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2020 Level II Mock Exam (B) AM The morning session of the 2020 Level II Chartered Financial Analyst®Mock

Examination has 60 questions. To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam.

SUZY MERCER CASE SCENARIO Suzy Mercer, CFA, is currently working as a capital market adviser in a developing country. While attending a regional securities exchange conference, she introduces herself to Terrence Ong, CFA. Ong is one of several partners at Shangri-­la Development Associates, a consulting firm specializing in capital market expansion in developing countries. When making her introduction, Mercer states, “I’m an independent adviser working with the government of a developing country to improve its capital market sector. I’ve heard a lot about the work you’ve done. Could we talk about my consulting assignment and a possible role for you?” Mercer continues, “I’m currently one of a handful of CFA Charterholders residing in the country right now. I’m looking for expertise to help with a capital market development project, but none of the charterholders are qualified to assist me with the assignment despite the rigor of the CFA exams. Frankly, I am a bit surprised I couldn’t find any one to assist me with this project.” Ong responds, “I can relate. I wanted to get the CFA charter, knowing it would help me gain credibility in the early stages of my career and eventually grow our firm. It helped me get capital market development assignments because of the reputation of the CFA Program, so I now have the experience you are looking for, whereas other CFA charterholders may not have had the same opportunity.” Mercer continues, “I’m looking for someone with your background and stellar reputation to help create a strategic plan to develop the asset management industry. The client’s goal is to get the Securities Exchange to be a part of a regional exchange. This will help the locally listed companies gain more exposure. However, given the budget I’ve been given, I can afford to hire only an individual. Ong, would this be of interest to you?” Mercer continues the conversation by informing Ong that she will also be approaching other industry participants, particularly in the fund management industry, who are attending the conference. Ong responds, “I sure hope you are not talking to Daniel Ngyue, who manages several startup funds. I think he has a drinking problem. There is a rumor his last startup fund was not well received by the investors, likely due to his drinking. As one charterholder to another, please do your due diligence first before you hire anyone. As you have already pointed out, my reputation is stellar. Why By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-­registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose CFA®, Chartered Financial Analyst®, AIMR-­PPS ®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. © 2020 CFA Institute. All rights reserved.

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2020 Level II Mock Exam (B) AM

don’t we meet tonight for dinner at my ‘members only’ club to discuss your project further? I can introduce you to other influential people who are currently looking for experienced advisers in your field for upcoming assignments. I’m sure if they knew we were working together, it would really go a long way in obtaining future assignments from these industry leaders.” Mercer informs Ong that she is unfortunately not able to meet him for dinner because of a previous engagement. She subsequently says to Ong, “I’m wondering how you would respond to a situation whereby a regulator chooses not to implement extensive policies and regulations regarding the integrity of capital markets I recommended. They say my suggested policies and regulations related to market manipulation, material nonpublic information, and protecting client interests are too complicated, and they do not have the judicial competency to back them up. Consequently, they have requested I recommend just one primary rule.” Thereafter, Mercer seeks out Daniel Ngyue, a CFA candidate, to ask for his version of what happened with his investors. Ngyue responds, “What actually happened was I got sick in a restaurant after having an adverse reaction to some medication. People uploaded photos to social media and stated I was falling over drunk. Subsequently, I wrote a letter to the investors explaining the situation and assuring them I had found another highly qualified fund manager after several weeks to take over until such time I had fully recovered. When I could, I looked at the fund when I was in the hospital for a week, but the fund needs close supervision, so that’s why I wanted to find another manager. One investor commented, ‘Key-­person risk was not identified in the fund’s prospectus.’ Within one week we sent out a revision to the prospectus identifying key-­person risk.” After Mercer explains to Ngyue her need to create a strategic plan to develop the asset management industry, she asks, “If you were to work with me, what suggestions would you give the regulators for establishing this new industry?” After thinking for a few minutes, Ngyue responds with the following recommendations: Recommendation 1: Compliance officers should endorse all personal trades after execution. Recommendation 2: Require a minimum of 30 hours of continuing education for all market service providers. Recommendation 3: Require supervisors to create simple incentive programs for their staff based on client returns. 1 During their initial conversation, is either Mercer or Ong most likely in violation of Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate? A No B Yes, Ong is most likely in violation. C Yes, Mercer is most likely in violation. 2 To avoid violating any CFA Institute Standards of Professional Conduct, which of the following is Ong’s most appropriate responseto Mercer’s question? A “I will need to touch base with my partners.” B “I’m not able to take on projects as an individual.” C “I can refer you to another independent adviser.” 3 In the continued conversation between Mercer and Ong, which sub-­standard of Standard I: Professionalism did Ong least likely violate? A Misconduct B Misrepresentation

2020 Level II Mock Exam (B) AM

C Independence and Objectivity 4 Which of the following should Ong most likely advise with regard to the regulator’s request? A Ban the “pumping up” of investment prices. B Require material information be made public within 24 hours. C When trading, insist service providers give preference to investors. 5 During the conversation between Ngyue and Mercer, Ngyue revealed he had most likely violated which CFA Institute Standards of Professional Conduct? A Standard I: Professionalism B Standard V: Investment Analysis, Recommendations, and Actions C Both Standard I: Professionalism and Standard V: Investment Analysis, Recommendations, and Actions 6 To be consistent with the CFA Institute Standards of Professional Conduct, Mercer should most likely consider endorsing which of Ngyue’s recommendations for developing the asset management industry? A Recommendation 1 B Recommendation 2 C Recommendation 3

GOOGOLMINING 2 CASE SCENARIO James Quinn is the founder and CEO of GoogolMining Inc. (GMI). The company applies data science and machine learning to assist lenders in predicting the credit risk of their customers. Today, Quinn is meeting with Judy Wu, the chief lending officer at onLineLoans. com. Wu’s company already uses some of Quinn’s machine learning (ML) methods to better screen loan applicants whose credit files are usually thin—that is, having limited or no past credit history and low incomes, making traditional credit evaluation difficult. Quinn is introducing Wu to the benefits of using text-­based data that can be found in the loan applications to further aid the screening process. Quinn states that the choice and pattern of words used by applicants in describing the loan request and its purpose and the use of pleading terms, excessive uppercase words, and spelling mistakes can all be very informative. He provides the following excerpts from two loan applications (Exhibit 1). Exhibit 1 Selected Text-­Based Data from a Few Credit Applications ID

Excerpts from Applicant’s Statements in Loan Request

1

While the past year has been wonderful living in our new house, the furnace has been acting up recently and I need to borrow $4,000 to replace it. I make a point of paying all my bills on time.

2

Humbly stated, I’m in sheer need of your kind aid. I am really needing $2,000 riteaway to fix the roof which has started to leak into the bedroom of my oldest daughtter. PLEASE HELP!

3

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Wu tells Quinn that she has heard a little about text mining for clues about an individual’s behavior and recalls that text preparation must be carried out by removing such items as HTML tags, punctuation, numbers, and stop words and eliminating the distinction between uppercase and lowercase words by lowercasing them all. Quinn subdivides the word clouds generated from the document term matrix (DTM) into defaulting and non-­defaulting loans and selectively illustrates how the words, n-­grams, and more common themes differ between the two groups: ■■

The wording in non-­defaulting loans often has indications of a brighter future— for example, “graduate” and “wedding”—and reasons why the loan is needed, such as “student_loan” or “car_insur.”

■■

The wording in defaulting loans often contains statements of desperation and pleading terms—for example, “and_need” and “your_help”—as well as detailed explanations as to why these circumstances have arisen, such as “loan_explain” and “loan_because.”

Quinn uses logistic regression to train the model: Defaulting loans are classified as Class 1, and non-­defaulting loans are classified as Class 0. After tuning, the threshold p-value of 0.60 (for Class 1) is used to predict the outcome for each loan application in the test data. Exhibit 2 indicates the result for one of those applications. Exhibit 2 Result for a Selected Credit Applicant in Test Data Applicant’s Cleansed and Preprocessed Text honest person face unusu cash_flow issu earli graduat wed present trip Nevada hous truli winner promot prosper sure futur after term like borrow tuition final

Actual Outcome Defaulted (Class 1)

p 0.41

The original statement by the credit applicant was “I am an honest person who now faces unusual cash flow issues from my early graduation and wedding present which was a trip to Nevada—the house was truly a winner. Promotion and prosperity are surely in my future after this term but I would like to borrow $10,000 for the tuition in my final term.”

After running his model on the test set, Quinn produces a confusion matrix for evaluating the performance of the model (Exhibit 3). He reminds Wu that since the number of defaults in the dataset is likely much smaller than the number of non-­ defaults, this needs to be considered in evaluating model performance.

2020 Level II Mock Exam (B) AM

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Exhibit 3 Confusion Matrix of Model Results for Test Data of Loan Default Classifications with Threshold p-Value = 0.60 Actual Training Results

Predicted Results

Class 1 Class 0

Class 1

Class 0

TP = 118

FP = 32

FN = 8

TN = 320

TP: True positive; TN: True Negative; FP: False positive; FN: False negative

7 Wu’s recollection about the preparation of the textual data is most accurate with respect to: A numbers. B stop words. C lowercasing. 8 After the cleansed textual data are normalized, the tokens added to the bag of words (BOW) arising from Applicant 2 (Exhibit 1) are most likely to include: A bedroom and kind. B really and needing. C HELP and daughtter. 9 Based on Exhibit 2, the most appropriate statement about the model’s performance for the selected credit applicant is that it results in: A a Type I error. B a Type II error. C the correct classification. 10 Using Exhibit 3 and Quinn’s reminder, the most appropriate measure of the accuracy of the model is: A 0.79. B 0.86. C 0.92.

ATLANTIC PRESERVES CASE SCENARIO Jim Loris is the Food and Beverage analyst at Eastern Trust & Investments. Jeremy Paul is an intern under Loris’s supervision. Loris is planning on reviewing the financial statements of Atlantic Preserves, Inc., in the next few days. The company has recently signed a new collective agreement with its workers, and Loris is interested in seeing how the company’s employment costs have been affected. The company prepares its financial statements in accordance with US GAAP, and the new collective agreement became effective 1 January 2018.

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Paul extracts portions of the new collective agreement related to the pension plan and mentions to Loris that there have been two changes related to the plan: ■■

The benefit formula has been changed to 1.75% × Final year’s salary × Number of years of service under the plan. Previously, the same formula was used, but with a factor of 1.65%.

■■

The vesting period has been changed from four years to three years. Paul makes the following two comments about these changes to the pension plan:

1 The new formula will have a big impact on income because the past service costs that arise will be expensed immediately. 2 The change to a shorter vesting period will give rise to an actuarial gain. Loris responds: “The past service costs that arise will be reported in other comprehensive income and amortized on the profit and loss statement over the average service lives of the employees.” Loris provides Paul with the information in Exhibit  1 about John Smith, an employee who has just started working for Atlantic, and other information taken from the company’s pension plan disclosures. Loris asks Paul to calculate the pension liability arising from Smith. Exhibit 1 Assumptions Relating to the Liability Arising from John Smith’s Pension Pension Plan Details and Assumptions

Employee Details

Annual wage increase

3.50%

Current salary

Discount rate

7.50%

Date hired

Pension Plan Benefit Payments

Expected retirement date

Annual payments are paid at year end and continue for the remainder of the retiree’s life

Estimated final salary Estimated years in retirement

$60,000 1 Jan. 2018 31 Dec. 2023 $71,261 25

Following his calculation of the pension plan liability, Paul asks Loris two questions about the discount rate that is used: 1 Exhibit 1 does not mention how you determined the discount rate that was used. What rate is the most appropriate rate to use? 2 What would be the effect of using a higher discount rate on various components of the company’s pension plan obligation? Loris answers Paul’s questions and then provides him with selected information from Note F of the 2017 Annual Report of Atlantic Preserves, shown in Exhibit 2. He mentions to Paul that he is aware that the company’s actual return on pension plan assets exceeds its expected return, and asks him to use the information in Exhibit 2 to calculate the periodic pension cost included in Atlantic’s 2017 income statment. Exhibit 2 Selected Information from Note F of Atlantic’s 2017 Annual Financial Statements ($ thousands) Start-­of-­year net pension liability

12,448

End-­of-­year net pension liability

12,265

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Exhibit 2 (Continued) Current service cost

1,151

Interest cost

5,441

Actual return on plan assets

5,888

Expected return on plan assets

4,597

Benefits paid to retired employees

5,059

Contributions

887

Amortization of past service costs

272

Finally, Loris tells Paul that he intends to adjust Atlantic’s operating income so that it excludes the non-­operating components of the reported pension expense. Paul asks what portion of Atlantic’s reported pension expense should be considered as an operating expense. 11 In regard to Loris and Paul’s discussion about the changes in the pension plan arising from the new collective agreement, which comment is most accurate? A Paul’s first comment about the impact on income B Loris’s response about past service costs C Paul’s second comment about the actuarial gain 12 At the end of Smith’s second year of service, the estimated defined-­benefit obligation arising from his employment is closest to: A $20,092. B $27,802. C $20,818. 13 The best answer to Paul’s first question is to use the: A company’s before-­tax cost of debt. B yield on high quality corporate bonds. C company’s overall cost of capital. 14 The least appropriate answer to Paul’s second question is that the: A interest cost may either increase or decrease. B opening obligation would decrease. C current service cost would increase. 15 The amount of Atlantic Preserve’s 2017 periodic pension cost reported in net income (in $ thousands) is closest to: A 1,995. B 976. C 2,267. 16 The best answer to Paul’s question about the operating portion of the pension expense if (in $ thousands): A 1,151. B 1,423. C 6,592.

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2020 Level II Mock Exam (B) AM

TREADWAY CASE SCENARIO Hannah Treadway is an analyst at Knight Investment Management (Knight). Knight holds Cooper Creek Cable Limited (CCCL) as part of its AFE (Australian and Far East) investment portfolio. CCCL is a diversified cable and communications company operating in Western Australia. The company consists of three divisions: Cable: Provides subscription television services and high speed internet to residential customers. Media: Owns and operates a group of radio stations and publishes several magazines. Wireless: Is engaged in wireless voice and data communications services. Treadway is just starting her annual review of the company based on its most recent financial statements, excerpts of which are in Exhibits 1 and 2. The financial statements for CCCL are prepared in accordance with Australian Accounting Standards (AASB), which comply with IFRS. All figures are in Australian dollars ($). Exhibit 1 Cooper Creek Cable Limited Statement of Earnings for Years Ending December 31 (all figures in $ thousands) 2016

2015

Revenue

711,200

674,600

Programming and communication expenses

312,900

317,000

Gross margin

398,300

357,600

98,750

78,650

Amortization of intangibles

7,250

8,150

Reversal of impairment loss

–12,500

Gain on sale of assets held for sale

–14,400

Operating costs

185,900

173,000

Interest expense

64,100

65,900

1,200

850

Profit before tax

70,400

32,750

Tax benefit (expense)

17,600

–8,187

Net profit for the year

88,000

24,563

Depreciation expense

Income from investments in associates

Exhibit 2 Cooper Creek Cable Limited Balance Sheet as of December 31 (all figures in $ thousands) 2016

2015

Cash

95,600

74,400

Accounts receivable, net

35,700

33,500

Assets held for sale Total current assets Investments in associates Capital assets, net

23,500 131,300

131,400

42,700

42,300

221,800

241,200

2020 Level II Mock Exam (B) AM

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Exhibit 2 (Continued) 2016

2015

Intangible assets, net

43,250

24,500

Goodwill

11,000

6,500

Deferred tax assets

185,500

169,900

Total assets

635,550

615,800

Trade payables

92,100

104,200

Interest bearing loans

49,700

Short-­term unearned revenue

12,500

Other liabilities

21,250

23,800

23,000

Total current Liabilities

178,100

148,450

Interest bearing debt

703,800

814,300

Long-­term unearned revenue

6,500

13,500

Total liabilities

888,400

976,250

Issued capital

556,400

536,800

Accumulated losses

–809,250

–897,250

Total equity

–252,850

–360,450

635,550

615,800

Total liabilities and equity

CCCL sustained substantial losses in its start-­up period (2001–2005) (from which it is still benefiting for tax purposes) but has been profitable since 2005, reporting a record profit after tax in 2016. However, Treadway is wondering if CCCL’s revenues in general are supported by cash flows and if the company might be trying to increase the appearance of profitability in order to increase the share price, which remains low. The Wireless division was acquired by CCCL in a share purchase in late 2015. Treadway wants to review the accounting policies CCCL has adopted for both revenue and expenses incurred on long-­term wireless contracts (Exhibit 3). On reading the note about the rapid reversal of the impairment loss related to the Broadcast licenses (Exhibit 3, Note 12) Treadway strongly believes that it arose as an attempt by management to manage earnings. She realizes that both her 2014 and 2015 analyses were impacted by these actions and now need to be reconsidered. As part of her annual review, Treadway determines the Altman’s Z-­scores for CCCL. The results for the current and past years are reported in Exhibit 4. Exhibit 4 Cooper Creek Cable Limited Altman Z-­Scores

Altman Z-­score*

2016

2015

2.14

1.82

* Critical values: 1.81 and 3.0

Finally, Treadway noted that during 2016 CCCL acquired 100% of MusicMusic (MM), a specialty cable music channel in an all-­stock deal. At the time of the acquisition MM reported intangible assets for broadcast licenses at a value of $2,500. CCCL

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2020 Level II Mock Exam (B) AM

estimated the fair value of those licenses to be $5,500 at that date and estimated the value of the MusicMusic brand name to be $2,000, all figures in thousands. The acquisition did not give rise to any goodwill. 17 The cash received (in thousands) from CCCL’s investments in associates in 2016 is closest to: A $1,200. B $400. C $800. 18 The change in which of the following items most likely indicates that CCCL might be recognizing revenue early? A Unearned revenue B Deferred tax assets C Days sales in receivables 19 The new accounting policy adopted in 2016 for the customer acquisition cost related to long-­term wireless contracts (Exhibit 3, Note 1 d) most likely increases CCCL’s: A quality of earnings. B cash from operations. C debt to asset ratio. 20 If Treadway’s belief about management’s motivation behind the 2014 treatment of the broadcast licenses is correct, compared to the actual economic results in 2015, her original 2015 analysis would most likely have: A understated fixed asset turnover. B overstated net profit margin. C understated ROA. 21 From her Altman Score results, Treadway is most likely to conclude that the probability of bankruptcy for CCCL has: A remained uncertain. B decreased. C increased. 22 Before the calculation of amortization expense, the increase in CCCL’s intangible assets (in thousands) arising from the 2016 acquisition of MM is closest to: A $2,500. B $4,500. C $7,500.

