Mock CFA Exam

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All mock CFA questions come directly from our TestBank Software. TestBank allows you to choose to see "only 3" or "all available" answer choices. Level I TestBank contains 6,400+ questions.

Total Questions:
Total Answered:
Total Correct:
Percent Correct:

Please review the answers and rationale for each question below.

Question:
Rebecca Dustin, a freelance research analyst, is currently working on a research study on the pharmaceutical industry for KLM Brokerage. She has been using KLM's research facilities in this endeavor. There has been no written agreement between Rebecca and KLM about the project, though there was a verbal agreement that KLM would provide reasonable support for the research. In return, KLM would pay for the final report in case she uncovers something worthwhile. Rebecca is now interviewing with Jacob & Associates, another brokerage firm, for a project and is considering submitting a rough draft of her KLM study to them. If she does this without KLM's permission, she would:

Answer Choices:
not be violating CFA Institute Standards, since she is not under any written obligation to KLM.

be violating Loyalty - because KLM has first rights over the study.

be violating Loyalty - because KLM has property rights over the study.

not be violating CFA Institute Standards, because she is the owner of the study.

Rationale:
Since Rebecca is acting as a freelance analyst under no written contractual agreement with KLM, the study does not belong to KLM. However, the verbal agreement and the support received from KLM make the first right to use the report a KLM property. Hence, Rebecca must allow KLM sufficient time to act upon her study before using it for any other purpose. Without KLM's permission, Rebecca cannot release the report without violating Loyalty.

9804

Question:
Neeson Pacino is the senior vice president in the corporate finance arm of Hindenberry Brokerage. Neeson was recently approached by Curare Creators, a pesticide manufacturer. Curare would like to offer new equity to raise capital and has provided Neeson with its current balance sheet and details about the pending projects.

Neeson carefully goes over the numbers with a couple of project managers at Curare and also two of his analysts at Hindenberry. He concludes from these discussions that the numbers presented by Curare are overly optimistic. The revised numbers would seriously lower the offering price. Not relishing this prospect, Neeson decides to go ahead with the numbers as drawn up by Curare and directs the department to prepare the IPO with the offering price.

Neeson has violated _______.

Answer Choices:
Misrepresentation

Duty to the Employer

Fair Dealing

Loyalty, Prudence, and Care

Rationale:
By knowingly misrepresenting the situation, Neeson has allowed the possibility that investors would end up paying more than the fair price in the seasoned equity offering.

He has thus violated Misrepresentation.

9832

Question:
Trust Fund is a reasonably successful investment management firm that has as its clients a few pension plans. Trust Fund executes all of its trades with Prime Brokerage, an average brokerage firm. Prime Brokerage charges higher commissions than comparable players in the market but in return, provides investment research on the stocks which are part of the pension plan assets under Trust Fund's management.

Portfolio managers at Trust Fund know about the close relationship on the golf links between Prime Brokerage's chief broker, Ralph Fiennes, and Trust Fund's CEO, Armis Arvanitis. They also believe that the research provided by Prime Brokerage, while not superlative, is quite useful and justifies the excess expense in brokerage. This "soft-dollars" practice is disclosed in Trust Fund's official documents and contracts. However, Sisko, a freshly minted CFA charterholder, thinks that Trust Fund's managers are in violation of the Code of Ethics.

Which of the following is true?

Answer Choices:
Trust Fund's managers are violating Referral Fees by not revealing the arrangement to pension plan beneficiaries.

Trust Fund's managers are violating Fair Dealing by unfairly diverting funds from the plan assets to Prime Brokerage through higher fees.

Sisko is not applying the Standards correctly. Trust Fund's managers are not violating any CFA Institute Standards.

Trust Fund's managers are violating Loyalty, Prudence, and Care by not executing the trades at the lowest price available.

Rationale:
The practice of using "soft dollars" (i.e., the usage of brokerage for purchase of research services) is not forbidden by CFA Institute Standards or securities laws, as long as they are commensurate with the services received and the practice is disclosed to the clients. In this case, there is no evidence that Trust Fund is overpaying Prime Brokerage or that it is not seeking best price and execution. Hence, Sisko is mistaken and Trust Fund managers are not in violation of CFA Institute Standards.

9851

Question:
In investment management applications, the internal rate of return (IRR) is commonly referred to as which of the following?

Answer Choices:
dollar-weighted rate of return

intrinsic rate of return

time-weighted rate of return

cost-averaged rate of return

dollar-averaged rate of return

Rationale:
Performance presentation is an important consideration in the field of investment management, and often involves a rather complex series of calculations. This is particularly true for portfolio's which are characterized by significant additions and withdrawals, as the cash flow measurement is periodically disrupted. In the Level I readings, two specific measurement tools are discussed: the dollar-weighted rate of return and the time-weighted rate of return. In investment management applications, the IRR equation is commonly referred to as the "dollar-weighted rate of return" because it incorporates both the timing and size of all cash flows in the determination of the return figure.

16161

Question:
Suppose you were given $4,000 today and deposited it into an account paying 8% per year, compounded monthly. If you know that you will need $5,000 in the account 6 years from now, what monthly withdrawal can you make from the account, beginning one month from now, that will leave the account with exactly $5,000 in it in 6 years?

Answer Choices:
$204.45

$123.45

$1.23

$15.80

Rationale:
On the BAII Plus, press 72 N, 8 divide 12 = I/Y, 4,000 PV, 5,000 +/- FV, CPT PMT. Make sure the BAII Plus has the value of P/Y set to 1.

On the HP12C, press 72 n, 8 ENTER 12 divide i, 4,000 PV, 5,000 CHS FV, PMT.

Note that the answer is a negative number. This is because it is a withdrawal from the account balance, just like the $5,000. It is a very small value because most of the $4,000 is needed to ensure there is $5,000 in the account in 6 years.

10092

Question:
The following is a distribution of monthly commissions:

Monthly Commissions	Class Frequencies
$600 - $799	3
$800 - $999	7
$1,000 - $1,199	11
$1,200 - $1,399	22
$1,400 - $1,599	40
$1,600 - $1,799	24
$1,800 - $1,999	9
$2,000 - $2,199	4

Referring to the table above, what is the relative frequency for those salespersons that earn between $1,600 and $1,799?

Answer Choices:
2%

2.4%

24%

20%

Rationale:
The sum of all the class frequencies is 120.

The relative frequency for the $1,600 - $1,799 class is therefore 24/120 = 20%.

10212

Question:
Suppose you have a discrete uniform probability function such that p(X = x) = 20% for X values of 0, 1, 2, 3, and 4. Find F(3).

Answer Choices:
80%

40%

10%

70%

20%

50%

60%

Rationale:
F(3) is the probability that the function takes on values less than or equal to 3. So F(3) = P(0) + P(1) + P(2) + P(3) = 0.20 + 0.20 + 0.20 + 0.20 = 0.80 = 80%.

10564

Question:
A resistance level:

Answer Choices:
is the price range above the current price at which the technical analyst would expect the stock supply to increase, abruptly reversing any price increase. A resistance level tends to develop after the stock has experienced a decline from a higher price level.

is the price range below the current price at which the technical analyst would expect the stock supply to increase, pushing down its price below that range. A stock nearing that range would be a good candidate for short selling because of the negative price support that it would receive.

is the price range below the current price at which the technical analyst would expect the stock to get an added boost of demand, keeping its price from falling below that range. The resistance level is usually near the 12-week low.

is the price range above the current price at which the technical analyst would expect the stock price to get an added boost of demand, pushing its price even higher. If the stock price makes it to the resistance level, future gains are expected.

Rationale:
Technical analysts believe that investors who have acquired a stock at a higher price will look for an opportunity to sell it near their break-even points. A resistance level is the target price range that these investors look for to sell their stock at minimum or no loss. Such a price range tends to develop after the stock has experienced a decline from a higher price level.

16153

Question:
A sample of 10 observations is drawn from a population with mean 17. The mean of the observations equals 14.3 and the sample standard deviation equals 4.8. The sampling error in mean equals ________.

Answer Choices:
4.8

9.6

-2.7

14.3

Rationale:
"Sampling error" refers to the difference between a sample statistic and the corresponding population parameter.

In this case, the sampling error equals 14.3 - 17 = -2.7.

43820

Question:
When a product is produced with a fixed factor and a variable factor, the marginal product of the variable resource will eventually diminish as the output of the firm expands. This diminishing returns to the variable factor explains why:

Answer Choices:
average fixed costs eventually diminish.

marginal costs eventually decrease.

average fixed costs eventually increase.

marginal costs eventually increase.

Rationale:
Marginal costs represent the additional cost associated with producing one more unit of output. If the marginal product of variable factors declines, this implies that the additional output associated with one more unit of input used diminished. Thus, it eventually takes more and more variable input to produce one more unit of output. Therefore, the marginal cost of one more unit of output rises if the number of variable inputs required to produce increases.

12403

Question:
A profit-maximizing firm would:

Answer Choices:
increase output in the next period if accounting profits during the previous period were positive.

expand current output if the revenues expected from doing so were less than the expected costs.

enlarge its current plant size if present depreciation costs were less than average variable costs.

consider opportunity costs rather than accounting costs when making decisions about output levels.

Rationale:
A profit-maximizing firm considers economic rather than accounting profits. Economic profits consider opportunity costs in the calculation and therefore more accurately reflect the true rate of return enjoyed by investing in the firm.

12450

Question:
An analyst has acquired the following price-quantity data for the commodity ZYX over the period between t = 0 and t = 1:

P₀ = $50
P₁ = $60
Q₀ = 600 units
Q₁ = 500 units

Over the examined period, the price elasticity of demand for commodity ZYX is approximately equal to _______.

Answer Choices:
0.0017

10.00

1.20

-1

Rationale:
The formula for the price elasticity of demand is as follows:

Percent change in quantity demanded / Percent change in price, where:

Percent change in quantity = (Q₀ - Q₁)/[(Q₀ + Q₁)/2] x 100 and the Percent change in price = (P₀ - P₁)/[(P₀ + P₁)/2] x 100

By plugging in the above figures into the formula, we find that dividing the percentage change in the quantity demanded (18.18) by the percentage change in price (-18.18) is equal to -1.

44512

Question:
Unlike a monopolistic competitor, an oligopolist cannot determine the product price that will deliver maximum profit simply by estimating demand and cost conditions. This is due to the fact that:

Answer Choices:
the oligopolist faces a downward-sloping demand curve, while the monopolistic competitor faces a horizontal demand curve.

the demand for an oligopolist's product tends to fluctuate more in the short run.

an oligopolist must predict how rival firms will react to price and quantity adjustments.

cost conditions are more volatile under oligopoly because of the large variance in economies of scale.

Rationale:
A key factor in determining the demand facing an oligopolist is the pricing behavior of close rivals. Thus, an oligopolist must predict how consumers will react to options and also how rival firms will react to alternative prices. Thus, it is impossible to determine the precise price and output policy that will prevail in oligopolistic industries.

