Level 2 mock exam question and answers 2008

Level Mock Exam - Part 1_2008 Click here to go to the online version of the Level II Study Guide Click here to go to the online version of the latest Candidate Bulletin Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, pp 70-71, 73, Example Study Session 1-2-a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations Neither is an acceptable reason for soliciting clients while at Portree The clients belong to Portree and Jun is not permitted to solicit their business until he leaves the firm As indicated in the Readings and Standards of Practice Handbook, even though Jun does not receive monetary compensation for his services, he may be considered an employee because as an intern he receives compensation and benefits in the form of work experience and knowledge Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, p 70 Study Session 1-2-a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations Velez has acted appropriately and has not violated her duty of loyalty to Portree According to the Standard relating to Duty to Employer, a departing employee is generally free to make arrangements or preparations to go into a competitive business before terminating the relationship with her employer provided that such preparations not breach the employee’s duty of loyalty Specifically, prior to leaving an employer, members must not contact existing clients or potential clients for the purpose of soliciting their business for the new business Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, p 70 Study Session 1-2-a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations Jun’s use of Fantine’s methods is acceptable The Standards not impose a prohibition on the use of experience or knowledge gained at one employer from being used at another employer According to the Standards, “Once an employee has left the firm, the skills and experience that an employee obtains while employed are not “confidential” or “privileged” information.” Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, pp 105-107 Study Session 1-2-a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations Jun’s statement about passing the exams on the first try was merely factual, while his business card, which he distributes to prospective clients, prematurely states that he is a CFA charterholder Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, pp 94-95, 98, Examples 8, Study Session 1-2-b recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct Priority goes to clients over accounts in which Upsala personnel are beneficial owners Code of Ethics and Standards of Professional Conduct and Guidance for Standards I-VII, CFA Institute 2008 Modular Level II, Vol 1, pp 69-70, 89 Study Session 1-2-a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations Whether or not Upsala’s compliance policy requires disclosure, Jun is obligated to comply with CFA Institute Standards The Standard relating to Loyalty to Employer requires that Jun disclose details of the consulting work and receive written consent from Upsala before rendering service “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, pp 362-367 Study Session 3-13-d discuss the structure of an autoregressive model of order p, calculate one- and two-period-ahead forecasts given the estimated coefficients, and explain how autocorrelations of the residuals can be used to test whether the autoregressive model fits the time series Testing for correct specification of an autoregressive (AR) model requires a test to determine if the correlations between the error term and several lagged error terms are statistically different from zero If the autocorrelations are significantly different from zero, the model is not correctly specified “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, pp 395-398 Study Session 3-13-l explain autoregressive conditional heteroskedasticity (ARCH), and discuss how ARCH models can be applied to predict the variance of a time series To examine for the presence of heteroskedasticity, Nordique should test whether the variance of the error in one period depends on the variance of the error in previous periods This is accomplished by regressing the squared residuals from the estimated model on the squared residuals lagged one period “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, pp 376-384 Study Session 3-13-i, j discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for them, and demonstrate how a time series with a unit root can be transformed so that it can be analyzed with an autoregressive model; discuss the steps of the unit root test for nonstationarity, and explain the relation of the test to autoregressive time series models The Dickey-Fuller test is used to test for the presence of a unit root The model is of the form: (P/E)t - (P/E)t-1 = b0 + g1 (P/E)t-1 + εt The null hypothesis (H0: g1 = 0) is that the series has a unit root and is not stationary The alternate hypothesis (H1: g1 ≠ 0) is that the series does not have a unit root and is stationary 10 “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, pp 376-380 Study Session 3-13-i discuss the implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for them, and demonstrate how a time series with a unit root can be transformed so that it can be analyzed with an autoregressive model Beloit is concerned that a unit root exists If she is correct, first differencing is a suggested solution, i.e., re-estimate the regression using the form: [(P/E)t - (P/E)t-1 ] = b0 + b1 [(P/E)t-1 - (P/E)t-2 ] + εt 11 “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, p 367 Study Session 3-13-e explain mean reversion, and calculate a mean-reverting level If the process is mean reverting, the market P/E will move toward the mean-reverting level over time If it is currently above its mean reversion level, the P/E will tend to fall, suggesting that underweighting stocks would be appropriate 12 “Time Series Analysis,” Richard A DeFusco, Dennis W McLeavey, Jerald E Pinto, and David E Runkel 2008 Modular Level II, Vol 1, pp 367-368 Study Session 3-13-d discuss the structure of an autoregressive model of order p, calculate one- and two-period-ahead forecasts given the estimated coefficients, and explain how autocorrelations of the residuals can be used to test whether the autoregressive model fits the time series The one-month forecast is 0.332 + (0.975 x 22.50) = 22.27 The two-month forecast is 0.332 + (0.975 x 22.27) = 22.04 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 10, 13, 24-26, 33-34 Study Session 5-21-b, d calculate and analyze the effect of marketable securities classification on the financial statements and financial ratios under SFAS 115; distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios The appropriate components of ACI’s net income derived from the equity investments in Exhibit (amounts in millions) are as follows: 13 Investment Method of Accounting Columbus De Soto Marco De Vaca Viking Total Consolidation Equity Method Available-for-Sale1 Cost Available-for-Sale Amount Included in ACI’s Income (0.60 x 65) = $39.0 (0.30 x 85) = 25.5 3.0 2.0 0.5 $70.0 Source Net Income Net Income Dividends Dividends Dividends Note 1: With a majority owner controlling Marco, there is no indication that ACI exhibits the degree of control consistent with a 30% stake; the Marco investment has been accounted for by Fanner as an available-for-sale security 14 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, p 13-15 Study Session 5-21-b calculate and analyze the effect of marketable securities classification on the financial statements and financial ratios under SFAS 115 A reclassification from held-to-maturity to available-for-sale would not change the 2007 pre-tax income for ACI Under held-to-maturity, interest that is received would be included in income but changes in market value of the securities would be ignored Under available-for-sale, interest would once again be included, but only realized rather than unrealized gains would appear in income Thus, as no gains were realized during the year, there would be no change “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, p 10-24 Study Session 5-21-c calculate and analyze the mark-to-market investment return on a marketable securities portfolio under SFAS 115 The analyst should track investment performance on a mark-to-market return basis, measuring the actual investment performance for each period (page 21) ACI has five investments classified under SFAS 115 (marketable securities where the company does not have the ability to exercise significant influence or control): Marco, De Vaca, Viking, Cortez and Da Gama De Vaca does not have a market value and hence is accounted for under the cost method It is not possible to calculate a mark-to-market return for it Calculation of the mark-to-market return includes interest and dividend income plus realized and unrealized gains and losses; see page 21 and 22 for sample calculations and definition The four qualifying securities and calculations of the mark-to-market portfolio return are as follows: (Note there were no realized gains or losses during the year.) The equity securities were purchased January 1, 2007, their cost basis is therefore equal to the opening market value The debt securities were purchased during the year so their cost basis is also equal to their opening market value.) 15 Fixed Maturities Interest or Dividend Income Cortez $3 $2 De Gama Marco Viking Market Valuation Adjustment Cortez ($4) De Gama ($5) Marco Viking Mark-to-Market Return, in $ millions Equities Total $5 $3 $0.5 $3.5 ($9) ($10) $20 $10 $9.5 16 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 24, 35-36 “Mergers, Acquisitions, and Other Intercorporate Investments,” Thomas R Robinson, Paul Munter, and Julia Grant 2008 Modular Level II, Vol 2, pp 77-78, 88-91 Study Sessions 5-21-d, 5-22-f distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios; identify situations when companies should apply the equity and consolidation methods of accounting for investments If ACI loses control over Columbus, Columbus will be treated under the equity method instead of under the consolidation method The equity method is one-line consolidation, the net income and common equity are the same but the reported revenues, assets and liabilities would decrease 17 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 13, 26-27 Study Session 5-21-b, d calculate and analyze the effect of marketable securities classification on the financial statements and financial ratios under SFAS 115; distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios The litigation will preclude ACI from using the equity method If De Soto is then classified under available-for-sale, book value per share could decrease because equity will not be increased by ACI’s share of De Soto’s income in excess of dividends 18 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 25-26 Study Session 5-21-d distinguish, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios De Soto must be classified according to the equity method According to the equity method, securities are carried on the balance sheet at cost plus an adjustment for the investor’s share of the investee’s income, less an adjustment for cash dividends received by the investor Thus, $125.0 million cost + (25.5 million income share - 5.0 dividends received) = $145.5 million 19 “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 163-165 Study Session 6-26-b distinguish among the local currency, the functional currency, and the reporting currency The functional currency will be the Euro for Catlette since the all-current method is used and the U.S dollar for Heren (temporal method) 20 “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 166-168 Study Session 6-26-c, d compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of the all-current and temporal methods on the parent company’s balance sheet and income statement Unrealized non-monetary gains are ignored when the temporal method is used All other gains are reported on the income statement 21 “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 163-165 Study Session 6-26-c, d, k compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of each on the parent company’s balance sheet and income statement; illustrate and analyze alternative accounting methods for subsidiaries operating in hyperinflationary economies Garrison is using the all-current method for Catlette The all-current method is most appropriate when the subsidiary (Catlette) is a self-contained independent operating entity 22 “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 166-168 Study Session 6-26-c, d compare and contrast the all-current (translation) method and the temporal (remeasurement) method; analyze and evaluate the effects of each on the parent company’s balance sheet and income statement All gains and losses are reported as a cumulative translation adjustment in equity when the all-current method is used “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 166, 173 Study Session 6-26-g translate a subsidiary’s balance sheet and income statement into the parent company’s currency, using the all-current method and the temporal method Under the all-current method, all assets would be translated at the year-end (current) rate of 0.75: 23 Cash and receivables Inventory Fixed Assets Total Assets *Rounded to 1,667 50 divided by 0.75 = 200 divided by 0.75 = 1,000 divided by 0.75 = 1,250 divided by 0.75 = 66.667 266.667 1,333.333 1,666.667* 24 “Analysis of Multinational Operations,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 2008 Modular Level II, Vol 2, pp 171-174 Study Session 6-26-g, h translate a subsidiary’s balance sheet and income statement into the parent company’s currency, using the all-current method and the temporal method; analyze how the translation of a subsidiary’s financial statements will affect the subsidiary’s financial ratios Catlette’s income statement will be translated using the average exchange rate: Sales CGS Gross Profit 1,000 divided by 0.78 = 700 divided by 0.78 = 1,282.051 897.436 384.615 Gross margin: 30.0% (note the same result can be obtained using pre-translation data) 25 “Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim 2008 Modular Level II, Vol 3, pp 193, 200-201 Study Session 9-34-a explain corporate governance, discuss the objectives and the core attributes of an effective corporate governance system, and evaluate whether a company’s corporate governance has those attributes Directors’ identification with managers’ interest rather than those of the shareholders is a source of conflict, which may call into question the directors’ objectivity 26 “Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim 2008 Modular Level II, Vol 3, p 202 Study Session 9-34-d describe the responsibilities of the board of directors, and explain the qualifications and core competencies that an investment analyst should look for in the board of directors All three listed board responsibilities are valid components of an effective corporate governance system 27 “Corporate Governance,” Rebecca Todd McEnally and Kenneth Kim 2008 Modular Level II, Vol 3, pp 231-232 Study Session 9-34-g discuss the valuation implications of corporate governance Dexter is not concerned about incomplete, misleading, or materially misstated financial statements, i.e., accounting risk 28 “Capital Structure and Leverage,” Raj Aggarawal, Cynthia Harrington, Adam Kobor and Pamela P Peterson 2008 Modular Level II, Vol 3, pp 126-129 Study Session 8-32-i, k, l discuss the effect of taxes on the MM propositions, the cost of capital, and the value of a company; explain and diagram the static trade-off theory of the optimal capital structure; compare the implications of the MM propositions, the pecking order theory of capital structure, and the static trade-off theory of capital structure Assuming static trade-off theory of capital structure holds the value of a levered firm is maximized at its optimal debt-to-equity ratio which is the case when the weighted average cost of capital are minimized 29 “Dividends and Dividend Policy,” George H Troughton and Catherine E Clark 2008 Modular Level II, Vol 3, pp 165-170 Study Session 8-33-j compare and contrast the following dividend policies: residual dividend, longer-term residual dividend, dividend stability, and target payout ratio A longer-term residual approach as used by TML S.A is defined to pay out a (more) stable cash dividend to shareholders and allocate a (more) flexible amount to share repurchases (see p 168) Hence, TML S.A already experiences stable cash dividends (based on sustainable earnings) and additional share repurchases (as a mean to distribute temporary earnings), and the management is most likely to keep everything as it is 30 “Dividends and Dividend Policy,” George H Troughton and Catherine E Clark 2008 Modular Level II, Vol 3, pp 168-170 Study Session 8-33-k calculate a company’s expected dividend using the variables in the target payout approach Formula to be applied is: Expected dividend = Last dividend + (Expected increase in earnings x Target payout ratio x Adjustment factor) where Adjustment factor = / period to adjust dividend The expected dividend = €0.50 + (€3.0 - €2.5) x 0.40 x / = €0.54 31 “Competitive Strategy: The Core Concepts,” Michael E Porter 2008 Modular Level II, Vol 4, pp 169-174 Study Session 11-41-a, b analyze the competitive advantage and competitive strategy of a company and the competitive forces that affect the profitability of a company and discuss the two fundamental questions determining the choice of competitive strategy; explain how competitive forces determine industry profitability Industry rivalries have increased the cost of doing business and reduced profits industry-wide Porter (p 169) says “the first fundamental determinant of a firm’s profitability is industry attractiveness,” which is evaluated using the five forces (p 170) of industry rivalry, buyer power, supplier power, threat of substitutes and threat of new entry The vignette says that new entry and substitute products are not a concern However, competition for customers and suppliers has reduced industry profitability (customers are paying less and costs for programming are rising) The vignette also indicates that revenues are cyclical in nature With regard to its position within the industry, Svensoft’s previous strategy of focusing on the financial services industry has been rendered invalid by the entry of major competitors into this segment 32 “Competitive Strategy: The Core Concepts,” Michael E Porter 2008 Modular Level II, Vol 4, pp 174-178 Study Session 11-41-a, c analyze the competitive advantage and competitive strategy of a company and the competitive forces that affect the profitability of a company and discuss the two fundamental questions determining the choice of competitive strategy; analyze basic types of competitive advantage that a company can possess and the generic strategies for achieving a competitive advantage, the risks associated with each of the generic strategies, the difficulties and risks of simultaneously using more than one of the generic strategies, and the difficulties in sustaining a competitive advantage with any generic strategy Svensoft’s plan to increase reliability constitutes a differentiation strategy 33 “Industry Analysis,” Jeffrey C Hooke 2008 Modular Level II, Vol 4, pp 191-192 Study Session 11-42-a discuss the key components that should be included in an industry analysis model External factors such as technology, government, social changes, demographics and foreign influences are not discussed 34 “Industry Analysis,” Jeffrey C Hooke 2008 Modular Level II, Vol 4, pp 192-197 Study Session 11-42-b, c illustrate the life cycle of a typical industry; analyze the effects of business cycles on industry classification (i.e., growth, defensive, cyclical) The high customer penetration, along with slowing growth prospects, indicate that the industry is mature That revenue declines and expands at greater-than-GDP rates indicates that it is a cyclical industry 35 “Industry Analysis,” Jeffrey C Hooke 2008 Modular Level II, Vol 4, pp 212-213 Study Session 11-42-f explain factors that affect industry pricing practices The entry of broader based competitors into the financial services market, with the ability to differentiate on both features and cost, is reducing segmentation However, the increased competition is raising wages and reducing revenue for existing players and makes it difficult for new players to emerge 36 “A Note on Asset Valuation,” George H Troughton 2008 Modular Level II, Vol 4, pp 5-7 “International Asset Pricing,” Bruno Solnik and Dennis McLeavey 2008 Modular Level II, Vol 6, pp 433-436 Study Sessions 10-36, 18-70-b explain how the classic works on asset valuation by Graham and Dodd and John Burr Williams are reflected in modern techniques of equity and fixed income valuation; state the assumptions of the domestic capital asset pricing model (CAPM), explain the extension of the domestic CAPM to an international context (the extended CAPM), and describe the additional assumptions needed to justify the extended CAPM Most valuation models are based on discounting future cash flows, as Kennant realizes On p 5, Troughton refers to the stock valuation process espoused in Graham and Dodd and states, “That epic work stressed a philosophy of investing centered on the concept of ‘intrinsic value’.” Another work by John Burr Williams proposes estimating the intrinsic value of common stock by calculating the present value of all future dividends per share (p 7) Contrary to Kennant’s belief, the modern portfolio theory applies to portfolios as well as for valuing individual stocks in the framework of CAPM (pp 434-436) 37 “The Equity Valuation Process,” John D Stowe, Thomas R Robinson, Jerald E Pinto, and Dennis W McLeavey 2008 Modular Level II, Vol 4, pp 27-31 Study Session 10-37-g contrast absolute valuation models to relative valuation models Both statements are correct definitions of the valuation models ... is 0.3 32 + (0.975 x 22 .50) = 22 .27 The two-month forecast is 0.3 32 + (0.975 x 22 .27 ) = 22 .04 “Analysis of Intercorporate Investments,” Gerald I White, Ashwinpaul C Sondhi, and Dov Fried 20 08 Modular... Ashwinpaul C Sondhi, and Dov Fried 20 08 Modular Level II, Vol 2, pp 25 -26 Study Session 5 -21 -d distinguish, given various ownership and/ or control levels and relevant accounting standards, whether... Pinto, and Dennis W McLeavey 20 08 Modular Level II, Vol 4, pp 325 - 328 “Equity: Concepts and Techniques,” Bruno Solnik and Dennis McLeavey 20 08 Modular Level II, Vol 4, pp 141-144 Study Sessions 12- 46-u,