Level 2 Mock Exam Question and Answers 2014

Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014 Level 2 Mock Exam Question and Answers 2014

2014 CFA Level II

“CFA Institute Research Objectivity Standards,” CFA Institute

Section 4

LeCompte provided all the recommended disclosures relating to potential conflicts of interest with respect to UniFlash She should have disclosed the "benefit received" from NanoMem concerning the trip she took, as well as her small equity position in NanoMem as required by Research Objectivity Requirement 2, Public Appearances

investment recommendations, and taking investment actions Changing a written

recommendation to what a subject company desires is not acting diligently, independently, objectively, and/or thoroughly and the analyst should immediately revise her recommendation to express her stated opinion of the company

2014 CFA Level II

“Guidance for Standards I-VII,” CFA Institute

Standard I(B), Standard V(A)

Block 2: Scott

Question

1 of 6

Economic income = Change in market value plus the after-tax cash flow

Market value = Present value of future expected after-tax cash flows

Beginning market value, at beginning of Year 3 (assuming end-of-year cash flows):

Ending market value at the end of Year 3:

Ludlow's suggestion of considering alternate economic environments is an example of scenario analysis

on the least common multiple of lives (LCML) approach The three-year project should be chosen using either approach as shown in the following

EAA for three-year project:

NPV × Present Value Annuity Factor (three years at 15%)

EAA = 128,146/2.2832 = 56,126

EAA for five-year project:

NPV × Present Value Annuity Factor (five years at 15%)

EAA = 183,109/3.3522=54,624

The three-year project is preferred because it has a higher EAA

LCML: The least common multiple, given 3 and 5, is 15 Compare the NPV of each project, assuming each project is repeated for 15 years

NPV (three-year project, 15 years):

NPV (five-year project, 15 years):

The three-year project is preferred because the NPV over 15 years is higher

2014 CFA Level II

"Capital Budgeting," by John D Stowe and Jacques R Gagne

Sections 7.1.1– 7.1.2

1 of 6

The components of growth can be determined using Solow’s growth accounting equation: ΔY/Y

= ΔA/A + αΔK/K + (1 − α)ΔL/L

where:

ΔY/Y = GDP percentage growth

ΔA/A = percentage growth from total factor productivity (TFP)

ΔK/K = percentage growth in capital

ΔL/L = percentage growth in labor

α = share of income paid to capital factor

1 – α = share of income paid to labor factor, also the elasticity of output with respect to labor TFP = Labor productivity growth – Growth in capital deepening = 1.7 – 2.3 = –0.6, which is given in Exhibit 1 Also given, 1 – α = 0.65 and α = 0.35

GDP growth = ΔY/Y = 3.75 Arising from the total of components below:

ΔA/A = growth due to TFP −0.6

αΔK/K = growth due to capital + 2.13 = (0.35) × 6.1

(1 − α)ΔL/L = growth due to labor + 2.21 = (0.65) × 3.4

2014 CFA Level II

“Economic Growth and the Investment Decision,” by Paul Kutasovic

Section 5.3

Question

3 of 6

Birol’s statement based on Mundell–Fleming model is inaccurate because restrictive (not

expansionary) fiscal policy, along with expansionary monetary policy, would lead to capital outflows and cause the currency to depreciate assuming high capital mobility

Calculate the interbank implied cross rate for (DRN/EUR)

Invert the (EUR/USD) quotes The 0.8045 bid becomes 1/0.8045 = 1.243 offer for (USD/EUR) The 0.8065 offer becomes 1/0.8065 = 1.240 bid for (USD/EUR)

Determine the interbank implied cross currency quotes for (DRN/EUR) as follows:

Bid: 1.205(DRN/USD) ᵡ 1.24 (USD/EUR) = 1.4942 (DRN/EUR)

Offer: 1.210 (DRN/USD) ᵡ 1.243 (USD/EUR) = 1.504 (DNR/EUR)

Convert to EUR at projected spot:

Minus borrowing cost: 100,000×0.8%=EUR800

Ending balance = EUR101,065

Minus 100,000 beginning value = EUR1,065 profit

2014 CFA Level II

“Currency Exchange Rates: Determination and Forecasting,” by Michael R Rosenberg and William A Barker

Section 4.1

2014 CFA Level II

"Currency Exchange Rates: Determination and Forecasting," by Michael R Rosenberg and William A Barker

Section 3.1.4

It is cheaper to buy Canadian dollars indirectly through Brazilian reals than directly with U.S dollars This creates a triangular arbitrage opportunity:

2014 CFA Level II

"Economic Growth and the Investment Decision," by Paul Kutasovic

Sections 5, 5.2.2, 5.4

Question

6 of 6

The possibility for permanent higher growth in per capita output exists within endogenous

growth theories but not in neoclassical growth theory nor in classical growth theory

Actual experience has shown that the amount expensed in prior years was too large The

adjustment would be a reversal of the reserve in 2013: a decrease in the warrant provision and an increase in net income in 2013 The decrease in the provision (lower current liabilities) would result in increase in the current ratio

2014 CFA Level II

"Evaluating Financial Reporting Quality," by Scott Richardson and Irem Tuna

Section 4.1

Deposits received $3 million

Revenue recognized on receipt of order $3 million/0.25 = $12 million

Increment to gross profit from early recognition policy 53% × $12 million = $6.36 million

Cash and investments –21,122 –25,000

Operating assets (A) 110,000 102,000

Balance sheet–based aggregate

accruals: change in net operating

Only the executive stock option plan is affected by volatility of the company’s stock The

volatility affects the initial valuation of the stock options granted (e.g., through use of the Black– Scholes model to determine the fair value of the options) The initial valuation of the options determines the expense recognized Compensation expense for stock grants is based on the fair market value of the stock on the day of the grant and is not affected by the stock’s volatility

Days of inventory on hand

= 365/Inventory turnover ratio

Inventory turnover ratio

= COGS/Inventory Piezo uses LIFO under U.S GAAP, whereas the European firms use FIFO under IFRS With rising prices, under LIFO, cost of goods sold (COGS) will be higher and the inventory carrying amount will be lower The result is that the inventory turnover ratio will be higher under LIFO than FIFO The higher inventory turnover will lead to fewer days of inventory on hand under LIFO

2014 CFA Level II

“Inventories: Implications for Financial Statements and Ratios,” by Michael A Broihahn Section

3

To be comparable with the European firms, it is necessary to adjust the net income and total asset from LIFO to FIFO Under FIFO, total assets increase by the LIFO reserve but decrease by the cash paid for the cumulative amount of additional income taxes that would arise Net income will be higher under FIFO because of lower COGS (i.e., the increase in the LIFO reserve, but it will be reduced by the taxes paid on the increase in operating profit)

(US$ thousands)

+ Reduction in COGS + 320 Increase in LIFO reserve: 867 – 547

– Tax on increased operating profit – 106.6 33.3% × 320 (use 2013 tax rate)

Net Income (FIFO) $391.4

Total assets (LIFO) $5,570

+Increase in inventory (FIFO) + 867 Add LIFO reserve: 867

– Tax paid on higher cumulative profits – 281.6 33.3% × 320 + 32% × 547a

Total assets (FIFO) $6,155.4

Interest expense from income statement $122

The expensing of the previously capitalised interest is a non-cash amount (the cash outflow was

in a previous period when the expense was incurred) and therefore does not affect operating cash flow Net income is lower as a result of the previously capitalized amount being expensed, but as

it is a non-cash expense it is added back to determine cash from operations (Lower net income but higher add back = no change in CFO)

2014 CFA Level II

"Long-Lived Assets: Implications for Financial Statements and Ratios," by Elaine Henry and Elizabeth A Gordon

Section 2.1

At the end of 2013, a test of impairment is required because “events or changes in circumstances indicate that its carrying amount may not be recoverable.”

U.S GAAP Impairment Test

Step 1: Assess recoverability: Compare carrying amount with undiscounted future net cash flows

Carrying amount 1,604 > 1,350 Expected future cash flows

The recoverability test is not satisfied, so an impairment loss is required.

Step 2: Write the asset down to its fair value

New carrying value: $1,225 (Exhibit 3)

proportions If this trend continues, the recreational products division will become less significant over time

Children’s

Products

Recreational Products

Home Furnishings

Total for the Three Divisions

0.5

1.1

1.0

Apply the 2012 operating margin for the children’s products division to the 2013 revenues for the division

to determine what the 2013 overall operating profit margin would have been if the margin had been maintained, and then compare it with the 2012 overall operating profit margin

Operating margin in children’s products in 2012

= Operating profit/revenues

115.7/1,236.2

9.4%

Apply the 9.4% margin to 2013 revenues for division 0.094 × 1,176.2 110.6

Increase in 2013 operating profit for division, had the

margin been maintained

110.6 – 64.7 45.9

Revised 2013 company operating profit with increase in

children’s products operating profit 172.7 + 45.9

218.6 Revised 2013 company operating margin 218.6/2,837.1 7.7%

2012 company operating margin 219.4/2,775.5 7.9%

Analysts should consider the foreign currency effect on sales growth for evaluating

management's historical performance Foreign currency fluctuations are out of management's control, so management should not be held accountable for the fluctuations when evaluating their performance

2014 CFA Level II

"Multinational Operations," by Timothy S Doupnik and Elaine Henry

Section 5.1

profits were earned in a lower tax jurisdiction The foreign operations are in lower tax regimes, therefore,

it is reasonable to conclude that more of the profits were earned internationally

Earnings before taxes 136.6 170.0

Net earnings after tax 109.9 132.3

Effective tax rate

(Income taxes/EBT)

19.6%

22.2%

Cash conversion cyclea 95.4 83.8

aCCC = Days in sales + Days in inventory – Days in payables

Alton Fair value through profit or loss Dividends 1,000

+ Unrealized gain (loss) (3,000) Barker Available for sale Dividends 2,000

Cosmic Available for sale Dividends 3,000

Darnell Equity method % of investees’ net income 15,000

it cannot account for its significant influence in Darnell using fair value

Associated companies are ones in which the investor (Foster) can exercise significant influence In addition to ownership between 20–50% (Foster owns 40%), significant influence may be evidenced by representation on the board of directors (Foster has representation on Darnell’s board) or by material transactions between the two companies

Value (C$ thousands)

Eldon Fair value through profit or loss $23,000

Investment Classification Income effect C$

(thousands)

Eldon Fair value through

profit or loss

Interest income + Unrealized gain

1,000 3,000 Fizz Available for sale Interest income 2,000

Gilt Held to maturity Interest income 2,000

Harp Held to maturity Interest income 5,000

Substituting the assumed values into the estimated model results from Exhibit 1 to determine the predicted monthly return:

The null hypothesis is H0: bspread = 1

The calculated value of the t-statistic is t = (1.0264 – 1.0)/standard error

The standard error is 1.0264/4.28 = 0.24

The calculated value for t = (1.0264 – 1.0)/0.24 = 0.11

The two-tailed critical t-value (1.972) is taken from the table with p = 0.025

The confidence interval is 0.3625 (1.972 0.055), or 0.25 to 0.47

Question

5 of 6

Multicollinearity occurs when two or more independent variables (or combinations of

independent variables) are highly (but not perfectly) correlated Correlation between independent variables may be a reasonable indication of multicollinearity in cases in which the regression contains only two independent variables In Hamilton’s regression model, the correlation

between the SPREAD and the S&P 500 variables is only 0.30

If errors are not serially correlated, the Durbin-Watson statistic will be close to 2 If the

regression residuals are positively correlated, the Durbin-Watson statistic will be less than 2, as it

is here A Durbin-Watson statistic greater than 2 suggests negative serial correlation

The cash flow is the difference between the net operating income and the debt service The equity is the difference between the market value of the property and the mortgage on the property ($700,000 – $600,000) / ($10,000,000 – $9,000,000) = 10%

2014 Modular Level 2, Vol 3, Reading 26, Section 3.2

“Investing in Hedge Funds: A Survey,” Keith H Black

Section 11

1 of 6

The information disclosed about the exams by either Sobhani or Miyagawa is not confidential CFA Program information so they are not in violation of Standard VII Sobhani's information was based upon his analysis of the readings and is his opinion, and Miyagawa referenced the practice exam, which does not reflect content in the actual CFA exam

The market environment forecast is stated as an opinion, not fact, and as such is not a violation

of Standard V(B)-Communication with Clients and Prospective Clients But, Sobhani's asset allocation recommendation, a 60% equity allocation is risky and does not relate to the long-term objectives and circumstances of Poundston, so, is in violation of Standard III(C)-Suitability A high equity allocation for a sick and elderly client who plans to retire soon is not a suitable recommendation, especially to a client who who is risk averse and seeking preservation of capital Finally, Sobhani has violated Standard V(A)-Diligence and Reasonable Basis because his recommendation that Poundston invest a large percentage of her assets in equities in an already highly priced market does not appear to be based on any evidence or analysis

2014 CFA Level II

"Guidance for Standards I – VII," CFA Institute

Standard III(C)-Suitability, Standard V(A)-Diligence and Reasonable Basis, Standard Communication with Clients and Prospective Clients

V(B)-Question

3 of 6

Standard IV(C)-Responsibilities of Supervisors has been violated As to it requires members and candidates with supervisory responsibility to understand what constitutes an adequate

compliance system for their firms and to make reasonable efforts to see that appropriate

compliance procedures are established, documented, communicated to covered personnel, and followed "Adequate" procedures are those designed to meet industry standards, regulatory requirements, the requirements of the Code and Standards, and the circumstances of the firm Once compliance procedures are established, the supervisor must also make reasonable efforts to

ensure that the procedures are monitored and enforced By not updating his compliance policies and procedures since founding his company, Sobhani has violated this standard

2014 CFA Level II

"Guidance for Standards I-VII," CFA Institute

Standard IV(C)-Responsibilities of Supervisors, Standard V(C)-Record Retention

Question

4 of 6

Sobhani has only stated historical returns for these types of investments based on research of other similar investments In addition, he has not promised a specific return Thus Sobhani is not

in violation of Standard III(D)-Performance Presentation But, Sobhani is in violation of

Standard III(A)-Loyalty, Prudence, and Care because he is required to identify the actual client, which in this case would be Purce and the trust beneficiaries, the twins From the information provided, there is no evidence that Sobhani knows or has considered the twin's investment objectives and constraints and thus is also in violation of Standard III(C)-Suitability

2014 CFA Level III

"Guidance for Standards I-VII," CFA Institute

Standard III(C)-Suitability, Standard III(D)-Performance Presentation, Standard V(A)-Diligence and Reasonable Basis

Question

5 of 6

Standard VI(C)-Referral Fees requires Members and Candidates to disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services before entry into any formal agreement for services In this case, Sobhani advises clients of the referral fee

arrangement after the fact, thus violating Standard VI(C)

2014 CFA Level II

"Guidance for Standards I-VII," CFA Institute

Standard III(B)-Fair Dealing, Standard VI(C)-Referral Fees

Sobhani has not violated Standard VI(A)-Disclosure of Conflicts because disclosure of his relationship with Wilder is not required because it would not impair Sobhani's independence and objectivity nor interfere with his respective duties to clients

But, by not following local law and reporting his cousin's malfeasance, Sobhani violated

Standard I(A)-Knowledge of the Law and as a result also violated Standard I(D)-Misconduct because his actions reflect adversely on his professional reputation and integrity

2014 CFA Level II

"Guidance for Standards I-VII," CFA Institute

Standard I(A), Standard I(D), Standard VI(A)

Block 2: Trendwise

Question

1 of 6

There was no violation of Standard II(A) Material Nonpublic information However, when Natali conducted

a thorough analysis that convinced her to sell the Cyclical stock and then reversed her decision and followed the request by an Omega Fund's director to hold Cyclical without having a reasonable basis for doing so, she violated both Standard II (A) Loyalty, Prudence, and Care and Standard V(A) Diligence and Reasonable Basis

2014 CFA Level II

"Guidance for Standards–VII", CFA Institute

Standard II(A) Material Nonpublic Information, Standard III(A) Loyalty, Prudence, and Care, Standard V(A) Diligence and Reasonable Basis

Question

2 of 6

Statements made by both Natali and Libra are consistent with the Standards According to

Standard III(A) Loyalty, Prudence, and Care voting proxies is an integral part of the management

of investments and a fiduciary who fails to vote proxies may violate the Standard The Standards

of Practice Handbook also states that a cost-benefit analysis may show that voting all proxies may not benefit the client, so voting proxies may not be necessary in all instances Members and candidates should disclose to clients their proxy-voting policies, which Natali has done

2014 CFA Level II

"Guidance for Standards I-VII", CFA Institute

Standard III(A)

Question

3 of 6

Disclosure of soft dollar amounts paid is not a requirement However, Standard III (A) Loyalty, Prudence, and Care, Soft Commission Policies requires disclosure of the methods or policies followed in addressing the potential conflicts of soft dollar arrangements

2014 CFA Level II

"CFA Institute Soft Dollar Standards," CFA Institute

Standard III(A) Loyalty, Prudence, and Care–Soft Commission Policies

CFA Institute Soft Dollar Standards, CFA Institute

Section 6(I)A Principles

Question

5 of 6

Both Policies 1 and 2 are inconsistent with the Research Objectivity Standards According to the Research Objectivity Standards, firms must establish and implement salary, bonus, and other compensation for analysts that do not directly link compensation to investment banking or other corporate finance activities on which the analyst collaborated (either individually or in the aggregate) The Standards also state that research analysts are prohibited from directly or

indirectly promising a subject company or other issuer a favorable report or specific price target,

or from threatening to change reports, recommendations, or price targets

2014 CFA Level II

"CFA Institute Research Objectivity Standards," CFA Institute

Section 4

Policy 4 is consistent Section 4, Requirement 6 outlines specific information, which must not be communicated including proposed recommendation, rating, or price target However, factual historical information such as a list of directors or historical financial results may be disclosed in advance of publishing a research report

S = the underlying price

F = the forward price

r = the risk-free rate

T = the time to expiration at contract initiation

t = the time elapsed since initiation

F(0,T) = the price of a forward contract initiated at time 0 and expiring at time T

S0 = the spot price of the underlying

δc = the continuously compounded dividend yield

rc = the continuously compounded interest rate

T = 180/365 = 0.4932, which is the time to expiration of the contract in years

S0 = the spot price

r = the domestic risk-free rate

The formula assumes the currency quote is dollars per yen If the quote is yen per dollar (as is the

case here), then the forward price is S0[(1 + rf)T/(1 + r)T], so

Note that the continuous formula, F= S0erf Te–rT, can be used Converting the given rates to

continuous rates gives rf = ln(1.01) = 0.00995 and r = ln(1.06) = 0.05827

2014 CFA Level II

"Forward Markets and Contracts," by Don M Chance

Section 5

The value of a futures contract before it has been marked to market can be greater than or less than zero The value is the gain or loss accumulated since the last mark-to-market adjustment

The futures price formula is f0(T) = S0 (1+r)T + FV(CB,0,T), where FV(CB,0,T) represents the

future value (FV) of the costs of storage minus the convenience yield Thus the convenience yield decreases the futures price

Question

2 of 6

According to put–call parity: Long bond + Long call = Long stock + Long put

Bond = 98.04 = 100/1.02360/360 (must be calculated from option data table)

Long call = $10.35 (given)

Long put = $9.25 (given)

Synthetic underlying stock = $99.14 = Long bond + Long call + Short put (“+ Short put” is another way of expressing “– Long put”) = 98.04 + 10.35 – 9.25

2014 CFA Level II

“Forward Markets and Contracts,” by Don M Chance

Section 7.3.1

Swap 2 represents a $100,000 liability to Toye as the receiving counterparty

Using the PVGO and assuming that the company has no positive net present value (NPV)

projects, the PVGO Model is:

Question not answered

Using the H-model:

H = 1/2 of the life of high-growth period = 10/2 = 5 years

Raman is most accurate with respect to his comments on the CAPM In portfolios, the

idiosyncratic risk of individual securities tends to offset against each other leaving largely beta (market) risk For individual securities, idiosyncratic risk can overwhelm market risk and, in that case, beta may be a poor predictor of future average return Thus the analyst needs to have multiple tools available

Question

5 of 6

Statement 3 by Raman is most accurate The residual income model, also called the excess earnings method, does not have the same weakness as the FCFE approach, because it is an estimate of the profit of the company after deducting the cost of all capital: debt and equity Further, it makes no assumptions about future earnings and dividend growth

Using a multi-stage residual income model and the data in Exhibit 3:

Equity charge = Equity capital × Cost of equity capital

= 20.97 × 0.124 = $2.60 million

Residual income of the more recent year = Net income – Equity charge

= 8.00 – 2.60 = $5.40 million

Raman’s assumed growth rate during the forecast period of five years = 15%

Annual residual income during the no growth period (after Year 5) = 5.40 × (1.15)5 = $10.86

Present value (PV) of the residual income from perpetual period, as at T = 5 =

1 of 6

The comparable transactions method uses details from recent takeover transactions for

comparable companies to make direct estimates of the target company's takeover value However

it is not necessary to separately estimate a takeover premium as this is already included in the multiples determined from the comparable transactions

E0/S0 = the business's long-term profit margin = 8.0%

g = the long-run earnings growth rate

r = required rate of return

2014 CFA Level II

"Market-Based Valuation: Price and Enterprise Value Multiples," by Jerald Pinto, Elaine Henry, Thomas Robinson, and John Stowe

Section 3.3.2

Question

4 of 6

Question not answered

Real required rate of return = Country return + Industry adjustment + Size adjustment – Leverage adjustment

Real required rate of return as given = 11.50%

FCFE0 = FCFF – Int (1 – Tax rate) + Net borrowing

Because of the three different growth periods, it is necessary to use the three-stage FCFF model and calculate the FCFF for each of Years 1 to 4 and a terminal value at the end of Year 4

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

Net income (given) = $626; Non-cash charges (depreciation, given) = $243; Interest expense (given) =

$186; Tax rate = 294/920 = 32%; Fixed capital investment (given) = $535

($ millions)

2011 ($ millions)

Net increase ($ millions)