12841

Question:
Sellers have a strong incentive to avoid competitive pressures in their market because:

Answer Choices:
externalities are normally reduced when a market is less competitive.

economies of scale are almost always present; therefore, costs and prices will decline if competition is reduced.

competition tends to lower prices and profit margins.

they wish to be more efficient than competition will permit.

Rationale:
Since competition is the enemy of prices higher than costs, sellers have a strong incentive to escape from its pressures. When there are only a few firms in a market, rather than competing, sellers may be able to collude effectively and raise prices above the competitive level.

12118

Question:
Under what conditions can a monopolist have potentially lower costs and possibly charge a lower price than would exist if the market were competitive?

Answer Choices:
when substantial diseconomies of scale are present

when the monopolist operates on the inelastic portion of the demand curve

when the monopolist is a profit maximizer rather than a revenue maximizer

when substantial economies of scale are present

Rationale:
When significant economies of scale are present (usually due to the presence of enormous fixed costs) it is more efficient for one firm to produce the entire industry's output because it can do so at a lower average cost than many small rival firms.

12775

Question:
Suppose the government borrowed $140 billion and cut taxes in an equivalent amount. According to the Rational Expectations Theory:

Answer Choices:
there will be no systematic effect on aggregate demand or interest rates.

the domestic currency will depreciate, causing an increase in exports.

the economy will experience inflation due to increased consumption.

resource prices will fall, leading to lower unemployment.

Rationale:
If the people behaved according to the Rational Expectations Theory, they would recognize that the current tax cuts financed with debt would lead to an equivalent amount of higher future taxes. This would induce them to save all of the money they receive in tax cuts in anticipation of higher tax liability in the future. This is the basis of Rational Expectations Theory's claim that discretionary fiscal policy will not affect the economy in any systematic way. This means that aggregate demand, real GDP, and real interest rates will all remain unaffected.

11413

Question:
Which of the following will most likely increase the natural unemployment?

Answer Choices:
an increase in the number of youthful (under age 25) workers as a share of the labor force

an increase in the number of retired workers collecting Social Security

a decrease in the minimum wage

an increase in the number of prime-age (30-55) workers as a share of the labor force

a decrease in unemployment compensation benefits relative to market wage rates

Rationale:
Youthful workers experience more unemployment because they change jobs and move in and out of the labor force often. Therefore, as the number of youthful workers increases in the labor force, the natural rate of unemployment is likely to increase also.

10986

Question:
Which of the following is/are components of the M2 money supply?

I. Traveler's checks
II. Small money market deposits
III. Currency
IV. Small denomination CDs

Answer Choices:
I and IV

I, II, III, and IV

I and III

I, II, and IV

Rationale:
Note that I and III are included in the M1 money supply and the M2 money supply consists of the M1 supply plus savings deposits, including money market deposits, time deposits of less than $100,000, and small denomination money market mutual fund shares.

11572

Question:
If inventory at the end of the year is understated (too low), the effect will be to:

Answer Choices:
understate purchases.

overstate goods available for sale.

overstate gross profit.

overstate cost of goods sold.

Rationale:
Opening inventory plus purchases is goods available for sale. Ending inventory does not directly affect either of these, as both are historic facts and the total of the two is therefore fixed and known. However, goods available for sale consist of cost of goods sold plus ending inventory (cost of goods not sold), so if one is too low, the other is too high, and vice versa.

45110

Question:
Repurchase of a company's own shares at an amount greater than that for which they were originally issued is an example of what kind of activity?

Answer Choices:
Investing

Operating

Financing

Extraordinary

Rationale:
Dealings in long-term liabilities or equity are signs of financing activity.

45129

Question:
Adjusting entries are necessary to:

Answer Choices:
properly match revenues and expenses.

properly balance operating and non-operating cash flows.

adjust assets and liabilities to their fair market values.

provide the figure for net income that management desires.

Rationale:
Adjusting entries match revenues and expenses in the proper period. Fair market value and cash flow are not considerations, and management's wishes as per net income are not relevant.

45102

Question:
The major use of common-size statements is:

Answer Choices:
to compare the ratios of companies within an industry.

to standardize financial statement components by expressing them as a percentage of a relevant base.

to standardize financial statement components by expressing them as a percentage of sales.

to compare the profitability of several companies over time.

to provide definitive information as to the economic characteristics of different industries.

Rationale:
Balance sheet components can be shown as a percentage of total assets; revenues and expenses can be computed as a percentage of total sales. Common-size statements provide information as a first step in developing insights into the economic characteristics of different industries and of different firms in the same industry.

14230

Question:
The main use of the balance sheet for creditors would be:

Answer Choices:
to review the short-term liquidity of the firm.

to provide information about the nature of assets that the firm uses as debt collateral.

to forecast future cash flow needs.

to forecast cash collections.

to forecast changes in fixed assets thereby assisting in the firm's profitability.

Rationale:
The balance sheet provides information about a firm's resources and obligations, including liquidity and solvency.

13763

Question:
Extraordinary items are placed on the income statement:

Answer Choices:
after net income from continuing operations and before taxes.

as a footnote to the statement as they are 1 time items and are not a part of the normal course of business for a corporation.

after net income from continuing operations and net of tax.

within income from operations net of tax.

Rationale:
Extraordinary items are always included net of tax after the net income from continuing operations. These items are unusual items for the company and occur infrequently.

13724

Question:
The market price of a bond issued at a discount is the present value of its principal amount at the market (effective) rate of interest:

Answer Choices:
plus the present value of all future interest payments at the market (effective) rate of interest.

minus the present value of all future interest payments at the market (effective) rate of interest.

minus the present value of all future interest payments at the stated rate.

none of these answers.

plus the present value of all future interest payments at the stated rate.

Rationale:
The cash flows associated with a bond are the amount due at the end of the life of the bond (face value) and periodic payments. These cash flows are future payments and need to be converted to present value for balance sheet purposes. Present value is always based on the market (effective) rate.

14474

Question:
Roberts Inc. sold its factory at a gain and simultaneously leased it back for 10 years. The factory's remaining economic life is 20 years. The lease was reported as an operating lease. At the time of sale, Roberts should report the gain as:

Answer Choices:
an asset valuation allowance.

an operating gain.

a separate component of shareholders' equity.

an extraordinary item, net of income tax.

a deferred credit.

Rationale:
When the leaseback is classified as an operating lease, the gain is deferred and amortized. The amortization is in proportion to the gross rental payments expensed over the lease term.

14562

Question:
The average age percentage of fixed assets using the straight-line method equals:

Answer Choices:
Ending gross investment /Accumulated depreciation

Ending gross investment / Depreciation expense

Depreciation expense / Ending gross investment

Accumulated depreciation / Ending gross investment

Accumulated depreciation / Depreciation expense

Rationale:
As long as straight-line depreciation is used, this is an accurate estimate of asset age as a percentage of depreciable life.

14380

Question:
Under international accounting standards, permissible inventory valuation methods include:

Answer Choices:
specific identification, weighted average, LIFO, and FIFO.

specific identification, weighted average, lower of cost and market, LIFO, and FIFO.

specific identification, weighted average, lower of cost and market, and FIFO.

specific identification, weighted average, and FIFO.

Rationale:
LIFO is not allowed under international accounting standards. LCM is applied after a valuation under one of the other methods has been obtained, if inventory is deemed to be impaired.

45185

Question:
The "fraud triangle" represents three conditions that are generally present when fraud occurs. They are:

Answer Choices:
an addiction, a crisis, and a reasonable excuse.

greed, availability of funds, and need.

incentives, opportunities, and rationalizations.

a motive, a means, and an alibi.

Rationale:
Factors like greed, addiction, and specific motives are not always present.

45067

Question:
Which of the following accounting diversity problems imposes the greatest cost on investors?

Answer Choices:
lack of comparability of financial statements across different countries

the need for a company wishing to raise money on a foreign market to prepare financial reports in accordance with market rules and regulations

the need for a company with foreign subsidiaries to prepare financial statements in accordance with local accounting rules

different tax rates across countries

Rationale:
Lack of comparability of financial statements across different countries imposes the greatest cost on investors who wish to buy foreign securities (both debt and equity) or undertake an acquisition of a foreign company.

Different tax rates across countries is not an accounting diversity problem. Other answers refer to problems for companies that actually attract investments.

44949

Question:
Given that current assets equal $100, current liabilities equal $170, cash equals $23, marketable securities equal $34, and receivables equal $36, what is the quick ratio?

Answer Choices:
0.34

0.59

0.45

0.55

0.14

Rationale:
Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities

In this question, the ratio equals (23 + 34 + 36) / 170 = 0.55.

13948

Question:
Rollins Corporation is constructing its MCC (marginal cost of capital) schedule. Its target capital structure is 20% debt, 20% preferred stock, and 60% common equity. Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock, which pays a 12% annual dividend, but flotation costs of 5% would be incurred. Rollins' beta is 1.2, the risk-free rate is 10%, and the market risk premium is 5%. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.

The firm's policy is to use a risk premium of 4 percentage points when using the bond yield plus risk premium method to find k_s (component cost of retained earnings). The firm's net income is expected to be $1 million, and its dividend payout ratio is 40%. Flotation costs on new common stock total 10%, and the firm's marginal tax rate is 40%.

What is Rollins' cost of preferred stock?

Answer Choices:
12.6%

10.0%

12.0%

11.0%

13.2%

Rationale:
K_ps (cost of preferred stock) = $12 / ($100 × 0.95) = 12.6%.

14696

Question:
Your company is choosing between the following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your cost of capital is 10 percent.

How much value will your firm sacrifice if it selects the project with the higher IRR?

Project S

0	1	2	3
-1,000	500	500	500

Project L

0	1	2	3	4	5
-2,000	668.76	668.76	668.76	668.76	668.76

Answer Choices:
$332.50

$243.43

$291.70

$535.13

$481.15

Rationale:
NPV(S) = $243.43; IRR(S) = 23.38%.

NPV(L) = $535.13; IRR(L) = 20.00%.

Value sacrificed: $535.13 - $243.43 = $291.70.

14828

Question:
A portfolio consists of 30% invested in the risk-free asset and the remaining in an asset with 20% standard deviation. The risk-free rate equals 6% and the risky asset has an expected return of 14%. The correlation coefficient between the portfolio and the risky asset is ________.

Answer Choices:
0.00

0.14

1.00

0.20

Rationale:
Remember that the risk-less asset is uncorrelated with all other assets. Hence, the correlation between the portfolio and the risky asset equals +1 (i.e., they are perfectly positively correlated). All other information in the problem is irrelevant.

17453

Question:
Two risky assets, A and B, have the following scenarios of returns:

Probability	A	B
35%	10	7%
35%	-4%	4%
30%	9%	-6%

The covariance between the returns of A and B is ________.

Answer Choices:
-7.14%

2.05%

-1.54%

6.0%

Rationale:
The expected return is a probability weighted average of the returns. Using this definition, the expected return of A equals 0.35 × 10% + 0.35 × -4% + 0.3 × 9% = 4.8%.

The expected return of B equals 0.35 × 7% + 0.35 × 4% + 0.3 × -6% = 2.05%.

The covariance between the returns equals the expected value of the product of the deviations of the individual returns from their means. Remember this. Hence, to calculate this, we construct the following table:

Probability	R(A) - E(A)	R(B) - E(B)
35%	10% - 4.8% = 5.2%	7% - 2.05% = 4.95%
35%	-4% - 4.8% = -8.8%	4% - 2.05% = 1.95%
30%	9% - 4.8% = 4.2%	-6% - 2.05% = -8.05%

The expected value of the product of the deviations equals:

0.35 × 5.2% × 4.95% + 0.35 × -8.8% × 1.95% + 0.3 × 4.2% × -8.05% = -7.14%

17357

Question:
The ________ investment strategy is appropriate when investors want the portfolio to grow in real terms over time to meet some future need.

Answer Choices:
capital preservation

current income

total return

capital appreciation

Rationale:
This is generally a very aggressive strategy for investors willing to take on risk to meet objectives.

17282

Question:
The assumption that stock prices move in trends that persist is a basic premise of which of the following?

Answer Choices:
strong-form Efficient Market Hypothesis (EMH)

semistrong-form Efficient Market Hypothesis (EMH)

technical analysis

leading indicators

weak-form Efficient Market Hypothesis (EMH)

Rationale:
The technical analyst believes that stock prices move in trends and that past trends are an indication of future price movements. This assumption directly opposes the notion of an efficient market and the Efficient Market Hypothesis (EMH).

15634

Question:
The assumption that stock prices adjust rapidly to the release of all public information, including nonmarket information such as economic releases and political announcements, describes which of the following?

Answer Choices:
leading indicators

the weak-form Efficient Market Hypothesis (EMH)

the semistrong-form Efficient Market Hypothesis (EMH)

the strong-form Efficient Market Hypothesis (EMH)

Maslow's Hierarchy Theory

Rationale:
While the weak-form EMH assumes that stock prices reflect all market information, the semistrong-form EMH asserts that stock prices react rapidly to all public information. This includes both market and nonmarket information. The strong-form EMH contends that stock prices reflect all information, both public and private.

15632

Question:
If the maintenance margin is 20%, the value of a stock bought on margin falls to $7,000, and the loan taken out to purchase the stock was $5,500, would a margin call be issued? If yes, for what amount?

Answer Choices:
no

yes, for $120

yes, for $50

yes, for -$100

yes, for $100

Rationale:
Owner's equity is $7,000 - $5,500 = $1,500. Maintenance margin dictates a minimum owner's equity of $7,000 x 0.20 = $1,400. Since current owner's equity is $100 greater than the minimum requirement, no margin call would be issued. Margin calls for negative amounts of money do not exist.

15431

Question:
Sherri Sheng is an analyst at Wenei Ltd. Sheng analyzes two companies in the semiconductor industry, Xongbao Semiconductor (XGB) and Utne Ltd. (UTN), and includes the following table in a recently released report.

Company	Current Price	Trailing CF/Share	P/CF	P/FCFE	Beta
XGB	$9.43	$0.43	21.9	32.5	1.45
UTN	$6.37	$0.26	24.5	15.8	1.41

Note: The consensus five-year growth forecast for both companies is 11%.

Using the information provided, which company appears to be relatively undervalued according to the P/CF multiple and according to the P/FCFE multiple, respectively and all else equal?

Answer Choices:
UTN; XGB

UTN; UTN

XGB; XGB

XGB; UTN

Rationale:
At a P/CF of 21.9, XGB is smaller than the P/CF of 24.5 for UTN. Thus, XGB appears undervalued according to P/CF. For P/FCFE, UTN is smaller at 15.8 in comparison to XBG at 32.5. UTN appears undervalued according to P/FCFE.

40167

Question:
In estimating a firm's earnings multiplier, finding the firm's required rate of return involves analyzing the firm's fundamental risk characteristics. Which of the following is not considered a fundamental risk?

Answer Choices:
Business risk

Government risk

Country risk

Financial risk

Liquidity risk

Exchange rate risk

Rationale:
In addition to the consideration of fundamental factors, one should consider market-determined risk (beta) based on the CAPM. A low beta combined with below-average fundamental risk, for example, would indicate that the firm's risk is quite low compared to the aggregate market. This means that the risk premium and the required rate of return for this firm should be lower than the market. By itself, this lower required rate of return would suggest an earnings multiplier above the market multiplier.

16056

Question:
You are going to hold a stock for 3 years. It is estimated to pay dividends of $1.10, $1.20 and $1.35. The estimated sale price at the end of the holding period is $34. Using the dividend discount model, calculate the value of the stock if your required rate of return is 14%.

Answer Choices:
$33.43

$25.75

$33.01

$25.86

Rationale:
The main idea is to find the present value of each dividend (keeping in mind that they have different payout dates) and the PV of the sales price. The calculation is as follows: $1.10/1.14 + $1.20/(1.14 x 1.14) + $35.35/(1.14 x 1.14 x 1.14) = $25.75.

15888

Question:
Anna List, a portfolio manager, wishes to construct a portfolio of bonds which will exhibit very little market value sensitivity to changes in interest rates. Which of the following strategies would be consistent with this desire?

A. She should purchase as many zero-coupon bonds as possible.

B. She should purchase bonds with relatively long maturities.

C. She should purchase high coupon bonds with short maturities.

D. She should purchase a wide variety of bonds with exposure to as many maturities as possible. It will also help if she can get a good mix of both high coupon bonds with equal weighting in low or zero-coupon bonds.

Answer Choices:
A and B

Rationale:
When all other factors are constant, bonds with short maturities and relatively high coupons will be less sensitive to changes in interest rates.

Thus, zero-coupon bonds tend to be the most price sensitive when rates change.

16485

Question:
A portfolio manager with Churn Brothers Brokerage manages a pension fund containing many bonds with embedded call and put options. When asked about this pension fund, the portfolio manager expressed his concern that a change in yield volatility would affect the value of many of these bonds. For instance, an increase in yield volatility would be detrimental to bonds with embedded call options and a decrease in yield volatility would be detrimental to bonds with embedded put options. The portfolio manager is very concerned about this risk and is searching for a way to mitigate it.

Which of the following types of risk is profiled in this example? Further, would this type of risk be applicable to a portfolio comprised of bonds with no embedded options?

Answer Choices:
Volatility risk, no

Yield curve risk, no

Liquidity risk, no

Volatility risk, yes

Liquidity risk, yes

Yield curve risk, yes

Rationale:
The risk profiled in this example is best characterized as volatility risk. Volatility risk is defined as the risk that an embedded option will decline in value from a change in yield volatility. This type of risk is only applicable to bonds that possess embedded options.

Liquidity risk is defined as the risk that a bondholder will not be able to sell his or her bond at its true value due to the lack of a liquid market. So said, bonds that are only lightly traded, or for which there exists only a spotty market, are considered to possess significant liquidity risk. The most indicative measure of liquidity risk is the bid-ask spread.

Yield curve risk refers to the fact that different portfolios react differently to shifts in the yield curve. For instance, a portfolio of short-term bonds would be affected differently from a portfolio of long-term bonds should the yield curve shift from, for example, a flat to an upwardly-sloping structure.

16637

Question:
Assume the following information about a Treasury Inflation Protection Security (TIPS).

Original principal: $300,000
Annual coupon rate: 4.25%
Inflation rate for first year: 3.5%
Inflation rate for second year: 3.8%

What are the last two coupon payments made by this TIPS?

Answer Choices:
None of these answers are correct.

$6,717; $6,844

The answer cannot be determined from the information provided.

$6,725; $6,853

$6,842; $6,972

$6,592; $6,717

Rationale:
Treasury Inflation Protection Securities (TIPS) were first issued on January 39, 1997 by the U.S. Department of the Treasury as a means for investors to experience an inflation-adjusted rate of return on government securities. The coupon rate on TIPS is set at a fixed rate, and these securities pay interest semiannually. The coupon rate is determined via an auction process and is referred to as the "real rate" because it is the rate of interest that an investor will experience above the inflation rate. The index used by the Treasury to compute inflation is the non-seasonally-adjusted U.S. City Average All Items Consumer Price Index for All Urban Customers (CPI-U).

The principal value of a TIPS is adjusted semiannually, and the cash flows of the TIPS profiled in this example is shown below:

1st coupon payment = {[$300,000 principal x (1 + 0.0175 semiannual inflation rate)] x 0.02125 semiannual coupon rate} = $6,486.56. The principal amount now is $305,250.

2nd coupon payment = {[$305,250 principal x (1 + 0.0175 semiannual inflation rate)] x 0.02125 semiannual coupon payment} = $6,600.08. The principal amount now is $310,591.88.

3rd coupon payment = {[$310,591.88 principal x (1 + 0.019 semiannual inflation rate)] x 0.02125 semiannual coupon payment} = $6,725.48. The principal amount now is $316,493.13.

4th coupon payment = {[$316,493.13 principal x (1 + 0.019 semiannual inflation rate)] x 0.02125 semiannual coupon payment} = $6,853.26.

16759

Question:
Portfolio A consists of 30% stocks and 70% bonds. The portfolio's standard deviation is 10% per year.

Portfolio B contains 75% stocks and 25% bonds. Its standard deviation is 16% per year.

The risk-free rate is 4% per year, the expected return for stocks is 14% per year, and the expected return for bonds is 8% per year.

Calculate the expected return of Portfolio A and determine which portfolio is better.

Answer Choices:
Expected return = 9.62%
Portfolio B is better.

Expected return = 9.8%
Portfolio B is better.

Expected return = 9.8%
Portfolio A is better.

Expected return = 9.62%
Portfolio A is better.

Rationale:
Portfolio A's expected return equals 0.30(14%) + 0.70(8%) or 9.8% per year

Portfolio B's expected return equals 0.75(14%) + 0.25(8%) or 12.5% per year

To determine which portfolio is better, use the Sharpe ratio to determine which has a higher reward/variability ratio.

Sharpe ratio = (Portfolio return - Risk-free rate)/(Standard deviation of portfolio)

Portfolio A = (9.8% - 4%)/(10%) = 0.5800
Portfolio B = (12.5% - 4%)/(16%) = 0.5313

As a result, Portfolio A has a higher Sharpe ratio and is the better portfolio.

45390

Question:
_______ describes the situation in which future prices are higher than the current spot price, due to an expected rise in the spot price over time.

Answer Choices:
Arbitrage

Backwardation

Contango

Put-Call Parity

Rationale:
Contango is the correct term for the situation described.

Backwardation is the condition in which the futures price is lower than its current spot price.

Arbitrage is attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage.

Put-call parity is the relationship between the price of a call and the price of a put for an option with the same characteristics (strike price, expiration date, underlying). It is used in arbitrage theory.

