2021 CFA LII Mock Exam 2 – PM Session

Victoria Duffy Case Scenario

1.

A is correct. Based on the information provided, Duffy has not violated

any CFA Institute Code of Ethics and Standards of Professional Conduct
during her lunch meeting with Kercheval. Including potential client names in
the presentation she shared with Kercheval, several of which are clients of her
former employer whom she had frequent contact with, is not a violation. There
is no evidence she approached them before leaving DalTex or got their
information from a DalTex client list. Standard IV, Duties to Employers,
specifically Standard IV(A), Loyalty, states that in matters related to their
employment, CFA Institute members and CFA candidates must act for the
benefit of their employer and not deprive their employer of the advantage of
their skills and abilities, divulge confidential information, or otherwise cause
harm to their employer. Once an employee has left the firm, the skills and
experience an employee obtained while employed are not confidential or
privileged information. Similarly, simple knowledge of the names and existence
of former clients generally is not considered to be confidential information
unless deemed such by a confidentiality agreement or by law. The standard
does not prohibit former employees from contacting clients of their previous
firm as long as the contact information does not come from the records of the
former employer or violate an applicable noncompete agreement. Because there
is no evidence Duffy is in possession of client information other than the
client’s name, she would also not be in violation of Standard III, Duties to
Clients, specifically Standard III(E), Preservation of Confidentiality, which
states members and candidates must keep information about current, former,
and prospective clients confidential.

B is incorrect. Duffy has most likely not violated any CFA Institute Code
of Ethics and Standards of Professional Conduct during her lunch meeting
with Kercheval, including Standard III, Duties to Clients. Because there is no
evidence Duffy is in possession of client information other than the client’s
name, she would also not be in violation of Standard III, Duties to Clients,
specifically Standard III(E), Preservation of Confidentiality, which states
members and candidates must keep information about current, former, and
prospective clients confidential.

C is incorrect. Duffy has most likely not violated any CFA Institute Code
of Ethics and Standards of Professional Conduct during her lunch meeting
with Kercheval, including Standard IV, Duties to Employers. There is no
evidence she approached them before leaving DalTex or got their information
from a DalTex client list. Standard IV, Duties to Employers, specifically
Standard IV(A), Loyalty, states that in matters related to their employment,
CFA Institute members and CFA candidates must act for the benefit of their
employer and not deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause harm to their
employer. Once an employee has left the firm, the skills and experience an
employee obtained while employed are not confidential or privileged
information. Similarly, simple knowledge of the names and existence of former
clients generally is not considered to be confidential information unless deemed
such by a confidentiality agreement or by law. The standard does not prohibit
former employees from contacting clients of their previous firm as long as the
contact information does not come from the records of the former employer or
violate an applicable noncompete agreement.

Guidance for Standards I-VII

Section: Standard III Duties to Clients and Standard IV Duties to

Employers

LOS a

2.
 C is correct. Option 3, “Give the client the name of Duffy’s new firm,”
most likely will prevent Kercheval from violating CFA Institute Code of Ethics
and Standards of Professional Conduct. This action allows her to place the
responsibility of the client talking with Duffy in the hands of the client. Option
1, “Call Duffy and give her a recount of the conversation,” and Option 2, “Do
nothing until she joins Victory then pass on the card to Duffy,” potentially
could result in Kercheval violating CFA Institute Code of Ethics and Standards
of Professional Conduct. A conflict exists between Kercheval’s duties to her
current employer and her duties to her client. Option 1 present a conflict with
Standard IV(A), Loyalty. Standard IV(A) states in matters related to their
employment, CFA Institute members and CFA candidates must act for the
benefit of their employer and not deprive their employer of the advantage of
their skills and abilities, divulge confidential information, or otherwise cause
harm to their employer. Passing the information along to Duffy potentially
could harm her current employer if the client were to move their assets to
Duffy’s new firm. Option 2 presents a conflict with Standard III(A), Loyalty,
Prudence, and Care. Standard III(A) states CFA Institute members and CFA
candidates must act for the benefit of their clients and place their clients’
interest before their employer’s or their own interests. Therefore, her first duty
is to her client. Doing nothing until she joined Victory would conflict with her
duty to her client who asked her to pass along the information. Therefore,
Option 3 is her best course of action.

A is incorrect. Option 1 would not prevent Kercheval from violating CFA

Institute Code of Ethics and Standards of Professional Conduct. Option 1
present a conflict with Standard IV(A), Loyalty. Standard IV(A) states in matters
related to their employment, CFA Institute members and CFA candidates must
act for the benefit of their employer and not deprive their employer of the
advantage of their skills and abilities, divulge confidential information, or
otherwise cause harm to their employer. Passing the information along to Duffy
potentially could harm her current employer if the client were to move their
assets to Duffy’s new firm.

B is incorrect. Option 2 would not prevent Kercheval from violating CFA

Institute Code of Ethics and Standards of Professional Conduct. Option 2
presents a conflict with Standard III(A), Loyalty, Prudence, and Care. Standard
III(A) states CFA Institute members and CFA candidates must act for the
benefit of their clients and place their clients’ interest before their employer’s or
their own interests. Therefore, her first duty is to her client. Doing nothing
until she joined Victory would conflict with her duty to her client who asked
her to pass along the information. Therefore, Option 3 is her best course of
action.

Guidance for Standards I-VII

Section: Standard III (A) Loyalty, Prudence and Care, and Standard
IV(A) Loyalty

LOS b

3.

C is correct. Tilton has violated both Standard IV(A), Loyalty, and

Standard I(B), Independence and Objectivity. She has violated Standard IV(A),
Loyalty, by agreeing to a mutually beneficial arrangement to provide Duffy with
a daily commentary about how she is navigating the market for her clients and
the firm with the idea that she will be able to join the firm at some later date
and become a potential equity owner. Standards IV(A) states that in matters
related to their employment, CFA Institute members and CFA candidates must
act for the benefit of their employer and not deprive their employer of the
advantage of their skills and abilities, divulge confidential information, or
otherwise cause harm to their employer. Her agreement with Duffy conflicts
with the requirements of Standard IV. She is not acting for the sole benefit of
her employer, and although she has not deprived them of the advantage of her
skills and abilities, she is causing them harm by giving the information she
uses in making her decision to another firm. She is also in violation of
Standard I(B), Independence and Objectivity, which states that CFA Institute
members and CFA candidates must not offer, solicit, or accept any gift, benefit,
compensation, or consideration that reasonably could be expected to
compromise their own or another’s independence and objectivity. She is
offering her current employer’s proprietary commentary in the idea that she
will be able to join DalTex and become an equity owner. Tilton has most likely
violated other CFA Institute Code of Ethics and Standards of Professional
Conduct, including but into limited to Standard III, Duties to Clients.

A is incorrect. Tilton has violated Standard IV, Loyalty,. by agreeing to a

mutually beneficial arrangement to provide Duffy with a daily commentary
about how she is navigating the market for her clients and the firm with the
idea that she will be able to join the firm at some later date and become a
potential equity owner. Standards IV(A) states that in matters related to their
employment, CFA Institute members and CFA candidates must act for the
benefit of their employer and not deprive their employer of the advantage of
their skills and abilities, divulge confidential information, or otherwise cause
harm to their employer. Her agreement with Duffy conflicts with the
requirements of Standard IV. She is not acting for the sole benefit of her
employer, and although she has not deprived them of the advantage of her
skills and abilities, she is causing them harm by giving the information she
uses in making her decision to another firm.

B is incorrect. Tilton has violated Standard I(B), Independence and

Objectivity, which states that CFA Institute members and CFA candidates must
not offer, solicit, or accept any gift, benefit, compensation, or consideration that
reasonably could be expected to compromise their own or another’s
independence and objectivity. She is offering her current employer’s proprietary
commentary in the idea that she will be able to join DalTex and become an
equity owner.
 Guidance for Standards I-VII

Section: Standard I(B) Independence and Objectivity and Standard

IV(A) Loyalty

LOS a

4.

B is correct. With regards to Tilton’s agreement with her previous

employer, Recommendation 2, “You and your former employer need to sign the
agreement,” is insufficient to prevent a violation of Standard IV(B), Additional
Compensation. Standard IV(B) states that CFA Institute members and CFA
candidates must not accept gifts, benefits, compensation, or consideration that
competes with or might reasonably be expected to create a conflict of interest
with their employer’s interest unless they obtain written consent from all
parties involved. Duffy addresses the requirement for written consent in
Recommendation 2, but it is incomplete. To be in compliance, Duffy should
also sign the agreement, not just Tilton and her former employer.
Recommendation 1, “You need to draft an agreement outlining what you’re
doing and how much they are paying you over the next year,” does meet
recommended procedures for compliance with Standard IV(B). The written
agreement should state the terms, which include the nature of the
compensation, the approximate amount of compensation, and the duration of
the agreement. Tilton’s agreement creates two different conflicts of interest.
One with Duffy’s clients and potential clients and one between Tilton and her
new employer. The conflict of interest the agreement creates with Duffy’s
clients is covered under Standard VI(A), Disclosure of Conflicts. Duffy
addresses the requirements under Standard VI(A) in Recommendation 3, “We
will also need to send notification to all our clients and potential clients
disclosing the agreement.” Standard VI(A) states that members and candidates
must make full and fair disclosure of all matters that could reasonably be
expected to impair their independence and objectivity or interfere with
respective duties to their clients, prospective clients, and employer. The second
conflict of interest created by Tilton’s agreement is under Standard IV(B) and
was addressed when Tilton disclosed the conflict to Duffy.

A is incorrect. Recommendation 1, “You need to draft an agreement

outlining what you’re doing and how much they are paying you over the next
year,” is necessary to address Tilton’s agreement with her previous employer.
The written agreement should state the terms, which include the nature of the
compensation, the approximate amount of compensation, and the duration of
the agreement. Tilton’s agreement creates two different conflicts of interest.
One with Duffy’s clients and potential clients and one between Tilton and her
new employer.

C is incorrect. Recommendation 3, “We will also need to send notification

to all our clients and potential clients disclosing the agreement,” is necessary to
address Tilton’s agreement with her previous employer. Standard VI(A) states
that members and candidates must make full and fair disclosure of all matters
that could reasonably be expected to impair their independence and objectivity
or interfere with respective duties to their clients, prospective clients, and
employer. The second conflict of interest created by Tilton’s agreement is under
Standard IV(B) and was addressed when Tilton disclosed the conflict to Duffy.

Guidance for Standards I-VII

Section: Standard IV(B) Additional Compensation Arrangement,

Standard VI(A) Disclosure of Conflicts

LOS b

Sagara Case Scenario

1.

