Professional Documents
Culture Documents
or warrant the accuracy of the products or services offered by organizations sponsoring or providing
CFA® exam preparation materials or programs, nor does AIMR verify pass rates or exam results claimed
by such organizations.
Instructors:
Peter Chau, CFA
Patrick Collins, Ph.D., CFA
Ed Cordisco, CPA
Don Davis, CFA
Jivendra Kale, Ph.D.
Terry Lloyd, CFA
Prof. John M. Veitch, Ph.D., CFA
Loren Walden, CFA, CFP
Item Set
1 – 10 Ethics SS # 1 & 2 15 minutes Loren
Walden
11 – 14 Quantitative Methods SS # 3 6 minutes Jivendra
Kale
15 – 27 Debt Instruments SS #13, 14, & 15 20 minutes Peter Chau
28 – 43 Derivatives SS #16 & 17 24 minutes Peter Chau
44 – 49 Portfolio Management 12 minutes Patrick
Collins
50 – 55 Financial Statement Analysis SS # 5 9 minutes Ed
Cordisco
56 – 63 Economics SS # 4 16 minutes John Veitch
64 – 70 Quant. Methods & Economics SS # 3&4 14 minutes John Veitch
Total 116 minutes
Essay/Item Set
71 – 73 Basic Valuation SS # 8 15 minutes Don Davis
74 – 79 Equity Valuation SS # 9 12 minutes Terry Lloyd
80 – 87 Equity Valuation SS # 10 20 minutes Terry Lloyd
88 – 91 Equity Valuation SS # 11 & 12 8 minutes Terry Lloyd
92 - 96 Financial Statement Analysis SS #7 12 minutes John Veitch
Total 67 minutes
Please note that the distribution of questions on the SASF CFA Level II Practice exam
broadly reflects the weights placed on each subject area by the CFA Level II study guide.
There is no guarantee that the questions on the actual CFA exam will reflect these relative
weights.
2. Which of the following is not a sanction that AIMR can impose on a covered person?
A. Public censure
B. Private censure
C. Revocation of membership
D. None of the above
A. Felony conviction.
B. Permanent disbarment under securities law
C. Failure to cooperate with and AIMR investigation
D. All of the above
4. Which of the following is a complete description of the principals of the New Prudent
Investor Rule?
5. Which of the following are general fiduciary standards carried over from the Prudent
Person Rule to the new Prudent Investor Rule?
Fink Quatronion, CFA is the senior portfolio manager at Clink LLC Investment Management,
a seven billion dollar firm. Clink focuses upon managing assets for pension funds of technology
companies located in the United States. Clink has adopted the AIMR Code and Standards. Fink
manages both the many research analysts as well as the portfolio managers at Clink.
One day, Billy Badly, a level II candidate for the Charter Financial Analyst designation, gets
called into Finks office. There are several things Fink is concerned about regarding Billy’s
conduct and has outlined them on a memo to help keep the meeting on track. The following is
the memo:
1. Purchased securities for his personal account that are under review for possible
consideration to sell for client accounts
2. Has delegated his research duties required under ERISA buy buying sector funds in
some of his client’s portfolios.
3. Has been working on a charity on weekends without disclosing this to his supervisor
in writing.
4. Does not review his account’s circumstances at least bi-annually.
5. Did not inform the firm in writing that he was bound by the code.
6. Assuming all of the items did occur, which of the items in the memo are clear violations
of AIMR’s Code and Standards?
A. None
B. 1,2,4,5
C. 1
D. 1,2,3,4
7. How could Fink Quatronion, CFA have done a better job and created an affirmative
defense?
A. He failed to have systems in place to avoid clear violations of the code. By having check
systems in place in writing he could avoid Billy type problems.
B. He could check all new hires for clues about integrity.
C. He should provide all employees a copy of the Code when they are hired and educate
them frequently about the code.
D. All of the above.
A. 1,2,3,5 only
B. 1,3,5,6 only
C. l,2,3,4,5 only
D. 1,2,3,4,5,6
9. Under the Prudent Investor Rule each individual security is taken on its own merits.
A. True
B. False
C. Only if ERISA is the operating rule then it is true
D. Only if ERISA and the Prudent Expert rule is enforced
A large group of portfolio managers and analysts meet once a year for an investment
conference at a fancy hotel to get educated wined and dined by a brokerage firm. The host firm
pays for meals, entertainment, expensive wine, and the hotel suites. At this meeting, breakout
sessions are provided for the brokerage firm’s top clients with senior management of publicly
traded companies presenting at the conference.
At one of these breakout sessions, an analyst named Tommy Toy, CFA overhears the CEO of
Reardon Steel talking into his cell phone before the meeting begins. The CEO said “I can’t say
anything right now because I have a room full of Wall Street jerks breathing down my neck. But
if they want to buy our firm for that much money, get the board together and we will meet
tomorrow morning at corporate headquarters. Send the jet out to get me tonight.”
After hearing this conversation, Tommy gets his own cell phone out and proceeds to call
in an order to by several thousand shares of Reardon Steel for his personal account.
A. Tommy can trade all he wants in Reardon Steel for himself but not for his clients.
B. Tommy cannot trade on the overheard information because it came directly from a senior
officer who would be considered an insider.
C. Tommy cannot trade on the overheard conversation because of the subject matter of
the information.
D. The only violation that occurred is the brokerage firms offer to pay for the lodging.
A junior analyst has developed the following regression model to predict tire industry sales at
time t based on the variables in Table 1.
SALES t = 504.44 + 13.18 INDRUBt + 9.88CAPt + 11.66 INDTRt + 5.92 MILES t + 10.45 PERS t
t-values: (1.02) (0.67) (1.48) (0.83) (1.76) (1.13)
Number of observations: 36
Standard error of estimate: 1637.38
Unadjusted R2: 0.955
11. The goodness of fit, or explanatory power, of a multiple regression equation is given by
A. The standard error of estimate for the regression
B. The F-statistic for the regression
13. What is the 95% confidence interval for the forecast of tire industry sales for 2003?
A. $17,692.774 to 20,967.534 million
B. -$1,637.380 to 1,637.380 million
C. -$2,839.090 to 3,847.970 million
D. $15,986.624 to 22,673.684 million
Alicia Quan is an analyst for a mutual fund that owns some high-yield bonds issued by AQT
Corporation. The following table shows AQT’s simplified balance sheet. Amounts are in millions
of dollars.
The long-term debt includes high-yield bonds, some of which are owned by the mutual fund.
AQT is planning to embark on a new project that requires additional capitalization of $200
million. It is not clear how AQT plans to fund the new project. It may issue more stocks and
possibly more bonds. Alicia is concerned that, if AQT decides to issue additional bonds, the
higher debt ratios would cause the existing high-yield bonds to go down in value. The high-yield
A. 16.7%
B. 41.7%
C. 50.0%
D. 58.3%.
16. If AQT were to fund the new project by issuing stocks, the long-term debt to equity ratio
would be
A. 30.0%
B. 42.9%
C. 60.0%
D. 71.4%.
18. Alicia is concerned that the high-yield bonds may drop in value if the new project is
capitalized in a way that is detrimental to existing bondholders. She can hedge this risk
by
19. To understand the interest rate risk of the high-yield bonds, Alicia would need
15. B. Long-term debt = 300 + 200 = 500. Total assets = 1000 + 200 = 1200.
17. B. If AQT funds the new project using all bonds, then long-term debt = 300 + 200 = 500,
total capitalization = 300 + 200 + 500 = 1000, and long-term debt to total capitalization =
500 / 1000 = 50%. This would violate the negative convenant.
18. D. A is definitely incorrect. Alicia is trying to hedge a credit risk event, not an interest
risk event. Therefore Treasury bond futures would not help. B is tempting. Prices of high-
yield bonds usually move in the same direction as the same company’s stocks. A put
option on the company stock would then move in the opposite direction and provide
some hedge. (Of course, finding the proper hedge ratio is still a problem.) In this case,
however, the new funding may hurt the bondholders and hence benefit the shareholders.
A put option would then lose when the high-yield bonds lose. This is no hedge. C is
always a good idea. However, it does not provide a hedge. By the time the news comes
out, the market may have reacted.
19. B. C is out since convexity does not help if one does not know the duration. D is out;
spreads do not measure interest rate risk. A may be an acceptable answer if the high-yield
bond is noncallable. However, since many corporate issues are callable, B is always a
safe answer.
Abdul Ramaswamy’s department has been analyzing the company’s investments in mortgage-
backed securities using nominal spreads and zero-volatility spreads. Some of the elements which
may enter the calculations for these spreads are:
(i) yield of a Treasury instrument with maturity equal to the weighted average remaining
maturity of the mortgage pool underlying the MBS,
(ii) yield of a Treasury instrument with maturity equal to the average life of the MBS,
(iii) spot rates for the entire Treasury yield curve,
(iv) expected cash flows for the MBS through its maturity,
(v) market price of the MBS.
A. have already accounted for expected prepayment and therefore accounted for the
embedded prepayment option in the MBS
B. have already accounted for expected prepayment but have not accounted for the
embedded prepayment option in the MBS
C. have not accounted for prepayment
D. are the same as the cash flows from the MBS with no prepayment.
Abdul wants to use more sophisticated techniques, such as option-adjusted spreads (OAS), to
analyze the MBS.
Abdul decides to use a Monte Carlo model to analyze the MBS. He uses an interest rate volatility
of 10% and obtains an OAS of 50 bp for a FNMA certificate. Later, he realizes that an interest
rate volatility of 12% is more appropriate.
24. As the assumed volatility goes up, the value of the embedded prepayment option in the
FNMA certificate
A. goes up
B. goes down
C. may go up or down
D. stays constant if the Monte Carlo model is properly calibrated to the interest rate
volatility.
Abdul has some experience with OAS in her work analyzing callable and putable bonds. After
analyzing a few MBS, Abdul feels that she understands a lot more about OAS.
20. C. Take the expected cash flows and discount them at the appropriate spot rates plus a
constant spread. This will result in a certain PV. Using trial and error, change the spread
until this PV equals the market price. This spread is the zero-volatility spread.
21. B. The embedded prepayment option manifests itself as different cash flows under
different interest rate conditions. One therefore need many cash flow scenarios to fully
appreciate the option-like characteristics. A single set of expect cash flows simply will
not do.
22. C.
25. B. When the volatility is increased to 12%, the embedded prepayment option is more
valuable. However, the FNMA is short such an option. Therefore the new model value of
the FNMA at 12% volatility is lower than the old model value at 10% volatility. The latter
must equal the market price, by definition of the OAS.
26. B. Think of the opposite case of 10. When volatility goes down, the OAS of a FNMA
goes up. In the extreme case when volatility goes to zero, the new OAS becomes the
zero-volatility spread. This must be higher than the old OAS.
27. B. Same reasoning as in an MBS. Like an MBS, a callable bond is short the embedded
call option. When volatility goes up, the embedded call option increases in value; hence
the model value of the callable bond decreases. To bring the model value back up to the
market price, one must decrease the OAS.
Tim Lopez is an analyst at Wo Chong, a major manufacturer and wholesaler of tofu. The sale
price of tofu is very stable. However, the cost of production fluctuates with the cost of the
ingredients, mainly soybeans.
Tim wants to hedge the cost of production with soybean futures. He wants to run a regression of
the cost of production against soybean futures prices:
∆COSTt = a + b ∆SOYBEANt + et
∆COSTt = change in cost of production in $ per lb of tofu
∆SOYBEANt = change in soybean futures price in $ per bushel
Tim understands that the regression results will tell him if hedging will be effective or not.
Tim wants to hedge the production cost of 1,000,000 lbs of tofu. Each soybean futures contract is
for 5,000 bushels. The July contract is trading at 564.75 ($5.6475 per bushel).
30. If Tim decides to hedge, the number of soybean futures contracts to buy or sell is
A. 1
B. 13
C. 325
D. 3,072.
Rightly or wrongly, Tim decides to hedge, and buys or sells the appropriate number of contracts.
A month later, he finds that production cost of tofu has gone up from $0.48 per lb to $0.50 per lb.
The July soybean futures contract is now trading at 594.75.
31. The cumulative mark-to-market cash flow over the month from the soybean futures
contract(s) is
A. negative $1,500
B. negative $19,500
C. positive $19,500
D. positive $921.60.
A. a gain of $19,500
B. a loss of $20,000
C. a gain of $500
D. a loss of $500.
The portfolio of Prime based loans have a current aggregate balance of $400 million. The
balance will decrease over time as borrowers are required to make principal payments every
month. The average life of a loan is 10 years.
In 2003, Nisei Bank stepped right into the 20th century and discovered a wide variety of swaps
besides the plain vanilla swap.
35. To best stabilize its earnings, Nisei Bank should enter into
A. an accreting swap
B. an amortizing swap
C. a basis swap to receive LIBOR and pay Prime
D. a yield curve swap.
Answers to Questions
28. The correct answer is D. Either a positive or a negative b can work. Tim can buy or sell
depending on the sign of b. However, if b is zero, then there is no hedge.
29. The correct answer is A. In buying soybean futures, Tim is locking in the price at which
Wo Chong can buy soybeans. That is the hedge.
30. The correct answer is B. From the regression, b = 0.0651 bushels of soybeans per lb of
tofu. Tim wants to hedge 1,000,000 lbs of tofu, therefore he should hedge with 1,000,000
31. The correct answer is C. Remember that each contract covers 5,000 bushels. A price
change from 564.75 to 594.75 means an increase in price from $5.6475 per bushel to
$5.9475 per bushel. Since Tim is long 13 contracts, the cumulative mark-to-market cash
flow is positive. The amount is 13 * 5,000 * ($5.9475 − $5.6475) or $19,500.
32. The correct answer is D. Loss from increase in production cost of tofu = 1,000,000 *
($0.50 − $0.48) = $20,000.
Gain from futures = 13 * 5,000 * ($5.9475 − $5.6475) = $19,500.
Net position = $19,500 − $20,000 = −$500.
33. B. The bank receives Prime, which fluctuates and causes earnings instability. When
Prime goes down, earnings go down, as does LIBOR. If the bank is long Eurodollar
futures, the futures position gains when LIBOR goes down, thus providing a hedge.
34. B. Matching the notional balance of the swap with the aggregate balance of the loan
portfolio is important. This swap will only hedge the earnings for the first five years. A
naïve view of D might lead one to think that 5 years at $800 million is equivalent to 10
years at $400 million. It isn’t.
35. B. The amortizing swap will take care of the declining aggregate balance of the portfolio
quite nicely. The basis swap in C merely exchanges the instability from Prime for the
instability from LIBOR. However, it is very useful when combined with a fixed for
floating swap. See question 5.
John Gambol is considering the purchase of JGD stocks and options for his company’s portfolio.
JGD stocks are currently trading at $100 per share. JGD options are available in European puts
and calls. The times to expiration are three months, six months, and nine months. Strike prices
are $90, 95, $100, $105 and $110. All combinations are possible for a total of 2 x 3 x 5 or 30
options.
37. If JGD stocks go up, the highest dollar payoff at expiration would come from
Of course, it is now prior to expiration. John is interested in doing some day trades to take
advantage of short-term stock price movements.
38. If JGD stocks go down, the biggest dollar gain per option would come from
39. If JGD stocks go up, the biggest return on investment would come from
John soon finds that day trading has its rewards, but comes with risks as well. His next strategy is
to buy or write options but hold the position until expiration.
40. If JGD stocks go up, the following option strategy would gain
41. If JGD stocks go up substantially, the following option strategy would have the most gain
A. long a straddle
B. long a strangle
C. long a butterfly spread
D. long a bull spread
43. If JGD stocks stay within a narrow range, the following option strategy would gain
Answers
36. B. The cheapest call is the one that is the most out-of-the-money and the closest to
expiration.
38. C. This is another question about the delta of options. The call delta is positive; so D is
out since the stock goes down. The put delta always negative; but since the stock goes
down, that implies a gain. The magnitude of the put delta increases as the option gets
more in-the-money. The deepest in-the-money put is C.
39. D. The return on investment is the increase in option value divided by the option cost.
From question 4, we know that the increase in option value is higher for the more in-the-
money calls. However, the in-the-money calls cost a lot more. Therefore the return on
investment is not as great as that of the out-of-the-money calls. If one were to rank the
return on investment from lowest to highest, it would be A, B, C, and D.
40. D. A short put position gains since the put remains unexercised. A long bull spread gains.
A short bear spread is identical to a long bull spread.
41. A. C can be eliminated easily since a long butterfly spread loses when stock prices go up
at lot. D can be eliminated because a bull spread gives up the extreme upside potential. A
straddle gains more than a strangle in extreme price movements. If this were not so, a
strangle would dominate a straddle in that it would have a better return at any stock price.
Another way of looking at this is the following. A straddle involves buying an at-the-
money call and an at-the-money put. A strangle involves buying an out-of-the-money call
and an out-of-the-money put. The straddle obviously costs more than the strangle, and
therefore should have better upside potential.
43. D. When stocks trade within a narrow range, a short straddle gains, a short strangle gains,
a long butterfly spread gains, and a long condor spread gains.
A. -32.60
B. -21.00
C. +144.82
D. -103.50
Answer: B.
Covariance = 1/nΣ(xi – xavg)(yi – yavg), where
Average of x = 4%
Average of y = 3%
[(4-4)(-6-3)+(-10-4)(8-3)+(8-4)(12-3)+(14-4)(-2-3)] / 4 =
[(0) + (-70) + (36) + (-50)] / 4 = -84 / 4 = -21.00
Investment Y:
{[(-6-3)2 + (8-3)2 + (12-3)2 + (-2-3)2] / 4}1/2 =
{[(81) + (25) + (81) + (25)] / 4}1/2 = (53)1/2 = 7.28
A. -0.3267
B. -0.8144
C. +0.0161
D. -0.6599
Answer: A.
r = Covxy / (SDx)(SDy)
r = -21.00 / (8.83)( 7.28) = -21.00 / 64.28 = -0.3267
47. The expected rate of return of a portfolio consisting of 40% Investment X and 60%
Investment Y is:
A. 3.3%
B. 3.8%
C. Cannot be answered with data provided
D. 3.4%
Answer: D.
E(Rp) = E(Rx)(%x) + E(Ry)(%y) =
(.04)(.4) + (.03)(.6) = (.016) + (.018) = .034 = 3.4%
48. The standard deviation of a portfolio consisting of 40% Investment X and 60%
Investment Y is:
A. 21.44
B. 13.89
C. 3.88
D. 4.63
A. +.02%
B. -.02%
C. +1.8%
D. +4.02%
Answer: B.
Alpha is the difference between Estimated Return and Required Return (as determined
by the Security Market Line under the Capital Asset Pricing Model)
Required return of Investment B = Risk Free Rate + Beta(Return of the Market – Risk
Free Rate).
Required Return of B = .03 + 1.1(.11 - .04)
Required Return of B = .03 + .077 = 10.7%
Below is selected data from String Corporation’s acquisition of Cord Corporation on January 1,
2001. On that date, String acquired, for cash, all of the outstanding $5 par value voting stock of
50. Which one of the following accounting methods would be appropriate to account for this
business combinations?
A. Pooling Method
B. Purchase Method
C. Cost Method
D. Equity Method
51. What is the primary difference between the Pooling Method and the Purchase Method
accounting for a business combination?
A. The Pooling Method values the assets and liabilities at Fair Market Value.
B. The Purchase Method combines net income for the entire year.
C. The Purchase Method values the assets and liabilities at Fair Market Value.
D. Goodwill is only created using the Pooling Method.
52. Assume both companies are located in a foreign country where the International
Accounting Board Standards (IASB) apply for the purchase method.
A. The fixed asset turnover ratio will increase under the pooling method.
B. The fixed asset turnover ratio will decrease under the pooling method.
C. The use of pooling method, under IASB, will result in a more consistency of
financial ratios.
D. The use of the purchase method under USGAAP and IASBGAAP will result in a more
consistency of financial ratios.
54. At year end December 31, 2001 what was the amount of inter-company sales from String
to Cord?
A. 27,000
B. 6,000
C. 12,000
D. 40,000
55. At year end December 31, 2001, what was the amount of inter-company Cord’s payable
to String for inter-company purchases?
A. 27,000
B. 6,000
C. 12,000
D. 40,000
You are given the following information about the Turkey and the U.S.:
Spot Rate in 1995
Turkish lira per US$ e1995 = l 59,650/US$
Price Level Index in 2000 (Base Year 1995 = 100)
PTurkey2000 = 1521.6
PUS2000 = 112.7
56. Using the above information, the PPP spot exchange rate for the US$ in terms of Turkish
lira in 2000 was closest to:
Junior Johnson, an international fixed income analyst, is given the following information
regarding the current spot rate and interest rates for the U.S. and Australia:
Table I
Current Spot Rate
Australian$/US$ AU$ 1.620/US$
Annual Interest Rate 3-month Gov’t 2-Year Gov’t
Australia 4.80% 4.68%
U.S. 1.22% 1.65%
57. The 3-month forward exchange rate between the Aussie dollar and the US dollar implied
by the information in Table I is closest to:
A. AU$ 1.565/US$
B. AU$ 1.677/US$
C. US$ 1.645/AU$
D. AU$ 1.634/US$
Take Australia as home country given the way the exchange rate is quoted.
Covered Interest Parity Condition requires:
AU 3-month return = Hedged 3-month US Return
[1+rAU/4) = 1/e0 x (1+rUS/4) x f3-month
(1 + .0480/4) = (1/1.620) x (1.0122/4) x f3-month
Solving for the 3-month forward from above yields f3-month = 1.620 x (1.0120/1.0031) = 1.634
58. Using the information in Table I above, Junior Johnson’s expected future spot exchange
rate for the US$ in terms of AU$ for two years in the future is closest to:
A. AU$ 1.668/US$
Australia is the Home Country and the EXR given is in Direct terms so that formula can be applied
in straightforward way. To construct a two-year in the future forecast you must adjust the annualized
interest rates to take into account the two-year forecast horizon.
Forecast Rate2005 = EXR2003 x [1+rAU]2/[1+rUS]2
Forecast Rate2005 = AU$1.62/US$ x [1.0468/1.0165]2 = AU$ 1.7180/US$
According to a poll of forecasters by The Economist magazine the expected inflation rate for the
U.S. is 1.8% this year and 1.5% next year, while the expected inflation rate for Australia is 2.7%
this year and 2.5% next year.
59. Using this information instead, Johnson’s expected future spot exchange rate for the US$
in terms of AU$ for two years in the future is closest to:
A. AU$ 1.635/US$
B. AU$ 1.650/US$
C. AU$ 1.689/US$
D. AU$ 1.718/US$
Using inflation differentials leads to a forecast for a smaller depreciation in the AU$ than does
using the interest rate differentials
Forecast Rate2005 = EXR2003 x {[1+πAU]2003 [1+πAU]2004}/{[1+πUS]2003 [1+πUS]2004}
60. Johnson’s supervisor decides that the best forecast for the Aussie dollar/US$ exchange at
the end of two years is AU$ 1.635/US$. Using this forecast and the information from
Table I, the expected US$ total return from a two-year investment in Australia
government bonds is closest to:
A. 3.72%
B. 8.57%
C. 7.44%
D. 5.04%
61. It is two years later. The actual exchange rate runs out to be AU$1.69/US$. The actual
total return from a two-year investment in Australia government bonds is closest to:
A. 3.72%
B. 8.57%
C. 7.44%
D. 5.04%
62. The exchange rate at which a Japanese bank will buy Phillipine pesos spot is closest to:
A. ¥ 2.1355/peso
B. ¥ 2.1413/peso
C. ¥ 0.4683/peso
D. ¥ 2.1422/peso
63. The value of the rate at which a Japanese bank will sell Phillipine pesos on the three-
month-forward is closest to:
A. ¥ 2.1301/peso
B. ¥ 0.4716/peso
C. ¥ 2.1224/peso
D. ¥ 2.1206/peso
A. Firm A
B. Firm B
C. Firm C
D. All the firms are equally sensitive.
65. An appreciation of the Euro against the US$ is likely to result in the greatest decrease in
the Debt/Equity ratio of which of the above three firms?
A. Firm A
B. Firm B
C. Firm C
D. All the firms are equally sensitive.
E(RSOP) = 0.032 + 1.245 RPW + 1.367 SRP¥ + 0.89 SRP€ + 0.45 SRP£
(0.015) (0.056) (0.987) (0.097) (0.109)
2
R = 0.346 N = 120
66. Which is the least significant currency exposure that this firm faces based on the results
of the above regression?
67. Based on the results of the ICAPM regression, which of statement is correct?
A. R2 is low indicating the model does not explain the firm’s returns adequately.
B. R2 is high indicating the model explains the majority of the firm’s returns.
C. R2 indicates the systematic risk in the firm’s returns.
D. R2 indicates the idiosyncratic or diversifiable risk in the firm’s returns.
69. Under ICAPM’s assumption regarding the behavior of international capital markets, what
is the least likely source of problems in the residuals of the regression?
A. Problems arising from omitting an important currency risk premium in the regression.
B. Heteroscedasticity due to changing volatility in foreign exchange markets.
C. Serial correlation arising from market inefficiency.
D. Multicollinearity due to the correlation between the world risk premium and the
currency risk premiums.
70. SOP’s expected US$ return based on the ICAPM regression and the information given
above is closest to
A. 12.17%
B. 13.04%
C. 13.82%
D. 14.70%
Interest expense 22 25
Income before taxes $250 $400
LIFO Reserve 10 15
Accumulated Goodwill Amort 10 17
Year End Market price per share $21.00 $23.00
(Total 15 minutes)
2000: 2001
Yr End Shares 320 360
x Yr End Stock Price $21 $23
Market Value of Equity $6,270 $8,280
73. Calculate the Market
Value Added in 2001.
Book Value of Debt: 300 350
(Assume that book value
Total Market Value: $6,570 $8,630
of debt equals market
Difference $2,060
value of debt.)
Invested Capital
(6 minutes)
(From Question 2. Above) 1,502 2,202
Difference $ 700
Question 71:
Correct Cash Operating Taxes 1
Correct Adjusted EBIT 1
Correct Final Result (NOPAT) 1
Question 72:
Correct Cost of Equity 2
Correct Weighted Avg Cost of Capital 2
Correct Adjustment for Capital 2
Question 73:
Correct Market Value 2
Correct Invested Capital 2
Correct Final Result (MVA) 2
Cost leadership. The firm seeks to be the low cost provider in the
industry and seeks to achieve lower operating costs across all product
74. List and describe three
lines. Prices are set at or jut below the industry average. The product
types of competitive
should be homogeneous.
strategies that allow a firm to
obtain a competitive Differentiation. The firm focuses on product attributes that are
advantage. important to buyers. The firm can charge a premium price for these
benefits.
(1½ minutes) Focus. A focuser attempts to achieve cost leadership or product
differentiation within a product niche.
80. An analyst has determined that the required rate of return for an equity investment in
shares of XYZ is 10.5%. If the risk free rate is 6% and XYZ’s beta is 1.2, calculate the
current equity premium.
This is a derivation of the risk premium from the CAPM and is solved algebraically:
81. XYZ is not expected to pay a dividend until 10 years from now, at which time it is
expected to pay a dividend of $1.25 and to increase the dividend at a rate of 6%
thereafter. If the required rate of return is 7%, calculate the current value of XYZ.
$1.25
V0 = = $67.99
(0.07 - 0.06) x (1 + 0.07)9
It is discounted back for nine years since it is next year’s dividend that is discounted
back.
(2 minutes)
82. XYZ is a stable firm with earnings and dividends expected to grow at 4% indefinitely. If
the current dividend is $1.23 and the current value of XYZ is $17.00, calculate the
required return.
D1 $1.23 x (1.04)
r = +g= +.04 = $11.52%
Po $17.00
(2 minutes)
83. A firm has a net income of $1.8 million on sales of $40 million, average assets of $40
million, and stockholders’ equity of $25 million. If the firm distributes 30 percent of its
profits as dividends, calculate the Sustainable Growth Rate.
1,800,000
g = ROE x b = x (1 - 0.30) =5.04%
25,000,000
(2 minutes)
84. If the required rate of return is 7%, calculate the value of a $100 par 5.5% fixed-rate
perpetual preferred share.
The formula for fixed rate preferred is the same as that of a stock with no expected
increase in dividends:
The Gray furniture company earned $3.50 per share last year. Investment in fixed capital was
$2.00 per share, depreciation was $1.60, and the investment in working capital was $0.50 per
share. Gray is currently operating at their target debt ratio of 40 percent, meaning 40 percent of
new working capital and fixed capital will be financed with new borrowings.
85. Calculate the value of Gray’s stock if the shareholders require a return of 14 percent on
their investment and the expected rate of growth in free cash flow to the equity is 4
percent per annum.
$2.96 x (1.04)
Equity value per share = = $30.78
0.14 - 0.04
(4 minutes)
The Anderson Door Co. earned $30 million before interest and taxes on revenues of $80 million
last year. Capital expenditures were $20 million, and depreciation was $15 million. The
additions to working capital were $6 million. Anderson is currently operating at their target debt
ratio of 25 percent, and their tax rate is 40 percent. The shareholders require return of 15 percent
on their investment, the firm’s cost of debt is 8 percent, and the expected growth rate in firm cash
flows is 5 percent. The market value of debt is $25 million.
86. Calculate the value of the firm and the value of the firm’s equity.
$7,000,000 x (1.05)
Value of the firm = = $98,657,718
0.1245 - 0.05
Given that the firm has $25 million in outstanding debt, the aggregate value of equity is
$98,657,718 - $25,000,000 = $73, 657,718.
(4 minutes)
FCFFirm models can be used to value a firm’s equity by first valuing the entire firm
and then subtracting the value of the debt. This approach should yield the same
estimate of equity value as an FCFEquity model if (1) consistent assumptions are made
about growth in the two approaches, and (2) the firm’s debt is correctly valued.
It is more appropriate to use an FCFFirm model to value a firm’s equity if the firm has
significant financial leverage or it is making substantial changes to its capital structure.
(2 minutes)
The stock of Western Graphics Co. paid a dividend of $0.40 per share last year on earnings of
$1.00 per share. The firm’s earnings and dividends are expected to grow at 5% per year forever.
88. Calculate the justified trailing price to earnings multiple based on these forecasted
fundamentals for Western’s stock if shareholders require a return of 12% on their
investment.
Trailing P/E
Po (1 - b) x (1 + g) ($0.40/$1.00) x (1.05)
= = = 6.0
Eo r-g 0.12 - 0.05
(2 minutes)
An analyst is valuing an electric utility with a dividend payout ratio of 0.65, a beta of 0.56, and
an expected earnings growth rate of 0.032. A regression on other electric utilities produces the
following equation:
Predicted P/E = $8.57 + (5.38 x dividend payout) + (15.53 x growth) - (0.61 x beta).
Predicted P/E = 8.57 + (5.38 x 0.65) + (15.53 x 0.032) – (0.61 x 0.56) = 12.2
(2 minutes)
A junior portfolio manager has been asked to consider price-to-cash flow for the analysis in
making a recommendation for an addition to the portfolio. She has gathered the following
information:
90. Compare the valuation of XYZ with ABC and make a recommendation for an addition
to the portfolio.
XYZ appears to be undervalued relative to ABC. This conclusion is based on (1) XYZ
is selling at a P/CF of 20.88, which is 88% of the P/CF for ABC (23.9), and (2) the
P/FCFEquity for XYZ (28.69) is 22% of the P/FCFEquity for ABC (132.78). An
investor can buy XYZ’s cash flow for a lower multiple and gets higher expected
growth, based on consensus growth forecast of 22.2% for XYZ relative to 17.5% for
ABC.
(2 minutes)
91. Explain the relationship between the residual income (RI) approach to valuation and
dividend discount model (DDM) and free cash flow to equity (FCFEquity) alternatives.
However, the recognition of value is different because FCFEquity and DDM models
forecast future cash flows while RIMs start with a balance sheet measure of equity and
the present value of expected future RI. An RIM can be used along with other models
to assess the consistency of results.
(2 minutes)
The company has noncontributory defined benefit plans covering substantially all U.S. employees. The
benefits for these plans are based primarily on years of service and employees' pay near retirement. The
company's funding policy is consistent with the funding requirements of federal law and regulations.
The projected benefit obligation was determined using a discount rate of 9 percent at December 31, 2002
and 7.25 percent at December 31, 2001, and an assumed long-term rate of compensation increase of 5
percent. All quantities are in millions of $.
The Plan assets consist principally of common stocks and U.S. government obligations. The expected
rate of return on plan assets is 9.25%
92. Which one of the following quantities is the most appropriate measure of the firm’s
pension obligation in the event of the firm’s liquidation – VBO, ABO, PBO or Fair
Market Value of the Plan Assets? Provide a brief justification for your choice.
PBO takes into account expected future increases in worker salaries. If the firm is expected to be
liquidated this clearly overstates the pension obligation of the firm.
FMV of Plan Assets measures the ability to meet the pension obligation.
VBO measures the obligation that the firm has towards workers even if they leave the firm.
The most appropriate measure is the ABO as it captures the obligation to existing workers
based on their existing salary structure.
(1 minute)
93. Calculate the value of the Interest Cost for the firm’s pension plan during the year 2002.
94. Calculate the value of the Service Cost for the firm’s pension plan during the year 2002.
95. Calculate the value of the Reported Pension Expense for the firm’s pension plan during
the year 2002.
96. Calculate the value of the Actual Economic Pension Expense for the firm’s pension plan
during the year 2002.
Pension Expense = Service Cost + Interest Cost – Actual Return on Plan Assets
= $499 + $645 – (–89) = $1,233
(2 minutes)
95. Calculate the Book Value of Pension Assets for the firm’s pension plan on December 31,
2002.
BVend
= BVBegin + Expected Return on Plan Assets + Employer Contributions – Benefits Paid
= $5678 + $6,197 x .0925 + $84 – $493 = $5,842
(2 minutes)
96. Calculate the Minimum Liability Adjustment for the firm’s pension plan on December
31, 2002.
(2 minutes)