45378

Question:
As an individual investor, you are researching the advantages of exchange traded funds or ETFs.

Which of the following is not a characteristic of ETFs?

Answer Choices:
ability to short

may be purchased on margin

intraday trading

tax efficiencies

active management

Rationale:
While there are numerous advantages to investing in ETFs, active management is not one of them. ETFs are baskets of securities and are traded on exchanges. They are passively managed as opposed to actively managed.

40782

Question:
Which of the following statements is/are false concerning duration and/or convexity measurements?

Answer Choices:
The convexity adjustment attempts to approximate the % price change from a change in interest rates that is attributable to the curvature of a particular bond's price/yield relationship.

A convexity adjustment should approximate the % price change not projected by duration.

All of these answers are correct.

Option-adjusted, or "effective," duration accounts for the effect of changes in the required interest rate on a bond's expected cash flows.

Duration is a linear approximation.

The accuracy of duration measures erode with increasingly large changes in the required interest rate.

Rationale:
All of these answers are correct.

While duration can be thought of conceptually as both a time measurement and a "first derivative" of the price-yield function, it is perhaps best to encapsulate duration within the bounds of a price-sensitivity measurement. More specifically, duration should be thought of as a measure of the sensitivity of a fixed-income security's price to changes in the required interest rate.

There are several conventional forms of duration, including Macaulay duration, effective (or "option-adjusted") duration, and modified duration. Each of these measures is a linear approximation of price sensitivity. The primary difference between effective duration and the other duration measures is that effective duration incorporates how a security's cash flows may change from an alteration in the required interest rate. For this reason, effective duration is superior to the other duration measurements when evaluating bonds with embedded options.

Because duration is a linear approximation, its effectiveness erodes with increasingly large changes in the required interest rate. Remember that the price/yield relationship is convex, rather than linear. Consequently, for large changes in required interest rates, the linear approximation produced by duration will differ from the actual price change that should be expected. To compensate for this differential, a convexity adjustment should be incorporated. The convexity adjustment is used to project the % price change expected from a given change in interest rates that is attributed to the curvature of the price/yield relationship. In other words, the convexity adjustment projects the expected price differential not estimated by duration.

33599

Question:
Consider the following information about a particular semiannual, $1,000 par bond:

Current price = $1,085.00
Annual coupon rate = 6.375%
Semiannual discount rate = 2.831%
Annual discount rate = 5.742%
Number of periods until maturity = 11.00

Using this information, what is the current yield and yield-to-maturity of this bond? (Assume no accrued interest and utilize the bond equivalent yield-to-maturity.)

Answer Choices:
5.962%; 4.723%

5.962%; 4.661%

none of these answers

5.962%; 4.608%

5.876%; 4.608%

5.876%; 4.661%

Rationale:
The current yield of this bond is simply the annual coupon payment divided by the current price of the bond, which is shown as follows:

Current yield = $63.75/$1,085.00 = 0.0587558, or 5.876%

The yield-to-maturity is found by inputting the following information into your calculator's TMV worksheet (Note: "P/Y" should be set to 1):

FV = $1,000.00
PV = ($1,085.00)
PMT = $31.875
N = 11
CPT I/Y

This will lead to a semiannual YTM of 0.023039045, or 2.304%, for this bond. Doubling this semiannual yield-to-maturity will lead to the "bond equivalent" yield-to-maturity. YTM figures are most commonly disseminated in the bond equivalent format.

33426

Question:
What is the value of a 5-year zero-coupon bond with a maturity value of $1,000 at an 8% interest rate?

Answer Choices:
$1,017.76

$749.75

$1,000.00

$680.58

$675.56

Rationale:
The value of a zero-coupon bond is calculated using the semi-annual discount rate in order to be consistent with valuation methods of coupon bonds.

Thus, the key inputs on your calculator for this calculation are: fv = -1,000, n = 10, I = 4.

16542

Question:
A European put option expires in 77 days, in which the underlying is 56 and the risk-free rate is 5.5 percent. The underlying makes no cash payments during the life of the option. What is the lower bound for the European put option with exercise prices of 55 and 60, respectively?

Answer Choices:
1.62; 3.32

1.62; 0

0; 4

0; 3.32

Rationale:
55 put: Max[0, 55/(1.055)^(77/365) - 56] = Max(0, -1.62) = 0

60 put: Max[0, 60/(1.055)^(77/365) - 56] = Max(0, 3.32) = 3.32

Keep in mind that with European puts, the lower bound of a European put is the greater of either zero or the present value of the exercise price minus the underlying price. For European puts, the lower bound is Max[0, X/(1 + r)^T - S₀]. For American puts, the minimum price is Max(0, X-S₀). Since the European lower bound is lower than the minimum price of the American put, the American put lower bound and the European put lower bound are not the same.

40238

Question:
Which of the following are securities that can be used to make up the underlying asset of an equity forward contract?

Answer Choices:
an individual stock, a private portfolio of stocks, and a stock index

a stock index only

an individual stock and a stock index only

an individual stock only

Rationale:
An equity forward contract can be written on an individual stock, a basket or portfolio of stocks and a stock index such as the S&P 500 or TSX 35.

40728

Question:
Which of the following statements about over-the-counter traded derivatives and exchange traded derivatives is false?

Answer Choices:
The choice of underlying for over-the-counter traded derivatives is as large as for exchange traded derivatives.

The notional amount of over-the-counter traded derivatives contracts can be specified by the involved parties.

Over-the-counter traded derivatives can be traded outside regular exchange opening time.

The default risk of the investor's counterparty is fundamentally different for over-the-counter traded derivatives than for exchange traded derivatives.

Rationale:
The choice of underlying is much larger for OTC than for ETDs: as an example for the equity market, the exchanges offer ETDs only on blue chips.

41586

Vignette:
Paula Stone, CFA, is a portfolio manager with Almanac Securities, a brokerage firm that manages a diverse group of clientele. She supervises two employees, Larry White and Bob Parker, both of whom are CFA Level I candidates. Recently, Larry accepted a directorship at YMG Inc., a publicly traded company, but receives no compensation for the position. Bob is also a director, but with a privately held company, and he is compensated in stock options. Neither Larry nor Bob have disclosed their directorships to Paula.

Larry has recently issued a hold recommendation on YMG stock. During a social round of golf with the CEO of YMG, Larry is impressed with the operations of the company and the high level of enthusiasm and optimism of the CEO. Larry decides to upgrade the stock from a hold to a buy, due to the optimism and enthusiasm of the CEO.

Bob notices that YMG stock has just been upgraded to a buy. He asks Larry about his recent upgrade of the stock. Larry informs him that he follows the company closely and that he expects strong earnings and better than expected sales growth, over the next 6 to 12 months. Bob purchases YMG stock for all of his clients' portfolios, ensuring that each client receives a pro-rated allocation and that the cost is spread evenly to all accounts.

Question:
Larry's upgrade of YMG stock from a hold to a buy based on the optimism of the CEO of the firm is:

Answer Choices:
a violation of Misrepresentation.

a violation of Material Nonpublic Information.

a violation of Communication with Clients and Prospective Clients.

not a violation since a CEO is an excellent source of research.

Rationale:
Larry's upgrade of YMG stock from a hold to a buy, based on the recommendation of the CEO of the firm, is a violation of Misrepresentation. Larry must conduct proper and thorough research of a company before making any recommendations. Simply taking the CEO's word for it is not sufficient in the least. After all, it is the role of the CEO to be optimistic about his company. If the CEO had disclosed a material fact that was not public, such as a tender offer or the hint of a better (worse) than expected quarter, than Larry would be in violation of Material Nonpublic Information.

41069

Vignette:
Paula Stone, CFA, is a portfolio manager with Almanac Securities, a brokerage firm that manages a diverse group of clientele. She supervises two employees, Larry White and Bob Parker, both of whom are CFA Level I candidates. Recently, Larry accepted a directorship at YMG Inc., a publicly traded company, but receives no compensation for the position. Bob is also a director, but with a privately held company, and he is compensated in stock options. Neither Larry nor Bob have disclosed their directorships to Paula.

Larry has recently issued a hold recommendation on YMG stock. During a social round of golf with the CEO of YMG, Larry is impressed with the operations of the company and the high level of enthusiasm and optimism of the CEO. Larry decides to upgrade the stock from a hold to a buy, due to the optimism and enthusiasm of the CEO.

Bob notices that YMG stock has just been upgraded to a buy. He asks Larry about his recent upgrade of the stock. Larry informs him that he follows the company closely and that he expects strong earnings and better than expected sales growth, over the next 6 to 12 months. Bob purchases YMG stock for all of his clients' portfolios, ensuring that each client receives a pro-rated allocation and that the cost is spread evenly to all accounts.

Question:
Neither Larry nor Bob have disclosed their directorships to Paula. According to Disclosure of Conflicts:

Answer Choices:
Bob is in violation since the company compensates him for his services.

neither Larry nor Bob are in violation.

both Larry and Bob are in violation.

Larry is in violation since the company he is a director of is publicly traded.

Rationale:
Larry must disclose his relationship with YMG Inc. because the firm is publicly traded and may constitute a conflict of interest if the firm trades the securities of YMG. Bob is not technically in violation since the firm that he is a director of is not publicly traded. However, he is in violation of Disclosure of Additional Compensation, since he receives compensation for his services.

41068

Vignette:
Veronica Van Hutton has just submitted her enrollment forms for the CFA program. She is also applying to Wyatt and Young Capital Management. On her resume, she states that she is a Level I CFA candidate. Mark Younger, CFA, is the Director of Equity Research at Wyatt and Young and hires Veronica as a junior research analyst.

Veronica knows that Mark is a CFA charterholder and that the firm has several copies of CFA Institute's Code and Standards. As such, she does not inform Mark of her obligation to the code and does not provide Mark with a copy of the Code and Standards.

Mark provides Veronica with a copy of the firm's compliance manual and schedules a meeting with her three days later to ensure that she has read and understood the manual. Mark does not provide her with a copy of the CFA Institute's Code and Standards since he assumes that she already has a copy.

Veronica's first job is to assist Mark with the preparation of a research report on a small Biotech company, BioVastech. From their research, they issue a speculative strong buy recommendation on the stock. Fred Ingles, a portfolio manager with RDC Investments, reviews the BioVastech recommendation. After investigating the stock further and reviewing the current recommendations of other analysts that follow the stock, Fred decides to purchase the stock for all of his clients with the appropriate investment objectives. Fred allocates the trades according to the size of the client's account.

Mark is pleased that his research was of value to Fred. He informs Fred that Wyatt and Young would like to offer free research for each trade directed by RDC to Wyatt and Young.

Question:
Veronica's application to Wyatt and Young for the junior research analyst position is:

Answer Choices:
a violation of Reference to CFA Institute, the CFA Designation, and the CFA Program.

not a violation of any standard.

a violation of Misconduct.

a violation of Misrepresentation.

Rationale:
Veronica has not been accepted into the CFA program by CFA Institute. As such, she may not call herself a CFA Level I candidate until she is actually enrolled in the program and been accepted. IF Veronica had misstated her academic or professional credentials (other than the use of the CFA designation) then she would have been in violation of Misrepresentation.

41061

Vignette:
Veronica Van Hutton has just submitted her enrollment forms for the CFA program. She is also applying to Wyatt and Young Capital Management. On her resume, she states that she is a Level I CFA candidate. Mark Younger, CFA, is the Director of Equity Research at Wyatt and Young and hires Veronica as a junior research analyst.

Veronica knows that Mark is a CFA charterholder and that the firm has several copies of CFA Institute's Code and Standards. As such, she does not inform Mark of her obligation to the code and does not provide Mark with a copy of the Code and Standards.

Mark provides Veronica with a copy of the firm's compliance manual and schedules a meeting with her three days later to ensure that she has read and understood the manual. Mark does not provide her with a copy of the CFA Institute's Code and Standards since he assumes that she already has a copy.

Veronica's first job is to assist Mark with the preparation of a research report on a small Biotech company, BioVastech. From their research, they issue a speculative strong buy recommendation on the stock. Fred Ingles, a portfolio manager with RDC Investments, reviews the BioVastech recommendation. After investigating the stock further and reviewing the current recommendations of other analysts that follow the stock, Fred decides to purchase the stock for all of his clients with the appropriate investment objectives. Fred allocates the trades according to the size of the client's account.

Mark is pleased that his research was of value to Fred. He informs Fred that Wyatt and Young would like to offer free research for each trade directed by RDC to Wyatt and Young.

Question:
Which of the following best describes Fred's actions with respect to the purchase of BioVastech stock?

Answer Choices:
a violation of Priority of Transactions

a violation of Fair Dealing

a violation of Misrepresentation

a violation of Suitability

Rationale:
Fred violated Fair Dealing since he placed the trades of his larger accounts ahead of his smaller accounts. Fred did not violate Priority of Transactions since he did not put his personal interests ahead of the client's interests. This is the main difference between violating Fair Dealing and Priority of Transactions.

Fred did not violate Misrepresentation as he researched the stock thoroughly.

Fred did not violate Suitability as he ensured that the stock was only purchased for clients with suitable investment objectives.

41064

Vignette:
You want to analyze the sensitivity of AT&T's stock to stock market movement. So you regress AT&T's returns on S&P 500 index's returns. Here are your results:

Intercept: 0.5
Coefficient of S&P: 1.5
Standard error of the coefficient: 0.23
Sample period: 60 months
Total variation of AT&T: 130
Explained variation of AT&T: 57.16
Unexplained variation: 72.84

Question:
What is the sample correlation between AT&T and S&P?

Answer Choices:
0.663

1.508

2.274

0.440

Rationale:
In a regression with only one independent variable, the correlation between dependent and independent variables equals the square root of the coefficient of determination.

The coefficient of determination = 1 - (Unexplained variation / Total variation) = 1 - (72.84 / 130) = 0.44. Therefore, the correlation = 0.44^0.5 = 0.663.

Note that if the slope coefficient is negative, the correlation shall also be negative.

37275

Vignette:
You want to analyze the sensitivity of AT&T's stock to stock market movement. So you regress AT&T's returns on S&P 500 index's returns. Here are your results:

Intercept: 0.5
Coefficient of S&P: 1.5
Standard error of the coefficient: 0.23
Sample period: 60 months
Total variation of AT&T: 130
Explained variation of AT&T: 57.16
Unexplained variation: 72.84

Question:
What is the coefficient of determination of this regression?

Answer Choices:
0.663

0.440

2.274

1.508

Rationale:
The coefficient of determination = Explained variation of the dependent variable / Total variation of the dependent variable = 57.16 / 130 = 0.44.

37273

Vignette:
Trevor Chekovsky, CFA, works at the foreign exchange desk of the Banque du Nationale located in Detroit. He is reviewing several potential foreign currency transactions using the following data and rates:

[US$/CND$] Spot = 0.6901
[US$/CND$] 30 day forward = 0.6921

[CND$/AUS$] Spot = 0.9274
[CND$/AUS$] 30 day forward = 0.9303
[CND$/AUS$] 1 year forward rate = 0.9335

[AUS$/US$] Spot = 1.4692

U.S. interest rate = 7%
Canadian interest rate = 5.75%
Australian interest rate = 5.25%

360 days per year

Question:
What is the arbitrage profit that Trevor can realize between the three currencies?

Answer Choices:
6.94 cents/US$ invested

5.97 cents/US$ invested

6.35 cents/US$ invested

5.35 cents/US$ invested

Rationale:
In order to determine if an arbitrage opportunity even exists, we shall apply a quick test to check it out. The test we use is to restate each quote such that a different currency is in the denominator. In other words, we want to make sure the US, CND and AUS symbols are in the denominator. Luckily, the three quotes have already met this criteria. If they did not, we would need to restate one or two of the quotes. How? Simply take the reciprocal of the quote.

For example, lets say instead of US$/CND$ you wanted CND$/US$; by dividing the quote into 1, you would get the CND$/US$ rate. Thus the CND$/US$ rate is equal to 1 / 0.6901 or 1.4491. Since each of the rates is quoted such that there is a different currency in each denominator, we can simply multiply the quotes together and see if they equal 1:

0.6901 x 0.9274 x 1.4692 = 0.9403, which is less than 1. Therefore an arbitrage opportunity exists.

Our next step is to determine what amount of profit can be made. Since 0.9403 is less than 1, assume that one of the three (it does not matter which one) is too low. Select whichever quote you wish. In this case we'll select the US$/CND$ rate, why? Why not.

So, we assume that the US$/CDN$ rate is too low, (either the US$ is overvalued or the CDN$ is undervalued, either way, we want to buy CND$) thus we take our one dollar US and convert it into 1.4491 Canadian by dividing 1 by 0.6901. Next we convert our 1.4491 Canadian into 1.5625 Australian by dividing 1.4491 by 0.9274. Finally we convert our 1.5625 Australian back into US dollars by dividing 1.5625 by 1.4692 and we make a profit of 6.35 cents per US dollar invested. If the arbitrage opportunity test had been greater than 1 instead of less than 1, than we would have assumed that one of the three quotes, or more, was too high. If we once again select the US$/CND$ quote, the US$ would be undervalued and the CND$ overvalued, thus we would have bought US$ instead and found ourselves working backwards.

37033

Vignette:
Trevor Chekovsky, CFA, works at the foreign exchange desk of the Banque du Nationale located in Detroit. He is reviewing several potential foreign currency transactions using the following data and rates:

[US$/CND$] Spot = 0.6901
[US$/CND$] 30 day forward = 0.6921

[CND$/AUS$] Spot = 0.9274
[CND$/AUS$] 30 day forward = 0.9303
[CND$/AUS$] 1 year forward rate = 0.9335

[AUS$/US$] Spot = 1.4692

U.S. interest rate = 7%
Canadian interest rate = 5.75%
Australian interest rate = 5.25%

360 days per year

Question:
What is the US$/CND$ forward differential?

Answer Choices:
3.47% premium

2.40% premium

2.40% discount

3.48% premium

Rationale:
The annualized forward premium/discount is calculated:

Forward premium/discount = [(Forward rate - Spot rate) / Spot rate] x (360/30)

Forward premium/discount = [(0.6921 - 0.6901) / 0.6901] x 12

Forward premium/discount = (0.0020 / 0.6901) x 12

Forward premium/discount = 0.0348 or 3.48%

37032

Vignette:
Linda Ng, an analyst with a major investment banking firm, is helping her client, Doler, Inc., consider the purchase of Fogg Corporation. She gathers the following information (in US$):

	Doler, Inc.	Fogg Corporation

Current assets	3,450	3,930
Property, plant and equipment	5,770	4,220
Other assets	500	200
Total assets	9,720	8,350

Current liabilities	4,150	3,650
Equity	5,570	4,700
Total liab & equity	9,720	8,350

The fair value of Fogg Corporation's current assets is $4,000 and its property, plant and equipment is $4,100. Its other assets consist only of goodwill. All other items on the balance sheet are correctly valued.

Assume Doler, Inc. pays $6,000 in cash for Fogg, finances the purchase by using long-term debt, and accounts for the combination using the purchase methods.

Question:
Doler, Inc. has been acquiring firms in an attempt to expand its core business and gain market share. It can use the cost method, the equity method, and the consolidation method to account for intercorporate investments. Which of the following statements is true?

Answer Choices:
Under the cost method, the investor records its share of the affiliate's income.

Under the equity method, the investor records its share of the affiliate's income.

Under the equity method, the investor records all of the affiliate's income.

Under the consolidation method, the investor records only dividends and interest from the affiliate.

Rationale:
Under the equity method, the investor records its share of the affiliate's income on its income statement.

35363

Vignette:
Linda Ng, an analyst with a major investment banking firm, is helping her client, Doler, Inc., consider the purchase of Fogg Corporation. She gathers the following information (in US$):

	Doler, Inc.	Fogg Corporation

Current assets	3,450	3,930
Property, plant and equipment	5,770	4,220
Other assets	500	200
Total assets	9,720	8,350

Current liabilities	4,150	3,650
Equity	5,570	4,700
Total liab & equity	9,720	8,350

$7,800

$3,500

$6,000

Rationale:
Long-term debt should be the purchase price paid by Doler using long-term debt financing.

35360

Vignette:
The investments of the Kenbush Companies in the equity securities of other companies are shown in Exhibit 1.

Exhibit 1
The Kenbush Companies' Equity Investments

	Trading
No. of shares	600,000
Cost/share	$65
Total cost	$39,000,000
	Available-for-sale
No. of shares	110,000
Cost/share	$40
Total cost	$4,400,000
	Totals
No. of shares	710,000
Total cost	$43,400,000

During Reporting Period 1, Kenbush Companies reported a dividend/share of $3.20 on its trading securities and a dividend/share of $1.33 on its available-for-sale securities. At the time of reporting, Kenbush's trading securities had a market value of $70/share and its available-for-sale securities had a market value of $32/share.

Financial data on the Kenbush Companies' fixed maturity portfolio is shown in Exhibit 2.

Exhibit 2

	Held-to-maturity	Available-for-sale	Total
Fixed Maturity Portfolio - Reporting Period 2 (in millions)
Market value	$10,947	$6,001	$16,948
Cost	$5,027	$12,397	$17,424
MVA	$5,920	($6,396)	($476)
Fixed Maturity Portfolio - Reporting Period 3 (in millions)
Market value	$8,472	$9,236	$17,708
Cost	$3,111	$11,793	$14,904
MVA	$5,361	($2,557)	$2,804

Exhibit 3

Kenbush Companies reported the following dividend income, interest income, and realized gains and losses for Reporting Period 3:

Fixed maturities (in millions)
Dividend and interest income	$522
Realized gains and losses	($147)
Reported income	$375

Question:
Which statement best describes the importance of analyzing a company's marketable securities?