NATIONAL PLASTICS CASE SCENARIO National Plastics Corp. is a leading manufacturer of high-­quality injection-­molded plastic packaging materials used by various industries, primarily food and beverage processing and packaging firms. In late November 2012, the company received approval for two important patent applications—one providing for improved tamper protection for plastic containers and another for an improved biodegradable plastic film that allows for better food preservation.

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On 4 January 2013, Haines Foods and Snacks, Inc., launched a hostile takeover bid for all of the shares of National at $30 per share (a $5 premium in excess of the pre-­bid price). Haines Foods is a national distributor of deli and dairy products. If its bid is successful, it plans to continue to operate National as a wholly owned subsidiary. Zenith ThermoPlastics Inc. produces plastic containers and bags that are used by the food and beverage industry. Keith Whelan, who is both chief executive officer and chief financial officer of Zenith, had been in discussions with National to either purchase or license their newly patented technologies. As a possible alternative, in view of the Haines bid, Whelan began to consider having Zenith make its own takeover bid for National. Whelan provided National’s most recent financial statements, shown in Exhibits 1, 2, and 3, to one of his assistants, Mike Noth, with directions to calculate National’s free cash flow using the discounted cash flow approach as a first step in determining the maximum value that Zenith should be willing to pay for National’s shares. Exhibit 1 National Plastics Corp. Selected Financial Data, for Year Ending 31 December ($ millions)

2012

Revenues

1,614

Cost of goods sold

841

Selling, general, and administrative expense

436

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

337

Depreciation expense

61

Operating income

276

Interest expense

47

Pretax income

229

Income tax (32%)

73

Net income

156

Share Information Number of outstanding shares (millions)

60

2012 Earnings per share

$2.60

2012 Dividends paid (millions)

$37

2012 Dividends per share

$0.62

Exhibit 2 National Plastics Corp. Consolidated Balance Sheets ($ millions) At 31 December Cash and cash equivalents

2012

2011

$8

$5

Other current assets

315

295

Total current assets

323

300

1,384

1,250

181

120

1,203

1,130

Fixed assets Less Accumulated depreciation Fixed assets, net

(continued)

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2020 Level II Mock Exam (B) AM

Exhibit 2 (Continued) At 31 December

2012

2011

Total assets

$1,526

$1,430

Current liabilities

$696

$670

Long-­term debt

562

611

Common stockholders’ equity

268

149

$1,526

$1,430

Total liabilities and stockholders’ equity

Exhibit 3 Other Financial Information for National Plastics Corp. as of 31 December 2012 Effective tax rate

32.00%

Cost of equity

12.00%

Weighted average cost of capital

9.00%

Noth soon returns and points out that the free cash flows from National will differ in future years as a result of its new patents—he suggests that, just as Zenith wanted to license the technology, other plastic firms would also be interested. Noth also suggests that because National has a lower debt-­to-­equity ratio than the rest of the industry, it could support more debt, so he has adjusted the weighted average cost of capital (WACC) accordingly. Noth’s projected cash flows and other estimates are provided in Exhibit 4. Exhibit 4 Estimates and Assumptions of Mike Noth Used in Valuing National Plastics as of January 2013 ($ millions except WACC) 2013 End-­of-­year free cash flow to firm WACC Total debt immediately following acquisition

170

2014

2015

2016

165

180

195

Thereafter Growth at 5% a year

10.50% 650

After a discussion about the appropriate cash flow estimates and discount rates to use in determining the value of National to Zenith, Whelan decides that Zenith should make a mixed offer for all of National’s shares at $35 per share, consisting of $23 in cash and Zenith common stock with an exchange ratio of 0.24. The details of the offer are in Exhibit 5.

2020 Level II Mock Exam (B) AM

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Exhibit 5 Details of Zenith’s Planned Tender Offer for All of National Plastics’ Common Shares National Plastics

Zenith ThermoPlastics

Pre-­merger price

$25/share

$50/share

Shares outstanding

60 million

100 million

Tender Offer

Zenith will pay $35 per share for National, consisting of $23 in cash and Zenith common shares with an exchange ratio of 0.24.

Post-­merger

Following the merger, Zenith’s shares are expected to be priced at $53/share.

Synergies from the merger

Zenith believes that most of the synergies arising from the merger will result from National’s new patents.

23 If Haines Foods is successful in its attempt to acquire National Plastics, the business combination is best classified as which type of merger? A Vertical, backward B Horizontal, conglomerate C Vertical, forward 24 National’s free cash flow to the firm (FCFF) for 2012 is closest to (in millions): A $121. B $182. C $104. 25 Based on Noth’s assumptions in Exhibit 4, the maximum that Zenith should be willing to pay per share for National is closest to: A $51. B $40. C $60. 26 Based on Zenith’s proposed tender offer and information in Exhibit 5, the synergy arising from this merger is closest to (in millions): A $1,063. B $643. C $943.

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2020 Level II Mock Exam (B) AM

VITALITY CASE SCENARIO Gregory Armishaw is an equity analyst specializing in the food and beverage industry at Fulsom-­Wagner Investment Counsel in Minneapolis, Minnesota. In late January 2014, he became aware of a new salt substitute, SansSalt, that was developed by a local company, Vitality FoodGroup, Inc. (VFG). With the continuing concern over health matters arising from excessive salt use, Armishaw believes that the addition of this product line could be quite beneficial to VFG. He uses the data in Exhibit 1 to calculate the value of VFG using (1) the residual income model and (2) the H-­model version of the dividend discount model. Exhibit 1 Vitality FoodGroup Selected Information for Valuation, 31 December 2013 Net income

$422 million

Common stock (par plus paid-­in-­excess of par)

$1,075 million

Retained earnings

$1,078 million

Weighted average cost of capital

11.9%

Cost of debt, before tax

7.0%

Cost of equity capital

15%

Expected dividend growth behavior:  Expected for 2014

14%

 After 2014, dividend growth rate declines linearly over a 6 year period  The final and perpetual growth rate:

5%

Estimated earnings per share (EPS) in 2019

$5.04

Dividend payout ratio

40%

Shares outstanding

150 million

Armishaw shows his report to Anthony Stack, Fulsom-­Wagner’s senior portfolio manager and Armishaw’s reporting official. In the H-­model calculation, Stack notices that Armishaw assumes a sustainable growth rate of 5% following the period of high growth. Stack asks Armishaw if it is true that the sustainable growth model assumes the company will require 1 external debt financing, 2 external equity financing, and 3 improving return on equity. Still concerned with the estimate of growth after 2019, Stack asks Armishaw what the present value of growth opportunities (PVGO) will be in 2019 when the perpetual growth period begins. Armishaw next presents Exhibit 2, which contains the basis for his estimates for the share price (as of 15 January 2014) if he assumes a terminal value in 2023 arising from treating 2023’s residual income as a perpetuity.

2020 Level II Mock Exam (B) AM

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Exhibit 2 Vitality FoodGroup Basis for Terminal Value and Revised Price Estimate, 15 January 2014 Forecasted residual income (RI) per share at end of 2023

$5.32

Estimated return on equity (ROE) in 2023

20%

Nature of stream beyond 2023

Perpetuity

Growth rate beyond 2023

0%

Cost of equity

15%

Dividend payout

40%

Stack questions Armishaw’s assumption in his 2014 valuation (Exhibit 2) that a perpetuity would best describe the terminal value of the stream and suggests that residual income should fade over time. Stack further suggests that a persistence factor of 0.50 might be appropriate. Stack tells Armishaw that he prefers the use of a residual income model to value the company over other available methods. He provides three justifications for his preference: 1 The model explicitly incorporates the cost of debt capital. 2 The model can be used when cash flows are unpredictable. 3 There is less of an impact arising from the uncertainty in forecasting terminal value. 27 Based on the information in Exhibit 1, Armishaw’s estimate of VFG’s residual income per share for 2015 is closest to: A $1.17. B $0.84. C –$0.28. 28 Based on the information in Exhibit 1, the H-­model per share valuation of VFG’s common shares is closest to: A $17.89. B $15.86. C $14.85. 29 Which of Stack’s three assumptions regarding the sustainable growth rate model is most accurate? A 1 B 2 C 3 30 The most appropriate answer to Stack’s question about the PVGO is: A –$14.11. B –$12.43. C $19.32. 31 Using the information in Exhibit 2, comparing Armishaw’s approach to terminal value to Stack’s approach, Stack’s assumption leads to a 2024 value that is approximately: A $6.50 lower than Armishaw’s approach. B $6.74 lower than Armishaw’s approach.

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2020 Level II Mock Exam (B) AM

C $26.30 higher than Armishaw’s approach. 32 The least appropriate justification that Stack makes in support of the use of the residual income model is Statement: A 3. B 1. C 2.

WADGETT CASE SCENARIO Tom Baker, director of equity investments at Private Wealth Fund, instructs his recently hired junior equity analysts Ida Paschel and Lyle Covey to review and evaluate opportunities in the automotive parts industry for a possible addition to the equity portfolio. Baker encourages the two analysts to consider Wadgett Manufacturing Inc., a rapidly growing maker of what it calls “smart mirrors.” Covey: The decline in price was the result of a recent failed acquisition of Wadgett; Wadgett’s price is moving back to an appropriate value as it no longer appears to be a takeover target. Paschel: We could compare the value to that of the value of a subsidiary of a large technology conglomerate that also works on “smart mirrors.” However, the value of a subsidiary tends to be higher than if it were a stand-­alone entity. Baker: Pairs trading analysis would help determine whether Wadgett’s market price seemed to be below its intrinsic value Since Wadgett has no plan to begin paying a dividend, Baker asks the analysts to calculate the free cash flow to the firm (FCFF). The two analysts discuss how to go about it, and they make the following comments: Paschel: If we begin with cash flow from operations (CFO), we do not have to make adjustments for working capital. Covey: We should begin with earnings before interest, taxes, depreciation, and amortization (EBITDA) but will have to add in all the non-­cash charges on the income statement. Paschel: Regardless of whether we start with net income, CFO, or EBITDA, we will have to add in net borrowing. Wadgett’s ambitious growth projections will likely require a substantial investment in manufacturing facilities. In order to finance the project, Wadgett expects to borrow substantially more than it has in the past and intends to retire the debt within the next 10 years. During a discussion of how this debt may influence the valuation, the analysts make the following statements: Statement 1 Because the capital structure seems very likely to change significantly, it would be best to use free cash flow to equity (FCFE) because the value to equity is more direct. Statement 2 I would select FCFF over FCFE. When we look forward, the required return on equity may be more sensitive to changes in financial leverage than just the changes in weighted average cost of capital (WACC).

2020 Level II Mock Exam (B) AM

17

Statement 3 With either model, we should discount future cash flows by the required return on equity because we are considering buying the stock. Baker asks his team to determine how sensitive the value of Wadgett’s common shares is to model parameters by using the single-­stage FCFE growth model for valuation. Baker instructs Paschel to calculate the current intrinsic value of the shares using the base case information. The valuation is shown in Exhibit 1. Exhibit 1 Valuation of Wadgett’s Common Shares Normalized FCFE

$1.38

FCFE growth rate

0.08

Equity risk premium

0.075

Beta

1.40

Risk-­free rate

1.2%

Baker informs Covey that the highest and lowest reasonable alternative estimates of the valuation model parameters are as follows: 15% for beta, 20% for equity risk premium, and 25% for growth rate. He asks Covey to perform a sensitivity analysis for each of these parameters while keeping all other inputs at the base case level. Covey’s results are shown in Exhibit 2. Exhibit 2 Sensitivity Analysis to Model Parameters in Valuation of Wadgett’s Common Shares Per-­Share Valuation with Low Estimate

Per-­Share Valuation with High Estimate

FCFE growth rate

$25.67

$89.29

Equity risk premium

$93.15

$25.70

Beta

$70.14

$28.25

Parameter

Note: The risk-­free rate is 1.2% in all cases.

33 In regard to calculating Wadgett’s FCFF, the comment that is most appropriate is the one dealing with: A working capital adjustments. B treatment of all non-­cash charges. C treatment of net borrowing. 34 In discussing Wadgett’s growth projections and the influence they may have on the FCFE and FCFF valuation process, which of the analysts’ statements is most accurate? A Statement 1 B Statement 3 C Statement 2 35 Using the data for the base case in Exhibit 1, the intrinsic value of Wadgett’s common shares is closest to: A $37.30.

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2020 Level II Mock Exam (B) AM

B $73.78. C $40.28. 36 Using the data in Exhibit 2, the parameter that causes the greatest sensitivity in valuing Wadgett’s common shares is the: A beta. B growth rate. C equity risk premium.

WINGAERSHEEK CASE SCENARIO Sandy Annisquam is the head of trading at Wingaersheek Arbitrage Opportunities, LLP, a hedge fund specializing in fixed-­income strategies. The firm’s investment approach is to exploit small price differences across similar or identical securities. Annisquam has asked Choate Hake to develop a comprehensive automated trading system that will allow traders to identify opportunities in the market. Annisquam and Hake are discussing several applications that need to be developed for the traders. Hake begins development on an algorithm that will evaluate government bonds that have been stripped. He tests his logic by evaluating a dollar-­denominated Tangoran government bond with a 3.20%, annual pay coupon maturing in three years, using data in Exhibit 1. The bond is quoted in the market at $103.50. Exhibit 1 Spot, Par, and Forward Rates Year 1

Year 2

Year 3

Spot Rate

1.10%

1.50%

2.01%

Par Rate

1.10%

1.50%

2.00%

Forward Rate

1.10%

1.91%

3.04%

Hake develops a framework for valuing bonds using a binomial interest rate tree. He understands that there are several factors used in developing the tree and asks Annisquam for counsel on the correct data to use. Annisquam makes the following comments to Hake: Comment 1 In the valuation process, the interest rate tree generates cash flows that are interest rate dependent but does not provide the interest rates used to discount those cash flows. Comment 2 Two assumptions must be made to create a binomial tree. The first is an interest rate model such as a lognormal model of interest rates. The second is a volatility of interest rates. Comment 3 Volatility can be measured relative to the current level of rates. By using a lognormal distribution, interest rate movements are proportional to the level of rates and are bounded at the low end by zero. Annisquam asks Hake to use a binomial interest rate tree to calculate the value of a bond. He tests the module using a three-­year, $100 par value, 4% annual pay coupon bond and the data in Exhibit 2.

2020 Level II Mock Exam (B) AM

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Exhibit 2 Three-­Year Binomial Rate Tree 4.50% 3.60% 2.90%

3.25% 2.60% 2.35%

Time 0

Year 1

Year 2

Annisquam tells Hake that he needs to calibrate the binomial interest rate tree to match a term structure of interest rates. Hake wants to better understand this process and asks Annisquam to describe it. Annisquam says, “Calibrating an interest rate tree requires an iterative process that ensures that the upper and lower rates are consistent with the volatility assumption, the interest rate model, and the observed market value of the benchmark bond. The cash flows of the bond are discounted using the interest rate tree, and if this doesn’t produce the correct price, another pair of forward rates is selected and the process is repeated.” Annisquam then develops a model that compares the value of a bond determined using a binomial interest rate tree to its value determined using spot rates. The bond he selects for the comparison is non-­benchmark, option-­free, and has five years to maturity and an annual-­pay coupon rate of 3%. The coupon rate is below the coupon rate of the benchmark bond. The yield curve is currently downward sloping. The output of Annisquam’s model shows that the spot rates generate a value equal to the market price of the bond, but the interest rate tree methodology produces a higher value. Annisquam wants Hake to develop a program for pricing securities that are interest rate path dependent, such as mortgage-­backed securities (MBS). He believes that using the Monte Carlo method and employing 2,000 simulations will provide an average present value across all scenarios equal to the actual market value of the securities. Hake runs a simulation and uses it to value a benchmark bond. He finds that the value generated does not equal the market price of the bond. 37 Based on the market price of the Tangoran government bond and the interest rates in Exhibit 1, what profitable arbitrage opportunity should Hake’s algorithm most likely identify? A Buying the strips and selling the bond B Buying the Year 1 and Year 2 strips and selling the Year 3 strip C Buying the bond and selling the strips 38 Which of Annisquam’s comments regarding binomial interest rate trees is least likely correct? A Comment 2 B Comment 3 C Comment 1 39 Using the backward induction method and the data in Exhibit 2, the value of the bond Hake has been asked to value is closest to: A 101.069 B 101.584 C 102.532

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2020 Level II Mock Exam (B) AM

40 Is Annisquam most likely correct in regard to his comments on calibrating a binomial interest rate tree? A No, he incorrectly describes the iterative process. B Yes. C No, he is incorrect regarding the interest rate used. 41 Assuming Annisquam’s spot rate valuation is correct, why does his model most likely produce a different result? A He is valuing a non-­benchmark bond. B The model is incorrect because both methodologies should value the bonds equally. C The yield curve is downward sloping. 42 To correct the problem Hake encounters when using a Monte Carlo simulation, he would most likely: A adjust the volatility assumption. B increase the number of simulations. C add a constant to all interest rates on all paths.

PARISI CASE SCENARIO Ryan Parisi is a managing director in the derivatives group at High Ridge Partners, an investment management firm. Parisi specializes in advising institutional clients on the use of forward contracts in their portfolio management strategies. Parisi is preparing a response to questions from one of the firm’s US-­based clients: Leslie Sheroda. Todd Curry, an intern in the derivatives group, will assist Parisi. Leslie Sheroda oversees both equity and fixed-­income portfolios for a pension fund. One month (30 days) ago, Sheroda had indicated that the pension fund expected a large inflow of cash in 60 days. In order to hedge against a potential rise in equity values over this period, Parisi advised Sheroda to enter into a long forward contract on the UAX 300 Index expiring in 60 days. Sheroda determined she was also underweight in one individual stock. Sixty days ago, she entered a long forward position on CHJ common stock, which does not pay a dividend. Sheroda has asked Parisi to calculate the value of her two forward positions today—that is, 30 days after the contracts were initiated. Parisi has collected the information in Exhibit 1 to carry out the valuation assignment. Prior to the meeting, Parisi shows the spot price of the UAX 300 index in Exhibit 1 to Curry and asks how the 30-­day forward price will relate to the current level of the index. Curry compares the spot index to the forward price. Parisi asks Curry a second question: “Are you clear about how the value of a forward contract can change?” Curry responds, “Yes, I am. In general, the value of a forward contract may be positive or negative at the inception of the contract, during its life, and at the expiration of the contract.” Exhibit 1 Selected Financial Information for Sheroda Meeting Price of a 60-­day UAX 300 forward contract 30 days ago

USD1403.22

UAX 300 Index level today

USD1450.82

Annualized continuously compounded risk-­free rate

3.92%

2020 Level II Mock Exam (B) AM

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Exhibit 1 (Continued) Annualized continuously compounded dividend yield for UAX 300

2.50%

Price of a 60-­day CHJ forward contract 30 days ago

USD100.30

Price of a 30-­day CHJ forward contract

USD96.31

Price of CHJ stock today

USD96.00

Using Exhibit 1, Parisi and Curry compute the value of the two forward contracts. Parisi continues the discussion about forward prices and asks, “Is it true that the forward price on an asset must equal the spot price of the asset on the expiration date of the forward contract? Explain why or why not.” Curry responds, “At expiration, forward prices and spot prices must converge. If the spot price exceeds the forward price, then an investor could purchase the forward contract and execute the contract to purchase the underlying at the lower forward price and sell at the higher spot price and make an arbitrage profit. If the spot price is less than the forward price at expiration, then an investor could purchase the asset at the spot price and enter into a short forward contract to sell at the higher price, thus locking in a profit.” They move to valuation of a bond futures contract employed by Sheroda. Parisi provides Curry with the following information for a Treasury bond and calculates the price of a futures contract on this bond. The bond has a face value of $100,000, pays a 7% semiannual coupon, and matures in 15 years. The bond is priced at $156,000, has no accrued interest, and yields 2.5%. The futures contract expires in 8 months, and the annualized risk-­free rate is 1.5%. There are multiple deliverable bonds, and the conversion factor for this bond is 1.098. 43 Curry’s best answer to Parisi’s first question is: “Given the information in Exhibit 1, the 30-­day UAX 300 forward price will be: A greater than the spot level of the UAX 300. B less than the spot level of the UAX 300 C equal to the spot level of the UAX 300. 44 In his response to Parisi, Curry is least likely correct with respect to the value of a forward contract: A at inception. B at expiration. C during the life of the contract. 45 Based on the information in Exhibit 1 and assuming a 360-­day year, the value of Sheroda’s forward contract on the UAX index is closest to: A USD 52.18. B USD 49.16. C USD 50.71. 46 Based on the information in Exhibit 1 and assuming a 360-­day year, the value of Sheroda’s forward contract on the CHJ stock is closest to: A 3.99 USD. B –3.98 USD. C –4.29 USD. 47 Is Curry’s response to Parisi regarding futures and spot prices most likely correct?

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2020 Level II Mock Exam (B) AM

A No, the explanation when the spot price exceeds the forward price is incorrect. B Yes. C No, the explanation when the spot price is less than the forward price is incorrect. 48 Based on the information provided by Parisi, which of the following correctly calculates the futures price of the Treasury bond? A

B C

$156, 000(1.015)(8 12) − $3,508.6958   = $140, 298.21 f 0 (T ) =  1.098 $156, 000(1.015)(8 12) − 3, 491.325   = $140,314.03 f 0 (T ) =  1.098 8 12 f 0 (T ) = 1.098 $156, 000(1.015)( ) − $3,508.6958 = $169,144.08  

SCHULMAN CASE SCENARIO Zoe Schulman is an alternative investments research analyst with Principal Investments, LLC, a wealth management firm. In the past, the account managers at Principal were free to select real estate investments without referring to a formal buy list, leading to inconsistent returns across client portfolios. To ensure a more consistent approach, the firm would like to create an approved list, which would provide a source of investment selections for all client portfolios. From the investments already held in client portfolios, Schulman identifies the three largest REIT holdings and asks the account managers to justify why these REITs were selected considering the current economic cycle. She compiles Exhibit  1 and presents it in a report to her manager, Holden Dwelley. Exhibit 1 Characteristics of Major REIT Holdings and Account Managers’ Justifications REIT

Sector

Region

Justification

1

Industrial

Midwest United States

The industrial sector has a large labor force and is most sensitive to new job creation.

2

Office

Southwest United States

Although recent news of rising GDP is beneficial to all sectors, the better-­than-­expected jobs report further enhances prospects for the office property sector.

3

Hospitality

Northeast United States

This sector has low sensitivity to new job creation and is resilient during times of economic contraction.

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Schulman determines that all three REITs use the historical cost method in their accounting statements. In her analysis, she calculates and reports net asset value per share (NAVPS), instead of book value per share (BVPS), as an absolute valuation metric and provides the following rationale for this approach being her preferred one: Reason 1 NAVPS accounts for the value of property not currently generating revenue. Reason 2 NAVPS includes the added value of the management of the REIT. Reason 3 NAVPS reflects the market value of the property portfolio rather than often stale historical cost values. Schulman collects financial data for all three REITs to calculate NAVPS. Exhibit 2 presents select data that she uses for her evaluation of REIT 1. Exhibit 2 Selected Data for REIT 1 Pro formacash net operating income (NOI) for last 12 months

$320 million

Cash and equivalents

$50 million

Land held for future development

$70 million

Accounts receivable

$25 million

Prepaid/other assets (excluding intangibles)

$7 million

Total debt Other liabilities Shares outstanding

$1,700 million $200 million 75 million

Estimated growth in NOI

5.00%

Capitalization rate

7.00%

Schulman submits a first draft of her report to Dwelley. He notes that she has failed to consider real estate operating companies (REOCs) in current client portfolios for inclusion on the approved list. She justifies the omission with the following reasoning: ■■

REOCs are more constrained in their use of leverage than REITs.

■■

REOCs are far less commonly traded in the United States than REITs.

■■

REOCs have more restrictive real estate investment choices.

When editing the report, Dwelley questions Schulman’s reliance on NAVPS over a dividend discount model (DDM) and notes the following characteristics of these valuation measures: Characteristic 1 DDM reflects all earned income, but NAVPS only reflects income that is retained by the property management company. Characteristic 2 NAVPS is based solely on historical revenue and does not reflect upcoming income growth expectations. Characteristic 3 DDM uses discount rates consistent with the required rate of return for public equity investment. For a more comprehensive analysis, Schulman’s report also presents relative valuation measures, such as the ratio of price to funds from operations (P/FFO). Selected information for REIT 3 is provided in Exhibit 3

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2020 Level II Mock Exam (B) AM

Exhibit 3 Selected Information for REIT 3 Property net operating income

$700 million

General and administrative expenses

$70 million

EBITDA

$630 million

Depreciation and amortization

$30 million

Net interest expense

$170 million

Net income available to common

$430 million

Non-­cash (straight-­line) rent adjustment

$15 million

Recurring maintenance-­type capital expenditures and leasing commissions

$33 million

Number of shares outstanding

140

Price per share

$49

49 Which of the account managers’ justifications in Exhibit 1 regarding the selection of each of the three REITs ismost likely correct? A The justification for REIT 1 B The justification for REIT 3 C The justification for REIT 2 50 Which of Schulman’s reasons regarding her preferred approach to valuing REITs is most likelycorrect? A Reason 3 B Reason 1 C Reason 2 51 Using the data in Exhibit 2, the NAVPS of REIT 1 is closest to: A $37.65. B $40.69. C $39.76. 52 Which of Schulman’s justifications for omitting REOCs from the approved list is most likely correct? A Her justification regarding leverage B Her justification regarding investment restrictions C Her justification regarding trading activity 53 Which of Dwelley’s characteristics of the DDM and NAVPS methods is most likely correct? A Characteristic 3 B Characteristic 2 C Characteristic 1 54 Using Exhibit 3, the P/FFO for REIT 3 is closest to: A 14.9. B 13.5. C 16.7.

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NECKAR CASE SCENARIO Sofia Poetzl is the chief investment officer of the Germany-­based Neckar Foundation, which finances projects for elementary and secondary education. Neckar has €1 billion in assets managed by eight outside portfolio managers. Poetzl’s department is responsible for manager selection and evaluating active portfolio managers. Poetzl has one analyst in her department, Klaus Dieter, and a new intern, Helena Lange. As part of the department’s quarterly review process, Poetzl asks Lange and Dieter to gather information for Neckar’s balanced funds, shown in Exhibits 1 and 2. Exhibit 1 Selected Fund Statistics One-­Year Returns

Weights Bond

One-­Year Total Return

Equity

Bond

Equity

Fund 1

14.0%

8.0%

58%

42%

11.48%

Fund 2

10.0%

7.8%

55%

45%

9.01%

Benchmark

11.0%

8.0%

50%

50%

9.50%

Exhibit 2 Selected Fund Statistics Fund 1

Fund 2

Benchmark

Five-­year annualized return

12.6%

11.7%

9.4%

Standard deviation

13.5%

9.5%

8.8%

Active return

3.20%

2.28%

Active risk

8.00%

2.00%

Risk-­free rate

5.3%

After examining the fund information, Lange is eager to explore manager evaluation. Dieter and Lange review three of Neckar’s fund managers with the following characteristics: Manager 1 A fund holding stocks of companies located in the major European markets. Its benchmark is the FTSE Developed Europe Index. Manager 2 A fund with a total return objective of exceeding the return of the FTSE Developed Europe Index Fund. The fund can hold up to 20% in cash. Manager 3 A fund that holds eurozone sovereign bonds. Its benchmark is the S&P Eurozone Sovereign Bond 10+ Years Index. Dieter then shares with Lange a graph titled the Correlation Triangle, which illustrates the Fundamental Law of Active Management by showing how a manager’s forecasted returns, decisions about a portfolio’s active weights, and realized active returns are intertwined. Lange observes, “Basically, it involves four elements: skill, portfolio construction, breadth, and aggressiveness. Some managers will not have full control over portfolio construction, and breadth may be overstated because many securities have a degree of correlation with each other.”

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2020 Level II Mock Exam (B) AM

Dieter and Lange assess two additional portfolio managers, described in Exhibit 3. Dieter observes the following: ■■

Manager 4 would improve its information ratio by re-­weighting its portfolio on a weekly basis.

■■

Manager 5 has a lower breadth than stated because country returns are likely to be highly correlated.

■■

Because both managers are required to use long-­only strategies, the transfer coefficients will be lower than if the managers were unconstrained.

Lange observes three practical limitations of the Fundamental Law of Active Management: Point 1: Investment decisions are not always as independent as one might assume. For example, almost all bonds pose some sort of credit risk and duration risk. Point 2: A portfolio with turnover constraints will affect the transfer coefficient because the manager is limited in how to implement the forecasted returns into active weights. Point 3: Most investors underestimate their forecasting abilities and thus understate the information ratio. 55 The performance attribution in Exhibit 1 most likely shows that: A Fund 1 added value through asset allocation, and Fund 2 added value through security selection. B Fund 1 added value through security selection and asset allocation. C Fund 2 underperformed through asset allocation. 56 Based on a calculation of the information ratio using the data presented in Exhibit 2, which of the following is most likelycorrect? A The manager of Fund 2 achieved the highest risk-­adjusted returns. B The manager of Fund 1 achieved the highest risk-­adjusted returns. C There is no material difference between the risk-­adjusted returns of Fund 1 and Fund 2. 57 Lange is least likely to use the Sharpe ratio to evaluate the ex postportfolio returns of: A Manager 1. B Manager 3. C Manager 2. 58 Is Lange correct in her observations about the Fundamental Law of Asset Management? A No, she is incorrect with respect to portfolio construction. B Yes. C No, she is incorrect with respect to breadth. 59 As described in Exhibit 3, with respect to the Fundamental Law of Active Management, Dieter is least likely correct in his observation about: A breadth. B the transfer coefficient. C the information ratio. 60 With respect to Lange’s observations concerning the limitations of the Fundamental Law of Active Management, she is most likely correct regarding:

2020 Level II Mock Exam (B) AM

A Points 1 and 3. B Points 2 and 3. C Points 1 and 2.

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