CFA Institute CFA Level II Chartered Financial Analyst CFA-Level-II Exam Questions

Susan Foley, CFA, is Chief Investment Officer of Federated Investment Management Co. (FIMCO), a large investment management firm that includes a family of mutual funds as well as individually managed accounts. The individually managed accounts include individuals, personal trusts, and employee benefit plans. In the past few months, Foley has encountered a couple of problems.

The Tasty IPO

Most portfolio managers of FIMCO have not participated in the initial public offering (IPO) market in recent years. However, recent changes to the compensation calculation at FIMCO have tied manager bonuses to portfolio performance. The changes were outlined in a letter that was sent out to clients and prospects shortly before the new bonus structure took effect. Carl Lee, CFA, is one portfolio manager who believes that investing in IPOs may add to his client's equity performance and, in turn, increase his bonus. While Lee's individual clients have done quite well this year, his employee benefit plans have suffered as a result of limited exposure to the strongest performing sector of the market. Lee has placed an order for all employee benefit plans to receive an allocation of the Tasty Doughnut IPO. Tasty is an over-subscribed IPO that Lee knew would make money for his clients. When he placed the order, Lee's assistant reminded him that one pension plan. Ultra Airlines, was explicitly prohibited from investing in IPOs in its investment policy statement, due to the under-funded status of the pension plan. Lee responded that the Tasty IPO would never actually be owned in Ultra's account, because he would sell the IPO stock before the end of the day and realize a profit before the position ever hit the books.

Another manager, Franz Mason, CFA, who manages accounts for about 150 individuals, is also interested in the Tasty IPO. Mason visits Lee's portfolio assistant and quizzes him about Lee's participation in the Tasty deal. Mason is sure that Lee would not have bought into Tasty unless he had done his homework. Mason places an order for 10,000 shares of the IPO. Mason returns to his desk and begins to allocate the IPO shares among his clients. Mason divides his client base into two groups: clients who are income-oriented and clients who arc capital gains-oriented. Mason believes those clients that are income-oriented are fairly risk averse and could not replace lost capital if the Tasty Doughnut deal lost money. Mason believes the capital gains-oriented accounts arc better able to withstand the potential loss associated with the Tasty IPO. Accordingly, Mason allocates his 10,000 share order of the Tasty IPO strictly to his capital appreciation clients using a pro rata allocation based on the size of the assets under management in each account.

FIMCO Income Fund (FIF)

Over the past three years, the FIF, with $5 billion in assets, has been the company's best performing mutual fund. Jane Ryan, CFA, managed the FIF for seven years, but resigned one year ago to start her own hedge fund. Under Ryan, the FIF invested in large cap stocks with reliable dividends. The fund's prospectus specifies that FIF will invest only in stocks that have paid a dividend for at least two quarters, and have a market capitalization in excess of $2.5 billion. Foley appointed FIMCO's next best manager (based on 5-year performance numbers) Steve Parsons, CFA, to replace Ryan. Parsons had been a very successful manager of the FIMCO Opportunity Fund, which specialized in small capitalization stocks. Six months after Parsons took over the helm at FIF. the portfolio had changed. The average market capitalization of FIF's holdings was $12.8 billion, as opposed to $21 billion a year ago. Over the same period, the average dividend yield on the portfolio had fallen from 3.8% to 3.1%. The performance of the FIF lagged its peer group for the first time in three years. In response to the lagging performance, Parsons purchased five stocks six months ago. Parsons bought all five stocks, none of which paid a dividend at the time of purchase, in anticipation that each company was likely to initiate dividends in the near future. So far, four of the stocks have initiated dividend payments, and their performance has benefited as a result. The fifth stock did not initiate a dividend, and Parsons sold the position last week. Largely due to the addition of the five new stocks, the FIF's performance has led its peer group over the past six months.

Before leaving FIMCO, Ryan had told Foley that above-average returns from both the management and client side could be gained from entering into the risk-arbitrage hedge fund market. Ryan had tried to convince FIMCO management to enter the risk-arbitrage market, but the firm determined that no one had the experience or research capability to run a risk-arbitrage operation. As a result, Ryan started the Plasma Fund LLC one month after leaving FIMCO. Foley remembers seeing Ryan at the annual FIMCO client dinner parly (before she left the firm) discussing the profits to be made from risk-arbitrage investing with several large FIF shareholders. Ryan mentioned that she would be opening the Plasma Fund to these FIMCO clients, several of whom made substantial investments in the first months of Plasma Fund's life. After Ryan resigned and left her office, Foley performed an inventory of firm assets signed out to Ryan. One of the copies of the proprietary stock selection software packages, FIMCO-SelectStock, assigned to Ryan was missing along with several of the SelectStock operating manuals. When Foley contacts Ryan about the missing software and manuals, Ryan states that the reason she took the SelectStock software was that it was an out of date version that FIMCO's information technology staff had urged all managers to discard.

Which of the following statements is most accurate with regard to Ryan's discussion of the new Plasma Fund with FIMCO clients?

MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:

Expected return for Portfolio X =15%

Standard deviation of returns for Portfolio X = 20%

Expected return for Portfolio Y = 7%

Standard deviation of returns for Portfolio Y = 5%

Expected return on Portfolio Z = 5%

Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.

Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:

Expected return on Burk's portfolio = 10%

Standard deviation of returns on Burk's portfolio = 12%

Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of Long Drives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%.

After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.

MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.

MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:

Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.

Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, the Treynor-Black model avoids this problem because it does not consider short positions in securities.

In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast and Elizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.

Kitna has hired MPTA to evaluate the CCT stock and to make a valuation recommendation. In order to determine if the CCT stock is undervalued, overvalued, or properly valued, MPTA must first determine the appropriate value for the CCT beta. Given a CCT beta of 1.5, what is the conclusion that MPTA should make about the value of CCT based on the consensus analyst forecast of CCT returns?

Ota L'Abbe, a supervisor at an investment research firm, has asked one of the junior analysts, Andreas Hally, to draft a research report dealing with various accounting issues.

Excerpts from the request are as follows:

* ''There's an exciting company that we're starting to follow these days. It's called Snowboards and Skateboards, Inc. They are a multinational company with operations and a head office based in the resort town of Whistler in western Canada. However, they also have a significant subsidiary located in the United States."

* "Look at the subsidiary and deal with some foreign currency issues including the specific differences between the temporal and all-current methods of translation, as well as the effect on financial ratios."

* "The attached file contains the September 30, 2008, financial statements of the U .S . subsidiary. Translate the financial statements into Canadian dollars in a manner consistent with U .S . GAAP."

The following are statements from the research report subsequently written by Hally:

Statement 1: Subsidiaries whose operations are well integrated with the parent will use the all-current method of translation.

Statement 2: Self-contained, independent subsidiaries whose operating, investing, and financing activities are primarily located in the local market will use the temporal method of translation.

Other information to be considered

* Exchange rates (CAD/USD)

* Beginning inventory for fiscal 2008 had been purchased evenly throughout fiscal 2007. The company uses the FIFO inventory value method.

* Dividends of USD 25,000 were paid to the shareholders on June 30, 2008.

* All of the remaining inventory at the end of fiscal 2008 was purchased evenly throughout fiscal 2008.

* All of the PP&E was purchased, and all of the common equity was issued at the inception of the company on October 1, 2004. No new PP&E has been acquired, and no additional common stock has been issued since then. However, they plan to purchase new PP&E starting in fiscal 2009.

* The beginning retained earnings balance for fiscal 2008 was CAD 1,550,000.

* The accounts payable on the fiscal 2008 balance sheet were all incurred on June 30, 2008.

* The U .S . subsidiary's operations are highly integrated with the main operations in Canada.

* The remeasured inventory for 2008 using the temporal method is CAD 810,000.

* All monetary asset and liability balances are the same as they were at the end of the 2007 fiscal year, except that long-term debt was USD 467,700.

* Costs of goods sold under the temporal method in 2008 is CAD 1,667,250.

Using the appropriate translation method, which of the following best describes the effect of changing exchange rates on the parent's fiscal 2008 financial statements?

Tobin Yoakam, CFA, is analyzing the financial performance of Konker Industries, a U .S . company which is publicly traded under the ticker KONK. Yoakam is particularly concerned about the quality of Konker's financial statements and its choices of accounting methodologies.

Below is a summary of Konker's financial statements prepared by Yoakam.

Konker has an operating lease for several of its large machining tools. The lease term expires in five years, and the annual lease payments are $2 million. The applicable interest rate on the operating lease is 9%. Yoakam believes that the operating lease should be capitalized and treated as a finance lease. For purposes of adjusting the financial statements, Yoakam believes that the machining tools should be depreciated using straight-line depreciation with a salvage value of $3 million.

At the beginning of 20X8, Konker formed a qualified special purposes entity (QSPE) and sold a portion of its accounts receivables to the QSPE. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) is considering the elimination of qualified special purposes entities.

Konker has three major operating divisions: Konker Industrial, Konker Defense, and Konker Capital. Yoakam has computed the EBIT margin for each division over the last three years as well as the ratio of the percentage of total capital expenditures to the percentage of total assets for each division.