A is correct. Substantive law focuses on the rights and responsibilities of

entities and relationships among entities. A well-developed legal system of
substantive and procedural laws and respect for property rights are likely to
encourage growth, not limit it. Factors that limit growth include restrictions on
imports and low rates of saving.

B is incorrect. This is a typical factor that limits growth in a developing

country.

C is incorrect. This is a typical factor that limits growth in a developing

country.

Economic Growth and the Investment Decision

LOS a

Section 2.7

Economics of Regulation

LOS d

Section 3.1

2.

B is correct. The stated conclusion is accurate in its entirety. The Cobb–

Douglas function exhibits constant returns to scale, which means that if all
inputs are increased at the same percentage, then output rises at that
percentage. Diminishing marginal productivity exists with respect to each
individual input (if the other input is held constant). Continued growth in per
capita output is possible even in the steady state as long as there is ongoing
technological progress (increases in TFP).

A is incorrect. The premise of the Cobb–Douglas production function is

constant returns to scale.

C is incorrect. Sustained growth in per capita output requires progress in

TFP.

Economic Growth and the Investment Decision

LOS d
 Sections 4.1, 4.2

3.

A is correct. Both her comments are incorrect. In the Dutch disease

scenario, currency appreciation driven by strong export demand for resources
makes other segments of the economy, in particular manufacturing, globally
uncompetitive. She is also incorrect regarding direct ownership of the rubber
plantations by foreigners; access to natural resources is essential but
ownership is not.

B is incorrect as both of her comments are incorrect.

C is incorrect as both of her comments are incorrect.

Economic Growth and the Investment Decision

LOS f

Section 4.5

4.

C is correct. N’Diarra’s understanding of classical growth theory is

correct, as is her understanding of its implications. Classical growth theory
holds the view that the growth rate of real GDP per person is temporary
because of population explosion. Her description of endogenous growth theory
is not accurate. She references a steady state rate of growth and diminishing
marginal returns, which are tenets of neoclassical growth theory.

B is incorrect because her understanding of the endogenous growth

theory is incorrect.

A is incorrect because her understanding of classical growth theory is

correct, but her understanding of endogenous growth theory is incorrect.

Economic Growth and the Investment Decision

LOS i
 Sections 5.1, 5.2, 5.3

5.

A is correct. Banantoumou’s concern is an example of regulatory

capture. Regulated companies’ efforts to fight particular regulations tend to
attract more public attention than when the companies are sympathetic to the
contemplated regulations. Even more fundamentally, academics have argued
that regulation often arises to enhance the interests of the regulated, often
called the “regulatory capture” theory. For example, regulatory actions and
determinations can restrict potential competition and coordinate the choices of
rivals.

B is incorrect. This is not an example of regulatory competition.

C is incorrect. This is not an example of regulatory arbitrage.

Economics of Regulation

LOS f

Section 3.2

6.

B is correct. Some independent regulators are SROs empowered to

enforce the law. They do not typically rely on government funding.

A is incorrect. SROs do not typically rely on government funding.

C is incorrect. SROs as independent regulators can enforce laws if so

empowered by a government body or agency.

Economics of Regulation

LOS e

Section 3, 3.1

Suburban Publishers Case Scenario

 1.

C is correct. Although Suburban’s ownership interest (24%) in West

Reach exceeds the amount that is normally deemed sufficient to presume
significant influence (20%), the inability to elect directors or influence the firm’s
policy making indicates a lack of significant influence. It would thus be
inappropriate to account for its holdings under the equity method. Instead
West Reach should be considered a passive investment of Suburban and
carried at full value. Although difficult to value because of its private status,
the recent sale by Mr. French provides an observable price that can be used to
revalue Suburban’s holdings per the table below.

Sales value of West Reach $6.2 million

shares

# shares sold 100,000

Implied unit value of West $62/share $6.2 million ÷ 100,000
Reach shares shares

# shares held by Suburban 240,000

Implied value of Suburban’s $14.88 million $62/share × 240,000
West Reach holdings shares

A is incorrect. This is the cost value of the investment.

B is incorrect. This would be the value if West Reach was considered an

equity investment, per the following table:

Less:
$ thousands Net income dividends @ 24%

Opening 12,000

2013 2,400 500 1,900 456

2014 1,800 200 1,600 384

2015 1,950 50 1,900 456

2016 2,000 4,000 1,600 384

 Ending 13,680

Intercorporate Investments

LOS b, c

Sections 4

2.

C is correct. Suburban owns 32.5% of Great Lakes implying the ability to

exercise significant influence. Since there is no information to suggest that they
are not able to exercise influence, they would use the equity method to account
for the investment.

Analysis of initial investment, in thousands

Amount paid in acquisition $1,365

Book value of acquired equity 858 32.5% × $2,640

Excess paid over book value $507

Amount attributable to fair value of identifiable assets 234 32.5% × (684 + 36):
• Excess paid for P&E (2,964 – 2,280) =684

• Excess paid for Land (1,476 – 1,440) = 36

Goodwill (residual value) $273

Calculation of investment in associates account, in thousands as at end of

2014

Start of year investment $1,365.00 Amount paid

+ Share of net income 390.00 32.5% × 1,200

– Share of dividends received (163.80) 32.5% × 504

– Amortization of excess amount paid for PPE (22.23) 32.5% × 684/10 years

End of year investment $1,568.97

 A is incorrect. It ignores the amortization of excess amount paid and just
adds in net income and deducts the dividends received: 1,365 + 390 – 163.8 =
1,591.2.

B is incorrect. It amortizes the land as well as PP&E: 1,365 + 390 – 163.8

– 234/10 = 1,567.80.

Intercorporate Investments

LOS b, c

Sections 4.1, 4.2, 4.3

3.

A is correct. Under US GAAP, if the fair value of the investment falls

below the carrying amount, and assuming the decline is considered to be
permanent (as Munroe expects), the impairment loss is recognized on the
income statement and the carrying value of the investment is reduced to its fair
value; the impairment loss is the difference between the carrying amount and
the fair value (i.e., $1,264.51 thousand – $940.00 thousand = $324.51
thousand).

B is incorrect. It ignores the stated carrying value and incorrectly

recalculates the equity in the subsidiary based on FV of net assets at
acquisition plus/minus income/loss – dividends from acquisition (same as BV),
and deducts the current fair value from it:

Incorrect carrying value based on GL book value: 0.325 × 3,256 =

1,058.2

Impairment loss: 1,058.2 – 940 = 118.2

C is incorrect. The loss has also not been calculated properly: $425 =
Price paid – FV investment = 1,365 – 940, but should be $324.51 (see A).

Intercorporate Investments
 LOS b, c

Section 4.5

4.

B is correct. The shareholders’ equity section of the post-acquisition

consolidated balance sheet will consist of the capital stock and retained
earnings account of the parent and the non-controlling interest of the minority
shareholders. Under US GAAP, the value of the non-controlling interest is
equal to the non-controlling interest’s proportionate share of the subsidiary’s
fair value.

A: Amount paid for 60% interest = 60% × $14/share × 8,000,000 shares

= $67,200 thousand

Fair value of subsidiary = 8 million shares × $14/share = $112,000

thousand

B: Non-controlling interest = $112,000 × (1 – 0.60) = $44,800 thousand

Shareholders’ Equity ($ thousands) Calculation

Non-controlling interest 44,800 See B above

Capital stock 347,200 280,000 + 67,200:

Original + Issued in acquisition

(see A. above)

Retained earnings 185,000 Suburban’s retained earnings

Total equity 577,000

A is incorrect. It ignores the non-controlling interest but adds the new

shares plus Suburban’s original capital stock plus retained earnings: 347,200
+ 185,000= 532,200.

A: Amount paid for 60% interest = 60% × $14/share × 8,000,000 shares

= $67,200 thousand
 Shareholders’ Equity ($ thousands) Calculation

Capital stock 347,200 280,000 + 67,200:

Original + Issued in acquisition
(see A above)

Retained earnings 185,000 Suburban’s retained earnings

Total equity $532,200

C is incorrect. It uses partial goodwill method to determine the non-

controlling interest, which is allowable under IFRS but not under US GAAP.

A: Amount paid for 60% interest = 60% × $14/share × 8,000,000 shares

= $67,200 thousand

Fair Value of Subsidiary’s net assets = $99,000 thousand

B: Non-controlling interest of FV of sub’s net assets = 99,000 × (1 – 0.60)

= $39,600 thousand

($
Shareholders’ Equity thousands) Calculation

Non-controlling interest $39,600 See B above

Capital stock 347,200 280,000 + 67,200:

Original + see A above

Retained earnings 185,000 Suburban’s retained earnings

Total equity $571,800

Intercorporate Investments

LOS b, c

Section 5.3

5.

C is correct. Carter’s conclusion is incorrect because there is no defined

obligation for the pension plan for management. The plan for management is a
defined contribution plan, HiQ’s obligations are limited to its annual
contribution. The pension assets for the defined contribution plan do not
appear on HiQ’s (or Suburban’s) financial statements. For the plan for the
unionized workforce the amount reported will be the net over or underfunded
status, not the separate assets and obligation.

A is incorrect. The pension assets for the defined contribution plan do

not appear on HiQ’s (or Suburban’s) financial statements.

B is incorrect. The pension assets for the defined contribution plan do

not appear on HiQ’s (or Suburban’s) financial statements. For the plan for the
unionized workforce, the amount reported will be the net over or underfunded
status, not the separate assets and obligation.

Employee Compensation: Post-Employment and Share-Based

LOS a

Section 2

6.

B is correct. The unionized plan is a defined-benefit plan, and the

amount reported on the balance sheet is normally the net of the fair value of
plan assets less the present value of defined-benefit obligation ($16.6 – $15.5 =
$1.1 million). However, if the plan has a surplus, as this one does, the net
pension asset is subject to a ceiling defined as the present value of available
refunds and reductions in future contributions, which in this plan is $500,000.

A is incorrect. It calculates the surplus but doesn’t consider the ceiling.

C is incorrect. It incorrectly adds the present value of available refunds

and reductions in future contributions to the defined-benefit obligation: 1.1 –
0.500 = 600,000.

Employee Compensation: Post-Employment and Share-Based

 LOS b

Section 2.3.2.1

Jason Perry Case Scenario

1.

B is correct. In a consolidation, the acquiring company and target

company cease to exist and form a new company. In the 2012 transaction,
WIKS Industrial Lighting and the lighting retailer cease to exist and the new
company is WIKS General Lighting.

A is incorrect. WIKS Industrial Lighting does not cease to exist after the
transaction, which is inconsistent with a consolidation. The 2010 transaction
exemplifies a subsidiary merger.

C is incorrect. WIKS General Lighting does not cease to exist after the
transaction, which is inconsistent with a consolidation. The 2016 transaction
exemplifies a statutory merger.

Mergers and Acquisitions

LOS a

Section 2

2.

B is correct. The purchase of the lighting retailer in 2012 extends WIKS

Industrial Lighting down the value chain because the company was not selling
directly to the consumer previously, making the transaction an example of
forward integration.

A is incorrect. The 2010 purchase of the residential lighting company is

not related to WIKS Industrial Lighting’s value chain. This transaction is a
horizontal merger.
 C is incorrect. The 2016 purchase of the LED company augments WIKS
General Lighting’s existing manufacturing operations and development
department. This transaction is a vertical merger.

Mergers and Acquisitions

LOS a

Section 2

3.

A is correct. WIKS makes a stock proposal to LIT’s board of directors

instead of LIT’s management team, which is a “bear hug” strategy.

B is incorrect. A proxy fight occurs when the shareholder’s vote to decide

a firm’s course of action. However, the stock proposal described in Comment 2
of LeBlanc’s discussion does not consider this action.

C is incorrect. WIKS eventually makes a cash tender offer to acquire LIT.

However, the stock proposal described in Comment 2 of LeBlanc’s discussion
does not consider this action.

Mergers and Acquisitions

LOS e

Section 4.2, 4.3.2

4.

C is correct.

From Exhibit 1: The premium paid per share is 25% and the cash offering is
$25 per share

Premium per share = $25.00 – {$25.00 ÷ (1 + 25%)} = $5.00 per share

WIKS owns 1 million of the 25 million shares, which requires WIKS to buy 24
million shares (they bought all the outstanding shares)

Target shareholder gain = premium per share × number of shares purchased

= $5.00 × 24 million = $120 million

Synergy = gain from selling 80% of domestic manufacturing unit for $200
million

WIKS’s increased value = Synergy – Target shareholder gain

= $200 million – $120 million = $80 million

A is incorrect. Premium per share is calculated as 25% × $25 = $6.25

$50 million = $200 million – ($6.25 × 24 million)

B is incorrect. WIKS purchased 25 million shares instead of 24 million

shares.

$75 million = $200 million – ($5.00 × 25 million)

Mergers and Acquisitions

LOS k

Section 7.2

McLaughlin Corporation Case Scenario

1.

B is correct.

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

Net
2012 2011 increase
($ ($ ($
Working Capital Investment millions) millions) millions)
 Current assets excluding cash 1,290 – 32 1,199 – 21
= 1,258 =1,178

Current liabilities 2,783 2,678

Working capital –1,525 –1,500 –25

FCFF = 626 + 243 + 186(1 – 0.32) – 535 – (–25) = 485.48 = $485 million

A is incorrect. It uses t not (1 – t).

FCFF = 626 + 243 + 186(0.32) – 535 – (–25) = 418.2 = $418 million

C is incorrect. It ignores working capital investment

FCFF = 626 + 243 + 186(1 – 0.32) – 535 = 460.48 = $460 million

Free Cash Flow Valuation

LOS c, d

Section 3.1

2.

B is correct.

FCFE = FCFF – Interest(1 – T) + Net borrowing

Given: 2012 FCFF base case estimate = $500; Interest expense = $186;
Tax rate = 32%

2012 2011 Net increase

Long-term debt ($) 2,249 2,449 –200

FCFE = 500 – 186 × (1 – 0.32) + (–200) = $174 million

A is incorrect. It switches the sign for net borrowing

FCFE = 500 – 186 × (1 – 0.32) + 200 = $574 million

 C is incorrect. It ignores tax adjustment for interest expense.

FCFE = 500 – 186 + (–200) = $114 million

Free Cash Flow Valuation

LOS c, d

Section 3.4

3.

C is correct. In the base case, the growth rate is stable, thus using the
constant-growth FCFF model the value of the firm is

FCFF1 600
Firm value
= = = $12,000 million
WACC − g 0.09 − 0.04

Equity value = Firm value – Market value of debt = 12,000 – 2,249 =

$9,751 million.

Value per share = Equity value/Number of shares

= 9,751 million/411 million

= 23.7251 = $23.73 per share

A is incorrect. It does not deduct the market value of debt: $12

million/411 million shares = $29.20.

B is incorrect. It uses cost of equity, not WACC: [600/(0.12 – 0.04) –

2249]/411 = 12.78.

Free Cash Flow Valuation

LOS i, j

Section 2.3.1

4.

C is correct. First, it is necessary to estimate FCFE2013.

 FCFE = Net income – (1 – DR) × (FCInv – Depreciation) – (1 – DR) ×
(WCInv)

where

DR = debt ratio, which is 40%

FCInv = investment in fixed capital, which is 30% of EPS

WCInv = investment in working capital, which is 10% of EPS

On a per-share basis:

FCFE1 (2013) = 1.80 – (1 – 0.40) × (0.30 ×1.80) – (1 – 0.40) × (0.10 ×1.80)

= 1.80 – 0.324 – 0.108

= 1.368.

FCFE will grow at the same rate as net income, 6% annually.

FCFE1 1.368
Equity=
value = = $22.80
r−g 0.12 − 0.06

The value per share is $22.80.

A is incorrect. It uses FCFE1 × (1 + g) = 1.368 × (1.06)/(0.12 – 0.06) =

24.17.

B is incorrect. It uses FCFF: (1.80 – 0.54 – 0.18 )/(0.12 – 0.06) = 18.00

Free Cash Flow Valuation

LOS i,j

Sections 2.3.2, 3.7

5.

A is correct. The three possible actions are:

1. Increasing common dividends = $110 million, which is a use of FCFE—no
effect on FCFE.

2. Share repurchase = $60 million, which is a use of FCFE—no effect on FCFE.

3. Debt repayment = $100 million, which will reduce FCFE by the full amount.

Therefore, FCFE will decrease by $100 million. Reducing debt by $100

million reduces FCFE (the amount of cash available to equity holders) by that
amount. The cash dividend and the share repurchase are uses of FCFE and do
not change the amount of cash available to equity holders.

B is incorrect. It adds all three amounts.

C is incorrect. It adds long-term debt of $100 million and $60 million

share repurchases.

Free Cash Flow Valuation

LOS g

Section 3.8.3

6.

C is correct. Nicosia’s first statement is correct. Analysts should use a

FCFE valuation whenever dividends differ significantly from the company’s
capacity to pay dividends or when a change of control is anticipated. A FCFF
valuation is preferred over a FCFE valuation whenever the capital structure is
unstable or ever-changing. So, Nicosia’s first statement is correct, and her
second and third statements are incorrect.

A is incorrect. Analysts should use free cash flow to equity valuation

whenever dividends differ significantly from the company’s capacity to pay
dividends. FCFF valuation is preferred over FCFE valuation whenever the
capital structure is unstable or ever-changing.
 B is incorrect. With control comes discretion over the uses of free cash
flow, as does the capacity to change dividend levels. As such, a free cash flow
valuation approach is likely to be superior to a discounted dividend valuation
approach.

Free Cash Flow Valuation

LOS f, g

Sections 1, 4.3

Tocantins Consultores Case Scenario

1.

A is correct. Pereira has correctly identified “change of control” as an

action that could negatively affect an investor and explained how it is typically
mitigated in convertible bond contracts with change of control conversion
prices and change of control put options.

B is incorrect. Although Pereira has correctly identified stock splits, stock

dividends, and cash dividends as actions that could harm investors, he has not
correctly described how cash dividends are treated. Convertible bonds typically
set a threshold amount and a cash dividend below the threshold would have no
impact on the conversion price.

C is incorrect. Although Pereira has correctly identified exercise of an

embedded call option as an action that could harm investors, he has not
described a key reason an issuer would call a convertible bond. Issuers
typically would call a convertible bond when the underlying share price exceeds
the conversion price to “force” the investor to convert and thereby would avoid
paying further coupon payments.

Valuation and Analysis of Bonds with Embedded Options

Section 6.1

LOS n
 2.

B is correct. The current conversion ratio is the par value of the bond
divided by the current conversion price or 100,000/25 = 4,000. The market
conversion price is the convertible bond price divided by the conversion ratio or
127,000/4,000 = 31.75. The market conversion premium is the market
conversion price minus the current share price or 31.75 − 30.20 = 1.55. The
market conversion premium ratio is the market conversion premium divided by
the current share price = 1.55/30.20 = 0.0513 = 5.13%.

A is incorrect. This is erroneously calculated as the market conversion

premium divided by the market conversion price.

C is incorrect. This is erroneously calculated as the market conversion

premium divided by the conversion price.

Valuation and Analysis of Bonds with Embedded Options

Section 6.2

LOS o

3.

C is correct. When the issuer’s share price is substantially below the

bond’s conversion price, the value of the convertible bond is closely related to
the floor value (the share price multiplied by the conversion ratio). A small
change in market interest rates or the issuer’s credit rating will not affect the
bond’s value. From a risk-return perspective, it most closely resembles the
issuer’s common stock.

A is incorrect. A convertible bond most closely resembles a hybrid when

the issuer’s share price is close to the bond’s conversion price. In such a case,
the bond’s value can change substantially from a change in the issuer’s share
price, a change in market interest rate, or a change in the issuer’s credit rating.
 B is incorrect. A convertible bond most closely resembles a
nonconvertible bond when the issuer’s share price is substantially below the
conversion price. In such a case, the embedded call option has little value and
small changes in the issuer’s share price will have a negligible impact in the
value of the bond. Changes in interest rates or the issuer’s credit rating will be
the primary risk factors, as they would be for a nonconvertible bond.

Valuation and Analysis of Bonds with Embedded Options

Section 6.4

LOS q

4.

C is correct. Silva has reversed the impact of embedded options that add
value to the bond (those that can be exercised by the investor) and those that
take away value (those that can be exercised by the issuer). The conceptual
value of a convertible is equal to the value of the straight bond plus the value of
any embedded options that can be exercised by the investor minus the value of
any embedded options that can be exercised by the issuer.

A is incorrect. Silva is incorrect regarding the conceptual value of a

convertible bond.

B is incorrect. Silva is correct that the arbitrage-free framework using a

binomial interest rate tree is the most common approach to valuation in
practice.

Valuation and Analysis of Bonds with Embedded Options

Section 6.3

LOS p

Meredith Whitney Case Scenario

1.
 B is correct. The appropriate present value factors are provided below:

PV(90) 0.996463

PV(180) 0.990884

PV(270) 0.984349

PV(360) 0.966931

For example, PV(90) is calculated as:

1
= 0.996453
1 + 0.0142 × (90 360)

Other present value factors are calculated in a similar manner.

The fixed rate is calculated as follows:

1.0 − PV0,tn (1)

rFIX =
n
∑ PV0,t (1)
n
i =1
1.0 − 0.966931
=
0.996463 + 0.990884 + 0.984349 + 0.966931
= 0.008396

The annualized rate is calculated as follows:

FS 0.008396
rFIX ,i
= = = 0.033584
APFIX ,i 90 360

A is incorrect.

C is incorrect.

Pricing and Valuation of Forward Commitments

LOS d

Section 4.1, 4.2

2.
 A is correct. The swap rate in a fixed-for-floating swap is the fixed rate
that sets the initial value of the swap equal to zero. This is accomplished by
setting the value of the fixed side equal to that of the floating side.

B is incorrect.

C is incorrect.

Pricing and Valuation of Forward Commitments

LOS c

Section 4.1

3.

C is correct. The appropriate PV factors for Euribor and Hibor are

calculated from Exhibit 1.

Euribor Hibor

PV(90) 0.995372 0.996959

PV(180) 0.989560 0.992408

PV (270) 0.983478 0.987411

PV (360) 0.977135 0.981643

Sum 3.945544 3.958421

1.0 − PV0,tn (1) 1 − 0.977135

rFIX ,€
= = = 0.005795
n (3.945544)
∑ PV0,tn (1)
i =1
1.0 − PV0,tn (1) 1 − 0.981643
rFIX ,HK $
= = = − 0.004637
n (3.958421)
∑ PV0,tn (1)
i =1

The annualized rate is simply (360/90) times the 90-day rates or

2.3181% for Euros and 1.8550% for HK$.

A is incorrect.
 B is incorrect.

Pricing and Valuation of Forward Commitments

LOS d

Section 4.2

4.

A is correct. The present value factors for Exhibit 2 are provided below:

PV(90) 0.994505

PV(180) 0.987069
PV(270) 0.972786

For example, PV(180) is calculated as:

1
= 0.987069
1 + 0.0262 × (180 360)

Other present value factors are calculated in a similar manner.

Using the fixed rate initially determined for the swap and the current PV
factors, the current value of the fixed bond is:

n
=FB C ∑ PVt ,ti (1) + PV0,tn
i =1
= 0.008396(0.994505 + 0.987069 + 0.972786) + 0.972786
= 0.997591

The value of the floating rate bond at reset is 1. The market value of the
pay-floating, receive-fixed rate swap is the value of the fixed-rate bond less the
value of the floating-rate bond, or $250,000,000 × (0.997591 – 1.000) = –
$602,250.

Using an alternative approach, the new fixed swap rate would be

 1.0 − PV0,tn (1)
rFIX =
n
∑ PV0,t (1)
n
i =1
1.0 − 0.972786
=
0.994505 + 0.987069 + 0.972786
= 0.009211

And the value of the swap is the difference between the value at the old
rate and the value at the new rate, or

n′
V
= (FS0 − FSt ) ∑ PVt ,ti
i =1
= (0.008396 − 0.009211) × (0.9945 + 0.9871 + 0.9728)
= −0.002409

The swap value = $250,000,000 × –0.002409 = –$602,250

B is incorrect.

C is incorrect.

Pricing and Valuation of Forward Commitments

LOS d

Section 4.1

5.

C is correct. Grand borrows HK$285,500,000 and exchanges it for

€25,000,000 based on the initial exchange rate of HK$11.42 per euro. Using
the results of question 3, Grand will pay an interest rate of 1.8550% on the
borrowed HK dollars and earn 2.3181% on the lent/invested euros.

Ninety days into the swap, the exchange rate is HK$9.96, and the PV
factors are:

Euribor Hibor

PV(90) 0.992704 0.995149

 PV(180) 0.985076 0.987898

PV(270) 0.977422 0.980152

Sum 2.955201 2.963199

 n′   n′ 
NAa,0  rFIX ,a,0 ∑ PVt ,ti ,a + PVt ,tn ,a  − S0 NAb,0  rFIX ,b,0 ∑ PVt ,ti ,b + PVt ,tn ,b 
=Va
   
=  i 1=   i 1 
= €25,000,000 × 0.005795(2.9552) + 0.977422 − 285,500,000/HK$/ €9.96 × 0.004637 (2.9632) + 0.980152
= €24,863,685 − €28,489,585
= −€3,625,900

A is incorrect.

B is incorrect.

Pricing and Valuation of Forward Commitments

LOS d

Section 4.2

6.

C is correct. KPS has entered into a swap to receive the equity index
return and pay floating Libor. The swap cash flow for a receive-equity, pay-
floating is

NA(Equity return – Floating rate)

Return on the equity index = (905 – 925)/925 = –0.021622

The first floating payment is made quarterly. Using a 30/360 day count,
we have (0.0142 × 90/360) = 0.003550.

Cash flow from the swap = (–0.021622 – 0.00355) × $100,000,000

= –$2,517,200

A is incorrect.
 B is incorrect.

Pricing and Valuation of Forward Commitments

LOS d

Section 4.2

Borah Culebra Case Study

1.

B is correct. There may be reason to place more confidence in the sales

comparison approach if multiple similar properties have sold recently, but in
other cases, there may be little or no sales history for the type of property
under evaluation. Sales data may be old or substantial differences may exist
between the property being evaluated and the properties that have sold,
making the sales approach relatively unreliable. An appraiser may prefer to use
another approach when he or she has more confidence in the data available.

A is incorrect. Culebra is incorrect regarding a generally greater level of

confidence among appraisers in the sales approach. There may be reason to
place more confidence in the sales comparison approach if multiple similar
properties have sold recently, but in other cases, there may be little or no sales
history for the type of property under evaluation. Sales data may be old or
substantial differences may exist between the property being evaluated and the
properties that have sold, making the sales approach relatively unreliable. An
appraiser may prefer to use another approach when he or she has more
confidence in the data available.

C is incorrect. Culebra is correct that each of the approaches requires

the appraiser to exercise judgment. For the income approach, cash flows must
be estimated with respect to possible vacancies, changes in rental rates, and so
on. Cap or discount rates must be estimated as well. For the sales approach,
adjustments must be made for differences between properties (e.g., age,
amenities, location) as well as how recently the sales have occurred. For the
cost approach, adjustments must be made for the age of the property being
appraised, special characteristics that cannot be reproduced, and outdated
design.

Private Real Estate Investments

Section 5.2

LOS e

2.

C is correct. Start with potential gross income (space multiplied by rental

rate, for each type of rental space), deduct for vacancy loss (15%) to calculate
effective gross income, and then deduct management fees (8% of effective gross
income) and other operating expenses to calculate net operating income. The
calculations are shown in the following table:

Retail space income 15,000 46 $ 690,000

Office space income 180,000 23 $ 4,140,000

Potential gross income $ 4,830,000

Vacancy loss 15% $ (724,500)

Effective gross income $ 4,105,500

Property management 8% $ (328,440)

Other operating $ (1,250,000)
expenses
Net operating $ 2,527,060
income

A is incorrect. It reduces net operating income further by the operating

expenses of $320,000 per year paid by tenants.

B is incorrect. It calculates the 8% property management fees on

potential gross income rather than effective gross income.

Private Real Estate Investments

 Section 6.1

LOS f

3.

B is correct. The single tenant has been in place for almost 9 years and
accounts for 40% of the office space. In 15 months, there is the risk of a very
high vacancy rate for some period of time with an unknown impact (positive or
negative) on future rents. This cannot be modeled with the direct capitalization
method.

A is incorrect. The direct capitalization method can use a lower cap rate
that includes the expected decline in rental rates over time.

C is incorrect. The direct capitalization method can use a higher cap rate
to reflect this risk of recession.

Private Real Estate Investments

Section 6.2, 6.4

LOS h

4.

A is correct. The sales price per unit for each comparable is increased by
the sum of the adjustments. The average of these adjusted prices is multiplied
by the number of units in the subject property to give the estimated value, or
adjusted price = (1 + the sum of the adjustments for size, age, condition,
location, and date of sale) multiplied by the sales price per unit. For Property 2:

Comparable 1 adjusted price per unit:

(1 + (.12 + .14 + .10 + .07 + 0 ) ) × 92653 =

132, 494

Comparable 2 adjusted price per unit:

(1 + ( −.14 − .1 − .1 − .07 + .05) ) ×184821 =

118, 286
 Comparable 3 adjusted price per unit:

(1 + ( −.05 + .03 + 0 + 0 + .03) ) ×132048 =133,368

132, 494 + 118, 286 + 133,368

Property 2 estimated value: × 372 =
47, 634,352
3

B is incorrect. It multiples the number of units by the average

unadjusted price per unit rather than the adjusted price per unit.

C is incorrect. The sales price per unit for each comparable is decreased
by the sum of the adjustments, rather than increased, or adjusted price = (1 –
the sum of the adjustments for size, age, condition, location, and date of sale)
multiplied by the sales price per unit. The value is the number of units in the
property multiplied by the average of these adjusted comparable prices.

Private Real Estate Investments

Section 7.2

LOS i

Nebbiolo Case Scenario

1.

A is correct. Barolo is correct in describing the process for selecting a

benchmark, the calculation of value added, and performance attribution. The
criteria she describes across these practices are a reasonable approach to
measuring value added in active portfolio management.

B is incorrect. Barolo’s comment regarding benchmark selection is

correct.

C is incorrect. Barolo’s comments regarding value-added calculation and

performance attribution are correct.

Analysis of Active Portfolio Management

 Section 2

LOS a

2.

C is correct. The correct measure of risk and return in this application is

the information ratio. The information ratio compares the active return from a
portfolio relative to a benchmark with the volatility of the active return. It
provides a way to measure the consistency of active returns. The Sharpe ratio
is used to measure portfolio return in excess of a riskless rate.

Calculate each fund’s information ratio as follows:

RP − RB RA 10.10 − 9.00 10.50 − 9.00 11.85 − 9.00

=IR = = ; IR = = 0.28; IR = = 0.39
STD ( RP − RB ) STD ( RA ) 4.00 6.25 7.30

The fund with the highest information ratio shows the most value added
from active management. The ranking per the calculations is therefore Fund C,
Fund A, Fund B.

A is incorrect. The correct ranking is based on the information ratio and

is Funds C (0.39), Fund A (0.28), Fund B (0.24).

B is incorrect. This is the ranking based on the Sharpe ratio.

Analysis of Active Portfolio Management

Section 3.2

LOS b

3.

C is correct. Barolo is correct with regard to Points 1 and 2. When she

discusses breadth in Point 3, mathematically, it is expressed as the square root
of the number of independent investment opportunities. Conceptually, breadth
is equal to the number of independent decisions made per year by the investor
in constructing the portfolio.