Level II CFA Mock Exam 1 Morning

2017
CFA EXAM REVIEW

MORNING
SESSION
LEVEL II CFA

MOCK EXAM 1
Mock Exam
1
Mock Exam 1 Morning Session Questions
Questions 1 to 6 relate to Ethical and Professional Standards
Silverman Group Case Scenario:
Robert Bernard, CFA, is a senior research analyst for major Wall Street firm Silverman Group, covering
the Technology, Media and Telecommunications sector. He has spent the last five years in his current role
and over time, has gained a solid good reputation a leading industry analyst.
Bernard is currently compiling an industry report entitled One Billion Likes which aims to identify the
companies best positioned to profit from the rise of social media. Bernard meets with senior management
of the major companies involved in the sector, and documents his personal notes from those meetings
in electronic format. He also follows the Twitter feeds of senior executives of the companies and
incorporates some of the public information that is released via this medium in his research. Bernard
is aware of his duties for record retention when compiling research under the CFA Institute Standards
of Practice, but he also notes that neither his firm nor the local regulator have a digital media retention
policy. He therefore decides to retain all electronic records of his personal notes from meetings but does
not record the information he took from the Twitter feeds of the executives.
Last month Bernard compiled a comprehensive research report on the company, Twitter. In his report,
which he labelled #buyorsell? he covered the risks and potential returns of investing in the company.
Upon completion of the report, Bernard sent a quick tweet to all existing followers of Silvermans Twitter
feed summarizing his recommendation.
Bernard has always been a big advocate of using social media to communicate with clients. Under the
direction of Silvermans technology and compliance departments, he establishes a new Facebook page
specifically for Silverman clients. In the instructions provided to clients, they are specifically asked to
join the group in order to access all posted content. Clients are also informed that all comments posted
by them on the platform would be available to the public, which made the platform an inappropriate for
communicating personal or confidential information.
Bernard also maintains a personal blog. He uses his blog as a diary for his journey through the CFA
program and has been successful in creating an active community of candidates attempting to pass the
CFA exams. Bernard prefers to remain anonymous as the administrator of the blog, and hence currently
posts under the name CFA Dude, CFA.
Being an active consumer of social media, Bernard maintains an active account on LinkedIn, which he
primarily uses for professional networking. He is a member of a specific group where discussions focus
on current issues in the social media sector. This is a private group and membership is granted at the
discretion of the group administrator. Several industry executives are members of the group, one of whom
starts a discussion thread entitled Another excellent quarter, in which the executive asserts that her
company will exceed analyst expectations at its upcoming earnings announcement. Bernard references
this thread in his research report on the company.
Through his extensive list of connections, Bernard is offered a more senior role at Silvermans competitor
Norton & Company. Silverman has a policy of three months notice for its investment analysts, with strict
Wiley 2017 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
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secrecy regarding the departure of the analyst until they actually leave the company. Bernard respects
this policy internally at Silverman, however he updates his profile on the professional networking site to
indicate his imminent change of employment.
1. When compiling the report One Billion Likes, does Bernard violate any CFA Institute Standards?
A. No.
B. Yes, because he uses information from Twitter in his research.
C. Yes, because he fails to retain records of the information taken from Twitter used in his
report.
2. When tweeting a summary of his recommendation in the report #buyorsell?, does Bernard
violate any CFA Institute Standards?
A. No.
B. Yes, relating to independence and objectivity.
C. Yes, relating to fair dealing.
3. When he establishes the new Facebook page specifically for his clients, does Bernard violate any
CFA Institute Standards?
A. No.
B. Yes, relating to preservation of confidentiality.
C. Yes, relating to material non-public information.
4. Does Bernard violate any CFA Institute Standards when administering his personal investment blog?
A. No.
B. Yes, relating to conduct as participants in CFA Programs.
C. Yes, relating to reference to CFA Institute, the CFA Designation, and the CFA Program.
5. In using the information posted in the thread Another excellent quarter. in his research
report,Bernard is least likely in violation of:
A. Standard V (A): Diligence and reasonable basis.

B. Standard I (B): Independence and objectivity.
C. Standard II (A): Material non-public information.
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6. Does Bernard violate any CFA Institute Standards in updating his job status on LinkedIn?
A. No.
B. Yes, he should respect Silvermans internal policy with regards to announcing his resignation
on the networking site.
C. Yes, he should force Silverman to disclose his resignation now it has been disclosed on the
website.
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Questions 7 to 12 relate to Derivatives
Jacob Martin Case Scenario:
Jacob Martin is a portfolio manager at BMS Investments, a U.S.based investment management firm that
makes extensive use of derivatives to manage risks. Shaharyar Khurram, a budding analyst, has just come
in for an interview. Khurram claims that his extensive coursework in financial derivatives while he was at
university stands him in good stead for the job, so Martin is keen to test him.
Martin describes three transactions to Khurram. He wants to test Khurrams ability to value different
types of forward contracts in the midst of their respective terms so that he can perform marktomarket
adjustments on the companys derivatives positions. None of the forward contracts described in the
transactions are offmarket forwards.
Transaction 1: Jim Packer intends to purchase a stock of Cisco in another 225 days. The stock is
currently selling for $50, and is expected to pay a dividend of $0.80 in 50 days, $0.75 in 120 days, and
$0.70 in 240 days. The riskfree rate equals 5%.
Martin expects the price of CISCO stock to be $45 in on Day 75 of the contracts term.
Transaction 2: DBK Inc. wants to hedge against a possible decline in interest rates. It plans to take a
position on an FRA that expires in 60 days based on a 150day LIBOR with a notional principal of $20m.
The current term structure for LIBOR is as follows:
Term (Days) LIBOR (%)

60 days 6%
210 days 7.25%
Martin expects that 40 days into the term of the FRA, 20day LIBOR and 170day LIBOR will be 6.45%
and 7.70% respectively.
Transaction 3: Artina Inc., a U.K.based importer of goods from Switzerland, expects the value of
Swiss franc to increase against the pound over the next 60 days. Artina will be making a payment on the
shipment of imported goods in 60 days and wants to hedge its currency exposure. The U.K. riskfree rate
is 5%, and the Swiss riskfree rate is 3.2%. Interest rates in both the countries are expected to remain
unchanged over the next two months. The current spot exchange rate is 1.75 GBP/CHF.
Martin expects that 20 days into the forward contract, the spot exchange rate will rise to 1.78 GBP/CHF.
After mentally draining him with some mind-numbingly tedious calculations, Martin decides to test
Khurrams conceptual knowledge. Martin asks Khurram a couple of questions, to which Khurram
responds with the following statements:
Statement 1: All other things remaining the same, the greater the expected future price of the asset, the
higher the forward price.
Statement 2: The value of a forward contract and otherwise identical futures contract at a particular point
in time will most likely be the same.
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7. Regarding Transaction 1, the value of the forward contract to Packer at t = 75 based on Martins
expectations is closest to:
A. $3.94.
B. $4.02.
C. $4.70.
8. Regarding Transaction 2, DBK will most likely take a position on a:
A. 2 7 FRA.
B. 2 5 FRA.
C. 7 2 FRA.
9. Regarding Transaction 2, the value of DBKs position on the FRA at t = 40 based on Martins
expectations is closest to:
A. $13,292.59.
B. $13,292.59.
C. $4,951.52.
10. Regarding Transaction 3, Artina will most likely enter into the forward contract to:
A. Buy Swiss francs forward.

B. Sell Swiss francs forward.
C. Buy British pounds forward.
11. Regarding Transaction 3, the value of Artinas position on the currency forward at t = 20 based on
Martins expectations is closest to:
A. 0.0282 GBP/CHF.
B. 0.0315 GBP/CHF.
C. 0.0630 GBP/CHF.
12. Regarding Khurrams statements in response to Martins questions, which of the following is
most likely?
A. Only Statement 1 is correct.

B. Only Statement 2 is correct.
C. Both statements are incorrect.
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Questions 13 to 18 relate to FixedIncome Investments.
Tommy Haas Case Scenario:
Tommy Haas manages a team of credit analysts at Standard Bank PLC. The analysts have been asked
to prepare a short presentation on the various types of credit scoring models used in the industry. Jeff
Shreeves steps up first and makes the following statements regarding traditional credit analysis models:
Statement 1: Credit scores provide a cardinal ranking of risk across borrowers.

