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

Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. Tf the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company's revenues will increase by $175,000 and costs by $25,000 for each year of the equipment's 3-year life. There is no expected change in net working capital.

The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of-$62,574.

Suppose for this question only that Malfoy has forgotten to reflect a decrease in inventory that will result at the beginning of the project. The most likely effect on estimated project NPV of this error:

Christopher Robinson, chairman of the board of directors for a private endowment fund, believes that the endowment fund for which he is responsible has diverged too far from its stated objectives. Over several years the board has increased the size of the fund's equity position beyond the stated limits of the investment policy statement. In an effort to realign the fund's investments, Robinson has elected to choose a mortgage-backed security (MBS) for inclusion in the endowment's portfolio. After surveying the MBS market, Robinson has selected four MBS securities to present as potential investments at the next investment committee meeting. Details on the selected MBS securities are presented below:

At the investment committee meeting, a fellow board member raises his concerns over the potential MBS investments stating, "While we all agree that the fixed-income proportion of the endowment is much too small, I am not sure the suggested MBS securities will fulfill the cash flow requirements of the endowment. What risks are we taking on by allocating a portion of the portfolio to these investments? We cannot afford to end up with a timing mismatch between the cash needs of the endowment and the cash provided from its investments. Also, we have given no consideration to commercial mortgage backed securities (CMBS). Isn't our analysis incomplete if we fail to give proper discussion of potential CMBS investment opportunities?"

Robinson responded to his fellow board member by addressing the board member's concerns as follows:

"Since the cash requirements of the endowment fund fluctuate directly with interest rates, the cash flows provided from the MBS will provide adequate protection against cash shortfalls arising from differences in the timing of cash needs and cash sources. In addition, we can further reduce uncertainty surrounding the timing of cash flows by purchasing planned amortization class CMOs, which are securities issued against pools of MBS. CMBS were not presented due to the unacceptable risk profile of the comparable CMBS trading in the marketplace."

Robinson commented that the MBS cash flows would match the cash needs of the endowment, and also that planned amortization class CMOs also help mitigate cash flow timing risk. Are Robinson's comments correct?

A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.

In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the hedge fund index.

As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.

Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in illiquid bonds if the opportunity presents itself.

in reviewing the correlation matrix (Exhibit 2), Nash concluded that the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure that the fund's returns will be positive when the returns of the index are negative.

After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition, Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future risk.

Nash is concerned about the impact a major market disruption would have on the performance of the selected hedge funds. Based solely on Exhibit 1, which hedge fund has the greatest risk if a major market disruption were to occur?

Glenda Garvey is interning at Samson Securities in the summer to earn money for her last semester of studies for her MBA, She took the Level 3 CFA exam in June but has not yet received her score. Garvey's work involves preparing research reports on small companies.

Garvey is at lunch with a group of co-workers. She listens to their conversation about various stocks and takes note of a comment from Tony Topel, a veteran analyst. Topel is talking about Vallo Engineering, a small stock he has tried repeatedly to convince the investment director to add to the monitored list. While the investment director does not like Vallo, Topel has faith in the company and has gradually accumulated 5,000 shares for his own account. Another analyst, Mary Kennedy, tells the group about Koral Koatings, a paint and sealant manufacturer. Kennedy has spent most of the last week at the office doing research on Koral. She has concluded that the stock is undervalued and consensus earnings estimates are conservative. However, she has not filed a report for Samson, nor does she intend to. She said she has purchased the stock for herself and advises her colleagues to do the same. After she gets back to the office, Garvey purchases 25 shares of Vallo and 50 shares of Koral for herself.

Samson pays its interns very little, and Garvey works as a waitress at a diner in the financial district to supplement her income. The dinner crowd includes many analysts and brokers who work at nearby businesses. While waiting tables that night, Garvey hears two employees of a major brokerage house discussing Metrona, a nanotechnology company. The restaurant patrons say that the broker's star analyst has issued a report with a buy rating on Metrona that morning. The diners plans to buy the stock the next morning. After Garvey finishes her shift, restaurant manager Mandy Jones, a longtime Samson client, asks to speak with her. Jones commends Garvey for her hard work at the restaurant, praising her punctuality and positive attitude, and offers her two tickets to a Yankees game as a bonus.

The next morning, Garvey buys 40 shares of Metrona for her own account at the market open. Soon afterward, she receives a call from Harold Koons, one of Samson's largest money-management clients. Koons says he got Garvey's name from Bertha Witt, who manages the Koons' account. Koons wanted to reward the analyst who discovered Anvil Hammers, a machine-tool company whose stock soared soon after it was added to his portfolio. Garvey prepared the original report on Anvil Hammers. Koons offers Garvey two free round-trip tickets to the city of her choice. Garvey thanks Koons, then asks her immediate supervisor, Karl May, about the gift from Koons but does not mention the gift from Jones. May approves the Koons' gift.

After talking with May, Garvey starts a research project on Zenith Enterprises, a frozen-juice maker. Garvey's gathers quarterly data on the company's sales and profits over the past two years. Garvey uses a simple linear regression to estimate the relationship between GDP growth and Zenith's sales growth. Next she uses a consensus GDP estimate from a well-known economic data reporting service and her regression model to extrapolate growth rates for the next three years.

Later that afternoon, Garvey attends a company meeting on the ethics of money management. She listens to a lecture in which John Bloomquist, a veteran portfolio manager, talks about his job responsibilities. Garvey takes notes that include the following three statements made by Bloomquist:

Statement 1: I'm not a bond expert, and I've turned to a colleague for advice on how to manage the fixed-income portion of client portfolios.

Statement 2: I strive not to favor either the remaindermen or the current-income beneficiaries, instead I work to serve both of their interests.

Statement 3: All of my portfolios have target growth rates sufficient to keep ahead of inflation.

Garvey is not working at the diner that night, so she goes home to work on her biography for an online placement service. In it she makes the following two statements:

Statement 1: I'm a CFA Level 3 candidate, and I expect to receive my charter this fall. The CFA program is a grueling, 3-part, graduate-level course, and passage requires an expertise in a variety of financial instruments as well as knowledge of the forces that drive our economy and financial markets.

Statement 1: I expect to graduate with my MBA from Braxton College at the end of the fall semester. As both an MBA and a CFA, I'll be in high demand. Hire me now while you still have the chance.

Which of Bloomquist's statements most likely applies to both the Prudent Man Rule and the Prudent Investor Rule?

Donnie Nelson, CFA, has just taken over as Chief Financial Officer of MavsHD, a high-tech company that delivers high-definition technology to a broad-based group of sports enthusiasts. MavsHD has 40% debt and 60% equity in its capital structure. For the year just ended, net income and dividends for MavsHD were equal to $145 million and $21.75 million, respectively. The consensus estimate for net income at the end of the current year is equal to $ 153 million. The company's current book value is $550 million. MavsHD's stock is currently trading on the NYSE for a price of S50 per share and has been steadily decreasing for the past twelve months.

MavsHD has gone through its pioneer and growth phases and is now settling in to the early stages of maturity. The business model is starting to shift from reliance almost exclusively on new customers, to a focus on retaining and satisfying existing customers. The previously experienced very high growth rate has slowed considerably. Nelson believes that the shareholder composition has changed over time as well, favoring shareholders who have a greater interest in dividend stability than explosive growth. In the past, however, the firm has favored a low dividend rate due to the availability of attractive internal investment opportunities.

Nelson wants to develop an optimal dividend policy for MavsIID that will create the most value for the shareholders and at the same time protect corporate assets. He is concerned, however, that there is sometimes a disconnect between an optimal dividend policy and how actual dividend rates are perceived in the marketplace.

Nelson is preparing a recommendation to senior management and the board of directors regarding the firm's dividend policy going forward. Nelson is considering recommending that MavsHD engage in a stock repurchase plan, and repurchase 1.5 million shares of the 12.75 million shares outstanding. This repurchase would eliminate any need to increase the cash dividend payout. Other managers at the firm, besides Nelson, believe MavsHD should increase its dividend and gravitate toward what they perceive to be the target payout ratio over the next eight years. Thus, at the end of the current year, the firm will increase the dividend payment by $250,000 over the dividend in the prior year.

During the board meeting, two of the directors raised concerns over Nelson's proposed repurchase plan. The directors' comments follow:

Director 1: I support the repurchase plan, especially relative 10 varying our dividend. Firms should not vary dividends---this lowers investors' confidence and can adversely impact the firm's cost of equity and its share price.

Director 2: A share repurchase does not take away the uncertainty associated with future stock value. According to the bird-in-the-hand theory, investors prefer higher dividends since capital gains are uncertain. The theory states that if we increase our dividend payout, the value of MavsHD equity will increase. Thus, 1 propose a dividend increase rather than a repurchase.

One of the board members, Jason Neely, proposed an alternative dividend policy plan one week after the meeting in which Nelson presented his plan. Neely's proposal involves utilizing a residual dividend model. Neely rationalizes his plan by claiming that relative to a stable dividend policy, his proposal would increase the volatility of dollar dividends paid to shareholders but would simultaneously increase the firm's ability to exploit value additive investment projects using internally generated funds. Because of this enhanced access to value additive projects, MavsHD's cost of equity capital will experience a marginal decrease which will further increase the overall value of the firm.

In light of the fact that there are several different groups of investors who hold shares in MavsHD, evaluate the directors' comments regarding Nelson's proposed stock repurchase plan.

Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for Anderson Brothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).

Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.

Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price. Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.

Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.

Williams asks the bank for a GBP/SFr cross rate.

From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:

* 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55

* 60-day forward rate: USD/GBP = USD/GBP = 2.0075 - 85

Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U .S . risk-free rate is 5%.

Is Williams's analysis of the effect of rising nominal Bundovian interest rates on the value and equilibrium quantity of the BU correct?

Stanley Bostwick, CFA, is a business services industry analyst with Mortonworld Financial. Currently, his attention is focused on the 2008 financial statements of Global Oilfield Supply, particularly the footnote disclosures related to the company's employee benefit plans. Bostwick would like to adjust the financial statements to reflect the actual economic status of the pension plans and analyze the effect on the reported results of changes in assumptions the company used to estimate the projected benefit obligation (PBO) and net pension cost. But first, Bostwick must familiarize himself with the differences in the accounting for defined contribution and defined benefit pension plans.

Global Oilfield's financial statements are prepared in accordance with International Financial Reporting Standards (IFRS). Excerpts from the company's annual report are shown in the following exhibits.

Which of the following best describes the effects of a decrease in the rate of compensation growth during 2009 all else equal? Global Oilfield's: