:
A. differences between each property.

B. uncertainty of cash flows.
C. infrequency of transactions.
111. Based on the initial information gathered by Cahill, the annual net operating income (NOI) of the
THG warehouse is closest to which of the following?
A. $236,800
B. $243,990
C. $244,635
112. In regard to Cahill’s revised valuation, the value of the THG warehouse is closest to which of the
following?
A. $1,316,732
B. $1,659,407
C. $2,141,697
113. Regarding Cahill’s and Leadenhall’s response to the committee about the private equity firms,
which of the following answer choices is most correct?

B. Only Cahill’s statement is correct.
C. Only Leadenhall’s statement is correct.
114. In regard to the private equity transaction example given in the MSJF investment pack, the
internal rate of return (IRR) earned by MSEF is closest to which of the following?
A. 32.4%
B. 46.2%
C. 54.7%
62
Questions 115 to 120 relate to Portfolio Management
Gregor Kinsley, CFA, is a junior portfolio manager for Grey Leaf Investment Partners (GLIP), a fund
manager situated in New Zealand. He works alongside Tania Ormsby, CFA, the head portfolio manager
for GLIP’s multi-asset suite of funds.
Kinsley is reviewing country weightings in their portfolios and has grown concerned with the conditions
in Metronesia, a fast-growing country in Southeast Asia. Kinsley prepares a report for the company on the
country, highlighting economic signals that he asserts indicate that Metronesia is headed for a recession,
and within the report he makes the following statements:
Statement 1: The Metronesian economy grew at a nominal rate of 5.5% over the past year, and the yield
curve for government treasuries has flattened significantly after being inverted for much of the past year.
Statement 2: Credit spreads on Metronesian corporate debt have begun to widen over the past 6 months,
which is most likely a sign that the default risk in the economy is increasing.
A neighboring country, Sian, is also being reviewed by Kinsley and Ormsby. It is a mature economy
with deep and liquid capital markets, and in which GLIP has a number of equity holdings. This part of
the portfolio has suffered over the past year as a result of the economy slipping into a mild recession.
However, signs are that the economy is ready to begin a healthy recovery, and GLIP is looking at
increasing its equity exposures in Sian. Ormsby puts together the following list of stocks for Kinsley to
assess:
• DLK, the largest chain of grocery stores in Sian

• SAU, a small logistics company servicing the Sian retail industry
• VIH, an online furniture, homewares, and home improvement company
Kinsley is also reviewing the Sian real estate market and is assessing the fair value level of the listed real
estate investment trust (REIT) sector. In his assessment, Kinsley estimates the following sector-specific
risk premiums:
Equity risk premium 1.9% p.a.

Default risk premium 2.6% p.a.
Illiquidity risk premium 3.8% p.a.
GLIP portfolios tend to use external active managers to gain access to markets beyond their internal
capabilities. One such market is the Sian micro-cap equity market, and GLIP currently gains exposure to
this market through the Delamazo Micro-Cap Share Fund. The benchmark for the market consists of only
five stocks, and Ormsby puts together the following data to assess the likely value added by the active
fund manager, Delamazo Asset Management.
63
Delamazo Benchmark Expected
Holding weightings weightings return (p.a.)
A 10% 20% 8.8%
B 5% 20% 7.3%
C 35% 20% 9.6%
D 20% 20% 12.4%
E 30% 20% 11.6%
Total risk 18%
Sharpe ratio 0.61
Information ratio 0.91
As part of her assessment, Ormsby compares the expected performance of the Delamazo fund with two
competitors in the same market and prepares the following information:
Gionder Bulle
Information coefficient 0.25 0.18
Transfer coefficient 0.80 0.81
Breadth 15 40
After reviewing this information, she concludes that the existing manager should remain in place, as it is
likely to provide a greater level of return above the benchmark than the competitor funds.
115. In regard to Kinsley’s statements about recessionary signals in Metronesia, which of the
following is most accurate?
A. Only statement 1 is correct.

B. Only statement 2 is correct.
C. Both statements are correct.
116. Out of the list provided by Ormsby, based on the prevailing business cycle conditions, which of
the nominated stocks would be least appropriate to include in the portfolio at this time?
A. DLK
B. SAU
C. VIH
64
117. In regard to the Sian REIT market, which of the following statements is most accurate? Kinsley
is likely to be incorrect regarding his estimation of the:
A. equity risk premium.

B. default risk premium.
C. illiquidity risk premium.
118. The ex ante active return for the Delamazo fund is closest to which of the following?
A. 0.63% p.a.
B. 1.73% p.a.
C. 1.97% p.a.
119. Assuming the Delamazo fund is unconstrained, the optimal level of active risk for the fund is
closest to which of the following?
A. 18.69%
B. 26.85%
C. 29.51%
120. Regarding Ormsby’s decision to retain the Delamazo fund, which of the following is least
correct?
A. Ormsby made the right decision.

B. Ormsby should have switched to the Bulle fund.
C. Ormsby should have switched to the Gionder fund.
65
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2018

CFA® EXAM REVIEW

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Questions 61 to 66 relate to Ethical and Professional Standards

A. not have made a recommendation on MJZ stock.

A. A quiet period should be implemented for EVS stock.

A. Knight’s comment regarding the MDF recommendation

A. delayed his report.

A. amend the two-dimensional framework.

Previous 4 quarters Quarterly wages growth

Two-tailed t-test values

x t = 0.0022 + 0.6893x t −1 − 0.1187x t − 2 + ε t

A. 0.8415 units per labor hour

A. Both statements are incorrect.

A. The model should be adjusted for seasonality.

71. The forecast for Q2 20X1 is closest to which of the following?

A. Both statements are correct.

• ASM Greater West, a U.S.-based logistics business, which reports in USD

Income and dividend statement

• Average CAD/USD rate for the period = 0.8250

A. Ferros Brasilia should recognize a foreign exchange gain on April 4, 20X0.

A. The loss could also have been recorded as an operating expense.

A. Both statements are correct.

1. Reducing the constant dividend payout ratio to 76%

A. Both statements are correct.

A. Both statements are correct.

• Capitalization of product development costs

Market premium 4.90%

Company A Company B Company C

A. The use of a liquidation valuation

A. Both statements are correct.

A. Company C is a large-cap value company.

A. The models used by WMB are macroeconomic multifactor models.

For the year ending December 31, 20X1

For the year ending December 31

• FCFE growth for years 0–5 of 7.5% p.a.

A. Both statements are incorrect.

A. calculating firm value.

A. CAD 79.6 million

A. CAD 39.5 million

A. The forward is overpriced.

A. Only Statement 1 is correct.

A. LWAM’s high use of swap contracts.

A. Only statement 3 is correct.

• Notional value of EUR 30,000,000

Term (days) % p.a.

• S&P 500 index at 2,231.72

A. Only his first point is valid.

A. Chung will sell call options.

Excerpt from investment committee meeting minutes:

A. differences between each property.

A. Both statements are correct.

• DLK, the largest chain of grocery stores in Sian

Equity risk premium 1.9% p.a.

A. Only statement 1 is correct.

A. equity risk premium.

A. Ormsby made the right decision.

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