Statement 2: Credit scores are not explicitly dependent on economic conditions.
Statement 3: Credit scores are not percentile rankings of borrowers among a universe of borrowers.
David Moyes, one of the more highly-rated members of the credit analysis team, then makes the
following statements regarding assumptions made by the structural model:
Statement 4: The companys zero coupon debt trades in markets that are frictionless and arbitrage-free.
Statement 5: The value of the companys assets at time T has a log-normal distribution.
Statement 6: The risk-free rate is constant over time.
Tim Howard, a relatively new member of the credit analysis team, rounds off this segment of the t = 20
discussion by making the following statements:
Statement 7: Under the structural model, the perspective of debt holders in the company can be
compared to holding a riskless bond that pays K at maturity and at the same time writing a put option on
the companys assets.
Statement 8: Under the reduced-form model, both the probability of default and the loss given default
are dependent on the state of the economy.
Brandon Walsh, a new intern hired by Haas, then provides the team with the binomial interest rate
tree presented in Exhibit 1. He wants to use the tree to value a floating-rate bond issued by Samdong
Industrials Inc. Information regarding the bond issued is provided in Exhibit 2:
Exhibit 1:
Binomial Interest Rate Tree Assuming an Interest Rate Volatility of 8%
2.6865%
2.0908%
0.5430% 2.2893%
1.7817%
1.9508%
t=0 t=1 t=2
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Exhibit 2:
Three-Year Floating-Rate Note Issued by Samdong Industrials Inc.
Coupon Annual coupon based on 12-month Libor + 320 bps
Cap 5.40%
Term Three years
Lassana Diarra then steers the discussion towards term structure theories. He asserts that the yield for
each maturity along the yield curve is determined independently.
Finally, Haas tells the team that he expects the short rate to decrease by 200 bps and the long rate to
increase by 100 bps.
13. Which of Shreeves statements regarding traditional credit analysis models is least likely correct?
A. Statement 1.
B. Statement 2.
C. Statement 3.
14. Which of Moyes statements regarding assumptions made by the structural model is least likely
correct?
A. Statement 4.
B. Statement 5.
C. Statement 6.
15. Which of the following is most likely regarding the statements made by Howard?

C. Both statements are correct.
16. Based on the data provided in Exhibits 1 and 2, the value of the bond issued by Samdong is
closest to:
A. $101.528.
B. $99.895.
C. $99.856.
17. Under the term structure theory that Diarra is talking about, yields are most likely to reflect:
A. Expected spot rates.

B. Liquidity premiums.
C. Supply and demand for funds for that particular maturity.
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18. Haass yield change expectations can best be described as:
A. Steepening of the yield curve as a result of changes in level and steepness.

B. Steepening of the yield curve as a result of changes in steepness and curvature.
C. Flattening of the yield curve as a result of changes in steepness and curvature.
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Questions 19 to 24 relate to Portfolio Management
Enell Investment Corp. Case Scenario:
The investment team of Enell Investment Corp. is discussing the impact of economics on investment
markets. The Chief Economist at the group, Shams Arfeen is leading the conversation. Arfeen kicks of
the discussion by asking his colleagues to initially assume that there is no default risk and no inflation. He
then makes the following statements:
Statement 1: Generally speaking, the higher the real risk-free rate, the more important current
consumption becomes relative to future consumption.
Statement 2: For an asset to serve as a hedge against bad consumption outcomes, the covariance between
the investors expected inter-temporal rate of substitution, and the future price of the asset must be
negative.
The discussion then moves on to a scenario where there is inflation, but still no default risk. Shazil Mufti,
one of the budding analysts on the team, chimes in with the following:
Statement 3: Generally speaking, nominal interest rates in an economy are positively related to the GDP
growth rate, the volatility of GDP growth rate, and the expected inflation rate.
Statement 4: Generally speaking, in tough economic times, the risk premium on short-term government
bonds tends to rise as investors place a greater value on their consumption-hedging properties.
Arfeen then presents the team with the following data regarding the changes in the U.K. government
bond yields and the U.K. breakeven inflation rates from the year 2007 to 2011:
U.K. Government Bond Yields (%) U.K. Breakeven Inflation Rates (%)
3-Year 25-Year 3-Year 25-Year
2007 6.25 5.03 2.98 4.11
2011 1.97 2.04 2.03 3.17
Haroon Khan, another analyst on the team, makes the following observations after studying the data. He
assumes that there is no risk premium embedded in investors expected return expectations and that the
volatility of GDP growth was unchanged through the period.
Observation 1: The fact that the U.K. yield curve had a negative slope in 2007 suggests that the economy
could be headed for a recession.
Observation 2: Compared to 2007, the 2011 data indicate that market participants expected a greater
decline in inflation than in economic growth.
The conversation then moves towards the impact of business cycles on stocks and bonds. Izzah Hasan
claims that:
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Statement 5: During expansions, low-rated corporate bonds tend to outperform higher-rated bonds.
Statement 6: During recessions, spreads for consumer cyclicals rise more than spreads for consumer
non-cyclicals.
Statement 7: During expansions, value stocks tend to outperform growth stocks.
Juan Diaz, a colleague, who heads the portfolio management department at Enell, is analyzing the returns
on a portfolio of two stocks, Alpha Ltd (AL) and Beta Ltd (BL). He attains the following results for his
two-factor macroeconomic model:
RAL = 0.20 + 3F1 6F2 + AL

RBL = 0.15 + 6F1 + 3F2 + BL
30% of the portfolio is invested in AL and 70% is invested in BL. F1 and F2 equal 1% and 2%
respectively and the error terms for both stocks equal 0.2%.
Asad Shafqat, an intern who works under Diaz, makes the following statements:
Statement 8: The intercept term in the APT equation is the risk-free rate.
Statement 9: The intercept term in multifactor models represents the expected return on the stock given
current expectations of priced risk factors identified in the model.
Statement 10: In fundamental factor models, the intercept term equals the expected return.
19. Which of the following is most likely regarding Arfeens statements?

20. Which of the following is most likely regarding Muftis statements?

21. Which of the following is most likely regarding Khans observations?
A. Only Observation 1 is correct.

B. Only Observation 2 is correct.
C. Both observations are correct.
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22. Which of Izzahs statements relating to the impact of business cycles on stocks and bonds is
least likely?
A. Statement 5.
B. Statement 6.
C. Statement 7.
23. Based on the macroeconomic model, the expected return and actual return on Diazs portfolio are
closest to:
Expected Return Actual Return

A. 17.5% 19.2%
B. 16.5% 22.4%
C. 16.5% 16.5%
24. Which of the following statements made by Shafqat is least likely?
A. Statement 8.
B. Statement 9.
C. Statement 10.
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Questions 25 to 30 relate to Economics
Sajjad Syed Case Scenario:
Sajjad Syed, chief economist at a large multinational bank, is preparing macroeconomic performance
reports for three countries in Southeast Asia. To simplify his analysis, Syed works with a two-factor
production function, with capital and labor as the two factors. His research team has come up with the
data provided in Exhibit 1:
Exhibit 1:
Selected Macroeconomic Data
Country Growth Rate of Labor Cost in Growth Rate Growth Rate in
Potential GDP Total Factor TFP (%) Labor Force
(%) Cost (%) (%)
Pakistan 5.43% 70 1.3 3.5
Malaysia 8.02% 42 2.6 1.8
Indonesia 6.15% 65 2.1 2.3
Aziz Bhuiya, one of the members of the research team, makes the following statements regarding the
neoclassical model:
Statement 1: In the short term, a countrys capitallabor ratio and output per worker would both increase
in response to an increase in the saving rate, a decrease in the labor force growth rate, or a decrease in the
depreciation rate.
Statement 2: An increase in the growth rate of technology results in a short-term decline in the capital
labor ratio and output per worker, but a long-term increase in their respective growth rates.
Amin Navrozally, another member of the research team, makes the following statements regarding the
classical growth theory and endogenous growth theory:
Statement 3: Under classical growth theory, only technological progress can result in long-term growth
in per capita output.
Statement 4: Under endogenous growth theory, marginal product of capital is constant.
The conversation then shifts to stimulating growth in open economies. Syed asserts that capital inflows
can help developing countries attain higher standards of living. However, he contends that opening up
economies cannot result in a permanent increase in the rate of economic growth in developing countries.
Finally, the trio begins to talk about the DoddFrank Act, which was enacted by U.S. Congress in July,
2010. They agree that the Act will have a significant impact on U.S. financial services companies.
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25. Based on the information in Exhibit 1, which of the three countries is most likely to be
experiencing significant diminishing marginal returns to capital?
A. Pakistan.
B. Malaysia.
C. Indonesia.
26. Based on the information in Exhibit 1, which of the three countries is least likely to be operating
in steady state equilibrium as defined under the neoclassical model?
A. Pakistan.
B. Malaysia.
C. Indonesia.
27. Which of the following is most likely regarding Bhuiyas statements about the impact on growth
rates under the neoclassical model?
A. Only Statement 1 is incorrect.

B. Only Statement 2 is incorrect.
28. Which of the following is most likely regarding the statements made by Navrozally?

29. Which of the growth theories is Syed most likely subscribing to in his comments relating to the
impact of opening up economies on economic growth?
A. Malthusian model.
B. Solows model.
C. Endogenous growth theory.
30. The DoddFrank Act is most likely classified as a(n):
A. Administrative regulation.
B. Statute.
C. Judicial law.
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Questions 31 to 36 relate to Financial Reporting & Analysis
Cesc Fabregas Case Scenario:
Cesc Fabregas is an equity analyst at Elite Investments. He is analyzing the financial statements of FCB,
a U.S.-based corporation. Fabregas is especially interested in understanding the effects of the securities
held in FCBs investment portfolios on its financial statements for the year. Exhibits 1 and 2 contain
information regarding FCBs equity and fixed income portfolios. Assume that the company operates in a
jurisdiction with no taxes.
Exhibit 1:
FCB Equity Portfolio
All Numbers Relate to the Year 2012
(All Amounts are Expressed in $000)
Security
Characteristic
Mercury Venus Jupiter Saturn
Heldfor Designated at Availablefor
Classification Equity method
trading fair value sale
Cost 130,000 180,000 210,000 600,000
Market value at end of the year 126,000 187,000 213,000 605,000
Dividends received during the year 2,000 5,000 3,000 4,000
FCBs share of investee net income
8,000 4,000 9,000 20,000
for the year
Note: FCB has a 35% stake in Saturn. It also has a presence on Saturns Board of Directors. However, it
does not have control over Saturn.
Exhibit 2:
FCB Fixed Income Portfolio
All Numbers Relate to the Year 2012
(All Amounts are Expressed in $000)
Security
Characteristic
Violet Tulip Magnus Rose
Availablefor- Heldto Heldfor Heldto
Classification
sale maturity trading maturity
Cost 68,000 120,000 45,000 95,000
Market value at year end 76,000 128,000 47,000 88,000
Interest received during the year 2,500 5,000 1,500 2,000
Note: All fixed income securities were purchased at par.
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31. The contribution of FCBs equity portfolio to its net income for 2012 is closest to:
A. $25,000.
B. $33,000.
C. $41,000.
32. Fabregas reclassifies all the securities that are eligible for reclassification as heldfortrading
securities. The amount that the entire equity portfolio would then contribute to FCBs 2012 net
income is closest to:
A. $36,000.
B. $41,000.
C. $35,000.
33. If FCB accounts for its investment in Saturn at cost instead of using the equity method, FCBs
total assets would most likely decrease by:
A. $16,000.
B. $15,000.
C. $11,000.
34. If FCB accounts for its investment in Saturn using the proportionate consolidation method instead
of the equity method, FCBs net income and return on assets would most likely be:
Net Income Return on Assets

A. Higher Lower
B. Lower Higher
C. No change Lower
35. The carrying value of FCBs fixed income portfolio at the end of 2012 is closest to:
A. $339,000.
B. $328,000.
C. $338,000.
36. Which of the following reclassifications would most likely have a positive impact on FCBs
reported net income for 2012?
A. Reclassify Tulip as availableforsale, and reclassify Rose as heldfortrading.

B. Reclassify Tulip as heldfortrading, and reclassify Rose as availableforsale.
C. Reclassify both as availableforsale.
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Questions 37-42 Relate to Derivatives
Hashir Majid Case Scenario:
Hashir Majid, an experienced derivatives trader at AKUH investments (AKUH), has taken on a new
intern, Junaid Khalid. Majid presents Khalid with the data presented in Exhibits 1 through 4.
Exhibit 1 contains information relating to a U.S. Treasury futures contract at initiation:
Exhibit 1
Contract value $100,000
Coupon on underlying bond 3.6%
Price of underlying bond 107 (excluding accrued interest)
Expiration of contract Three months
Last coupon payment on underlying bond Paid one month ago
Risk-free rate 3%
Conversion factor for bond 0.7542
Majid adds that he took a long position on two of these contracts one month ago. The current futures
price is 141.96.
Exhibit 2 contains information relating to an equity swap at initiation:
Exhibit 2
Notional amount $10,000,000
Tenor Three years
Reset frequency Annual
Day count convention for fixed leg 30/360
Swap fixed rate 3.5%
Equity value 105
Majid informs Khalid that AKUH took the receive-fixed, pay equity side of this swap, which is now six
months into its term. Currently, the term structure is flat with spot rates being 3.2%, and the equity value
stands at 112.
Exhibit 3 describes three different American style options:
Exhibit 3
Option Type of Option Underlying Stock
A Call Pays dividends
B Call Does not pay dividends
C Put Pays dividends
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Majid wonders which of the options described in Exhibit 3 can be valued using the expectations approach
to option valuation in a multiperiod setting.
Exhibit 4 provides information regarding otherwise identical call and put options on XYZ Stock:
Exhibit 4:
Current stock price $50
Strike price $50
Risk-free rate 5%
Time to expiration One year
Implied volatility 25%
PV (Strike price) $47.562
d1 0.325
d2 0.075
N(d1) 0.627
N(d2) 0.530
Call price $6.17
Put price $3.73
Upon looking at the information in Exhibit 4, Khalid makes the following statements:
Statement 1: The probability that the call will expire in-the-money equals 53%.
Statement 2: The probability that the put will expire in-the-money equals 62.7%.
Statement 3: The no-arbitrage approach for replicating the put option will require buying 0.47 units of
the bond and shorting 0.373 units of stock.
Another intern, Asad Rashid, walks in on the meeting. He has been working with options extensively,
and is beginning to use options to create other derivative instruments. He asserts the following:
Statement 4: If the exercise rate equals the current FRA rate, then a long position on an interest rate call
option combined with a short position on an interest rate put option is equivalent to a receive-floating,
pay-fixed FRA.
Statement 5: Taking a long position on an interest rate cap and short position on an interest rate floor
with the same exercise rate is equal to a receive-fixed, pay-floating interest rate swap.
Rashid adds that he currently holds a short position in put options on 5,000 shares of ABC Stock. Call
option delta is given as 0.487, while put option delta equals 0.521. Each option has one unit of ABC
stock as the underlying. Rashid wants to use call options on ABC to delta hedge his current portfolio.
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37. Referring to Exhibit 1, the value of Majids forward position is closest to:
A. $224.79.
B. $449.58.
C. $2,716.94.
38. Referring to Exhibit 2, the current value of AKUHs position on the equity swap is closest to:
A. $102,000.
B. $106,000.
C. $405,000.
39. Which of the options described in Exhibit 3 can most likely be valued using the expectations
approach to option valuation in a multiperiod setting?
A. Option A
B. Option B
C. Option C
40. Referring to Exhibit 4, which of the following of the statements made by Khalid is least likely?
A. Statement 1
B. Statement 2
C. Statement 3
41. Which of the following is most likely regarding the assertions made by Rashid?

42. The appropriate delta hedge strategy for Rashids portfolio is most likely:
A. Sell 5,349 call options.

B. Buy 5,349 call options.
C. Sell 4,674 call options.
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Questions 43 to 48 relate to Corporate Finance
Jonathan De Guzman Case Scenario:
Jonathan De Guzman is a senior analyst at AMZ Securities. He covers three companies in the consumer
electronic industry. All firms in the industry face a tax rate of 35%. Selected financial information for the
three companies is presented in Exhibit 1:
Exhibit 1:
Selected Company Financial Data
Amstel Bodema Cruty
EBIT ($) 750,000 850,000 450,000
DE ratio (based on market values) 0.60
Debt (market value) ($) 2,000,000 Nil Nil
WACC 8% 9%
De Guzman learns that Bodema has announced a debtfinanced share repurchase program. As a result of
the program, Bodemas DE ratio will increase to 0.6, and its before-tax cost of debt will be 5%.
Further, De Guzman comes to know that Cruty plans to issue $1 million in debt to buy back an equivalent
amount of equity. Crutys before-tax cost of debt will also be 5%.
De Guzman then calls a meeting with his team of junior analysts. He asks Arthur Newman, a senior
acquisitions analyst, to describe the pecking order theory. Arthur responds with the following statements:
Statement 1: The pecking order theory implies that issuance of debt usually sends a positive signal about
the company to the market.
Statement 2: The pecking order theory asserts that in terms of sources of finance, managers prefer debt,
then internal financing, and finally issuing equity.
The discussion strays into the impact of costs of financial distress on the cost of capital and value of a
company. Lars Bender, a junior analyst at the company, states that under the static tradeoff theory, as the
proportion of debt in the capital structure increases:
Effect 1: The aftertax cost of debt initially falls and then rises.
Effect 2: The value of the firm initially rises, but then falls.
Effect 3: The cost of equity rises.
Finally, the conversation moves towards the impact of countryspecific factors on investment analysis. De
Guzman, who has covered capital markets all around the globe, states that in addition to company and
industryspecific factors, countryspecific factors also play an important role in determining the optimal
capital structure. While focusing on the impact of financial markets and the banking sector on capital
structure, he makes the following statements:
Statement 3: Companies in countries with more liquid and active financial markets tend to use more
longterm debt relative to shortterm debt.
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Statement 4: In countries where shareholder rights are not so strong, debtequity ratios tend to be higher
and companies tend to rely heavily on bank financing.
43. Based on the Modigliani and Miller propositions with taxes, Amstels WACC is closest to:
A. 9.14%.
B. 14.06%.
C. 14.63%.
44. Based on the Modigliani and Miller propositions with taxes, Bodemas weighted average cost of
capital after the completion of its debtfinanced repurchase program is closest to:
A. 5.62%.
B. 6.95%.
C. 9.17%.
45. Based on the Modigliani and Miller propositions with taxes, Crutys cost of equity after the
issuance of debt is closest to:
A. 9%.
B. 10%.
C. 10.33%.
46. Which of the following is most likely regarding Newmans statements describing the Pecking
order theory?

47. With respect to the statements made by Newman relating to the static trade-off theory, which of
the following is least likely?
A. Effect 1.
B. Effect 2.
C. Effect 3.
48. Which of the following is most likely regarding De Guzmans statements regarding the impact of
financial markets and the banking sector on capital structure?
A. 0nly Statement 1 is incorrect.

B. 0nly Statement 2 is incorrect.
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Questions 49 to 60 relate to Equity Investments
Samantha Behrami Case Scenario:
Samantha Behrami is an equity analyst at Global Traders. She is analyzing the stock of ABC Company.
She finds that the industry that ABC operates in is characterized by few barriers to new entrants, high
intra-industry rivalry among industry participants, low product substitution costs for customers, and a
large number of raw material suppliers.
At lunch, Behrami meets with three of her colleagues and discusses with them which valuation model she
should use. They make the following statements:
Laura: You should use the dividend discount model since the definition of cash flow received by
investors on their equity investments is theoretically justified. However, the DDM should only be used if
the companys dividend policy is related to its earnings.
Alina: If you want to value the company based on a control perspective, then you can use the free cash
flow model. However, forecasting cash flows far out into the future is a relatively challenging exercise.
Peter: You may use the residual income model, but only if the cleansurplus relation holds. However,
the terminal value constitutes a significant proportion of total intrinsic value; therefore, the model is very
sensitive to forecasts about the future.
Behrami then asks her colleagues how she should calculate the required rate of return on equity. Laura
replies that when given a choice between FamaFrench model (FFM) and PastorStambaugh model
(PSM) to calculate required return, she always prefers the PSM. While explaining the PSM, she makes
the following comments:
Statement 1: It adds a liquidity factor to account for the premium demanded by investors for investing in
assets that are relatively illiquid.
Statement 2: The baseline value for the liquidity beta is one, which represents average liquidity.
Behrami decides to use the FFM to calculate the required return, as she believes that adding more
explanatory variables will only complicate the process and will not necessarily lead to better results.
Information relevant to the analysis is provided in Exhibit 1:
Exhibit 1:
Required Return Estimates: Saturn Inc.
Market beta 1.10
Size beta 0.15
Historical size premium 1.9%
Value beta 0.24
Historical value premium 3.3%
Liquidity premium 2.7%
Liquidity beta 0.18
Riskfree rate 5%
Expected return on equity market 12%
23
Based on the data in Exhibit 1, Peter makes the following statements:
Statement 3: Saturns cost of equity falls from the companys aboveaverage market capitalization,
which offsets the stocks aboveaverage premium for market risk.
Statement 4: If growthoriented portfolios are expected to outperform value-oriented portfolios in
the short term, it would be more appropriate to use the CAPM as opposed to the FFM to estimate the
required return.
Behramis boss believes that the stocks intrinsic value is $95.25. Further, she believes that the companys
dividend growth rate, which was 12% until now, will immediately start declining over a period of 7 years
to a longterm constant growth rate of 6%. ABCs last annual dividend was $2.14.
49. Based on Behramis industry analysis, which of the following characteristics would positively
affect the industrys profitability?
A. Entry costs for new firms

B. Substitution costs for customers
C. Number of suppliers
50. When recommending the different valuation models to Behrami, who is least likely correct?
A. Laura.
B. Alina.
C. Peter.
51. Are the two statements made by Laura regarding the use of the PSM most likely correct?
A. Yes.
C. Only Statement 2 is correct.
52. Based on the FFM, the required return on Saturns stock is closest to:
A. 11.62%.
B. 12.16%.
C. 8.78%.
53. Which of the following is most likely regarding Peters statements about Saturn Stock?

24
54. The implied required rate of return on ABC given Behramis bosss forecasts is closest to:
A. 8.85%.
B. 8.99%.
C. 9.33%.
25
Roberto Baggio Case Scenario:
Roberto Baggio, CFA, has recently started working as a junior analyst at Atlas Capital. His supervisor,
Andy Zimmerman, gives him a report that he prepared on Dico Inc last year (2011). He asks Baggio
to study the report and update it based on current years (2012) financial figures. Baggio notices that
Zimmerman used the residual income model to value the companys stock. Exhibit 1 shows how
Zimmerman calculated the companys residual income.
Exhibit 1:
Residual Income: Dico Inc. for Year 2011
Book value per share at the beginning of 2011 ($) 7.50
Earnings per share ($) 1.88
Less: Equity charge per share ($) 0.825
Residual income per share ($) 1.055
Other information:
t In 2011, Dico paid out 40% of its earnings as dividends.
t The required rate of return on equity used by Zimmerman is 11%.
Roberto makes the following forecasts in order to calculate the residual income:
t The firms EPS is expected to increase by 20% in 2012 and 30% in 2013.
t The dividend payout ratio is expected to increase to 60% this year. In 2013, the firm is expected
to pay a liquidating dividend.
Roberto is apprehensive about using the required rate of return used by Zimmerman. He chooses to
come up with his own estimate of required return using the buildup method. He gathers the following
information:
t Riskfree rate = 5.2%
t Equity risk premium = 3.3%
t Market beta = 0.9
t Size premium = 1.3%
t Beta for size premium = 0.8
t Companyspecific premium = 1.6%
t Beta for companyspecific premium = 0.7
After performing his calculations, Roberto takes his report to Zimmerman, who tells him that he prefers
using the residual income model due to the following advantages:
Advantage 1: The model can be used even if the company has negative cash flows.
Advantage 2: The model is based on accounting data which is easily available.
Advantage 3: The model focuses on accounting profitability.
26
However, Zimmerman accepts that analysts must be careful when applying the model and ensure that in
the calculation of book value:
Statement 1: Adjustments should be made to the carrying amount of assets and liabilities to reflect their
fair values.
Statement 2: The calculation of book value of equity should include separately identifiable intangible
assets that can be sold and goodwill resulting from acquisitions.
Zimmerman differs in his expectations regarding future residual income for Dico. He believes that the
company will continue to operate as a going concern. His forecasts are provided in Exhibit 2:
Exhibit 2:
Residual Income Estimates: Dico Inc.
t ROE = 15%.
t Expected EPS for years 20122015 is calculated as ROE times beginning book value per share.
t Dividend payout ratio is expected to be constant at 20%. Yes, now it makes sense.
t Required rate of return on equity = 11%.
t He believes that ROE will start to decline in year 2014 and beyond towards the required return on
equity with a persistence factor of 0.7.
Finally, Baggio tells Zimmerman that residual income is very similar to economic value added (EVA). He
says that in order to compute EVA, the following adjustments must be made to reported NOPAT:
Adjustment 1: All expenses and amortized R&D expenses are added back.
Adjustment 2: All cumulative amortization of goodwill is added back.
Adjustment 3: The LIFO reserve is added back.
55. The value of the company based on Robertos forecasts and required return on equity used by
Zimmerman, is closest to:
A. $10.20.
B. $10.88.
C. $11.33.
56. Based on the required return on equity estimated by Roberto, the value of the company would
most likely be:
A. Higher than the original estimate.

B. Same as the original estimate.
C. Lower than the original estimate.
27
57. Andy is least likely correct regarding which of the following when he talks about the advantages
of the residual income model?
A. Statement 1.
B. Statement 2.
C. Statement 3.
58. Which of the following is most likely regarding the statements made by Zimmerman about
calculating book values when applying the residual income model?
A. Only Statement 1 is incorrect.

B. Only Statement 2 is incorrect.
59. Based on Zimmermans estimates, the value of the companys stock is closest to:
A. $8.98.
B. $10.02.
C. $10.11.
60. Regarding Baggios comments about adjustments to NOPAT to compute EVA, which of the
adjustments mentioned is least likely correct?
A. Adjustment 1.
B. Adjustment 2.
C. Adjustment 3.
28
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2017

CFA EXAM REVIEW

Questions 1 to 6 relate to Ethical and Professional Standards

Silverman Group Case Scenario:

A. Standard V (A): Diligence and reasonable basis.

Jacob Martin Case Scenario:

Term (Days) LIBOR (%)

8. Regarding Transaction 2, DBK will most likely take a position on a:

A. Buy Swiss francs forward.

A. Only Statement 1 is correct.

Tommy Haas Case Scenario:

Statement 1: Credit scores provide a cardinal ranking of risk across borrowers.

t=0 t=1 t=2

A. Only Statement 7 is correct.

A. Expected spot rates.

A. Steepening of the yield curve as a result of changes in level and steepness.

Enell Investment Corp. Case Scenario:

Statement 7: During expansions, value stocks tend to outperform growth stocks.

RAL = 0.20 + 3F1 6F2 + AL

19. Which of the following is most likely regarding Arfeens statements?

A. Only Statement 1 is correct.

20. Which of the following is most likely regarding Muftis statements?

A. Only Statement 3 is correct.

21. Which of the following is most likely regarding Khans observations?

A. Only Observation 1 is correct.

Expected Return Actual Return

24. Which of the following statements made by Shafqat is least likely?

Sajjad Syed Case Scenario:

A. Only Statement 1 is incorrect.

A. Only Statement 3 is correct.

30. The DoddFrank Act is most likely classified as a(n):

Cesc Fabregas Case Scenario:

Note: All fixed income securities were purchased at par.

Net Income Return on Assets

A. Reclassify Tulip as availableforsale, and reclassify Rose as heldfortrading.

Hashir Majid Case Scenario:

Exhibit 1 contains information relating to a U.S. Treasury futures contract at initiation:

Exhibit 2 contains information relating to an equity swap at initiation:

Exhibit 3 describes three different American style options:

A. Only Statement 4 is correct.

A. Sell 5,349 call options.

Jonathan De Guzman Case Scenario:

A. Only Statement 1 is correct.

A. 0nly Statement 1 is incorrect.

Samantha Behrami Case Scenario:

A. Entry costs for new firms

A. Only Statement 3 is correct.

A. Higher than the original estimate.

A. Only Statement 1 is incorrect.

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