Answer Choices:
Analyzing investment results makes it impossible for managers to manipulate reported earnings through reclassification.

Segregating investment results and operating results gives a truer picture of how the company's core business performs apart from investments.

Analyzing investment results gives a clearer picture of accounting "tricks" the company may be employing to improve earnings.

Analyzing a company's marketable securities gives analysts and potential investors insight into how sound a company's investments actually are.

Rationale:
Reported income from investments can distort trends in the company's operations. It is important to know how the firm's core business performs aside from investment results.

35878

Vignette:
The investments of the Kenbush Companies in the equity securities of other companies are shown in Exhibit 1.

Exhibit 1
The Kenbush Companies' Equity Investments

	Trading
No. of shares	600,000
Cost/share	$65
Total cost	$39,000,000
	Available-for-sale
No. of shares	110,000
Cost/share	$40
Total cost	$4,400,000
	Totals
No. of shares	710,000
Total cost	$43,400,000

	Held-to-maturity	Available-for-sale	Total
Fixed Maturity Portfolio - Reporting Period 2 (in millions)
Market value	$10,947	$6,001	$16,948
Cost	$5,027	$12,397	$17,424
MVA	$5,920	($6,396)	($476)
Fixed Maturity Portfolio - Reporting Period 3 (in millions)
Market value	$8,472	$9,236	$17,708
Cost	$3,111	$11,793	$14,904
MVA	$5,361	($2,557)	$2,804

Exhibit 3

Kenbush Companies reported the following dividend income, interest income, and realized gains and losses for Reporting Period 3:

Fixed maturities (in millions)
Dividend and interest income	$522
Realized gains and losses	($147)
Reported income	$375

Question:
Leaving aside the issue of taxes, and taking into consideration the cost and market methods of accounting, income from Kenbush's equity portfolio, as reported on its income statement, is closest to:

Answer Choices:
$4,850,000

$5,000,000

$4,100,000

$2,000,000

Rationale:
On available-for-sale securities, only realized gains and losses are counted as income on the income statement. For trading securities, both realized and unrealized gains and losses are counted as income. For both types of securities, dividends are counted as income on the income statement.

Income from trading securities:
(600,000 x $70) - (600,000 x $65) = $42,000,000 - $39,000,000 = $3,000,000

Dividends:
600,000 x $3.20 = 1,920,000

Income from available-for-sale securities:
(110,000 x $32) - (110,000 x $40) = $3,520,000 - $4,400,000 = -$880,000

Dividends:
110,000 x $1.33 = $146,300
$3,000,000 + 1,920,000 + 146,300

Income on income statement = $5,066,300

35833

Vignette:
Snohomish Utilities, a U.S.-based energy utilities provider, maintains a defined-benefit pension plan for all its employees.

The details of this plan are provided in the following table and footnotes:

Snohomish Utilities (January 1, 20X8)
Accumulated benefit obligation	45M
Projected benefit obligation	49M
Vested benefit obligation	35M
Plan assets	36M
Unrecognized loss	2.2M
Discount rate	6.5%
Compensation growth rate	3.0%
Expected return on assets	8.0%
Actual return on assets over the year 20X8	2.0%
Current interest cost	6.0%
Current service cost	2M
Prior service cost	10M
Employee contributions	1.8M
Benefits paid	1M

Notes:
1. Gains/losses on assets are recognized in the year that they occur.
2. Average remaining service period is eight years.
3. Prior service costs are due to plan amendments made during 20X8 and will be amortized over the average remaining service period.

Question:
What is the approximate economic pension expense of Snohomish Utilities for the year 20X8?

Answer Choices:
4.22M

5.19M

4.47M

5.91M

Rationale:
Economic pension expense = Service cost + Interest cost (approximate PBO at the beginning of year x discount rate) - Actual return on plan assets (reported plan assets at beginning of year × actual return)

Thus, the economic pension expense = 2M + 3.185M (=49M × 0.065) - 0.72M (=36M × 0.02) = 4.465M or 4.47M.

Economic pension expense is considered the best measure for evaluating past and current performance because it is based on actual plan asset returns.

37984

Snohomish Utilities (January 1, 20X8)
Accumulated benefit obligation	45M
Projected benefit obligation	49M
Vested benefit obligation	35M
Plan assets	36M
Unrecognized loss	2.2M
Discount rate	6.5%
Compensation growth rate	3.0%
Expected return on assets	8.0%
Actual return on assets over the year 20X8	2.0%
Current interest cost	6.0%
Current service cost	2M
Prior service cost	10M
Employee contributions	1.8M
Benefits paid	1M

Notes:
1. Gains/losses on assets are recognized in the year that they occur.
2. Average remaining service period is eight years.
3. Prior service costs are due to plan amendments made during 20X8 and will be amortized over the average remaining service period.

Question:
The PBO at the end of year 20X8 will be ________.

Answer Choices:
53.94M

54.44M

51.94M

54.19M

Rationale:
PBO at year end = PBO at the start of the year × (1 + Discount rate) + Service cost +/- Prior service cost - Benefits paid

Note: Prior service cost is equivalent to adjustment due to plan amendments. It is positive as given in the case study.

Thus, PBO at year end = 49M x (1 + 0.065) + 2M + 10M/8 - 1M
= 52.19M + 2M + 1.25M - 1M
= 54.44M.

Do not get the "current interest cost" rate and the discount rate (settlement rate) mixed up. The discount rate is the rate assumption that is used to calculate the PBO.

37980

Vignette:
Nicky Matheson is evaluating the stock of Better Business Book Inc, BBB. She meets with Karen Bali, CFA, and gathers the following financial information in Table 1:

Table 1

Debt	$20 million
Market value of equity	$50 million
Recent corporate issue of similarly rated firm	at 7%
Cost of equity capital	18%

FCFE

Year 1	$1.1 million
Year 2	$1.125 million
Year 3	$1.155 million
Terminal value	$10.2 million

Question:
What is the weighted average cost of capital (WACC) if the firm has a 30% tax rate?

Answer Choices:
13.5%

12.6%

15.1%

14.3%

Rationale:
WACC = (D / (D + E)) x K_d x (1 - 0.30) + (E / (D + E)) x K_e

WACC = 20/70 x .07 x .7 + 50/70 x 0.18

= 0.014 + 0.1286

= 0.1426

WACC = 14.3%

37667

Vignette:
Nicky Matheson is evaluating the stock of Better Business Book Inc, BBB. She meets with Karen Bali, CFA, and gathers the following financial information in Table 1:

Table 1

Debt	$20 million
Market value of equity	$50 million
Recent corporate issue of similarly rated firm	at 7%
Cost of equity capital	18%

FCFE

Year 1	$1.1 million
Year 2	$1.125 million
Year 3	$1.155 million
Terminal value	$10.2 million

Question:
What is the value of the firm's equity from Table 1?

Answer Choices:
$12.64 million

$8.65 million

$7.70 million

$11.51 million

Rationale:
We are applying the FCFE, Free Cash Flow to Equity valuation model. Luckily, most of the work is already done for us and all we need to do is take the present value of the future cash flows. Therefore, we apply the formula:

PV FCFE = FCFE /(1 Cost of Equity Capital (the discount rate we need to apply in this case)ⁿ) where n is the number of years we need to bring the value back by:

PV FCFE = 1.1/1.18¹ + 1.125/1.18² + 1.155/1.18³ + FCFE TV/1.18³

Remember that we must discount the FCFE TV back the same number of years as the furthest cash flow, in this case, year 3

PV FCFE = 0.9322 + 0.80796 + 0.70297 + 6.20803
= $8.65 million

37666

Vignette:
Alan Morgan, a real estate analyst with XYZ Investments, is analyzing a project: the proposed development is a 45-story, luxury high-rise building. The building will contain 236 units and 240 parking spaces situated on a 2-acre waterfront parcel. The subject project will offer fabulous views, indoor pool and spa, 24-hour concierge, and luxurious amenities and fixtures. The following additional information is available:

1. Average room rate for comparable properties is $3,000 per unit per month. Assumed vacancy rate and collection losses are 8% of revenue.

2. Operating expenses for the owner are estimated at 10% of rent revenue.

3. The purchase price of land was $10 million. XYZ Investments purchased this land 5 years earlier and used it for warehouses.

4. Total construction cost is estimated at $65 million. To calculate tax depreciation as required by the Tax Reform Act of 1986, straight-line cost recovery should be used assuming a 27.5-year life.

5. Estimated construction period is 1 year.

6. Required loan-to-value ratio for the construction of this project is 80%. The mortgage may be obtained at 8% for 30 years. Payments of interest and principal are assumed to be made on an annual basis in equal installments. During the construction period, interest is not paid but accumulated and paid in arrears upon sale of the property.

7. XYZ Investments has a 36% marginal income tax rate. The investor's capital gains tax rate is 20%. Recaptured depreciation will be taxed at the rate of 25%.

8. XYZ Investments has a minimum of 15% per year after-tax required rate of return on any equity investment.

9. The property is assumed to be held for 3 years, during which time its net operating income is not expected to increase. At the end of the third year, the property will be sold at $400,000 per unit. Selling costs are assumed to be 7% of the sales price.

Question:
What is the after-tax equity reversion?

Answer Choices:
30,951,056

29,811,456

28,685,456

31,305,602

Rationale:
1. Calculate net sales revenue:

(236 units)(400,000 price per unit) - (7%(236)(400,000)) = 87,792,000

2. Calculate net book value upon sale:

65,000,000 (total cost of building) - (2,363,636)(3) (accumulated depreciation) = 57,909,091

3. Calculate gain on sale:

87,792,000 - 57,909,091 = 29,882,909

4. Calculate gain recognized on sale less depreciation recaptured:

29,882,909 - 7,090,909 = 22,792,000

5. Tax on depreciation recaptured:

(7,090,909)(25%) = 1,772,727

6. Tax on capital gain:

(22,792,000)(20%) = 4,558,400

7. Calculate taxes due on sale:

4,558,400 + 1,772,727 = 6,331,127

8. Calculate after tax equity reversion:

87,792,000 - 6,331,127 - 50,509,816 (mortgage balance outstanding at the end of year 3) = 30,951,056

45091

Vignette:
Alan Morgan, a real estate analyst with XYZ Investments, is analyzing a project: the proposed development is a 45-story, luxury high-rise building. The building will contain 236 units and 240 parking spaces situated on a 2-acre waterfront parcel. The subject project will offer fabulous views, indoor pool and spa, 24-hour concierge, and luxurious amenities and fixtures. The following additional information is available:

1. Average room rate for comparable properties is $3,000 per unit per month. Assumed vacancy rate and collection losses are 8% of revenue.

2. Operating expenses for the owner are estimated at 10% of rent revenue.

3. The purchase price of land was $10 million. XYZ Investments purchased this land 5 years earlier and used it for warehouses.

4. Total construction cost is estimated at $65 million. To calculate tax depreciation as required by the Tax Reform Act of 1986, straight-line cost recovery should be used assuming a 27.5-year life.

5. Estimated construction period is 1 year.

6. Required loan-to-value ratio for the construction of this project is 80%. The mortgage may be obtained at 8% for 30 years. Payments of interest and principal are assumed to be made on an annual basis in equal installments. During the construction period, interest is not paid but accumulated and paid in arrears upon sale of the property.

7. XYZ Investments has a 36% marginal income tax rate. The investor's capital gains tax rate is 20%. Recaptured depreciation will be taxed at the rate of 25%.

8. XYZ Investments has a minimum of 15% per year after-tax required rate of return on any equity investment.

9. The property is assumed to be held for 3 years, during which time its net operating income is not expected to increase. At the end of the third year, the property will be sold at $400,000 per unit. Selling costs are assumed to be 7% of the sales price.

Question:
What is the net operating income from this project in the years after construction is completed?

Answer Choices:
7,646,400

5,210,880

7,034,688

521,088

Rationale:
1. Calculate net rental income:

(3,000)(236)(12)(1 - 8%) = 7,816,320

2. Calculate operating expense:

(10%)(7,816,320) = 781,632

3. Calculate NOI:

7,816,320 - 781,632 = 7,034,688

45088

Vignette:
Lorne Rajavek is discussing his work with Tom Sanderson, a colleague in the equity division of AK&M Securities. Tom asks Lorne to explain how he values bonds with embedded options. Lorne replies, "We use an interest rate model to construct an interest rate tree. Our model relates short, medium, and long-term interest rates to interest rate volatility." Lorne further explains that, "We must ensure that the interest rate tree is consistent with our assumption about interest rate volatility and that it pops out a value that matches the current market price for each off-the-run Treasury."

Question:
Which of the following securities can be valued by the backward induction method?

I. Floating rate note
II. Step-up callable note
III. Convertible bond
IV. Callable bond
V. Capped floater

Answer Choices:
I, II, and V

I, II, IV, and V

III and IV only

I, II, III, and IV

Rationale:
The backward induction method (or option tree) is used to value option-free bonds and bonds with embedded options. Convertible bonds however have another variable that affects their price, the stock price of the issuer. Therefore, while the method can be used to value the bond portion of the convertible security, it does not take into account the convertibility of the bond into stock, and the value that this may entail.

42087

Vignette:
Lorne Rajavek is discussing his work with Tom Sanderson, a colleague in the equity division of AK&M Securities. Tom asks Lorne to explain how he values bonds with embedded options. Lorne replies, "We use an interest rate model to construct an interest rate tree. Our model relates short, medium, and long-term interest rates to interest rate volatility." Lorne further explains that, "We must ensure that the interest rate tree is consistent with our assumption about interest rate volatility and that it pops out a value that matches the current market price for each off-the-run Treasury."

Question:
Calculate the arbitrage-free value for a 3-year 5% annual coupon callable bond at par ($100.000), using the following information:

Volatility: 10%
One-year spot rate: 4.000%
One-year rates next year: 4.797%, 3.910%
One-year rates in two years: 6.663%, 5.430%, 4.430%

Answer Choices:
$99.253

$100.000

$99.981

$100.603

Rationale:
If the bond is not called, it will pay 105 at the end of three years, regardless of the path that interest rates follow.

At the end of two years, there are three possible values:

105 / (1.06663) = 98.441
105 / (1.05430) = 99.592
105 / (1.04430) = 100.546, but the bond is callable at 100.000, so set the value equal to 100.

At the end of one year, there are two possible values:

(.5(98.441 + 5) + .5(99.592 + 5)) / 1.04797 = 99.255
(.5(99.592 + 5) + .5(100.000 + 5)) / 1.03910 = 100.853, but the bond is callable at 100.000, so set the value equal to 100.

Today, there is one value.

(.5(99.255 + 5) + .5(100.000 + 5)) / 1.04000 = 100.603, but the bond is callable at 100.000, so its value equals 100.000.

42085

Vignette:
Wesley Martin is analyzing the mortgage pool seen in Table 1 for a research report on the MBS's and CMO's of North Humber Finance Corporation. In his report, he compares North Humber Finance Corporation with several other similar firms.

Mortgage	Balance remaining	Contract rate	Number of payments
1	$225,000	5%	360
2	$222,000	6%	265
3	$105,000	6.5%	185
4	$95,000	6.75%	105

Question:
Wesley compares the mortgage pool in Table 1 with another mortgage pool with the following characteristics:

Mortgage balance: $1,000,000
Time: 26th month
Principal payment: $300.00

If the Public Securities Association, PSA, is at 100, what is the conditional prepayment rate (CPR) and single monthly mortality (SMM) for the mortgage pool?

Answer Choices:
The CPR is 5.2% and the SMM is 0.44%.

The CPR is 5.0% and the SMM is 0.43%.

The CPR is 6.0% and the SMM is 0.51%.

The CPR is 5.8% and the SMM is 0.50%.

Rationale:
CPR = CPR up to 30 months x Number of months, CPR is 0.2 up to 30 months and then a flat 6.0 thereafter
= 5.2%

SMM = 1 - (1 - CPR)^(1/12)

= 1 - (0.9480)^0.0833

= 0.0044

38644

Mortgage	Balance remaining	Contract rate	Number of payments
1	$225,000	5%	360
2	$222,000	6%	265
3	$105,000	6.5%	185
4	$95,000	6.75%	105

Question:
"The last tranche to receive principal repayments is also the last tranche to receive interest repayments. The interest payments are simply added to the principal until all other tranches have been paid off."

This is a description of what kind of CMO?

Answer Choices:
sequential-pay

accrual

planned amortization class (PAC)

structured interest-only

Rationale:
An accrual CMO is the last tranche to receive either principal or interest repayments. Interest is added (accrued) to the balance outstanding until all other tranches have been paid out in full.

38640

Vignette:
The risk and return of four asset types in the market are as follows:

	Expected return	Standard deviation	Beta
Small cap stocks	17%	15%	1.32
Stock market index	11%	9%
Bonds	7%	6%
International stocks	19%
T-bills	4%

The correlation between the small cap stocks and bonds is .30, and the composition of the tangential portfolio (T) is 55% small cap and 45% bonds.

Question:
The return demanded by an investor for taking on each additional unit of risk is closest to which of the following?

Answer Choices:
1.0532

0.8856

0.7532

0.9027

Rationale:
Return per unit of additional risk = (Return of T portfolio - Risk-free rate) / Standard deviation of T portfolio = (12.50% - 4%)/9.42% = 0.9027

Return of Portfolio T = (.55 x .17) + (.45 x .07) = 12.50%

Standard deviation of T = (.55 x .15)² + (.45 x .06)² + 2 x (.55 x .15) x (.45 x .06) x .30

= 0.0068 + 0.000729 + 0.001337

= 0.008874^.5 = 0.0942 = 9.42%

37881

Vignette:
The risk and return of four asset types in the market are as follows:

	Expected return	Standard deviation	Beta
Small cap stocks	17%	15%	1.32
Stock market index	11%	9%
Bonds	7%	6%
International stocks	19%
T-bills	4%

The correlation between the small cap stocks and bonds is .30, and the composition of the tangential portfolio (T) is 55% small cap and 45% bonds.

Question:
If an investor wanted to allocate 80% of his funds to portfolio T and the remainder in T-bills, what is the standard deviation of this portfolio?

Answer Choices:
7.53%

7.06%

8.52%

6.56%

Rationale:
The standard deviation of the portfolio T is 9.42%.

(.55 x .15)² + (.45 x .06)² + 2 x (.55 x .15) x (.45 x .06) x .30

= 0.0068 + 0.000729 + 0.001337

= .008866^.5 = .0942 = 9.42%

The standard deviation of T-bills is zero, and therefore the standard deviation of the portfolio allocating 80% of the funds to portfolio T is equal to 0.8 x 9.42% = 7.53%.

37880

Vignette:
An analyst needs to know if company ABC is adding economic value by applying the Economic Value Added (EVA) approach. He will therefore go through the necessary steps of the method in order to get the EVA of the company and will then interpret the figure obtained.

Information available about Company ABC:

Net income	$400M
Operating income	$525M
Net interest paid	$9.5M
Depreciation	$15M
Amortization	$5M
Equity	$250M
Short-term debt	$20M
Middle-term debt	$20M
Long-term debt	$110M
Credit spread for short-term debt	0.5%
Credit spread for middle-term debt	1.5%
Credit spread for long-term debt	2.5%
Company's tax rate	30%
Beta	1.30
Expected return of the equity market	9%
Risk-free rate	4.5%

Question:
The analyst had to make several adjustments to his previously calculated numbers. Given the following information what is the economic value added (EVA) of company ABC?

Net income: $370M
Market capitalization of company ABC: $750M
Net operating profit after tax: $450M
Common equity: $350M
Preferred stock: $50M
Total debt: $180M
Cost of capital: 8.5%

Answer Choices:
$374.6M

$320.7M

$700.7M

$400.7M

Rationale:
EVA = Net operating profit after tax - Cost of capital × Total capital
= 450,000,000 - 8.5% × (350,000,000 + 50,000,000 +180,000,000) = $400.7M

Total capital includes preferred stock. Ignoring the preferred stocks, EVA is 450,000,000 - 8.5% × (350,000,000 + 180,000,000) = $404.95M.

When net income is used instead of net operating profit after tax, the value is $320.7M.

Using the market capitalization instead of the net operating profit after tax, the value is $700.7M.

Wrongly adding the risk free rate to the cost of capital, EVA becomes: Net operating profit after tax - (Risk free rate + Cost of capital) × Total capital = 450,000,000 - (4.5% + 8.5%) × 580,000,000 = $374.6M.

41951

Net income	$400M
Operating income	$525M
Net interest paid	$9.5M
Depreciation	$15M
Amortization	$5M
Equity	$250M
Short-term debt	$20M
Middle-term debt	$20M
Long-term debt	$110M
Credit spread for short-term debt	0.5%
Credit spread for middle-term debt	1.5%
Credit spread for long-term debt	2.5%
Company's tax rate	30%
Beta	1.30
Expected return of the equity market	9%
Risk-free rate	4.5%

Question:
Given the following adjusted components after the restructuring of its capital, what is the weighted average cost of capital (WACC) of company ABC?

Equity: $250M
Increase in the amount of debt: 15%
Cost of equity: 12.5%
Cost of debt: 6%

Answer Choices:
7.04%

9.85%

11.54%

10.06%

Rationale:
Debt after increase = $150M × 1.15 = $172.5M.

WACC = [(Equity × Cost of equity) + (Debt × Cost of debt)] / (Equity + Debt)
= [(250,000,000 × 12.5%) + (172,500,000 × 6%)] / 422,500,000 = 9.85%.

Not taking into account the increase in debt, the WACC = 10.06%.

Wrongly adjusting by the tax effect, the percentage is 7.04%

Adding the risk-free rate to the wrongly tax adjusted figure, the cost is 11.54%.

41950

Vignette:
Miguel Valdez, CFA, is a mergers and acquisitions analyst at Helado LLP analyzing the textile industry. Valdez has the following basic data for two companies that have been discussed in the trade press as potential merger candidates:

	Wooten Inc.	Wallingford Co.
Earnings per share	$2.00	$1.00
Dividend per share	$0.50	$0.70
Number of shares	1,000,000	300,000
Stock price	$45	$14

Valdez estimates that investors currently expect a steady growth rate of about 3% in earnings and dividends for Wallingford Co. Under new management, this growth rate will increase to 5% per year, without any additional capital investment required.

Proposed acquisition:

Wooten pays $35 in cash for each share of Wallingford. Or, Wooten offers one share of Wooten, Inc. for every three shares of Wallingford.

Question:
If the expected growth rate of Wallingford Co. were unchanged by the merger, what would be the cost of the cash offer and the share offer, respectively? Assume: Wooten pays $35 in cash for each share of Wallingford; Wooten offers 1 share of Wooten stock for every three shares of Wallingford.

Answer Choices:
$6.3M; $720,000

$4.2M; $273,000

$4.2M; $720,000

$6.3M; $273,000

Rationale:
Because this is a cash acquisition, the following formula applies:

Cost = Cash paid - PV_B = ($35 x 300,000) - ($14 x 300,000) = $10.5M - $4.2M = $6.3M

If the acquisition is for stock, the cost is different. This is because the new growth rate affects the value of the merged company. This, in turn, affects the stock price of the merged company and, hence, the cost of the merger. Thus, with no change in growth rate from the merger, the following calculations apply:

PV_AB = ($45 x 1,000,000) + ($14 x 300,000) = $49,200,000

New share price = $49,200,000 / 1,100,000 = $44.73

Cost = ($44.73 x 100,000) - ($14 x 300,000) = $273,000

39417

	Wooten Inc.	Wallingford Co.
Earnings per share	$2.00	$1.00
Dividend per share	$0.50	$0.70
Number of shares	1,000,000	300,000
Stock price	$45	$14

Valdez estimates that investors currently expect a steady growth rate of about 3% in earnings and dividends for Wallingford Co. Under new management, this growth rate will increase to 5% per year, without any additional capital investment required.

Proposed acquisition:

Wooten pays $35 in cash for each share of Wallingford. Or, Wooten offers one share of Wooten, Inc. for every three shares of Wallingford.

Question:
What is the share price of Wooten Inc. if it offers one share of its stock for every three shares of Wallingford Co.?

Answer Choices:
$40.00

$40.91

$52.00

$47.27

Rationale:
Because this acquisition is financed with stock, we have to take into consideration the effect of the merger on the stock price of Wooten Inc. After the merger, there will be 1,100,000 shares outstanding. Thus, the share price will be the value of the combination, PV_AB, divided by the number of shares.

$52,000,000 / 1,100,000 = $47.27.

39415

Vignette:
Prospective clients are being invited to a lunch during which one of the firm's analysts will present some concepts and models he uses before recommending a stock. Gerry Klatt wants to use the Gordon Growth model for a British company, Bangers Galore, specializing in sausages for pubs. The following information is available on BG:

Current price: £ 28.47
Estimated earnings per share for current year: £ 0.92
Dividends for the current year: £ 0.29
Dividend growth rate: 6.8%
Risk-free rate: 4.7%
Equity risk premium: 4.6%
Beta: 0.91

Question:
Calculate the actual P/E.

Answer Choices:
21.79

22.43

28.98

30.95

19.64

Rationale:
Current stock price / Earnings per share for the current year (use the estimate here)

28.47/.92 = 30.95

38596

16.10

11.55

30.95

15.07

Rationale:
The required return for the equity, r, can be found using the security market line equation:

0.0889 = 0.047 + 0.91(0.046)

The justified leading P/E (based on next year's earnings) is:

P₀ / E₁

= (D₁ / E₁) / (r - g)

= (1 - b) / (r - g)

= 0.315 / (0.0889 - 0.068) = 15.07

38589

Vignette:
Table 1 provides information on various T-bill prices, the current S&P 500 equity index spot price, and the current USD/CAD spot rate.

Table 1

Future expiry	75 days
Underlying	90-day T-bill
Price of 75 day T-bill	98.125
Price of 165 day T-bill	96.875
Price of 210 day T-bill	93.500
Day count	360
Discount rate	4.75%
F/X spot	0.75 USD/CAD
S&P 500 spot	1128

Question:
Calculate the price of the futures contract on the T-bill.

Answer Choices:
98.257

97.873

98.575

98.726

Rationale:
To calculate the price of the 75-day T-bill futures contract, we simply divide the price of a 165-day T-bill by the price of a 75-day T-bill as follows:

Futures0_(T) = T-bill_{165 days} / T-bill_{75 days}

Futures0_{(75 days)}= 96.875 / 98.125

= 98.726

40878

Vignette:
Table 1 provides information on various T-bill prices, the current S&P 500 equity index spot price, and the current USD/CAD spot rate.

Table 1

Future expiry	75 days
Underlying	90-day T-bill
Price of 75 day T-bill	98.125
Price of 165 day T-bill	96.875
Price of 210 day T-bill	93.500
Day count	360
Discount rate	4.75%
F/X spot	0.75 USD/CAD
S&P 500 spot	1128

Question:
Calculate the implied repo rate for a futures contract on a 90-day T-bill with 120 days till expiry, trading at 94.750.

Answer Choices:
4.255%

4.333%

4.475%

4.122%

Rationale:
Repo₀(120) = (Futures₀(120) / T-bill_{210 days})^(365/T) - 1

= (94.750 / 93.500)^365/120) - 1

= ((1.01337)^3.04167) - 1

= 0.04122 or 4.122%

40877

Vignette:
John Manning, CFA, is an investment dealer for DBC Securities. Mark King is the CFO of Value Brand Inc. and has contacted John to setup an interest rate swap.

Mark asks John to describe the characteristics of an interest rate swap. John replies:

"An interest rate swap is an agreement between two parties to exchange interest rate payments on a periodic basis. The interest rate payments are based on an amount known as the notional amount, which is exchanged at the initiation of the swap. Both parties are exposed to interest rate risk and counterparty risk."

Mark has used forward contracts before and inquires about the differences between an interest rate swap and a forward contract.

Mark is also interested in learning about caps, floors, and collars.

John provides Mark with the following details on an interest rate floor:

Table 1

Reference rate	90-day LIBOR
Current LIBOR	4.75
Strike rate	5.25%
Term	1 year
Period	90 days

Question:
Mark would like to purchase an interest rate cap on $10 million. Given the information in Table 1, and assuming LIBOR rises 0.25% each quarter, what is the payoff of the cap to Mark for period 1 and period 4?

Answer Choices:
$18,750.00, 0

$6,250.00, -$37,500.00

0, $12,500.00

-$6,250.00, $12,500.00

Rationale:
Payoff_Cap = Notional principal x (Reference rate - Strike rate) / 4

Payoff_CapP1 = $10,000,000 x (4.75% + 0.25% - 5.25%) / 4
= $10,000,000 x (5.00% - 5.25%) / 4
= $10,000,000 x (-0.0625%)
= 0, since Cap rate > Reference rate (the buyer of a cap has a payoff that cannot be less than 0)

Payoff_CapP4 = $10,000,000 x (4.75% + 1.00% - 5.25%) / 4
= $10,000,000 x (5.75% - 5.25%) / 4
= $12,500.00

41995

Reference rate	90-day LIBOR
Current LIBOR	4.75
Strike rate	5.25%
Term	1 year
Period	90 days

Question:
Which of the following statements about interest rate caps and floors is true?

Answer Choices:
The seller of an interest rate floor faces counterparty risk.

An interest rate cap has a payoff when the reference rate rises above the strike rate.

Both the buyer and seller of either an interest rate floor or cap face counterparty risk.

An interest rate floor has a payoff when the reference rate rises above the strike rate.

Rationale:
An interest rate cap has a payoff when the reference rate rises above the strike rate, while an interest rate floor has a payoff when the reference rate falls below the strike rate. Only the buyer of an interest rate cap or floor faces counterparty risk (i.e. the risk that the other party - the seller - will default on payment).

41994

Vignette:
Shiposh Singh, CFA, is an international equities analyst at Global Research Advisors LLP. Singh is analyzing the returns of Echiden Inc., an international conglomerate based in Germany and trading on the Frankfurt stock exchange. Singh recommends that U.S. investors purchase 1,000 shares of Echiden Inc. at 56.91 euros (€) each, when the exchange rate is U.S. dollars $ / € = 0.9790 - 0.9795.

Three months later, Echiden distributes a dividend of 0.50€ per share. At the same time, Singh then recommends that investors sell the shares at the then prevailing price of 61.10€ per share. The exchange rate is $ / € = 0.9810 - 0.9815. The dividend withholding tax rate in Germany is 15%, and there is a tax treaty between the U.S. and Germany to avoid double taxation. Ignore any commissions on purchase and sale of shares.

Question:
What is the tax credit that the U.S. investor can be expected to receive?

Answer Choices:
$135.00

$73.57

$73.36

$490.50

Rationale:
Because of the tax treaty between U.S. and Germany, the U.S. investor can deduct from income tax a tax credit for the dividends withheld in Germany.

The tax credit is $490.50 - $416.93 = $73.57.

The tax credit can be computed alternatively as 0.50€ per share x 1,000 shares x 0.15 x $0.9810 ($/€) = $73.57.

39455

Vignette:
Shiposh Singh, CFA, is an international equities analyst at Global Research Advisors LLP. Singh is analyzing the returns of Echiden Inc., an international conglomerate based in Germany and trading on the Frankfurt stock exchange. Singh recommends that U.S. investors purchase 1,000 shares of Echiden Inc. at 56.91 euros (€) each, when the exchange rate is U.S. dollars $ / € = 0.9790 - 0.9795.

Three months later, Echiden distributes a dividend of 0.50€ per share. At the same time, Singh then recommends that investors sell the shares at the then prevailing price of 61.10€ per share. The exchange rate is $ / € = 0.9810 - 0.9815. The dividend withholding tax rate in Germany is 15%, and there is a tax treaty between the U.S. and Germany to avoid double taxation. Ignore any commissions on purchase and sale of shares.

Question:
What is the amount of dividend income that must be declared by the U.S. investor on a U.S. tax return?

Answer Choices:
$417.14

$416.93

$558.28

$490.50

Rationale:
The U.S. investor would need to declare the total dividends, that is, without deducting the withholding tax, as dividend income.

So, the dividend income to be declared is 0.50€ per share x 1,000 shares x $0.9810 $/€ = $490.50.

39454

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