CFA Institute CFA-Level-II CFA Level II Chartered Financial Analyst Exam Practice Test

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

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

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

Andrew Carson is an equity analyst employed at Lee, Vincent, and Associates, an investment research firm. In a conversation with his supervisor, Daniel Lau, Carson makes the following two statements about defined contribution plans.

Statement I: Employers often face onerous disclosure requirements.

Statement 2: Employers often bear all the investment risk.

Carson is responsible for following Samilski Enterprises (Samilski), a publicly traded firm that produces motorcycles and other mechanical parts. It operates exclusively in the United States. At the end of its 2009 fiscal year, Samilski's employee pension plan had a projected benefit obligation (PBO) of $320 million. Also, unrecognized prior service costs were $35 million, the fair value of plan assets was $316 million, and the unrecognized actuarial gain was $21 million.

Carson believes the rate of compensation increase will be 5% as opposed to 4% in the previous year, and the discount rate will be 7% as opposed to 8% in the previous year.

This past year, Samilski began using special purpose entities (SPEs) for various reasons. In preparation for analyzing the SPE disclosures in the footnotes to the financial statements, Carson prepares a memo on SPEs. In the memo, he correctly concludes that the company will be required under new accounting rules to classify them as variable interest entities (VIE) and consolidate the entities on the balance sheet rather than report them using the equity method as in the past.

Under current U .S . GAAP pension accounting standards, the amount of the pension asset or liability that Samilski should report on its 2009 fiscal year end balance sheet is closes/ to a:

Ryan Hendricks serves as a security analyst for Investment Management, Inc. (IMI), which employs the Treynor-Black model to evaluate securities and to make portfolio recommendations. IMI uses the capital asset pricing model (CAPM) to determine the degree to which securities may be mispriced relative to IMFs forecasts.

Hendricks evaluates the common shares of Computer Software Associates (CSA), a small company specializing in a unique computer software market niche. Hendricks obtains the following market model results for CSA, using monthly returns for the past 60 months:

Hendricks uses the adjusted beta method to derive his forecasts for companies' future betas. In deriving his forecast for any company beta, Hendricks uses the following first-order autoregressive formula:

forecast beta = 0.33 + 0.67 x (historical beta) (2)

Hendricks derives required returns for individual securities using the CAPM after making appropriate adjustments using his adjusted beta formula in equation (2).

IMI provides Hendricks with the following capital market forecasts to use as inputs for the CAPM.

IMI asks Hendricks to make decisions to take long and short positions in individual securities for IMl's actively managed portfolio, IMI-Active. Specifically, Hendricks is asked to examine CSA and Millennium Drilling (MD), an oil and gas drilling company specializing in deep sea drilling. After a thorough examination of the prospects for each company, Hendricks derives the following alpha forecasts for CSA and MD.

Hendricks forecasts that the unsystematic variance (the variance of the market model regression error) for MD will be more than double that of CSA .

After determining the appropriate allocations across securities within the IMI-Active portfolio, Hendricks derives the portfolio predictions shown in Exhibit 3.

IMI forecasts that the total standard deviation for the S&P500 returns will equal 20%. After examining the historical forecasting abilities of Hendricks, IMI determines that Hendricks has demonstrated perfect forecasting ability in regards to CSA stock, but imperfect forecasting abilities in regards to MD stock. IMI finds that the correlation between the realized alphas for MD and the forecast MD alphas provided by Hendricks equals 0.50.

Referring to the Treynor-Black model, Hendricks makes the following statements:

Statement 1: All else equal, the Treynor-Black model increases the weight to the active portfolio as its unsystematic risk increases.

Statement 2: The Treynor-Black model is based on the premise that only a limited number of stocks should be included in the actively managed portfolio.

Using the Treynor-Black model along with the alpha and unsystematic variance information for CSA and MD, should CSA or MD receive a larger weight within the IMI-Active portfolio?

Mike Zonding, CFA, is conducting a background check on CFA candidate Annie Cooken, a freshly nudled MBA who applied for a stock-analysis job at his firm, Khasko Financiar.vZoftding does not like to hire anyone who does not adhere to the Code and Standards' professional conduct requirements.

The background check reveals the following:

(i) While doing a full-time, unpaid internship at Kale Investments, Cooken was reprimanded for working a 30-hour-a-week night job as a waitress.

(ii) As an intern at Lammar Corp., Cooken was fired after revealing to the FBI that one of the principals was embezzling from the firm's clients.

(iii) Cooken performed 40 hours of community service in relation to a conviction on a misdemeanor drug possession charge when she was 16 years old.

(iv) On her resume, Cooken writes, "Recently passed Level 2 of the CFA exam, a test that measures candidates' knowledge of finance and investing."

During the interview, Zonding asks Cooken several questions on ethics-related issues, including questions about the role of a fiduciary and Standard III(E) Preservation of Confidentiality. He asks her about her internship at Kale Investments, specifically about the working hours. Cooken replies that the internship turned out to require more time than she originally planned, up to 65 hours per week.

Zonding subsequently hires Cooken and functions as her supervisor. On her third day at the money management boutique firm, portfolio manager Steven Garrison hands her a report on Mocline Tobacco and tells her to revise the report to reflect a buy rating. Cooken is uncomfortable about revising the report.

To supplement the meager income from her entry-level stock-analysis job, Cooken looks for part-time work. She is offered a position working three hours each Friday and Saturday night tending bar at a sports bar and grill downtown. Cooken does not tell her employer about the job.

During her first week, Cooken has lunch with former MBA classmates, including Taira Basch, CFA, who works for the compliance officer at a large investment bank in town. Basch arrives late, explaining, "What a day, it's only noon and already I have worked on the following requests:

1. A federal regulator called and wanted information on potentially illegal activities related to one of the firm's key clients.

2. A rival company's employee wanted information regarding employment opportunities at the firm.

3. A potential client contacted an employee and wanted detailed performance records of client accounts so he can decide whether to invest with the firm."

Basch goes on to say that she is responsible for developing a presentation on the differences between the Prudent Investor and the Prudent Man rules for managing trust portfolios. Basch explains to Cooken that the Prudent Investor rule requires a trustee to exercise five fiduciary standards in managing the assets of a trust account, including care, skill, caution, loyalty, and impartiality. She states that although there are many differences between the Prudent Man and the newer Prudent Investor rule, one element of continuity is the duty of the trustee to delegate investment authority in the event that the trustee lacks sufficient investment knowledge.

Toward the end of the lunch meeting, Basch suggests that in exchange for research published by Cooken and Khasko, Basch can have portfolio managers at her firm send clients that are too small for their firm to Khasko. Since Khasko specializes in clients with smaller portfolios, the arrangement sounds like a good idea to Cooken. Cooken tells Basch that she will think the arrangement over and get back with her next week with a decision.

In the context of the Code and Standards, which of the items from the background check would most likely indicate that Zonding should not have hired Cooken?

High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide.

The U .S . steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U .S . producers are experiencing declining margins as labor costs continue to increase. In addition, the U .S . steel mills arc technologically inferior to the foreign competitors. Also, the U .S . producers have significant environmental issues that remain unresolved.

High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case. High Plains would have no choice but to file bankruptcy.

High Plains follows U .S . GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2.

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured.

2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31,2008 and 2007, respectively.

3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1,2008.

4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing:

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end.

6. High Plains conducts some of its operations in facilities leased under noncancelable capital leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term.

7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively.

Using only the information found in Exhibit 1 and Exhibit 2, which of the following is most indicative of lower earnings quality?

Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments.

On December 31,2007, Wayland purchased a 35% ownership interest in a strategic new firm called Optimax for $300,000 cash. The pre-acquisition balance sheets of both firms are found in Exhibit 1.

On the acquisition date, all of Optimax's assets and liabilities were stated on its balance sheet at their fair values except for its property, plant, and equipment (PP&E), which had a fair value of $1.2 million. The remaining useful life of the PP&E is ten years with no salvage value. Both firms use the straight-line depreciation method.

For the year ended 2008, Optimax reported net income of $250,000 and paid dividends of $100,000.

During the first quarter of 2009, Optimax sold goods to Wayland and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Optimax remained in Wayland's inventory.

Wayland currently uses the equity method to account for its investment in Optimax. However, given the potential significance of the investment in the future, Rathbun believes that a proportionate consolidation of Optimax may give a clearer picture of the financial and operating characteristics of Wayland.

Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers the data in Exhibit 2 from Wayland's financial statements. The year-end portfolio value is the market value of all Vanry shares held on December 31. All security transactions occurred on July 1, and the transaction price is the price that Wayland actually paid for the shares acquired. Vanry pays a cash dividend of $1 per share at the end of each year. Wayland expects to sell its investment in Vanry in the near term and accounts for it as held-for-trading.

Wayland owns some publicly traded bonds of the Rotor Corporation that it reports as held-to-maturity securities.

What amount should Wayland report in its balance sheet as a result of its investment in Optimax at the end of 2008?

Russell Larson, CFA, is an investment analyst for Sentry Properties, Inc., a group of wealthy investors that is currently interested in purchasing Riviera Terrace, a 60- unit apartment complex in Southeastern Florida. The current owners of Riviera Terrace have agreed to sell the property for $40,000,000. Larson estimates that Rivjera Terrace's net operating income for the first year after the sale is finalized will be $4,200,000, and it is expected to maintain its historic annual growth rate of 5%.

At Sentry's request, Larson will evaluate the investment in Riviera Terrace over a 5-year horizon using selling prices of $45,000,000 and S60,000,000.

During the due diligence process, Larson has determined that the average selling price for apartment complexes similar to Riviera Terrace is $1,250,000 per unit, with annual net operating income equal to $ 135,000 per unit. Larson has also determined that net operating income is typically 80% of gross income.

Larson has collected the following information to aid in his evaluation of Riviera Terrace.

* The property will be fully depreciated at a rate of S 1,250,000 per year over 32 years.

* Rental contracts are expected to be reissued on the date the sale is completed.

* Sentry has arranged to finance the investment with a 30-ycar, 7% interest-only loan, with monthly payments and a face value equal to 80% of the initial investment.

* Selling expenses will be 7% of the gross selling price.

* The capital gains tax rate is 15%, the tax on recaptured depreciation is 28%, and the tax rate on ordinary income is 40%.

* Sentry Properties' required return on equity is 20%.

* The interest rate on U .S . government bonds after adjustments for real estate based tax savings = 5.0%.

* The premium investors require for the illiquidity of real estate investments = 2.5%.

* The average real estate return net of appreciation = 1.25%.

* The real estate investment risk premium = 3.0%.

* The average internal rate of return for properties that are comparable to Riviera Terrace is 22%.

As part of the diligence process, Larson deems it to be appropriate to estimate the.market value of Riviera Terrace using capitalization rates based on the market extraction and built-up methods. One of the partners in Sentry Properties has also asked Larson to estimate the market value of Riviera Terrace using: (1) the direct income capitalization approach and (2) the gross income multiplier approach.

There are several indicators that the Florida real estate market may take a downward turn over the next five years. With this in mind, Larson determines that there is a reasonable chance that Sentry will have to terminate its investment in Riviera Terrace at the end of year 3 at the initial purchase price of $40,000,000. Under this scenario, he estimates the equity reversion after tax (ERAT) in year 3 to be $4,934,000. Cash flow after tax in years 1 and 2 are $1,676,000 and $1,802,000, respectively.

In the scenario in which Sentry will sell Riviera Terrace for $45,000,000 at the end of the investment horizon, the equity reversion after tax is closest to: