CFA Institute CFA-Level-II CFA Level II Chartered Financial Analyst Exam Practice Test

Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.

Ferguson Department Stores, Inc.

FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.

Assuming a tax rate of 34%, the underlying earnings per share (EPS) for FDS in 2008 is closest to:

Janice Palmer, CFA, is an international equity analyst at a large investment management firm catering to high net worth U .S . investors. She is assisted by Morgan Greene and Cathy Wong. Both Greene and Wong have prepared their preliminary security selections and are meeting along with Palmer today for detailed security analysis and valuation. They have narrowed their focus to a few closed-end country funds and some firms from Switzerland, Germany, the U.K. and the emerging markets.

The initial decision is to choose between closed-end country funds and direct investment in foreign stock markets. Wong is in favor of country funds because:

1. Country funds provide immediate diversification.

2. Buying country funds is a better choice than direct investment for most emerging markets.

However, Wong has observed a premium to NAV that is prevalent in closed-end country funds. Wong is curious as to how the observed premiums would affect investments in such instruments.

In contrast to Wong, Greene is more inclined towards individual stocks and has started looking into their financial statements. One firm Greene is analyzing is a German conglomerate. Kaiser Corp. Kaiser has a history of growing by acquiring high-growth firms in niche markets. Exhibit 1 provides key financial information from Greene's analysis of Kaiser Corp.

Exhibit 1: Financial information---Kaiser Corp.

While going through their sample of emerging market stocks, Wong observed that these markets in general have high inflation and that sales for the stocks were extremely seasonal. Wong compensated by adjusting reported sales growth in the emerging market firms by deflating the sales using annual inflation adjustments. Wong also made upward adjustments to reported depreciation figures.

Wong suggested to her colleagues that they add a country risk premium to the discount rate they were using to evaluate emerging market stocks. She further suggested that they estimate country risk premiums by calculating the spread between the yield of U .S . government bonds and that of similar maturity local bonds.

Subsequently they started working on the financial projections for Emerjico, Inc., an emerging market stock. Their assumptions are given in Exhibit 2.

Exhibit 2: Key Assumptions---Emerjico

Wong made two adjustments to the financial statements of the emerging market stocks. Which of the adjustments are correct?

Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.

Ferguson Department Stores, Inc.

FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:

Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.

Statement 2: A high E/P implies the security is overpriced.

Given Emery's dividend forecast for FDS, is the H-model the appropriate valuation model to use to value FDS?

Tom Vadney, CFA, is president and CEO of Vadney Research and Advisors (VRA), a large equity research firm that specializes in providing international investment and advisory services to global portfolio managers. He has a staff of five junior analysts and three senior analysts covering industries and firms across the Americas, Europe, and Asia-Pacific regions.

In a recent meeting with an institutional portfolio manager, Vadney is asked to review the differences between U .S . GAAP and International Financial Reporting Standards (IFRS) as well as provide a comprehensive industry analysis for the telecommunications sector in Europe and the Asia-Pacific region. Vadney asks Maria Mnoyan, a senior analyst covering the sector, to research the requested information for the client meeting.

Prior to the meeting, Vadney and Mnoyan meet to prepare for the client presentation. They first discuss differences between U .S . GAAP and IFRS. Mnoyan states that although there will be increasing convergence between the two accounting standards, one major difference currently is that IFRS permits either the "partial goodwill" or "full goodwill" method to value the goodwill and the noncontrolling interest under the acquisition method. U .S . GAAP requires the full goodwill method. Vadney adds that U .S . GAAP requires equity method accounting for joint ventures, while under IFRS, proportionate consolidation is preferred, but the equity method is permitted.

Vadney then asks Mnoyan to share her findings on the telecommunications sector. Mnoyan first presents an overview of the competitive forces that characterize the sector in the two regions. In particular, she notes that the sector in both regions is characterized by high switching costs. Vadney asks how high switching costs would affect the bargaining power of buyers and suppliers.

Mnoyan firmly believes that investing in companies located in developing countries provides strong growth potential through technological change and increases in capital, labor, and savings that contribute to higher dividend levels, even if the dividend growth rate is unaffected.

In her research report Mnoyan identifies several countries and industries with attractive investment potential. She notices that the telecommunications sector in one of the countries is characterized by a duopoly. The $50 billion telecom industry in another country in her analysis is dominated by h\e firms with market shares of $10 billion each.

Finally, Vadney and Mnoyan discuss investment opportunities in specific firms. Mnoyan values firms using both the discounted cash flow model and the franchise value method. She makes the following statements on the franchise value method:

Statement 1: A higher asset turnover ratio increases the franchise P/E ratio, one of the components of the intrinsic P/E value.

Statement 2: When firms pay out profits as dividends at a higher rate, a firm's intrinsic P/E value decreases.

Are Mnoyan and Vadney correct about differences between U .S . GAAP and IFRS?

Sentinel News is a publisher of over 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. The family members are concerned that Midwest News's declining newspaper circulation is not cyclical, but rather permanent. The family members would reinvest the cash proceeds from the sale of Midwest News into a diversified portfolio of stocks and bonds. Miller's staff collects the financial information shown in Exhibit 1.

Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom's estimated beta is 0.90, and 40% of the company's capital structure is debt. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn S3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of S15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value.

Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. The staff uses the Gordon growth model (GGM) to estimate Midwest's equity risk premium. The equity risk premium calculated by the staff is provided in Exhibit 2.

Miller believes the best method to estimate the required return on equity Midwest News is the build-up method. All relevant information to determine Midwest News's required relurn on equity is presented in Exhibit 2.

The specific-company premium reflects concerns about future industry performance and business risk in Midwest News. Miller makes two statements concerning the valuation methodology used to value Midwest News's equity.

Statement I: The required return estimate that is calculated from Exhibit 2 reflects all adjustments needed to make an accurate valuation of Midwest News.

Statement 2: It is better to use the free cash flow model to value Midwest News than a dividend discount model.

Miller considered two different valuation models to determine the price of Midwest News's equity: a single-stage free cash flow model and a single-stage residual income model.

Which of the following is NOT an input used to estimate Midwest News's equity risk premium based on the Gordon growth (GGM)?

Michael Robbins, CFA, is analyzing Universal Home Supplies, Inc. (UHS), which has recently gone through some extensive restructuring.

Universal Home Supplies, Inc.

UHS operates nearly 200 department stores and 78 specialty stores in over 30 states. The company offers a wide range of products, including women's, men's, and children's clothing and accessories as well as home furnishings, electronics, and other consumer goods. The company is considering cutting back on or eliminating its electronics business entirely. UHS manufactures many of its own apparel products domestically in a large factory located in Kentucky. This central location permits shipping to distribution points around the country at reasonable costs. The company operates primarily in suburban shopping malls and offers mid- to high-end merchandise mainly under its own private label. At present more than 70% of the company's customers live within a 10-minute drive of one of the company's stores. Web site activity measured in dollar sales volume has increased by over 18% in the past year. Shares of UHS stock are currently priced at $25. Dividends are expected to grow at a rate of 6% over the next eight years and then continue to grow at that same rate indefinitely. The company has a cost of capital of 10.2%, a beta of 0.8, and just paid an annual dividend of $1.25.

UHS has faced serious cash flow problems in recent years as a consequence of its strategy to pursue an upscale clientele in the face of increased competition from several "niche retailers." The firm has been able to issue new debt recently and has also managed to extend its line of credit. The two financing agreements required a pledge of additional assets and a promise to install a super-efficient inventory tracking system in time to meet holiday shopping demand.

Robbins is asked by his supervisor to carefully consider the advantages and drawbacks of using the price-to-sales ratio (P/S) and to determine the appropriate valuation metrics to use when returns follow patterns of persistence or reversals.

Robbins also estimates a cross-sectional model to predict UHS's P/E:

predicted P/E = 5 - (10 x beta) + [3 x 4-year average ROE(%)]

+ [2 X 5-ycar growth forecast(%)]

Based on the H-model, the implied expected rate of return for UHS is closest to:

Mark Taber, CFA, is the Chief Investment Officer of the Taber Emerging Markets Fund, (TEMF). Taber uses a top-down approach to investing in countries. By interviewing government officials and the managements of foreign companies, Taber often gains economic and investment insights not yet fully understood by the foreign market. Taber is currently researching a potential investment in the emerging market country of Alphia. Taber travels to Ullom, the capital of Alphia, to discuss past, present, and future economic growth theory development with Dr. Raman Satish, managing director of the Alphia Economic Development Agency (AEDA).

Dr. Satish starts the conversation with Taber by discussing the three great growth cycles that the Alphian economy has experienced over the past 120 years: (1) the classical growth era, (2) the neoclassical growth era, and (3) the new growth era. Taber takes down the following statements from the meeting with Dr. Satish's meeting.

1. The Classical Growth Era of Alphia (1850-1950)

This hundred-year era was noted for periodic high levels of population growth and the sporadic introductions of technology. The average Alphianian's income was very modest and the standard of living remained almost the same over the 100-ycar period, except when new technology was introduced. Dr. Satish cites the example of the one-time introduction of electricity to the Alphian economy from 1947 to 1950. E

2. The Neoclassical Growth Era o/Alphia (1951-1990)

During the neoclassical growth period, Alphia experienced a period of great economic growth. For example, from 1986 to 1990, Alphia's capital per hour of labor grew at a 9% annual rate, while real GDP grew at 7% per annum.

Also, Alphia was able to achieve economic growth rates and income levels comparable with many of its neighboring countries during the neoclassical growth period. Alphian scientists, together with the engineering department of the University of Ullom, provided access to the finest technology in the world. In addition, Alphia opened up its equity markets to outside investors and allowed its currency to float. Dr. Satish believes that, given time, these capital market improvements should allow the Alphian economy to achieve an economic growth rate and per capita income level comparable to any country in the world.

To understand the role of technology in the growth of the Alphian economy (using neoclassical growth theory assumptions), the following table was developed to show the increased productivity of Alphian farmers using disease resistant grains. Assume new disease resistant grain technology was introduced into the Alphian farm economy at Point A .

3. The New Growth Era (1991-Today)

Since the Alphian energy crises of the late 1980s, the economy has been in transition. The AEDA goal is to have more than 50% of Alphian GDP coming from what we now call knowledge capital based industries by the year 2020. Given the large and growing population and their constant need for health care, the pharmaceutical industry was Alphia's first knowledge capital based industry. Dr. Satish believes that a focus on knowledge capital will enhance the long term growth prospects of Alphia's economy.

According to classical growth theory, what is the real wage rate for Alphiain 1950?