Since Yoakam is concerned about the quality of Konker's earnings, he decides to analyze the accrual ratios using the balance sheet approach. The table below contains the last three years of accrual ratios for Konker and the industry average.

With respect to the balance sheet accrual ratio, which of the following, other things equal, would most likely lead to an increase in the ratio for a growing company?

Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments.

On December 31,2007, Wayland purchased a 35% ownership interest in a strategic new firm called Optimax for $300,000 cash. The pre-acquisition balance sheets of both firms are found in Exhibit 1.

On the acquisition date, all of Optimax's assets and liabilities were stated on its balance sheet at their fair values except for its property, plant, and equipment (PP&E), which had a fair value of $1.2 million. The remaining useful life of the PP&E is ten years with no salvage value. Both firms use the straight-line depreciation method.

For the year ended 2008, Optimax reported net income of $250,000 and paid dividends of $100,000.

During the first quarter of 2009, Optimax sold goods to Wayland and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Optimax remained in Wayland's inventory.

Wayland currently uses the equity method to account for its investment in Optimax. However, given the potential significance of the investment in the future, Rathbun believes that a proportionate consolidation of Optimax may give a clearer picture of the financial and operating characteristics of Wayland.

Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers the data in Exhibit 2 from Wayland's financial statements. The year-end portfolio value is the market value of all Vanry shares held on December 31. All security transactions occurred on July 1, and the transaction price is the price that Wayland actually paid for the shares acquired. Vanry pays a cash dividend of $1 per share at the end of each year. Wayland expects to sell its investment in Vanry in the near term and accounts for it as held-for-trading.

Wayland owns some publicly traded bonds of the Rotor Corporation that it reports as held-to-maturity securities.

What amount should Wayland report in its balance sheet as a result of its investment in Optimax at the end of 2008?

Fashion Inc. is a major U .S . distributor of high quality women's jewelry and accessories. The company's growth in recent years has been moderately above the industry average. However, competition is intensifying as a number of overseas competitors have entered this mature market. Although Fashion has been a publicly held company for many years, members of senior management and their families control 20% of the outstanding common stock. Martin Silver, the Chief Executive Officer, has been under intense pressure from both internal and external large shareholders to find ways to increase the company's future growth.

Silver has consulted with the company's investment bankers concerning possible merger targets. The most promising merger target is Flavoring International, a distributor of a broad line of gourmet spices in the United States and numerous other countries. In recent years, Flavoring's earnings growth rate has been above competitors' and also has exceeded Fashion's experience. Superior income growth is projected to continue over at least the next five years. Silver is impressed with the appeal of the company's products to upscale customers, its strong operating and financial performance, and Flavoring's dynamic management team. He is contemplating retirement in three years and believes that Flavoring's younger, more aggressive senior managers could boost the combined company's growth through increasing Fashion's operating efficiency and expanding Fashion's product line in countries outside the United States. Alan Smith, who is Silver's key contact at the investment banking firm, indicates that a key appeal of this merger to Flavoring would be Fashion's greater financial flexibility and access to lower cost sources of financing for expansion of its products in new geographic areas. Fashion has a very attractive performance based stock option plan. Flavoring's incentive plan is entirely based on cash compensation for achieving performance goals. Additionally, the 80% of Fashion's stock not controlled by management interests is very widely held and trades actively. Flavoring became a publicly held company three years ago and doesn't trade as actively.

Silver has asked Smith to prepare a report summarizing key points favoring the acquisition and an acceptable acquisition price. In preparing his report, Smith relics on the following financial data on Fashion, Flavoring, and four recently acquired food and beverage companies.

Using the comparable transaction approach based on the four recently acquired companies, Smith determines an estimated takeover value based on equally weighted key valuation variables. The estimated takeover value would be closest to;

Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.

Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the "neglected firm effect," in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be "neglected."

Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:

Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei

where:

Ri = the rate of return on stock i

COVERAGEi = one if there are three or fewer analysts covering stock

i, and equals zero otherwise

LN(SIZEi) = the natural logarithm of the market capitalization

(stock price times shares outstanding) for stock i,

units in millions

FORECASTi = the 1-year consensus earnings growth rate forecast for stock i

Pilchard derives the following results from her cross-sectional regression:

The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.

Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.

Pilchard is asked whether her regression indicates that small firms outperform large firms, after controlling for analyst coverage and consensus earnings growth forecasts. Pilchard determines the appropriate hypothesis test to answer the question. Eiffel Investments uses a 0.01 level of significance for all hypothesis tests. Given the results of her regression, Pilchard should make the following decision after controlling for analyst coverage and consensus earnings forecasts: