CFA L2 Answers PDF

Reading 1 Code of Ethics & Standards of Professional Conduct FinQuiz.
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CFA Level II Item-set - Solution
Study Session 1
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Reading 1 Code of Ethics & Standards of Professional Conduct FinQuiz.com
FinQuiz Level II 2019 – Item-sets Solution
Reading 1: Code of Ethics & Standard of Professional Conduct
Please download item-sets file Reading 2.

Reading 2 Guidance for Standard I-VII FinQuiz.com
FinQuiz.com
CFA Level II Item-set – Solution
Study Session 1
June 2019
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or redistribution of this material is strictly prohibited. info@finquiz.com.

Reading 2: Guidance for Standard I-VII
1. Question ID: 10536

Correct Answer: A
Standard II (A) Material Nonpublic Information prohibits members/candidates who possess
material nonpublic information, which could affect the value of the security, from act or
causing others to act/trade on the information. Information is considered to be nonpublic until
it has been publically made available in the marketplace. This standard does not prohibit
members/candidates to use items of non-material or material and public information to form
an opinion regarding a potential corporate action. This holds true even if the
member/candidate’s analysis leads him/her to producing conclusions which comprise of
material nonpublic information. This is termed as the mosaic theory.
By using his observations of Y.T. Automobiles’ production site to produce his conclusion,
Webber has not violated this standard (with the information obtained from the observations
constituting items of material, public information as well as non-material non-public
information). This holds true despite the fact that Webber used the information to conclude
that the manufacturer could be at risk of being acquired in a takeover or could file for
bankruptcy (which itself can be considered material nonpublic information that investors
would like to know). Furthermore the discussions with industry experts and representatives
from different manufactures as well as the industry information used as part of the analysis do
not violate this standard. In short, Webber has used mosaic theory to arrive at his conclusion
and has thus not violated this standard.
Standard V (A) Diligence and Reasonable Basis requires members and candidates to exercise
thoroughness, independence, and diligence when conducting investment analysis, making
investment recommendations and taking investment action. Additionally the standards
require members to have a reasonable and adequate basis supported by an appropriate level of
research and thorough investigation. Webber’s conclusion is backed by thorough research
and investigation and is thus in compliance with this standard.

Correct Answer: C
Standard II (B) Market Manipulation prohibits members and candidates from “engaging in
practices that distort prices or artificially inflate trading volume with the intent to mislead
market participants.” Transactions that artificially distort prices or volume to give the
impression of activity or price movement in a financial instrument reflect violations.
By transferring stocks, possessing a low level of liquidity, from the distressed fund to the
developed equity fund, Bridges has violated this standard. This is because he has transferred
stocks to the latter fund to artificially increase the demand for these stocks. Although this
action has been done to improve the value of stocks which may benefit potential investors,
such an activity deceives potential investors into believing the stocks they are buying are
highly liquid and attractively priced.

Standard III (C) Suitability requires members and candidates, in advisory roles, to make a
reasonable inquiry into the client’s investment experience, risk and return objectives, and
financial constraints and must reassess and update this information regularly. The standard
also requires recommending investments and taking investment actions which are consistent
with the client’s financial constraints, risk and return objectives, constraints, and written
mandates. Additionally members/candidates must judge the suitability of the investment in
the context of the client’s total portfolio.
The process of transferring securities from the former to the latter fund does not violate this
standard as these stocks are not owned by any clients nor recommended at the time of the
transfer.

Correct Answer: A
Webber has described distressed securities as possessing a low level of liquidity. In addition
such stocks of distressed companies are generally highly risky and require a long-term
investment horizon. These securities are suitable for those investors with high risk tolerances;
sufficient liquidity reserves/low liquidity requirements; and an intermediate to long-term
investment horizon making them capable of tolerating the associated risks.
Based on standard III (C) Suitability’s requirements, recommending these stocks to client
categories A, B and E violate this standard. This is because:
• client category A has a short-term time horizon, significant liquidity requirements, and a
low risk tolerance level;
• client category B has significant liquidity requirements;
• client category E has a below average risk tolerance; making such an investment highly
unsuitable for all three categories.
Additionally by sending out the recommendation to existing clients only as opposed to

suitable prospective clients and existing clients, standard III (B) Fair Dealing has been
violated. This standard requires members and candidates to deal fairly with clients when
disseminating investment recommendations and in their professional activities.

Correct Answer: C
All the three client categories to receive the recommendation should not have received such
an investment recommendation (see the solution to Part 3).

Correct Answer: B
Standard III (D) Performance Presentation requires members and candidates to make every
reasonable effort to ensure that the performance they present is fair, accurate, and complete.
Members and candidates should not mislead clients by misrepresenting their past
performance or reasonably expected future performance.
By presenting the performance attained by Emerson at Denver Associates as being attained at

Holler and Brookes Associates, the advertisement has violated this standard.

Standard V (C) Record Retention requires members and candidate to “develop and maintain
appropriate records to support their investment analysis, recommendations actions and other
investment related communications with clients and prospects.” This standard is not relevant
in the context of the advertisement.
Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program
requires members and candidates to avoid misrepresenting or exaggerating the “meaning or
implications of membership in CFA institute, holding the CFA designation or candidacy in
the CFA Program.” Additionally, there is no such thing as a partial designation.
Forecasting that Emerson will successfully complete and pass the Level III examinations
violates this standard. Additionally indicating that Emerson will achieve the completion
status following the upcoming June examinations violates this standard as there is no such
designation.

Correct Answer: B
The six components of codes of ethics that CFA institute’s members and candidates are
required to follow are:
• Act with integrity, competence, diligence, respect, and in an ethical manner with the
public, clients, prospective clients, employers, employees, colleagues in the investment
profession, and other participants in the global capital markets.
• Place the integrity of the investment profession and the interests of clients above their
own personal interests.
• Use reasonable care and exercise independent professional judgment when conducting
investment analysis, making investment recommendations, taking investment actions,
and engaging in other professional activities.
• Practice and encourage others to practice in a professional and ethical manner that will
reflect credit on themselves and the profession.
• Promote the integrity of and uphold the rules governing capital markets.
• Maintain and improve their professional competence and strive to maintain and improve
the competence of other investment professionals.
The requirement that members and candidates/investment professionals must exercise

diligence, independence, thoroughness and independence when analyzing investments,
making recommendations or taking investment actions is covered by the CFA Institute’s
Standards of Professional Conduct [Standard V (A) Diligence and Reasonable Basis].

Correct Answer: B
When managing accounts to a specific mandate, strategy or investment style, the CFA
Institute Standards of Professional Conduct require members and candidates to, “make
investment recommendations or take investment actions that are consistent with the stated
objectives and constraints of the portfolio.’
Based on the investment policy of Grace Incorporated’s pension plan, Peltier will need to
assure he does not make allocations to growth stocks, and chooses securities which bring

industry diversification (belongs to industries distinct from Grace Incorporated) and are
securities of stable companies.
Based on the data provided, Peltier should ignore stock B altogether as it belongs to the same
industry as the surgical manufacturer.
Peltier cannot choose stock A as its high P/E and P/B ratio (11.2 and 13.4, respectively)
indicate it is a growth stock. Similarly the high projected EPS growth further confirm that it is
a growth stock. Thus Peltier should not consider stock B for inclusion to the plan’s
investment account.
Peltier may select stock C for inclusion into the plan’s investment account. The low P/E ratio
and high P/B ratios (3.8 and 13.6, respectively) indicate the stock is a balanced stock.
Additionally, stock C belongs to the automobile manufacturing industry which indicates it
will bring industry diversification to the plan’s account. By allocating stock C to the
investment account, Peltier does not violate the standards.
Thus by selecting stock B for the plan’s investment account, Peltier has violated standard
III(C) Suitability as he has not followed the plan’s mandate pertaining to industry
diversification.

Correct Answer: A
Standard III (B) Fair Dealing requires members and candidates “to deal fairly and objectively
with all clients when providing investment analysis, making investment recommendations,
taking investment action, or engaging in other professional activities.” By allocating 80% of
the purchased shares to suitable client accounts, Lawson has not violated this standard.
However by not allocating the 20% portion to interested clients and holding them back for an
eight-month period, Lawson has violated this standard as she has denied the interest clients of
these oversubscribed corporation shares.
Standard III (C) Suitability requires members and candidates to make a reasonable inquiry
into the client’s circumstances, risk and return objectives and financial constraints prior to
making any investment recommendation or taking investment action, determining whether
the investment is suitable to the client’s financial situation and consistent with the client’s
written objectives, and judging the suitability of investments in the context of the client’s
total portfolio. There is nothing in the case which indicates Lawson has violated the standard.
There is nothing to indicate that standard III (A) Loyalty, Prudence and Care has been
violated.
Additionally standard VI (B) Priority of Transactions requires members and candidates to

place investment transactions of clients and employers ahead of transactions in which a
member and candidate is the beneficial owner. By depositing 20% of the oversubscribed
corporation’s shares in her account for a period of eight months, instead of the investment
accounts of interest clients, Lawson is benefitting from any potential increase in the stock’s
value.

Correct Answer: C

Should Lawson accept the round trip cruise offer, Lawson will be violating standard I (B)
Independence and Objectivity which requires members and candidates not to “accept any gift,
benefit, compensation or consideration that reasonably could be expected to compromise
their independence and objectivity.” The condition (to allocate 40% of the shares to
Schmidt’s account in exchange for a reward) attached the cruise trip will itself impair
Lawson’s independence and objectivity since, after accepting the offer, she will favor
Schmidt and allocate a portion of the corporation’s shares to his account only rather to the
accounts of other individuals who have expressed an interest in the shares.
The allocation of the 40% shares solely to Schmidt’s account additionally suggests that
Lawson has violated the standard, III (B) Fair Dealing. Schmidt should have allocated the
shares proportionally to those accounts expressing an interest, for which the investment is
suitable, as well as distribute amongst suitable accounts on a pro-rata basis.
Standard IV (B) Additional Compensation Arrangements requires members and candidates

not to accept any 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. Unless Lawson does not obtain consent
for the trip, she will violate this standard. She has informed her employer, MIA, of the offer
and thus does not violate this standard.

Correct Answer: A
Standard II (A) Material Nonpublic information prohibits members and candidates from
trading on material non-public information or causing others to trade on such information.
A problem with the source code of a software development corporation’s major product line
is a piece of material information. However it is not necessary that the problem may lead to
the discontinuation of the corporation’s major product line and result in a drop in forecasted
product revenues. The two retirees are merely speculating and sharing this information with
others (either with his friend or fellow portfolio manager) does not result in Brewer violating
this standard.

Correct Answer: C
Standard III (C) Suitability requires members and candidates to make investment
recommendations and take investment actions which are consistent with the client’s
investment account and risk and return objectives as well as constraints. However members
and candidates can only make suitable investment recommendations or take investment
actions provided clients are forthcoming in providing the relevant information to their
portfolio managers.
The chief investment officer's claims are not valid. This is because the officer has not
prohibited the portfolio manager from avoiding emerging market stocks. Additionally, the
chosen stocks meet the socially responsible criteria. Thus by including such stocks, Brewer
has not violated this standard.
Additionally, Brewer has not violated III (B) Fair Dealing.


Correct Answer: C
Standard IV (C) Responsibility of Supervisors requires members and candidates to prevent
and detect any violations of the codes and standards, laws, rules and/or regulations by anyone
subject to their supervision or authority.
As the portfolio manager of The Senior Citizen Endowment’s portfolio, Brewer has not
violated any standards (See the solution to Part 5). Thus there are no violations which Peltier
need to prevent and/or detect. Thus as supervisor he has not violated this standard.
Standard III (C) Suitability is not relevant in this context.

Correct Answer: C
Standard II (A) Material Nonpublic Information prohibits members and candidates, “who
possess material nonpublic information that could affect the value of the security, from taking
action on it or causing others to take action on the information.” Although the information on
the G&J’s expansion plans may be material and nonpublic, the discussion between Sutton
and Mullins does not violate this standard as no effort was made to act or cause someone to
act on the information.
Standard III (E) Preservation of Confidentiality requires members and candidates to keep
information about current, former, and/or prospective clients confidential unless the client
permits disclosure; disclosure is required by law; or the information concerns illegal activities
on part of the client. As the investment banker of G&J, Sutton has the obligation to preserve
the confidentiality of any information received on his client’s expansion plans, which he has
exclusively received. Thus by sharing these plans with Mullins, he has violated this standard.
Standard IV (C) Responsibility of Supervisors requires members and candidates to make

reasonable efforts to prevent and detect any violations of any applicable laws, codes and
standards, rules and regulations by anyone subject to their supervision or authority. This
responsibility includes implementing adequate compliance procedures, making reasonable
efforts to ensure these procedures are monitored and enforced. By implementing a structure
to control the interaction between the two departments (investment banking and investment
counseling/management departments) and not monitoring the effectiveness of the structure
nor ensuring the flow of information between the departments is limited, Herrera as a senior
compliance officer has violated this standard.

Correct Answer: A
Standard I (B) Independence and Objectivity requires members and candidates to use
reasonable care and judgment to achieve and maintain independence and objectivity in their
professional activities. Any recommendations should be independently arrived at. If
investment recommendations are made following instructions, which conflict with the
member/candidate’s recommendations, the member or candidate is in violation of this
standard.
The best action for Mullins to undertake would be to develop a research report and conclude
it with a recommendation solely based on his analysis of G&J’s future prospects. Since

Mullins believes G&J’s expansion plans may not succeed, he will probably produce a
different recommendation to the buy recommendation instructed by Herrera.

Correct Answer: B
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act for the
benefit of their clients and place client interests first. The standard also requires members and
candidates to maintain their duty of loyalty to their clients, act with reasonable care, and
exercise prudent judgment. In the course of their duty to their clients members and candidates
should seek best price and execution.
Although Mace Brokerage charges fees higher than the existing broker, the access to global
and local research as well as higher execution speed (relative to the current broker) justify the
fees. Thus by appointing Mace Brokerage, Delgado will not be violating this standard but
instead will be providing Mighty-You Inc. with greater benefits (i.e. execution).
Although Harold and Haroon Associates charges fees lower than the existing broker the
execution speeds are relatively slower. Additionally the firm provides access to local research
only. Thus the relatively slow execution speed makes this broker unsuitable for Mighty-You
Inc. Thus the appointment of this broker-candidate will violate the standard in question as
Delgado will not be providing its client with best execution.

Correct Answer: B
Standard III (C) Suitability requires members and candidates, in an advisory relationship, to
make investment recommendations which are suitable to the individual client’s financial
situation, risk and return objectives, and written investment mandates. Additionally, members
and candidates must judge the suitability of the investment in the context of the total client
portfolio.
There is a lack of sufficient evidence which may suggest that the firm may have conducted a
suitability analysis prior to implementing the derivative strategy on a portion of the client
portfolios. It is possible that such a strategy may not be suitable for or may be expressly
prohibited by some clients. Thus by implementing a derivative strategy, the firm has violated
this standard.
Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a
reasonable and adequate basis, supported by appropriate research and investigation, for any
investment analysis, recommendation or action.” The volatility of the national market, which
in turn has substantially increased the risk of several securities in client portfolios, justifies
the use of derivative to offset these risks. Thus this standard has not been violated.
Under Standard V (B) Communication with Clients and Prospective Clients, member and
candidates must disclose to clients the basic format and general principles used to analyze
investments, select securities and construct portfolios and promptly disclose any material
changes to the processes. By delaying the notification to clients (regarding the inclusion of
derivatives in their portfolios) for a period of one month, this standard has been violated.


Correct Answer: A
Policy 1:
Standard II (A) Material Nonpublic Information requires members and candidates to establish
a firewall between the investment banking and investment research divisions to prevent the
flow of material nonpublic information. Interdepartmental communication must preferably
pass through a clearance area within the firm in either the compliance or legal department.
Allowing unsupervised communication between the two departments (investment banking
and counseling, in the firm’s case) makes Policy 1 inconsistent with this CFA Institute
Standards of Professional Conduct standard.
Policy 2:
Standard III (A) Loyalty, Prudence and Care requires members and candidates to vote proxies
in the best interests of clients and their ultimate beneficiaries as well as to vote proxies in an
informed and responsible manner. A fiduciary who votes blindly with management on non-
routine governance issues violates this standard. Due to cost and benefits, it is not necessary
to vote all proxies. Policy 2 is not consistent with this standard as it does not call for voting
in the best interests of clients and ultimate beneficiaries. This is because the policy calls for
taking into account any benefits to the firm, in addition to clients’ benefits, and ignores the
benefits to beneficiaries (accruing to them as a result of the votes cast). In addition, the policy
requires votes to be cast in line the firm’s management which hampers the
member/candidate’s ability to cast his or her vote in the best interests of its clients and
ultimate beneficiaries.
Policy 3:
Under Standard V (C) Record Retention members and candidates are required to develop and
maintain appropriate records to support their investment analysis, recommendation, actions
and other investment related communications with clients and prospective clients. In the
absence of any regulatory requirements, the CFA Institute recommends a holding period of at
least seven years. By complying with local record retention regulations, policy 3 is consistent
with this standard.

Correct Answer: A
By allocating highly risky securities to the investment portfolios of his risk-averse clients
(which require less risky securities), Strickland has clearly violated the standard, III (C)
Suitability.
Additionally, Strickland’s statement does not justify the addition of these securities to the
portfolios. The expected decrease in market and securities’ volatility is merely a prediction
which may not materialize after the quoted six-month period. Thus by basing the purchase
decision on a mere prediction of a market factor, Strickland has violated the standard V (A)
Diligence and Reasonable Basis.
There is nothing which may suggest Strickland has been dishonest or engaged in fraudulent
practices adversely affected his professional reputation, integrity or competence. Thus
Strickland has not violated standard I (D) Misconduct.
Strickland has not violated Standard I (C) Misrepresentation nor has he violated standard III
(A) Loyalty, Prudence and Care. The justification statement does not guarantee the volatility

will fall from its current levels, but instead uses the term ‘projected’ which implies Strickland
has not guaranteed any expected performance and thus has not violated standard III (D)
Performance Presentation.

Correct Answer: A
Standard VI (A) Disclosure of Conflicts requires members and candidates “to make full and
fair disclosures of all matters that could reasonably be expected to impair their independence
and objectivity or interfere with their respective duties to their clients, prospective clients, and
their employer.” The disclosures need to be prominent, delivered in plain language and
communicated effectively.
Ideally, to avoid the appearance of any conflicts, Howell should not be asked to cover a
company with which he may be affiliated. Howell’s family relationship with H.O. Zone’s
executive director must be disclosed in his research report as well as to his employer, Trinity
Associates. Without taking any steps to minimize this potential conflict and failing to make
the relevant disclosures to clients, prospective client and to his employer, Howell has violated
this standard.
Standard II (A) Material Nonpublic Information requires members and candidates who
possess material nonpublic information, which has the potential to affect the value of a
security, from acting or causing others to act on the information. There is lack of evidence to
suggest that Howell may have not independently arrived at a buy recommendation or used
insider information to arrive at the recommendation. A mere speculation by Thackeray does
not necessarily mean Howell has used insider information. Additionally by using the
recommendation, Thackeray has not violated this standard (due to the uncertainty of the
information being acquired from insider resources or not).
Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a
reasonable and adequate basis, supported by appropriate research and investigation, for any
investment analysis, recommendation or action.” Additionally when using secondary
research it is necessary to make reasonable and diligent efforts in evaluating the objectivity
and independence of the recommendations; reviewing the assumptions used, the rigor of
analysis performed, and the date/timeliness of the research.
The question of whether Howell may have arrived at his buy recommendation using insider
sources remains. Without thoroughly evaluating the independence and/or objectivity of the
recommendations and relying on the recommendation Thackeray has violated this standard.

Correct Answer: A
Standard I (C) Misrepresentation prohibits members and candidates from knowingly making
any misrepresentations relating to investment analysis, recommendations, actions or other
professional activities in oral or written communications. The standard requires members and
candidates to identify or acknowledge the source of ideas or material that is not their own.
Additionally it is necessary to cite all sources which are used to develop research reports and
work products (other than those obtained from recognized statistical and financial reporting
sources).

Although Byrd’s model has been considerably modified from the model developed by the
pharmaceutical chief industry executive, Byrd should acknowledge the fact that his model’s
structure was inspired by the latter model and continues to use the same factors as those
employed by the latter model. By not doing so and marketing the model as his own, he has
violated the standard.
According to this standard, Byrd must cite the annual industry forecasts obtained from
discussions with industry experts but not the industry reports published by the local
government agency in his research report.

Correct Answer: B
Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program
requires members and candidates to avoid misrepresenting or exaggerating the “meaning or
implications of membership in CFA institute, holding the CFA designation or candidacy in
the CFA Program.” Additionally, there is no such thing as a partial designation.
The newsletter has accurately referred to Terry and Sosa as CFA Level III candidates.
However by stating that Terry will attain a ‘Passed Finalist’ status, the newsletter has
incorrectly referenced Terry’s candidacy in the CFA Program and this reflects a violation of
this standard. This is because there is no such status.

Correct Answer: C
Standard I (D) Misconduct prohibits members and candidates from engaging in any
professional conduct involving fraud, deceit, dishonesty or committing any act that reflects
adversely on their professional reputation, integrity or competence. By assuring McFadden
that the financial consultancy department will provide the required tax consultancy services
when the firm outsources such services, Terry has been dishonest with her client and has
violated this standard.
Standard II (B) Market Manipulation prohibits members and candidates from engaging in
practices that distort the prices or artificially inflate trading volume with the intent to mislead
market participants. However the standard does not prohibit transactions done for tax
purposes. Thus the tax-loss harvesting strategy recommended by Terry (selling securities
which have fallen in value to offset the gains on securities which have risen in value) does not
violate this standard.
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in the
best interests of clients, place client interest before their own, use reasonable care, and
exercise prudent judgment when managing the accounts of their clients. As McFadden’s
financial consultant, Terry has acted in his client’s best interests. Thus she has not violated
this standard.
Standard I (C) Misrepresentation requires members and candidates to have knowledge of all
the services the firm provides and should recommend where a client can obtain the requisite
service should the firm not be able to provide it. By assuring her client that the firm is able to
address her taxation concerns and is able to provide the necessary consultancy services, Terry
has violated his standard. This is because the firm outsources tax consultancy rather than
providing it internally. Additionally, Terry has misrepresented the tax-loss harvesting strategy

by incorrectly stating that it will help to reduce the portfolio’s taxable base in both the current
and future years. In reality, tax-loss harvesting reduces the portfolio’s taxable basis in the
current year to increase it in the future.

Correct Answer: C
Practice 1:
Standard IV (A) Loyalty requires members and candidates, in matters related to their
employment, to act in their employer’s best interest and not deprive them of the advantage of
their skills and abilities or cause any harm to their employers. Members/candidates must
continue to work in their employer’s best interest until resignation is effective.
A buyout of the firm’s financial consultancy department by the firm managers does not
constitute a violation of this standard. This is because the firm may choose how to respond to
such an action. Thus practice 1 does not reflect a violation of this standard.
Based on standard VI (A) Disclosure of Conflict’s requirements (see the solution to Part 1), a
meeting between some of the firm’s managers after office hours does not constitute a
violation of this standard.
Thus practice 1 does not reflect any violations of the CFA Institute Standards of Professional
Conduct.
Practice 2:
The portfolio managers have complied with standard III (A) Loyalty, Prudence and Care by
using the brokerage arrangement to obtain high quality research to directly assist the
managers in managing the client portfolio.
Standard IV (B) Additional Compensation Arrangements prohibits member and candidates

from accepting any gift, benefits, compensation or consideration “that competes with or
might create a conflict of interest with their employer’s interest unless they obtain a written
consent from all the parties involved.” The portfolio managers have not received any
additional compensation which would require disclosure under this standard. Thus this
standard has not been violated.
Standard VI (C) Referral Fees requires members and candidates to disclose to their
employers, current clients, and prospective clients “any compensation, consideration, or
benefit received from, or paid to, others for the recommendation of products or services.” The
firm’s portfolio managers have referred their clients to their respective broker and have
received research in return. This arrangement must be disclosed to their existing clients
and/or any prospects who wish to employ any of these portfolio managers to manage his/her
investment portfolio. By not disclosing the arrangements to their clients, the portfolio
managers have violated this standard.

Correct Answer: A
With respect to practice 3, Byrd has violated standard I (C) Misrepresentation. This is
because Byrd should have known about the error in his resume as he has been quoting his
experience for several years. By quoting his experience incorrectly, Byrd has misrepresented
his experience with the two industries and has thus violated this standard.

By incorrectly stated his years of experience, Byrd has not violated standard III (D)
Performance Presentation, which requires members and candidates to make reasonable efforts
to ensure that the performance they present is fair, complete, and accurate. Since the error
pertains to his industry experience as opposed to performance information, Byrd has not
Standard V (C) Record Retention is not relevant in this context and there is a lack of
sufficient evidence to conclude that Byrd has not retained records used to develop research
reports and make recommendations.

Correct Answer: B
Standard I (A) Knowledge of the Law requires members and candidates to understand and
comply with all applicable laws, rules and regulations of any government, regulatory
organization, licensing agency, or professional association governing their professional
activities. In the event of any conflict, members and candidates must comply with the stricter
of the two: applicable laws or code and standards.
Standard I (D) Misconduct requires members and candidates to avoid any professional
misconduct that may reflect adversely on their professional reputation, integrity, or
competence and encourages employers to conduct reference checks on potential employees
for any past infractions of laws.
The law which is applicable to Riku Associates is the local Shimautanian law as opposed to
the Japanese law applicable to its parent organization. Because employees with past
infractions of securities and/or trading laws of two or more counts are likely to violate such
laws again, it is advisable to avoid hiring such employees. Thus the requirements of the
Institutes’ codes and standards govern [I (D) Misconduct]. Riku Associates must preferably
hire employees with a clean past record.

Correct Answer: A
Standard IV (C) Responsibility of Supervisors requires members/candidates to make every
reasonable effort to prevent and detect violations of the laws, rules, regulations, and/or codes
and standards by anyone subject to their supervision or authority. It is permissible to delegate
such responsibility but such delegation does not absolve the member/candidate of his/her
responsibilities. By instructing Sayuki to review Smith’s portfolio after every 18 months,
Sayuki has not complied with this standard as his instructions violate the requirements of III
C Suitability (see below). This is because client portfolios need to be reviewed at least
annually and whenever there is a change in client and/or market conditions. Any reason given
to support this review schedule does not justify such a policy.
Standard III (C) Suitability requires members and candidates, who are in an advisory role, to
make a reasonable inquiry into the client’s investment experience, risk and return objectives,
investment constraints and must reassess and update this information regularly. Client
portfolios must be reviewed at least annually and whenever a change in client circumstances
and/or market circumstances occurs. By instructing Lowery to conduct reviews for a period
longer than the minimum 12-month required, for whatever reason, Sayuki has violated this
standard. Additionally, Lowery has also violated this standard as he has conducted the
reviews as instructed.

Standard III (A) Loyalty, Prudence and Care does not address client portfolio reviews has not
been violated.

Correct Answer: C
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their
client’s best interests, to exercise prudent judgment, and use reasonable care. The client’s
interests should always have priority over the firm’s and portfolio manager’s interests. By
recommending the sale of a stock which is harming the client’s portfolio, Lowery has
complied with this standard.
Standard III (E) Preservation of Confidentiality requires members and candidates to keep all
information concerning former, current, and prospective clients confidential unless the client
permits disclosure; the disclosure is required by law; or the information pertains to illegal
activities on the part of clients. By sharing information regarding Smith’s portfolio holdings
with his family friend, Lowery has violated this confidentiality standard.

Correct Answer: A
Standard II (A) Material Nonpublic Information prohibits members and candidates who
possess material nonpublic information, that could affect they value of a security, from acting
or causing other to take action on the information.
The fact that such information has not yet been disclosed and pertains to the discontinuation
of a product line provides sufficient evidence that this piece of information is material and
nonpublic. Although Conway may discuss this piece of information with his supervisor,
Sayuki, his first course of action should have been to make reasonable efforts to achieve
public dissemination of the information by encouraging Furniture Ltd to make the
information public. If Furniture Ltd had refused to release the information, his next course of
action should have been to disclose the information to his supervisor or compliance
department.
However Conway has not made any such efforts and thus has violated this standard.
Standard III (E) Preservation of Confidentiality is not relevant here as the standard covers
confidential client information received by portfolio managers as opposed to the information
received by research analysts on the companies they cover.

Correct Answer: C
employment, to act for the benefit of their employer, and not deprive their employer of the
advantage of their skills and abilities, or otherwise cause harm to their employer. Members
and candidates must not take any actions such as appropriating property for themselves, client
lists, or any information or material from their employer without their permission.
Members/candidates must continue to act in their employer’s interest until resignation is
effective.

In Fukui’s case, participating in an online interview does not violate this standard as she is
not disrupting her duties to the firm as an employee. Additionally, since Fukui has not
undertaken the potential job opportunity at Howell S. Erwin Associates, there is no need to
disclose the opportunity to her employer. Thus Fukui has not violated this standard.
Although Gifu has complied with this standard by informing the employer of the job
opportunity before resigning, he has violated this standard with respect to the backups of past
firm information stored on his home computer. In order to avoid violating this standard, he
should have removed the information from his computer before departing Riku Associates or
should have received his employer’s consent to continue to store the information. Even if he
believes the information to be obsolete, Gifu has violated this standard.

Correct Answer: A
Standard I (B) Independence and Objectivity requires members and candidates to strive to
achieve and maintain independence and objectivity in all their professional activities.
Members/candidates must not accept gifts, benefits, compensation or consideration which
could reasonably comprise their independence or someone else’s independence and
objectivity. Gifts must be disclosed to the member’s employer whatever the case. Fukui has
informed her employer of the offer and has thus not violated this standard.
Standard III (D) Performance Presentation requires members and candidates to make every
reasonable effort that the performance they present is fair, accurate and complete. By
intentionally increasing the portfolio return by 0.2% (10.0% – 9.8%) when the portfolio
actually achieved a return of 9.8%, Fukui has clearly violated this standard.

not to accept any 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 the parties involved. Furthermore, the standard requires
members/candidates to disclose the nature of the compensation, the approximate amount of
compensation and the duration of the arrangement. A simple description of the location of the
underwater farm is not a disclosure which meets the requirements of this standard. Thus by
not disclosing the required details, Fukui has violated this standard.

Correct Answer: C
Standard I (C) Misrepresentation requires members and candidates to avoid knowingly
making any misrepresentations when analyzing, making investment recommendations, and/or
taking investment action. Among the standard’s requirements is the prohibition imposed on
members and candidates from guaranteeing future investment results. Youssef has not
guaranteed investment results nor has he made any misrepresentations. Thus he has not
Standard V (B) Communication with Clients and Prospective Clients requires members and
candidates, amongst other things, to separate opinion from fact in their research reports and
recommendations. By using terms such as ‘will’, Youssef is implying that the political crisis
in Kenya will definitely intensify as opposed to stating the probabilities of such an event
happening. Thus he has violated this standard.


Correct Answer: A
Standard V (C) Record Retention requires members and candidates to maintain records
indicating the nature of their research recommendations, investment analysis, actions, and
other investment related communications with clients and prospects. By maintaining a
database which contains these records, Youssef has complied with this standard.
In addition to requirements presented in the solution to Part 1 standard I (C)

Misrepresentation requires members and candidates to cite all the sources used to generate
work products and research reports (recognized governmental and statistical sources need not
be cited). By not specifically citing the analysts’ reports, surveys, and quotations used and,
instead, making a general statement, Youssef’s statement (included as part of his database)
violates this standard.
Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients
when disseminating investment recommendations, taking investment actions or analyzing
investments. Youssef has discriminated between investors by providing free access to the
database to particular investor categories while charging other investors a nominal fee.

Correct Answer: C
Standard V (B) Communication with Clients and Prospective Clients defines communication
in the form of a recommendation pertaining to an asset allocation, the market, or classes of
investments. However any brief communications must be supported by background reports or
data that can be made available to interested parties on request. By issuing the
recommendation two days prior to the full-length research report, Youssef has not violated
this standard. This is because he intends to make the full-length report available as soon as
the communication problem abates.

Correct Answer: C
Under Standard VII (A) Conduct as Members and Candidates in the CFA Program, members
and candidates must not engage in any conduct that compromises the integrity or reputation
of the CFA Institute, the CFA designation or the integrity, validity or the security of the CFA
examination. Members and candidates are not prohibited from expressing their opinions
concerning the CFA Institute or CFA Program. Hanson’s statement regarding the CFA
Program does not violate this standard.
However, standard VII (B) Reference to the CFA Institute, the CFA designation, and the
CFA Program, requires members and candidates not to exaggerate or misrepresent the
meaning or implication of candidacy in the CFA Program, amongst other requirements. By
implying that individuals with a certain level of intellect (who are ‘apt’ enough) are likely to
succeed in the program, Hanson has violated this standard.

Correct Answer: A
Standard I (B) Independence and Objectivity requires members and candidates to achieve and
maintain independence and objectivity and not to accept gifts, benefits, compensation, or
consideration which could compromise their own or someone else’s independence and

objectivity. Members and candidates should pay for their own commercial transportation and
residence and only use the corporate aircraft offered by a client when commercial
transportation is not available.
By accepting the residential and transportation arrangements offered by the client and not
disclosing these arrangements to his employer, Hanson is in violation of this standard. In the
course of allowing JTL to make these arrangements, Hanson may have compromised his
independence and objectivity. Despite his client’s headquarters being half an hour away,
Hanson did not make any attempts to explore the transportation alternatives available.
Additionally despite the residential accommodation being modest, Hanson should have used
the residential allowances provided by his employer to seek and pay for his own residence
and transportation.
employment, to 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 harm the
employer. During his stay in Malaysia, Hanson has not violated this standard.

Correct Answer: A
Hanson has not violated Standard I (B) Independence and Objectivity as he will be receiving
a flat fee for preparing the research report. This makes the research report independent of
Hanson’s potential recommendation on the steel manufacturer.
By not disclosing the research opportunity offered by the steel manufacturer to Greenwich
Limited and seeking permission prior to beginning the assignment, Hanson has violated the
standard IV (A) Loyalty which requires members and candidates to disclose all aspects of
independent practice and receive employer permission prior to the start of the proposed
independence practice.
Standard VI (A) Disclosure of Conflicts requires members and candidates to make “full and
fair disclosure of all matters that could reasonably be expected to impair their independence
and objectivity or interfere with their respective duties to their clients, prospective clients, and
their employer.” By not disclosing the fact that he is an employed research analyst serving
Greenwich Limited and misleading the steel manufacturer’s executive to believe that he is an
independent research analyst, Hanson has violated this standard.

Correct Answer: C
Standard III (C) Suitability requires members and candidates, in advisory roles, to make a
reasonable inquiry into the client’s investment experience, risk and return objectives,
financial constraints and reassess and update this information regularly. Additionally
members and candidates are required to judge the suitability of the investment in context of
the client’s total portfolio. By instructing portfolio managers to conduct a suitability analysis
prior to allocating the emerging market stocks, Russet has complied with this standard.
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their
client’s best interest and exercise prudent judgment and use reasonable care. There is no
evidence that Russet has violated this standard.

Standard IV (C) Responsibility of Supervisors requires members and candidates to make

reasonable efforts to prevent and detect any violations of the laws, rules, codes and standards
by anyone subject to their supervision or authority. There is no information in the case which
may provide evidence that Russet has violated this standard.

Correct Answer: C
Standard III (C) Suitability requires members and candidates to undertake a client portfolio
review on an annual basis (minimal) and whenever client circumstances and/or economic
circumstances change. Rapidly changing economies will require more frequent portfolio
reviews as opposed to stable economies. Thus the portfolio review frequency is in
compliance with this standard’s guidelines.
The factors which Russet instructs her portfolio managers to analyze all are factors which
have been prescribed by the suitability standard. Thus her instructions are in compliance with
the standards.

Correct Answer: A
Standard II (B) Market Manipulations prohibits members and candidates from engaging in
market participants. However, this standard does not prohibit legitimate trading that exploits
a difference in market power, information, or other market inefficiencies.
Green did not intentionally manipulate the prices of the crude oil commodity futures traded.
The heavy futures volume being traded has forced the futures contract prices downward
resulting in a (larger than expected) positive roll return when rolling into new futures
contracts. Thus Green has not violated this standard.
Standard V (B) Communication with Clients and Prospective Clients requires members and
candidates to use reasonable judgment in identifying the factors important to investment
analysis, recommendations, or actions and include those factors in communications with
clients and prospects. Additionally members and candidates must disclose the basic principles
and general format of the investment process used to analyze investments, select securities,
and construct portfolios and disclose any changes materially affecting this process. There are
no changes to the investment process which require communication with clients and/or
prospects. Thus Green has not violated this standard.

Correct Answer: B
Standard III (E) Preservation of Confidentiality requires members and candidates to keep
information concerning present, former and prospective clients confidential unless the client
permits disclosure; information concerns illegal activities on part of the client; or disclosure is
required by law.
By sharing information on Sanchez’s current financial circumstances with the banking

consultant, Russet has not respected the confidentiality of her client’s information and has
thus violated this standard.

Additionally, by not revising Sanchez’s IPS to reflect her changed risk tolerance and liquidity
requirements (which has decreased and increased, respectively following her bankruptcy),
Russet has violated the standard, III (C) Suitability, which calls for revising client
information whenever client circumstances change. Speculative investments in commodity
futures are no longer suitable for Sanchez and thus by not liquidating the holdings Russet has
violated the suitability standard.

Correct Answer: B
Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients and
prospects when disseminating investment recommendations, taking investment actions, and
in their general professional activities. In case of oversubscribed issues, members and
candidates must allocate them to suitable and interested client accounts on a pro-rata basis.
Cooper is in violation of the fair dealing standard on two counts. Firstly, relative to other
accounts, he has allocated a larger proportion of the trade to his aunt's account. Secondly, by
delaying the allocation of the trade to a regular-fee paying client, he has treated his aunt's
account unfairly.
Standard VI (B) Priority of Transactions requires members and candidates to undertake

personal transactions after clients and employers have had a reasonable opportunity to act
upon the recommendation. Family accounts which are client accounts should not be
disadvantaged and must be treated like any other client account.
By allocating the pharmaceutical manufacturer’s stocks to his aunt’s account a day later
following the allocation of the issue to his clients’ accounts, Cooper has unfairly treated his
aunt’s account and has violated this standard.

Correct Answer: C
The portfolio manager has not made any misrepresentations and has not violated the standard,
I (C) Misrepresentation.
Standard VI (B) Priority of Transactions additionally requires members and candidates to

disclose the firm’s personal holding policies upon request. By not fulfilling the client’s
inquiry concerning the firm’s personal trading policies and blackout period established, the
portfolio manager has violated this standard.

Correct Answer: A
Armstrong has violated best practice. Best practice is for analysts to accept only a flat fee for
their work prior to writing the report, without regard to their conclusions or the report’s
recommendations. Direct compensation; payment based on the conclusions of the report, or
indirect compensation, such as warrants that could increase in value based on positive
coverage in the report are fraught with potential conflicts. Since Armstrong will receive the
warrants after the report is completed, it most likely will depend on the conclusions of the
report. In addition, Armstrong needs to fully disclose potential conflicts, including the nature
of the compensation (although here disclosing the nature of the compensation is not sufficient
to meet the Code and Standards).


Correct Answer: C
Keeling is not in violation of the Standard. In this case, the trip is strictly for business and
Keeling is not accepting irrelevant or lavish hospitality. The itinerary required chartered
flights, for which analysts are not expected to pay, and Green Motels is the only
accommodation in the area. These arrangements, hence, did not violate the standard, since
they most likely do not impinge on Keeling’s independence and objectivity. The policy of
Salkey’s firm complies closely with Standard 1(B) by avoiding the appearance of a conflict
of interest, but Keeling and other analysts do not necessarily violate the Standard.

Correct Answer: B
RIM is in accordance with the CFA Institute Standards of Professional Conduct with regards
to the guarantee. Standard 1(C), misrepresentation, does not prohibit members and candidates
from providing clients with information on investment products that have guarantees built
into the structure of the product itself or for which an institution has agreed to cover any
losses. In this case, the securities are backed by the U.S. government and in case of any
losses, RIM has agreed to cover them.
As long as RIM describes the concepts in its own words, it does not need to cite the source.
However, for the concepts of price multiples, RIM quotes the words of another author, so it
needs to cite the source from which the descriptions are quoted (even though these are
general concepts).

Correct Answer: A
Armstrong is not in violation of the Standard. Since Armstrong has obtained the information
directly from the original source, he does not need to report how she found out about the
information. In fact, best practice is to obtain the study from the original author (CFA
Institute in this case), and cite only that author (this will eliminate the risk of relying on
second hand information that may misstate the source). If Armstrong used the study provided
by Charles in his report, he would need to cite both sources.

Correct Answer: C
The information about the sale is both material and non-public. Craven has violated the
Standard by communicating the inside information to her broker. Roy has violated the
standard by initiating a transaction to buy the shares based on material nonpublic information.
Pettit is in violation of the standard relating to material nonpublic information because as the
firm's CEO she knew the information was both material and nonpublic and by disclosing the
information to her daughter, she is in violation.

Correct Answer: A
Drewry did not violate any Standards. He used information available to the public, and used
his own expertise to interpret the information. Simply because the public in general finds the
conclusions material does not require that Drewry make his or her work public. Investors who

are not his clients can either do the work themselves or become his client if they want access
to his expertise.

Correct Answer: B
Mayer has violated Standard 3(A), Loyalty, Prudence and Care, because he is using the assets
of his clients to benefit his firm and himself. The trading was carried out solely to reach the
minimum commission level and not to benefit the clients.
Kew has violated Standard 3(A), Loyalty, Prudence and Care, and 3(C), Suitability. The
private equity fund is an illiquid investment since it locks up the fund’s asset for three years.
The IPS clearly states investment in liquid assets. Therefore, private equity is not suitable for
the pension fund.

Correct Answer: A
Kew has violated his duty to his clients by giving priority to the Growth Fund over the Equity
Fund, even though both the funds have the same investment objectives and have similar
portfolios. Also, Kew has violated Standard 3(B) Fair Dealing, by giving priority to the
discretionary accounts over nondiscretionary accounts. In this case, even though disclosure is
made, this would not change the fact that the policy is unfair.

Correct Answer: C
If MMI fully discloses its agreement with members to boost liquidity over the initial eight
months, it does not violate the Standard. MMI may engage in a liquidity-pumping strategy to
give its clients a better service, but it must be disclosed.

Correct Answer: C
Dawe does not violate any of the Standards. He widely disseminated the recommendation and
provided the information to all his clients prior to discussing it with the firm’s largest clients.
Dawe can provide premium service to some clients provided that he properly distributes the
recommendation to all his clients before discussing it with the select few. Also, annual review
of the IPS is reasonable, however, in the case of Morrison, there was a major change in
income that warrants a more frequent review. Hence, Dawe does not violate any Standard.

Correct Answer: A
James has violated the Standard. This is because James must obtain the consent of her
employer before she accepts such a supplemental benefit. Members and candidates must
obtain permission from their employer before accepting additional compensation or other
benefits. James accepted the benefit, and then informed her employer.

Correct Answer: C
Statement 1 is correct. Although a prohibition on all types of proprietary trading when a firm
comes into possession of material nonpublic information is not appropriate, in risk-arbitrage

trading, the case for a trading prohibition is compelling. In such a case, the potential for
illegal profits is great so the most prudent course for firms is to suspend arbitrage activity
when a security is placed on the watch list.
Statement 2 is correct. Adequate compliance procedures are those designed to meet industry
standards, regulatory requirements, the requirements of the Code and Standards, and the
circumstances of the firm.

Correct Answer: A
Orswitz is required to undertake local trading exams in Trotia and Horsha in order to better
comply with the CFA Institute Standards of Professional Conduct.
Standard I (A) Knowledge of the Law requires members and candidates to “understand and
comply with all the applicable laws, rules, and regulations of any government”, amongst
other institutions, “governing their professional activities”. In the event of a conflict, the most
strict law, rule, or regulation applies.
Based on this standard, the strictest law, amongst U.S., Trotia, and Horsha, is the Trotian law,
which requires undertaking local examinations to trade in local and international markets.
However, at the same time, Orswitz can not violate the trading laws of Horsha, which also
requires traders to undertake the local trading exam. Since Orswitz will be trading solely in
Horsha, he will be need to clear Horsha’s trading exam to be granted the country’s trading
license, in addition to Trotia’s, in order to avoid violating the professional conduct standards.

Correct Answer: B
Holly has not violated any standards of professional conduct whereas Earl has violated the
standard, independence and objectivity.
Standard I (B) Independence and Objectivity requires members and candidates to “use
reasonable care and judgment to achieve and maintain independence and objectivity in their
professional activities”. Research analysts frequently work closely with investment-banking
colleagues to help evaluate prospective investment-banking clients. This is appropriate
provided conflicts are adequately and effectively managed and disclosed. Given the close
relationship between Earl and Holly, which enables them to discuss shared clients, the
independence and/or objectivity of the two employees may have been compromised.
Additionally, by discussing his research with Holly, Earl may have compromised his own and
his sister’s independence and objectivity with respect to dealing with Woodline Inc.
However, Holly has not violated this standard.
Standard II (A) Material Nonpublic Information requires that members and candidates who
“possess material nonpublic information that could affect the value of an investment must not
act or cause others to act on the information”. Speculating on a potential takeover offer
involving Woodline Inc. by a larger floorboards manufacturer does not amount to material
nonpublic information. Thus this standard has not been violated.
Standard III (E) Preservation of Confidentiality requires members and candidates to keep all
information acquired on current, potential, or former clients confidential unless the client
permits disclosure; the information concerns illegal activity on the part of the client; or

disclosure is required by the law. Speculations on a potential takeover offer do not amount to
confidential information. Thus this standard has not been violated.

Correct Answer: B
Holly’s best course of immediate action would be to disclose her relationship with Earl to
OA’s senior compliance officer.
Standard VI (A) Disclosure of conflicts requires members and candidates to disclose any
actual and/or potential conflicts of interest which may hinder their duties to their clients and
their employer and impair their independence and objectivity. Her relationship with Earl may
impair her impartiality when serving clients and thus disclosure to a senior compliance officer
may be the optimal solution.
Although asking for a change in assignment is a potential solution, it may not help resolve the
problem in the event the new assignment pertains to a client which is also covered by Earl.

Correct Answer: A
The trading department’s trading practices are in compliance with the CFA Institute’s
Standards.
Standard II (B) Market Manipulation prohibits members and candidates from ‘engaging in
market participants’. The standard, however, does not prohibit transactions that exploit a
difference in market power, information, or other market inefficiencies. Since OA’s trading
division has a significant presence in Horsha’s derivatives markets, any derivative contracts
entered into on behalf of clients may significantly influence contract prices and allow them to
move to the benefit of the firm. Thus this standard has not been violated.
Given the lack of information on clients’ requirements and/or circumstances, the suitability of
derivatives trades to client portfolios is not relevant in this context.

Correct Answer: C
Red’s first statement, included within his CV, complies with the standards. His second
statement does not comply with the standards. By referring to himself as an employee of R.
Owens, he does not violate any standards. Serving as a full-time paid trainee gives him an
employee status at the brokerage house.
Red’s second statement fails to comply with the standard, VII (B) Reference to CFA Institute,
the CFA Designation, and the CFA Program. The standard requires members and candidates,
amongst other requirements, not to misrepresent the meaning or implications of membership
in CFA Institute, holding the CFA designation, or candidacy of the CFA Program. There is
no violation in stating that he has passed the two levels of the CFA exam program in
consecutive attempts as he has done so. Additionally, there is no violation in stating his
intention to appear for the upcoming Level III examination as he has not cited an expected
completion date and is currently registered for the Level III exam. However by including a
statement pertaining to his educational achievements in the experience section of his CV, Red

has violated this standard. Red should have included this statement in the educational section
of his CV.

Correct Answer: B
Earl has not violated any standard with respect to disclosing the call options purchased to
OA. The independence and objectivity standard has not been violated as the options have not
been granted by Lazline.
The disclosure of conflicts standard requires members and candidates to disclose any actual
and/or potential conflicts of interest which may hinder their duties to their clients and their
employer and impair their independence and objectivity. Earl ought to have disclosed the call
options purchased on Lazline’s stock to his clients. This is because he covers the
pharmaceutical manufacturer and purchasing call options on the manufacturer may impair his
independence and objectivity when preparing a research report. This is a matter which
requires disclosure to clients as well as the employer. Since he has disclosed the purchase to
OA, he has not violated this standard with respect to his employer only. However, by failing
to make appropriate disclosure to clients Earl has violated this standard as opposed to the
communications with clients and prospects standards.
By not sharing the results of his analysis with his employer, Earl has violated the Loyalty
standard. His employer has full rights over the research prepared by any employee and by
denying his employer these rights, he has violated this standard.

Correct Answer: C
not to ‘accept any gifts, benefits, compensation, or consideration that competes with, or might
reasonably, be expected to create a conflict with, their employer’s interest unless they obtain
written consent from all parties involved’.
Ramirez may accept the opera tickets and cash bonus as long as he obtains written consent
from DHFM.

Correct Answer: C
DHFM’s client communications policy is inconsistent with the standards. Standard V (B)
Communications with Clients and Prospects requires members and candidates to use
reasonable judgment to assess what factors are important to their investment analyses,
recommendations or actions and include such factors in their communication with clients and
prospective clients. Additionally, members and candidates should outline the limitations of
their analyses and conclusions contained in their investment analysis.
The assumptions underlying linear and multiple regression models as well as any regression
variables used are important and thus should be disclosed.

Correct Answer: A

Ramirez has violated standard II (A) Material Nonpublic Information. This standard prohibits
members and candidates possessing material nonpublic from acting on the information.
Based on his special relation with the two corn producers, access to information on a
potential unannounced merger between Milanto and Sprout constitutes material nonpublic
information. In the case of risk-arbitrage propriety activity, the most prudent course of action
would be to suspend such activity while a firm possesses material nonpublic information. By
engaging in risk-arbitrage propriety trading based on his access to material nonpublic
information Ramirez has violated this standard.
Standard III (B) Fair Dealing requires members and candidates to deal fairly and objectively
with all their clients when providing investment analysis, making investment
recommendations and taking investment action. Since Ramirez has not taken action on any
client accounts, he has not violated this standard.
Standard VI (B) Priority of Transactions requires members and candidates to place

investment transactions undertaken for clients and their employers ahead of their own
investment transactions. There is no evidence which may indicate that this standard has been
violated.

Correct Answer: A
Cowbell has violated standard I (C) Misrepresentation which prohibits members and
candidates from guaranteeing clients a specific return on an investment. Given that profits
generated on a reverse cash-and-carry arbitrage strategy may contain counterparty risks,
Cowbell has most likely violated this standard.
Standard III (D) Performance Presentation prohibits members and candidates from
misrepresenting past or reasonably expected future performance. This standard has not been
violated.

Correct Answer: A
Standard IV (A) Loyalty requires members and candidates to act for the benefit of their firm
and not deprive the employer of the advantage of their skills and abilities, divulge
confidential information, or otherwise cause harm to their employer.
Cowbell will not violate the loyalty standard if she and the other hedge fund manager form
their hedge fund management firm as they plan to open the firm after leaving their present
employment.
However, contacting clients using client records stored on the employer’s system, without the
employer’s permission, is a violation of the standard. Even though the clients are former,
contacting them using DHFM’s database will constitute a violation of the loyalty standard.
This will hold true even if the managers contact former clients after resigning from their
current positions.

Correct Answer: B

The standards recommend members and candidates consider the following procedures,
amongst others, when devising a written trade allocation policy:
• requiring orders and modifications or cancellations of orders to be in writing and time-

stamped;
• processing and executing orders on a first-in, first-out basis;
• when allocating trades for new issues, obtaining advance indications of interest,
allocating securities by client (rather than portfolio manager) and provide a method for
calculating allocations.

Correct Answer: A
By cheating during his CAIA exam, Watts was in violation of the standard relating to conduct
as members and candidates in the CFA Program. The standard’s function is to hold members
and candidates on a high ethical standard while they are participating in, or involved with, the
CFA Program. The conduct covered includes cheating on the CFA examination or any other
examination.

Correct Answer: B
Watts’ first statement is in compliance with the Code and Standards as he accurately
describes his current candidacy in the Level III examination in an appropriate way.
The second statement is incorrect as Watts has relayed that he is professionally superior to
other candidates due to his current CFA Candidacy status.

Correct Answer: C
Watts and N.M.N Securities did not violate standards relating to fair dealing and suitability as
they communicated the information of a new recommendation to all the relevant clients. They
are allowed to follow up separately with individual clients as long as they do not give favored
clients advanced information when such pre-notification may disadvantage other clients.

Correct Answer: A
The CFA designation should not be given more prominence than the charter holder’s name.
When using the CFA designation, there should be no use of periods.

Correct Answer: A
If an individual is registered for the CFA exam but declines to sit for an exam or otherwise
does not meet the definition of a candidate as described in the CFA Institute bylaws, then that
individual is no longer considered an active candidate. Once that person is enrolled to sit for a
future examination, his or her candidacy resumes.
Addison is no longer an active candidate because she did not appear for the Level I exam.
Therefore, she is correct in stating that she is not a Level I candidate. She may refer to herself
as a Level I candidate when she next enrolls for the Level I exam.



Correct Answer: B
The following procedure will help in the compliance of Standard VI B- Priority of
Transactions:
• Investment personnel involved in investment decision making process should establish

blackout procedures prior to trades with clients so that managers cannot take advantage
of their knowledge of the client activity by ‘front-running’ client trades.

Correct Answer: C
According to the standard relating to Knowledge of Law, if a member has reasonable grounds
to believe that imminent or ongoing client or employee activities are illegal or unethical, the
member or candidate should take appropriate steps which include attempting to stop behavior
by bringing it to the attention of the employer through a supervisor or the compliance
department. The member should also seek legal advice. However, the standard does not
require members and candidates to report violations to the appropriate governmental or
regulatory organizations.

Correct Answer: B
The revised compensation plan is acceptable under the standard related to Conflicts of
Interest, but the company must disclose the plan to its clients.

Correct Answer: A
The CFA Institute standard relating to fair dealing requires that members should not use their
position to disadvantage clients, specifically in the case of IPOs. Since this is a stated policy
of the firm, there is no violation of standard relating to disclosure of conflict of interest.

Correct Answer: A
The following policies improve compliance with the Standards and Codes:
• Members and candidates should maintain a list of all clients and the securities of other
investments each client holds to facilitate notification of clients of a change in investment
recommendation.
• When the full amount of the block order is not executed, partially executed orders will be
allocated amongst the participating client accounts pro rate on the basis of order size.

Correct Answer: A
Members who are involved in personal bankruptcy filing are not automatically assumed to be
in violation of the standards because personal bankruptcy may not reflect on the integrity or
trustworthiness of the person declaring bankruptcy. However, if the bankruptcy involved
fraudulent or deceitful business conduct, it may be a violation of this standard.


Correct Answer: C
Members and candidates should document any violations when disassociating from an
activity that violates the Code and Standards.
When attending meetings at client’s headquarters, members and candidates should pay for
commercial transportation and hotel charges.
Standard I does not cover legal transgressions resulting from acts of civil disobedience in
support of personal beliefs because such conduct does not reflect poorly on the member’s or
candidate’s professional reputation, integrity or competence.

Correct Answer: A
The Standard related to fair dealing states that all clients cannot be treated equally because it
is impossible to reach everyone simultaneously and each client has unique needs and
objectives.

Correct Answer: A
The following reporting requirements are recommended for monitoring and enforcing
procedures established to eliminate conflicts of interest related to personal trading:
• Disclosure of personal holdings.

• Disclosure of beneficial ownerships.
• Preclearance procedures.
• Duplicate confirmation of employee transactions.

Correct Answer: A
Chang’s decision to invest is directly correlated with Park’s statement about the successful
quarter at Jeutte and thus violates Standard II.
Park’s information would be considered material as it would influence the share price of
Jeutte Tech and probably influence the price of the entire exchange-traded fund.
Park shared information that was both material and non-public. Company employees
regularly have such information about their firms, which is not a violation. However, sharing
this information, even in a conversation with friends, constitutes a violation.

Correct Answer: A
Chang did not violate any standards in trying to solicit donations from readers. Option B is
incorrect because the clause in the column does not violate Standard III.


Correct Answer: A
According to Standard V, Carmen needed the permission of her employer to maintain the
files at home after her employment ended. Without permission, she should have deleted the
files upon termination. All files created as a part of professional activity are property of the
firm, even those created outside work hours. The Code and Standards do not prohibit using
one’s personal computer to complete work for one’s employer.

Correct Answer: B
Carmen violated Standard III by not disclosing that she was a part of a team of managers that
achieved the performance shown. if she had also included the return of the portion she
directly managed, she would not have violated the standard.

Correct Answer: C
Members are not required to disclose their responsibilities as CFA charter holders to clients.
They are, however, required to disclose all matters that could be expected to impair their
independence or objectivity. Service as directors and their firm’s market-making activities are
examples of such matters.

Correct Answer: B
Wes’ duty to his former employer prohibits him from violating any applicable non-compete
agreement.

Correct Answer: C
It is not evident that Peterson did not disclose any additional compensation arrangements to
her employer as a result of being a relative to a minority shareholder of Perene. However, he
violated Standard IV by not fully disclosing his position as shareholder of Fossil.
Additionally, he also violated Standard I by not avoiding a situation that could cause or be
perceived to cause a loss of objectivity in making investment recommendations.

Correct Answer: A
The Standards of Professional Conduct require members to consider client interests ahead of
the member and employer interests. As Peterson’s compensation was dependant on a ‘buy’
recommendation, he was not reasonably objective in his analysis.

Correct Answer: C
Compensation received for recommendation of any kinds of product or services represents a
conflict of interest. According to the CFA Institute Standard VI C, Peterson must disclose the
referral fee arrangement.


Correct Answer: A
Peterson’s use of astrology as a research methodology violates the Standard of Diligence and
Reasonable Basis. His research methodology and blog may also reflect poorly on his
employer and cause Perene harm.

Correct Answer: C
All clients should be treated fairly and impartially. The flexible trading terms will allow the
hedge fund manager to enrich himself and Is a violation of Standard II, concerning trading on
material non-public information.

Correct Answer: B
According to the CFA Institute Standard on Responsibilities of Supervisors, members are
supposed to take preventive measures in case of suspected violations. Ward failed in his
supervisory role when he accepted Nelson’s explanation for the unusual trading activity. He
should have reviewed the client’s goals and objectives, and correspondence records, to see if
they have, in fact, requested month end trading. Regardless of the information provided, he
should have investigated further.

Correct Answer: A
Nelson has breached his duty to his family by treating them differently from other clients.
They are entitled to the same treatment as any other client of the firm.

Correct Answer: B
Option B is correct as there is no evidence of unfairly treating clients.

Correct Answer: B
According to Standard VII, Andrew cannot claim to have finished the CFA Program or be
eligible for the CFA charter until he officially learns that he has passed the Level III exam.
Until the results for the most recent exam are released, those who sat for the exam continue to
refer to themselves as candidates.

Correct Answer: C
In revealing that questions related to the analysis of inventories and taxes were on the exam,
Andrew has violated Standard VII, by providing information to other candidates and the
public that is considered confidential to the CFA Program.

Correct Answer: B
Option B is correct as companies which disclose information to the public on a limited basis
create the potential for insider-trading violations.


Correct Answer: A
Information relating to a tender offer is material by nature. As this information is non-public,
Graham cannot trade on this information.

Correct Answer: C
Graham is required to disclose all matters and information that impairs or is reasonably
perceived to impair his independence and objectivity.

Correct Answer: C
Graham did not fulfill the duty he owed to his clients by not treating them fairly according to
the priorities approved by the company.

Correct Answer: A
The Standards require Graham to make reasonable efforts to make sure performance
information is fair, accurate and complete.

Correct Answer: C
Graham should not have initiated providing services to his family before receiving written
consent by his employer. Mere informing is not sufficient.

Reading 6 Fintech in Investment Management FinQuiz.com
FinQuiz.com
Study Session 3
June 2019


FinQuiz Level II 2019 – Item-set: 169439 Solution
Reading 6: Fintech in investment management
1. Question:
Correct Answer: C
C is correct. The analysts are incorrect regarding Development 3. ML still requires human judgment
in understanding underlying data and selecting the appropriate techniques for data analysis.
A is incorrect. The analysts are correct regarding Development 1. The application of fintech to the
investment industry means that a greater number of decisions will be executed through computer
applications or automated trading applications. Automated trading will provide a number of benefits
to investors including lower transaction costs and anonymity.
B is incorrect. The analysts are correct regarding Development 2. In addition to the growing amount
of traditional data, massive amounts of alternative data from non-traditional sources such as the social
media can now be integrated into the portfolio manager’s investment decision-making process.
2. Question:
Correct Answer: C
C is correct. Cole’s understanding of ML models is inadequate. ML models require massive amounts

of data for training and insufficient data have historically limited broader application of such models.
B is incorrect. Before data can be used in an ML model, they must be clean and free from bias and
spurious data.
3. Question:
Correct Answer: B
B is correct. Models which overfit the data may discover false relationships that will lead to
prediction errors and incorrect output forecasts.
A is incorrect. Models which underfit the data, the ML model treats true parameters as if they are
noise and is not able to recognize relationships in the training data. In such cases, the resulting model
may be too simplistic.
C is incorrect. See above.

4. Question:
Correct Answer: C
C is correct. Davis is correct regarding Reason 3. Most robo-advisers follow a passive investment
approach implementing their investment recommendations with low cost, diversified index mutual
funds or exchange-traded funds. Because of their low-cost structure, robo-advisors are able to reach
the undeserved members of the population which otherwise may be unable to afford a traditional
financial advisor.
A is incorrect. Davis is incorrect regarding Reason 1. Although regulations may vary, robo-advisors
are likely to be held to a similar level of scrutiny and code of conduct as other investment
professionals in a given region.
B is incorrect. Davis is incorrect regarding Reason 2. Although they can cover both passive and active
investment approaches, most robo-advisors follow a passive investment approach. This investment
approach has a zero alpha.
5. Question:
Correct Answer: B
B is correct. Algorithmic trading breaks a large order into smaller pieces and executes these orders
across different exchanges and trading venues. By doing so, algorithmic trading lowers the market
impact (and trading costs) of an extremely large order making it highly desirable for institutional
investors who place large orders.
A is incorrect. Algorithmic trading does not yield greater transparency for the trader.
C is incorrect. Algorithmic trading does not seek to eliminate market mispricing for investors.
6. Question:
Correct Answer: A
A is correct. An application of DLT to investment management is tokenization. DLT streamlines the

process of representing ownership to physical assets by creating a single, digital record of ownership
with which to verify ownership title and authenticity, including all historical activity.

Reading 7 Correlation and Regression FinQuiz.com
FinQuiz.com
Study Session 3
June 2019


Reading 7: Correlation and Regression

Correct Answer: B
Statement 1 is incorrect. A correlation coefficient of zero indicates that there is absolutely no
linear relation between the two variables. Variables with a correlation of 0 can have a strong
non-linear relationship. If there is no linear relationship, the value of one variable tells us
nothing about the value of the other variable.
Statement 2 is correct. Correlation coefficients can be computed validly if the means and
variances of the two variables, and the covariance between them, are finite and constant.
When these assumptions are not true, correlations between two different variables can depend
greatly on the sample that is used.

Correct Answer: B
Correlation that is induced by a calculation that mixes each of the two variables under
consideration with a third is termed as a spurious correlation, since it does not measure the
direct relationship between the variables. Spurious correlations can suggest results that may
not be true.

Correct Answer: A
Exhibit 1 shows that the correlation between large-cap and small-cap stocks is positive but
very low (0.13) which means the two indices represent distinct styles of investing. However,
the correlation of the micro-cap index with the large-cap index (and the small-cap index) is
very high (almost 1.0), which shows that there is very little difference between the two return
series, and therefore, we may not be able to justify distinguishing between large-cap value
and micro-cap value, or small-cap value and micro-cap value, as distinct investment styles.
Therefore, Option A is most appropriate as it also provides the most opportunity of
diversification.

Correct Answer: B
The t-statistic equals:
−0.642√10 − 2
= −2.368
1 − (−0.642)ଶ
Since the t-value is not less than –2.7854, the correlation coefficient is not statistically
significant (we cannot reject the null hypothesis).


Correct Answer: C
The slope coefficient equals:
0.000865
ଵ = = 1.248
0.000693
Since in a linear regression, the regression line fits through the point corresponding to the
means of the dependent and independent variables, solving for the intercept using this point,
we have:
଴ = 0.1156 − 1.248(0.0785) = 0.0176

Correct Answer: A

ଶ =

0.2187
= = 0.6547
0.2187 + 0.1153
The F-statistic equals:

0.2187
1 = 157.434
0.1153
(85 − 2)

Correct Answer: C
Kitsis is incorrect with respect to Statement 1. If the correlation is positive one (perfect
positive correlation), all the points on the scatter plot lie on a straight line with a positive
slope. However, the slope depends on the relationship between the two variables; it could be
that when one variable increases by one unit the other increases by half a unit (with an
increase in one unit in one variable associated with exactly the same half-unit increase in the
other variable). The slope of the line can be different (but positive), but as long as the points
lie on a straight line the correlation between them will be 1.
Statement 2 is incorrect. Sample correlation can be an unreliable measure when outliers are
present. However, removing the outliers is not always the right thing to do, if the outliers
provide important information about the variables during the period under analysis. One must
use judgment to determine whether the outliers contain information about the variables’
relationship (should be included in the analysis) or contain no information (and should be
excluded).

Correct Answer: A
Even though the correlation between NI and FCFF for the restaurant chain is much higher
than the correlation for the sports-wear manufacturer, however, only the correlation
coefficient for the sports-wear manufacturer is significant. This is most likely because the
sample size used for the analysis of the sports-wear manufacturer is much larger than the
sample size used for the restaurant chain. The larger the sample, the smaller the evidence in
terms of the magnitude of the sample correlation needed to reject the null hypothesis of zero
correlation. Recall that the t-statistic equals r√(n-2)/√1-r2. This shows that as n increases, the

t-statistic increases, so that even for a small value of r, the null hypothesis can be rejected. A
null hypothesis is more likely to be rejected as we increase the sample size, all else equal.

Correct Answer: C
Assumptions 1 and 4 are incorrect. The relationship between the dependent variable and the
independent variable should be linear in the parameters b0 and b1. This requirement does not
exclude the independent or dependent variable from being raised to a power other than one.
Assumption 4 is not an assumption of linear regression.

Correct Answer: A
If Tannis uses a lower level of significance, which is the same as using a higher level of
confidence, the critical t-value will increase. This choice leads to wider confidence intervals
and to a decreased likelihood of rejecting the null hypothesis. Decreasing the level of
significance from 0.05 to 0.01 decreases the probability of the Type 1 error, but it increases
the probability of the Type 2 error (failing to reject the null hypothesis when, in fact, it is
false).

Correct Answer: A
Bergren is correct. If the standard error is reduced to half of its current value, the confidence
interval will be half as large and the t-statistic twice as large (with a small standard error, the
t-value increases). When this happens, the probability of rejecting the null hypothesis
increases.

Correct Answer: A
If forecasts are unbiased, the value of b0 should be 0 and the value of b1 should be 1. At a
0.05 significance level, with 72-2 = 70 degrees of freedom, the critical t-value is 1.994. Given
the information in Exhibit 2, the 95% confidence interval for b0 is:
0.0239 ± 1.994(0.4531)
–0.8796 to 0.9274
The value of 0 falls within this interval so we cannot reject the null hypothesis that b0 = 0.
The 95% confidence interval for b1 is as follows:

0.9248 ± 1.994(0.0948)
0.7358 to 1.1138
The value of 1 falls within this confidence interval, so we cannot reject the null hypothesis
that b1=1 at the 0.05 significance level. Because we cannot reject either of the null
hypotheses, we cannot reject the hypothesis that the forecasts are unbiased (which means they
are unbiased).


Correct Answer: A
The type of data used by the research team at West Newman for conducting their regression
analysis is cross-sectional data. This is because the analysts are comparing the effects of
earnings announcements on price changes across corporations.
If they had used earnings announcements for a single corporation and compared the effects of
announcements on that corporation’s share price change across time, the research team would
have been using time series data.
Factor models are not relevant here.

Correct Answer: A
The first assumption is consistent with the underlying assumptions. Linear regression
assumes that the relationship between the dependent variable and independent variable is
linear in the parameters, b0 and b1. This requires the latter two parameters to be raised to the
first power only. This requirement does not exclude, the independent variable (in this case E),
from being raised to a power other than 1.
The second assumption, outlined by the two senior analysts, is inconsistent with the
assumptions normally underlying linear regression. Linear regression assumes that the
expected value of the error term is 0 and not 1.
The third assumption is inconsistent with the underlying assumptions. Linear regression
assumes that the error term is normally distributed. Although linear regression may be
modified and still be used in the event error term is not normally distributed, the analysts’
assumptions are inconsistent with the assumptions underlying linear regression.

Correct Answer: B
In order to determine the confidence interval, the following steps need to be followed:
1. Make the prediction:

Using the regression model, an EPS of $2.50 indicates change in per share value of
$39.056.
P1 – P0 = 1.2458 + 15.1242($2.50) = $39.0563
2. Compute the variance of the prediction error:
The variance is calculated using the following formula:
s 2
 1
= s 1 + +
2 (X −X 
2
)
 n (n − 1)s x 
f 2
 1 (2.50 − 1.6344 ) 
2
= 0.7542 1 +
2
+ 
 62 (62 − 1)0.4248 
= 0.59444

The standard deviation of the forecast error is sf = (0.59444)0.5 = 0.7710
3. Determine the critical value of the t-statistic.

Given a 95% confidence interval and 62 – 2 = 60 degrees of freedom, the critical value of
the t-statistic, tc, 2.00.
4. Compute the value of the t-statistic.

The 95% confidence interval for P1 – P0 extends from 39.0563 – 2.00(0.7710) to 39.0563
+ 2.00(0.7710), or 37.51430 to 40.59830.

Correct Answer: B
The hypothesized value of the slope coefficient does not fall within the confidence interval.
Therefore the null hypothesis that the slope coefficient is 3.50 is rejected. Since the null
hypothesis is rejected, this indicates the slope coefficient will not contribute in producing an
unbiased estimate of price change.
In order to test whether the regression model is able to produce unbiased forecasts, in terms
of the slope coefficient only, a confidence interval needs to be constructed for the slope
coefficient. Based on the hypothesized value of b1, 3.50, the confidence interval is
constructed as follows:
bˆ1 ± t c sbˆ
1
15.1242 ± 2.00*(2.6556)
9.81300 to 20.43540
*The degrees of freedom are 62 – 2 = 60. Using a 95% confidence interval, the t-statistic is
2.00.

Correct Answer: A
The most appropriate response question 1 is a no and to question 2 is a Type I error.
The magnitude of r, the correlation coefficient, needed to reject the null hypothesis decreases
as sample size n decreases, for two reasons: 1) due to the degrees of freedom and the absolute
value of the critical tc value decreasing and 2) due to the absolute value of the numerator
increasing with larger n, resulting in larger magnitude t-values.
Selecting a 90% confidence interval, as opposed to 95%, will decrease the width of the
confidence interval and increase the likelihood of rejecting the null hypothesis when it is true,
i.e. increases the probability of a Type I error.
The tc value increases with higher levels of confidence. This will lead to a wider confidence
interval and a decreased likelihood of rejecting the null hypothesis. The converse can be said
to be true for lower levels of confidence, which will lead to narrower confidence intervals and
an increased chance of rejecting the null hypothesis.


Correct Answer: A
Limitation 1 fails to correspond with the limitations generally underlying linear regression. A
limitation of regression analysis is that public knowledge of the regression relationships may
negate their future usefulness. Public knowledge of stocks categorized as ‘High’, i.e. with
strong price reactions, may lead to analysts acting upon the relationship and bidding the price
of the stock up, rather than down. Thus stocks in this category may exhibit substantial price
increases. This may decrease the usefulness of the model to predict future price changes. The
standard estimate of the model may increase as the regression model produces inaccurate
forecasts of price changes.
Limitation 2 accurately captures a limitation of linear regression. Parameter instability can be

a particular problem when comparing the price changes of stocks across the three different
categories, in a cross-sectional context, as the characteristics of each category will certainly
differ.
Limitation 3 accurately captures a limitation of linear regression. If any of the regression

assumptions are violated, hypothesis tests and predictions based on linear regression will not
be valid.

Correct Answer: B
The regression model tries to explain the dependent variable through the use of the
independent variable.

Correct Answer: A
The coefficient of determination measures the fraction of the total variation in the dependent
variable that is caused by the independent variable.

Correct Answer: B
The critical value at 80% significance level with 10 degrees of freedom is 1.372.

Correct Answer: B
R2 = (Multiple R)2
= 0.40692 = 0.1656

Correct Answer: B
s2f = 0.002391×[1+(1/12) + {(0.0518 – 0.0412)2 / (11 × 0.0846)}]
= 0.002391×[1 + 0.0833 + (0.00011236/0.9306)]
= 0.002391×[1 + 0.0833 + 0.00012074]
= 0.002391×(1.08342)
= 0.0026


Correct Answer: C
Sf = 0.00261/2 = 0.0510
Predicted value of interest rate +/- tcsf = 0.02546 +/– (1.372 × 0.0510)
= 0.02546 +/– (0.0700)
= –0.0445 to 0.0954

Correct Answer: A
Regression residual is the difference between the actual and the predicted values of the
dependent variable.
Standard error of estimate measures the degree of variability between the actual and the
predicted values of the dependent variable.

Correct Answer: A
The covariance factor cannot tell the magnitude of the relation between two variables. It can
only point out the direction of the relationship.

Correct Answer: B
It is not possible to measure slope of a scatter graph with zero correlation as there is no linear
relation between the observations.

Correct Answer: A
The standard error of a correlation coefficient is used to determine the confidence intervals
around a true correlation of zero. If your correlation coefficient falls outside of this range,
then it is significantly different than zero.

Correct Answer: C
SSE = 0.00872 = 0.000076
SEE = [SSE/ (n-k-1)]1/2
= [0.000076/ 43]½
= 0.001329

Correct Answer: A
SST = 0.00922 = 0.000085
RSS = SST – SSE
= 0.000085 – 0.000076
= 0.000009


Correct Answer: C
Uncertainty in error term and uncertainty in the estimated parameters are the two sources of
uncertainty while carrying out regression analysis.

Correct Answer: A
Parameter instability states that the regression relations like correlations can change over
time. Regardless of whether the analyst is carrying out cross- section regression or time-series
regression, collecting samples from more than one population would increase parameter
instability.

Correct Answer: A
ANOVA is the procedure through which total variability is divided into components that are
matched to their respective sources. This analysis of variance is carried out through the F-test,
which is used to test whether all the slope coefficients are equal to zero.

Correct Answer: A
Confidence Range = B1+/– tc (sb1)
= 0.8 +/– 1.734 (0.48)
= –0.03 to 1.63

Correct Answer: B
Since the null hypothesis lies within the critical range, Brick would fail to reject the null
hypothesis.

Correct Answer: A
t = (B1 – b1)/sb1
= (0.8 – 1.2)/ 0.48
= –0.833

Correct Answer: B
Acceptance of the null hypothesis is a binary decision. It will lead to an imminent rejection of
the alternative hypothesis.

Correct Answer: A
We cannot assume the independent variable is caused by the dependent variable, simply
because of the existence of correlation. A third variable could be the reason for the change in
both of the previous variables.


Correct Answer: A
Outliers are small numbers of observations at either extreme of a sample. Analysts need to
use judgment to determine whether the outliers contain information pertaining to the
relationship between the two variables or not.

Correct Answer: B
A Type II error = failure to reject the null hypothesis although it is wrong.
A decrease in the sample size will lead to an increase in the magnitude of the correlation
coefficient needed to reject the null hypothesis. This will also lead to an increase in the
critical value of the t-statistic, because of which the t-statistic will most likely fall within the
critical range.

Correct Answer: C
R2 = (Total Variation – Unexplained Variation)/Total Variation
R2 = (0.004348 – 0.000532)/ 0.004348 = 0.877645

Correct Answer: C
SEE = [SSE/ (n – k – 1)]1/2
SEE = [0.000532/ (40 – 1 – 1)]½
SEE = 0.003742 = 0.37%
or use
SEE = MSE1/2
SEE = 0.0000141/2
SEE = 0.003742

Correct Answer: A
Since the data uses many observations from across time periods for the same company, it can
be classified as time-series data.
The expected value of the error term is assumed to be zero in the linear regression model.

Correct Answer: B
t = r √(n-2)/ (1-r2)
t = 0.154 √123/ √(1-0.1542) = 1.708/0.988 = 1.729
The calculated t-statistic is 1.729. Since this value falls outside the critical range, Cooper can
reject the null hypothesis and conclude that the relation between Revco and the automotive
index is statistically significant.


Correct Answer: C
SEE = √MSE = √0.0064 = 0.08

Correct Answer: B
The calculated t-statistics for the intercept and the slope coefficients are
–9.269 and 3.576 respectively. Since both these value fall outside the critical range, Cooper
can reject the null hypothesis and conclude that the relation between Revco and the
automotive index is statistically significant.
Intercept t-statistic = –0.0482/0.0052 = –9.269

Slope Coefficient t-statistic = 0.5893/ 0.1648 = 3.576

Correct Answer: B
Individual independent variables and their respective residuals are assumed to be
uncorrelated.

Correct Answer: A
Linear regression is also known as linear least squares since the selected values of the
intercept and the slope coefficient minimize the sum of squared vertical distances between the
observations and the regression line.

Correct Answer: A
The error of regression coefficient is the standard error of the slope.

Correct Answer: A
A higher level of significance will lead to a narrower confidence interval. In this case,
probability of rejecting the null hypothesis increases. Thus, the probability of Type I error
increases.

Correct Answer: A
A lower level of significance results in a higher critical value of the
t-statistic. This would decrease the probability of rejecting the null hypothesis. Thus, the
probability of Type I error would decrease.

Correct Answer: C
The p-value is the smallest level of significance at which the null hypothesis can be rejected.
When p<significance level, H0 can be rejected. If p>significance level, H0 cannot be rejected.


Correct Answer: B
The sum of squared regression residuals is the accumulated square of the difference between
the actual values of the dependent variable and the predicted value of the dependent variable.
The estimated parameters help in reducing this difference.

Correct Answer: B
Mean Square Error = Sum of Squared Errors/(n-2)
MSE = 125000/ (76) = 1645

Correct Answer: A
The correlation coefficient measures both the direction and the magnitude of a linear
relationship.

Correct Answer: A
The significance level of the correlation coefficient needs to be tested regardless of its value.
The t-test used to check the significance of the coefficient requires the number of
observations recorded.

Correct Answer: C
Correlation = Covariance/ (Std Devx × Std Devy)
= 79.37/ {(50)1/2 (350)1/2}
= 0.600

Correct Answer: A
t = r (n – 2)1/2/ (1 – r2)1/2 = 0.6 √(43)/ √(1 – 0.36)
= 3.934/0.8 = 4.918

Correct Answer: A
The critical value of the t-statistic is 1.302 with 43 degrees of freedom and a p-value of 0.10.
Since the t-statistic falls out of the critical rang, Crater can reject the null hypothesis.

Correct Answer: C
Option C indicates a reliable correlation between two variables. However, Option A is
spurious as the two variables indicated can only have a viable correlation through dividing
them by another variable i.e. the number of shares. Option B is also spurious, as many other
factors affect a manager’s performance other than their gender.

Reading 8 Multiple Regression and Issues in Regression Analysis FinQuiz.com
FinQuiz.com
Study Session 3
June 2019


Reading 8: Multiple Regression and Issues in Regression Analysis

Correct Answer: C
Statement 1 is incorrect. If the natural log of the change in inflation rate increases from 5% to 6% in a
specific period, we can expect the stock returns to increase by 0.0986% in that period compared to the
previous period, only if all other independent variables are held constant. It is quite likely that if the
inflation rate changes, the interest rate and GDP growth rate will also change relative to the previous
period, which will affect the dependent variable.
Statement 2 is incorrect. If the changes in the inflation rate, GDP growth rate and interest rate are 2%,
1.5% and 3% respectively, the change in the stock market returns will be of:
Change in stock market returns = 1.567 + 0.0986[ln(change in inflation rate] + 0.7790[ln(change in

GDP growth rate)] –0.2364(change in interest rate)
= 1.567 + .0986(0.6931) + 0.7790(0.405465) –0.2364(3)
= 1.242%

Correct Answer: B
t-statistic = 1.567–0/0.1798 = 8.715
F-statistic = [1109.67/3]/[1011.09/(590–4)] = 214.378

Correct Answer: A
Hofmann is correct. The F-test is more useful in case of multiple regressions. In case of regressions
with a single independent variable, the F-test provides the same information as the t-test (since there
is only one variable). However, in a multiple regression, the F-test provides useful information on the
regression’s overall significance. R2 is more appropriate when there is only one independent variable
because it provides an accurate measure of goodness of fit. In case of multiple regressions, the
adjusted R2 provides a much more reliable measure of the explanatory power of the regression (it
does not automatically increase with an increase in the number of independent variables).
Parks is incorrect. Testing individual coefficients using t-tests and testing them together using an F-
test can yield different results. We can reject the hypothesis that all the slope coefficients equal 0 even
though none of the t-statistics for the individual coefficients is significant. Conversely, the estimated
coefficients can be significantly different from 0 when jointly they are not.


Correct Answer: A
Statement 3 is correct. The larger the value of the F-statistic, the more likely it is that there will be a
miniscule probability of incorrectly rejecting the null hypothesis, a mistake known as the Type 1
error. This is because the larger the F-statistic, the more likely it is that it will be statistically
significant.
Hofmann is correct with regards to heteroskedasticity. Heteroskedasticity does not affect the
consistency of the regression parameter estimates. A parameter is consistent if the probability that
estimates of a regression parameter differ from the true value of the parameter decreases as the
number of observations used in the regression increases. The regression parameter estimates from
ordinary least squares are consistent regardless of whether the errors are heteroskedastic or
homoskedastic.

Correct Answer: B
Since the predicted value of portfolio returns from the regression model has the average value of
portfolio returns (the dependent variable), this means that the regression variables do not explain the
dependent variable at all. This means that the regression sum of squares (explained variation) is 0 and
therefore, the coefficient of determination is also 0. The F-statistic will also be 0, but the t-statistics
can still show statistical significance (especially if there is multicollinearity).

Correct Answer: C
Positive serial correlation is serial correlation in which a positive error for one observation increases
the chance of a positive error for another observation. It also means that a negative error for one
observation increases the chance of a negative error for another observation. Positive serial
correlation affects the ability to conduct valid statistical tests. First, the F-statistic may be inflated
because the MSE will tend to underestimate the population error variance. Second, positive serial
correlation causes the standard errors to underestimate the true standard errors. As a result, if positive
serial correlation is present, standard linear regression analysis will typically lead us to compute
artificially small standard errors for the regression coefficient, which will cause the estimated t-
statistics to be inflated, which may, in turn, lead us to incorrectly reject the null hypotheses (type 1
errors). Conditional heteroskedasticity can lead to both type 1 and type 2 errors, whereas
multicollinearity most likely leads to type 2 errors.

Correct Answer: B
The critical t-value value using the information in Exhibit 3, at the 5% significance level is 2.021.
Given the computed t-statistics in Exhibit 1, Stowe can conclude that a pharmaceutical firm’s:
• reputation affects its cost of capital as 15.76 (t-statistic in absolute terms) > 2.021;
• earnings quality affects its cost of capital as 15.71 (in absolute terms) > 2.021; and
• market capitalization affects its cost of capital as 87.9 (in absolute terms) > 2.021.


Correct Answer: C
The addition of an independent variable will increase R2, possibly even to a value of 0.45, if the new
independent variable contributes to explaining any of the unexplained variation in the regression
model.

Correct Answer: B
Using the information in Exhibit 1, the F-statistic is 1.459.
The degrees of freedom in the numerator are 3 (k).
The degrees of freedom in the denominator are 36 [40 – (3 + 1)].
The formula for the F-statistic is:
RSS
k MSR 1, 465 3
F= = = =1.45892
SSE MSE 12, 050 36
n − ( k +1)

Correct Answer: C
Stowe is incorrect with respect to comment 1. Since the DW test for Stowe’s OLS regression is 1.32
and r (the sample correlation between regression residuals from one period to the next) is +0.34 [1 –
(1.32/2)], this raises questions of positive serial correlation. Because the DW test of 1.32 is lower than
the dl value of 1.34, Stowe should reject the null hypothesis of no serial correlation and conclude that
the OLS regression has positive serial correlation.
Stowe is incorrect with respect to her second comment. It is possible to correct conditional
heteroskedasticity by computing robust standard errors or using the generalized least squares method.
Unconditional heteroskedasticity causes no major problems for statistical interference.

Correct Answer: A
In order to compare ܴത ଶ under both models, it is necessary that the dependent variable be defined in an
identical manner in both models and that the sample sizes used to estimate the models are the same.
Even though the regression equation used for Canadian pharmaceutical industry stocks has the same
and type of number of independent variables and sample size and period, the fact that the dependent
variable used in the modified version of the regression model is not identical, COCap(x + 1) , to the
dependent variable used in the original model, COCap, ܴത ଶwill be different. Thus the two models are
not comparable.


Correct Answer: C
Stowe is correct with respect to effect 1. When errors are heteroskedastic, the F-test for the overall
significance of the regression is unreliable. This unreliability occurs because the mean squared error
is a biased estimator of the true population variance.
Stowe is correct with respect to effect 2. Multicollinearity will inflate OLS standard errors for the
regression coefficients. With inflated standard errors, t-tests on the coefficients have little power
(ability to reject the null hypothesis). This increases the occurrence of Type II errors, a failure to
reject the null hypothesis when it is false.

Correct Answer: C
Statements 1 and 2 are incorrect. This is because the p-value of 0.1511 for the F-test means that the
smallest level of significance at which we can reject the null hypothesis is roughly 0.15. Even though
two of the coefficients are significant, the other coefficients may be insignificant implying that we
cannot reject the null hypothesis that returns are equal across quarters at a 5% level of significance.
The significance of the two coefficients may be the result of random variation. Hence, portfolio
strategies based on differing weights of technology stocks in different quarters will most likely not be
profitable.

Correct Answer: B
Since there is only one independent variable, the critical value of the test statistic for a variable from a
x2 distribution with one degree of freedom at the 0.05 level of significance is 3.841. The test statistic
equals nR2= 120(0.174) = 20.88. Hence, we can reject the hypothesis of no conditional
heteroskedasticity at the 0.05 level. This means that the standard errors are not correct and therefore,
the t-tests are not valid.

Correct Answer: A
To determine whether the errors are serially correlated, we have to calculate the Durbin Watson
statistic. For a large sample, it is approximately equal to 2(1-r). In this case it is 2(1-0.650) = 0.70. To
test for significance we see that the critical dl value for 120 observations and one independent variable
is greater than 1.65 (this is the value for n=100 and k=1, so the value for n=120 will be even higher).
Since the DW statistic is far below the dl value, we can reject the null hypothesis of no correlation in
favor of the alternative hypothesis of positive serial correlation.

Correct Answer: C
Statement 3 is incorrect. After correcting for serial correlation using the Hansen method, the
regression coefficients and the Durbin-Watson statistic remain unchanged. Only the standard errors
are changed (these are called robust standard errors).
Statement 4 is incorrect. Multicollinearity occurs when two or more independent variables are highly,
but not perfectly, correlated with each other. The case where one independent variable is an exact
linear combination of other independent variables is known as perfect collinearity.


Correct Answer: B
The classic symptom of multicollinearity is a high R2, a significant F-statistic, even though the t-
statistics on the estimated slop coefficients are not significant. The insignificant t-statistics reflect
inflated standard errors.

Correct Answer: B
The predicted value equals: 15.986 – 1.893(5) = 6.521%. The standard deviation of the forecast error
is: √0.4301 = 0.65582
Given 12–2 = 10 degrees of freedom and a 95% confidence interval, the critical value of the t-statistic
is 2.228. The 95% confidence interval is 6.521 ± 2.228(0.65582)
= 5.0598% – 7.982%

Correct Answer: A
When relevant variables are omitted from the regression, both the parameter coefficients and the
standard errors are biased and inconsistent.

Correct Answer: A
Conditional heteroskedasticity exists when the error variance increases as the value of the
independent variables increases. When conditional heteroskedasticity exists in the original regression,
the independent variables explain a significant portion of the squared residuals’ variance.

Correct Answer: A
Computing robust standard errors corrects the standard errors of the estimated coefficients of the
model, effectively decreasing or eliminating conditional heteroskedasticity.

Correct Answer: A
In the presence of conditional heteroskedasticity, the F-test to judge the overall significance is
unreliable. T-tests for the significance of the individual regression coefficients are also unreliable as
the heteroskedasticity introduces bias into the estimators of the standard errors of the regression
coefficients.

Correct Answer: B
t-statistic = n × R2 residuals = 275 × 0.828% = 2.277

Correct Answer: A
The calculated t-statistic is 2.277. Since this value falls inside the critical range of 3.841, Miller
would fail to reject the null hypothesis and conclude that no conditional heteroskedasticity exists in
the regression.


Correct Answer: A
When the independent variables do not explain any variation in the dependant variable, the predicted
value of the dependant variable is its mean.

Correct Answer: A
Adj R2 = 1 – [(n – 1)/ (n – k – 1)] (1 – R2)
Adj R2 = 1 – [(25 – 1)/ (25 – 3 – 1)] (1 – 0.64)
Adj R2 = 1 – (1.142857) (0.36)
Adj R2 = 1 – 0.41 = 0.59

Correct Answer: C
The number of slope coefficients used in a regression equation is equal to the number of independent
variables included in the regression.
The number of regression coefficients is equal to the number of independent variables plus one.

Correct Answer: B
One of the assumptions of regression analysis is that the error scatter plot is normally distributed.

Correct Answer: B
A random independent term with no correlation with the error term will result in a reliable forecast.

Correct Answer: A
The exclusion of an independent variable decreases R-squared, as the omission will generally lead to
a reduced amount of explained variation.

Correct Answer: B
Positive Serial Correlation Negative Serial Correlation

Standard Errors Underestimated Overestimated
T-Statistics Inflated Understated
F- Statistics Inflated Understated
Type I error Increases Decreases
Type II error Decreases Increases


Correct Answer: B
When heteroskedasticity results in underestimated standard errors,
t-statistic values are inflated and the probability of Type I error increases.

Correct Answer: A
Unconditional heteroskedasticity occurs when the error variance does not systematically increase or
decrease with changes in the value of the independent variable.

Correct Answer: A
d = 2(1 – r) = 2(0.2) = 0.4

Correct Answer: A
The Hansen’s method applies the technique of using robust standard errors to account for serial
correlation.

Correct Answer: C
A typical symptom of multicollinearity is a high R-squared value and a significant F-statistic figure,
even though the t-statistics of the slope coefficients are insignificant.

Correct Answer: A
The collection of 300 observations would not be economical in terms of time and cost, as it is
yielding only a slightly higher R-squared. Thus, the extended model would be non-parsimonious.

Correct Answer: B
When an irrelevant independent variable is included, standard errors are overestimated.

Correct Answer: B
The hyperinflationary time period represents a separate pool of data that should not be merged with
the normal time series data used for the regression.

Correct Answer: A
Discrimant analysis creates an overall score on the basis of a linear function, and this score is used to
classify observations into binary or dual categories.


Correct Answer: B
Qualitative dependant variables are dummy variables used as dependant variables instead of
independent variables.

Correct Answer: B
The probit model is based on the normal distribution.
The logit model is based on the logistic distribution.
Discrimant analysis is computed through a method similar to the regression equation.

Correct Answer: A
Heteroskedasticity results in an incorrect estimate of the error term of the slope coefficient.

Correct Answer: A
When the independent variable does not explain any variation in the dependant variable, the F-
statistic has a value of zero. This is because the F-statistic divides total variance into explainable
components. When the variation itself is unexplainable, its F-statistic can only give a value of zero to
the components.

Correct Answer: A
The only instance, in which serial correlation affects the consistent of the parameter coefficients, is
when a lagged value of the dependant variable is used as an independent variable. This carries
forward the serial correlation to the next parameter coefficient.

Correct Answer: A
Adj R2 = 1 – [(n – 1)/ (n – k – 1)] × (1 – R2)
= 1 – [(19/17)] × (1 – 0.4747)
= 1 – (1.118) × (0.5253)
= 1 – 0.5873
= 0.4127

Correct Answer: B
Adjusted R-squared decreases when the new variable added does not have a significant increase in
explanatory power. This is because the factor [(n – 1)/ (n – k – 1)] would decrease with an increase in
n.


Correct Answer: B
F-statistic attempts to explain the variation in the dependent variable. With an increase in explanatory
power, the F-statistic figure would most likely increase. An increase in explanatory power, would also
lead to an increase n the adjusted R-squared.

Reading 9 Times-Series Analysis FinQuiz.com
FinQuiz.com
Study Session 3
June 2019


Reading 9: Times-Series Analysis

Correct Answer: A
The first lag of a time series exhibits the autocorrelation of the time series with the previous period. It
is the value of the time series in the previous period.

Correct Answer: B
Whenever we refer to autocorrelation without qualification, we mean autocorrelation between the
time-series itself rather than the autocorrelation of the error term or residuals.

Correct Answer: A
t-statistic = autocorrelation/standard error

Correct Answer: C
Standard Error = 1/ (52)1/2 = 0.1387

Correct Answer: B
Since the t-statistics of the individual lags are economically insignificant, Brien will conclude that the
error term is not serially correlated.

Correct Answer: A
Growth Rate = 0.0641 + 0.6954 (0.052) + 0
= 10.0261%

Correct Answer: C
The two conditions for accurately carrying out the OLS method are:
• the time-series has to be covariance stationary.

• the errors need to be uncorrelated.

Correct Answer: B
Past stationarity does not guarantee future stationarity because the state of the world is dynamic and
ever-changing.


Correct Answer: A
A time-series with seasonality has a non-constant mean and is covariance non-stationary.

Correct Answer: A
Time-series observations have a logical ordering. Thus, they need to be processed in chronological
order of the time periods involved.

Correct Answer: B
The consequences of a time-series being covariance non-stationary are:
• the t-statistics will not follow a t-distribution.

• the estimate of the trend coefficient will be biased and any hypothesis will be invalid

Correct Answer: A
Serial correlation in a regression with distinct dependent and independent parameters, only affects the
estimates of the error term and not the parameter coefficients.

Correct Answer: B
Mean Reverting Level = b0/ (1 – b1) = 5,210/ (1 – 0.5380) = 11,277

Correct Answer: B
The regressive model with the smallest RMSE based on out-of-sample data is the most accurate. In-
sample data forecasts will not be relevant as the best forecast model chosen will be able to
accommodate unexpected events in its regression.

Correct Answer: A
The covariance of a variable with itself is its own variance. That is why the third assumption of
covariance stationary time-series is inherently inbuilt into the second assumption.

Correct Answer: A
A time series accurately explained by the linear or log linear models is generally covariance non-
stationary as such data observations do not have a mean reverting scale.

Correct Answer: C
To accurately evaluate the uncertainty of a forecast, uncertainty related to both the error term and the
estimated parameters needs to be considered.


Correct Answer: A
The serial correlations between residuals in an autoregressive model can be reduced through adding
lags of the dependent variable as explanatory variables.

Correct Answer: A
Statement 1 is correct. The current model is a log linear trend model. Such a model predicts a
constant growth rate in the dependent variable (in this case, annual sales) equal to eb1 – 1. In this case
b1 = 0.0965. Therefore, the predicted annual growth rate of sales in each period is e0.0965 – 1 =
10.13%. In contrast, a linear trend model predicts that the dependent variable grows by a constant
amount from one period to the next. Since the trend coefficient is 1154.78, the model predicts that
sales would grow by $1154.78 from one year to the next.
Statement 2 is incorrect. Since the model uses the recent 20-year data, the value of sales next year
will be the 21st observation. The predicted value equals:
Ln y21 = 6.789 + 0.0965(21)

Y21 = 6737.87586 million.

Correct Answer: A
Statement 3 is correct. Serial correlation in the error term is much more critical in terms of its
consequences in the case of autoregressive models (like the one Blessing has estimated) than for other
models, such as cross-sectional. In AR time-series regressions, serial correlation in the error term
causes estimates of the intercept and slope coefficient to be inconsistent. Also, if the profit margin is
more volatile in some periods, this means that the variance of the time-series will not be constant, and
so the time-series will not be covariance stationary.
The standard error equals: 1/√T = 1/√59 = 0.1302
At a 0.05 level of significance and 59-2= 57 degrees of freedom, the critical t-value is about 2.
Following is a calculation of the t-statistic for each of the autocorrelations.
Lag Autocorrelation Standard error t-statistic

1 0.0986 0.1302 0.7574
2 0.0438 0.1302 0.3364
3 –0.1743 0.1302 –1.3388
4 –0.2319 0.1302 –1.7813
None of the t-statistics has a value greater than 2.0, hence none of the above autocorrelations differs
significantly from 0. Hence, the residuals are not serially correlated and the model is correctly
specified.


Correct Answer: C
The mean-reverting level for the regression equals:
B0/1-b1 = 0.0934/1-0.7986 = 0.4637 = 46.37%
Hence, if the current profit margin is above 46.37%, the model predicts that the profit margin will fall
in the next period. If it is below 46.37%, the model predicts that the profit margin will rise in the next
period. If it is at the mean-reverting level, then the profit margin will be the same in the next period.

Correct Answer: B
The current profit margin is 35%. CareLink’s profit margin in the next quarter will be:
0.0934 + 0.7986(0.35) = 0.3729
The profit margin in two quarters will be:

0.0934 + 0.7986(0.3729) = 0.3912 = 39.12%

Correct Answer: B
Contrasting their standard errors the AR (1) model has a lower standard error than the AR (2) model
(3.129 vs. 3.325). Hence, the AR (1) model has a lower in-sample forecast error variance than the AR
(2) model. However, comparing their root mean squared error (RMSE), we find that the AR (2)
model has a lower RMSE (√15.158 = 3.8933 than the AR (1) model (√15.963 = 3.9953). Hence, the
AR (2) model is slightly more accurate out of sample. Since out of sample performance is critical in
evaluating a model’s real world contribution, the AR (2) model has more accurate forecasting
performance.

Correct Answer: A
A random walk (and a random walk with a drift) has an undefined mean-reverting level and has no
upper bound on its variance. Hence, it is not covariance stationary. However, the error term has a
constant variance and is uncorrelated with the error term in previous periods (these are assumptions
that we have to make).

Reading 10 Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & FinQuiz.com
Simulations
FinQuiz.com
Study Session 3
June 2019


Simulations
Reading 10: Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Tree & Simulation

Correct Answer: B
B is correct. Because of the shifts in the market, Campbell has judged historical data to be unreliable.
Instead, he has decided to employ cross-sectional data. One of the potential issues which may be
encountered is that the real estate funds offered in the market may not be comparable to the three
shortlisted funds.
A is incorrect. An issue which is encountered when using historical data is that market shifts may
render the data unreliable. Campbell is not employing historical data.
C is incorrect. An issue with using statistical distributions is that the data may not precisely fit the
stringent requirements of a statistical distribution. Therefore, the distribution selected may only
approximate and not be close enough to the real distribution.

Correct Answer: C
C is correct. The first stage of the simulation process involves determining probabilistic variables.
Although there is no limit on how the variables can be allowed to vary in a simulation, analysts
should focus their attention on a few variables that have a significant impact on value.
A is incorrect. While it is true that specifying probability distributions represents the most difficult
and crucial stage, this is the second stage of the simulation process.
B is incorrect. Checking for correlation across variables is done right after specifying probability
distributions (Step 2) and before the actual simulation is run (Step 3).

Correct Answer: B
B is correct. Campbell will need to run the greatest number of simulations for the Alpha Fund as it
has the second highest number of probabilistic inputs and, in addition, has diversity in its
distributions. The required number of simulations will be lower where all the inputs have normal
distribution (Zone) than one is which some are based on statistical and some on normal, for example
(Vector and Alpha).
A is incorrect. Although the distributions for Vector’s input variables are diverse, Campbell has
specified the lowest number of probabilistic inputs for this fund.
C is incorrect. Although Zone has the highest number of probabilistic inputs, the distributions of its
input variables are not as diversified as that of Alpha’s.

Simulations

Correct Answer: A
A is correct. Simulation is least appropriate for Vector. Simulations are better suited for continuous
risks. On the other hand, decision trees and scenario analysis are better suited for discrete outcomes.
B is incorrect. Simulation is appropriate for Alpha as the approach is better suited for continuous risks
and allows for the explicit modeling of correlations.
C is incorrect. Simulation is appropriate for Zone as the approach is better suited for continuous risks
and can be used when the correlations across variables (risks) are independent.

Correct Answer: B
B is correct. Since Campbell is basing his decision on the variability in simulated values, he will be
assuming that all of the risks built into simulations are solely relevant for the investment decision. In
effect, he will be ignoring the line between the risks which could have been diversified away
(nonsystematic risk) and asset-specific risk. In other words, he may be rejecting a fund which has a
high standard deviation in simulated values, even though much of the risk can be diversified when
the fund holdings are allocated to client portfolios.
A is incorrect. The values derived from simulation represent expected cash flows and are not risk-
adjusted.
C is incorrect. Since Campbell is making his selection of the real estate fund solely based on
standard deviation in simulated values, he is not penalizing the unsuitable funds for risk on two
counts. Had Campbell rejected Alpha and Zone based on their risk-adjusted discount rates in
addition to volatility in simulated values, he would have been penalizing the funds twice for their
risk.

Correct Answer: C
The factor outlined by Campbell in his research report represents an earnings and cash flow
constraint. The constraint is internally imposed and managers will want to avoid the possibility of
failing to meet performance expectations and missing out on being awarded an incentives
compensation.

Reading 11 Currency Exchange Rates: Determination and Forecasting FinQuiz.com
FinQuiz.com
Study Session 4
June 2019


Reading 11: Currency Exchange Rates: Determination and Forecasting

Correct Answer: C
C is correct. The larger the transaction, the further away from the current spot exchange rate
the dealing price will be. The order placed by the client is large and will widen the bid-offer
spread quoted by the dealer.
A is incorrect. The type of client, individual or institutional, should not have an effect on the
size of the spread quoted.
B is incorrect. The trade will take place when the London FX trading center is open, that is,
the interbank FX market will be relatively liquid. Thus should narrow the spread quoted by
the dealer.

Correct Answer: B
B is correct.
Smart originally purchased CAD 5 million under the original forward contract. To close out
its long position in CAD, it will need to sell CAD 5 million forward to the same settlement
date. Thus Smart will sell CAD, or alternatively buy USD, at the all-in offer rate of 1.0065 +
(–14.1/10,000) = 1.00509.
At settlement, Smart will need to purchase CAD 5 million under the original forward contract
and sell CAD 5 million under the offsetting forward contract; the CAD will net to zero.
However the USD will not net to zero because the forward rate has changed since contract
initiation. At settlement Smart will receive CAD 5 million and pay out USD 5,022,097.23
(5,000,000/0.9956) under the original forward contract and sell CAD 5 million and receive
USD 4,974,678.88 (5,000,000/1.00509) under the new contract.
The difference between the USD received and paid is - USD 47,418.35 (USD 4,974,678.88 –
USD 5,022,097.23). This represents an outflow because the original contract was long the
CAD (or short the USD) and the CAD subsequently depreciated (or the USD appreciated,
because the all-in forward rate increased from 0.9956 to 1.00509). The present value of this
outflow is calculated as follows:
− USD 47,418.35
= − 47,397.81
60
1 + 0.0026 360


Correct Answer: A
A is correct.
To determine whether arbitrage profits are possible, it is first necessary to calculate the bid-
offer cross rate on the EUR/USD implied by the interbank market.
௎ௌ஽ = ௃௉௒ × ௎ௌ஽ = 105.438 × 0.01222180*

ா௎ோ ா௎ோ ௃௉௒
௕௜ௗ ௕௜ௗ ௕௜ௗ
= 1.2886

=
×
௔௦௞ ௔௦௞ ௔௦௞

= 105.440 × 0.01222210*
= 1.2887
*The JPY/USD rate is calculated as the inverse of the USD/JPY rate. Since the bid is the
lower of the two inverse amounts, 0.01222180 and 0.01222210, the bid-offer spread is
0.01222180/0.01222210.
Based on the interbank-implied cross rate of 1.2886/1.2887, the dealer is posting an offer rate
to sell the USD cheaply, at a rate below the interbank market bid (1.2816 vs. 1.2886,
respectively). Therefore, a triangular arbitrage would involve buying USD from the dealer
selling it in the interbank market.

Correct Answer: B
B is correct. Arbitrage profits cannot be earned if the bid (offer) shown by the dealer is lower
(higher) than the current interbank market offer (bid). Given that dealer’s bid, 1.4864, is
lower than the interbank’s offer, 1.4865, and the dealer’s offer, 1.4866, is higher than the
interbank’s bid, 1.4863, arbitrage profits cannot be earned.
A is incorrect. The dealer’s offer of 1.4862 is lower than the interbank bid of 1.4863. It is
possible to buy USD from the dealer and sell it in the interbank market and earn a profit.
C is incorrect. The dealer’ bid of 1.4867 is higher than the interbank offer of 1.4865. It is
possible to buy USD from the interbank and sell it to the dealer.

Correct Answer: B
B is least likely correct. Because Eoria is running a current account deficit, it is expected that
the domestic currency will depreciate. However, a depreciation of the domestic currency
should contribute to an improvement in Eoria’s trade competitiveness, in the long run, as the
level of exports should increase relative to the imports. Masood’s comment with respect to
trade competitiveness is incorrect.
A is most likely correct. As stated in the preceding paragraph, Eoria’s domestic currency
should depreciate because of its current account deficit.

C is most likely correct. Relatively long lags can occur between changes in exchange rates,
the ultimate adjustment in traded good prices and the eventual impact on import demand,
export demand, and the underlying current account imbalance.

Correct Answer: C
C is least likely correct. The long-run equilibrium real value of Belare’s currency should
increase as market participant revise upward their assessment of the domestic currency. This
is because a tight fiscal policy should improve Belare’s long-run competitiveness, generate
price stability, and gradually boost the real equilibrium value of its exchange rate.
A is most likely correct. An improvement in long-run competitiveness and the gradual

achievement of price stability policy will encourage investors to reduce the premium
demanded for holding the high yield currency’s assets. Therefore the relative risk premium,
ϕH ϕL, should decline.
B is most likely correct. A tight fiscal policy will put downward pressure on domestic interest
rates. With a decrease in Belare’s yield, the interest rate differential, iH – iL, should decline.

Reading 12 Economic Growth and the Investment Decision FinQuiz.com
FinQuiz.com
Study Session 4
June 2019


Reading 12: Economic Growth and the Investment Decision

Correct Answer: A
A is correct. A monetary tightening policy will be pursued when actual forecasted GDP is
above potential GDP. A’s actual forecasted GDP growth rate, 4.4% (2.6% + 1.8%), is higher
than its potential GDP growth rate of 1.5%. This indicates that A’s economy is growing at a
rate faster than its long-run potential, which will put an upward pressure on inflation. To
bring inflationary pressures under control, the government will need to tighten the monetary
policy.
B’s actual forecasted GDP growth rate is, 2.3% (1.4% + 0.9%), is below its potential GDP
growth rate, 4.0%, suggesting that the monetary authority will pursue a monetary easing
policy to close the output gap.
C’s actual forecasted GDP growth, 3.6% (2.5% + 1.1%), is equal to its potential GDP growth,
suggesting that the monetary will not take any policy action.

Correct Answer: B
B is correct. B’s actual GDP growth is below the potential growth rate (3.0% vs. 4.0%,
respectively); therefore, this will put downward pressure on inflation and nominal interest
rates and an upward pressure on bond prices.
A is incorrect. As discussed, bond prices should rise when actual GDP growth is below
potential GDP growth.
C is incorrect. Because potential GDP is growing at a faster rate than actual GDP, consumers
will expect their real incomes to rise more rapidly and real interest rates will need to be
higher to encourage savings required to fund capital accumulation. Thus, higher rates of
potential GDP growth will translate into higher real interest rates and expected real asset
returns.

Correct Answer: A
A is correct. Country A has experienced the greatest growth due to capital deepening relative
to country B and C (7.2% vs. 4.0% and 5.5%, respectively) and the greatest growth in labor
productivity (7.9% vs. 5.0% and 3.5%, respectively). This suggests that the impact of
diminishing marginal returns on per capita output growth was significantly low enough to
allow for 91% of labor productivity growth (7.2%/7.9%) to be attributable to capital
deepening investments.
Although labor productivity growth in country C is purely driven by capital deepening

investments, the growth due to capital deepening did not translate into a high labor
productivity growth. This suggests that the impact of capital deepening investments was not
as successful and that the impact of diminishing marginal returns on GDP growth was higher.

Similarly in country C, growth due to capital deepening did not translate into a high growth in
labor productivity. This suggests that the impact of diminishing marginal returns is higher.

Correct Answer: B
B is correct. A permanent increase in the rate of labor productivity growth will increase
sustainable economic growth, earnings growth and potential return on equities. Based on the
forecast for country C, equity returns in the country should be higher and equity investment
activity will increase.

Correct Answer: B
B is correct. Country B has experienced the highest growth in TFP, 0.8% (see below) over
2000-2010.
Growth in TFP(%) = Growth in labor productivity(%) + Growth due to capital deepening(%)
Growth in TFP (A) = 7.9% – 7.2% = 0.7%

Growth in TFP (B) = 5.0% – 4.0% = 1.0%
Growth in TFP (C) = 3.5% – 5.5% = – 2.0%

Correct Answer: A
A is correct. Country C suffers from the Dutch disease because it is rich in natural resources
but has experienced an appreciation in its currency, driven by the strong export demand for
its resources.
B is incorrect. Country D does not possess ownership of a natural resource supply and its
currency has not appreciated (see above).
C is incorrect. Without any other indication, sluggish economic growth does not indicate that
that country D suffers from the Dutch disease.

Reading 13 Economics of Regulation FinQuiz.com
FinQuiz.com
Study Session 4
June 2019


Reading 13: Economics of Regulation

Correct Answer: B
B is correct. Statement 1 is most likely representative of regulatory arbitrage whereby
Blackstone exploited differences in economic substance and regulatory interpretation to avoid
higher corporate tax rates. By going public as a master limited partnership it was able to take
advantage of the differences in tax treatment with respect to organizational structure.

Correct Answer: C
C is correct. Based on the facts presented in Statement 2, companies will most likely benefit
from regulatory competition. Any U.S. based exporter can relieve itself of domestic antitrust
laws by trading with U.S. customers, residing in a foreign country, at its discretion with less
risk of violating such laws.

Correct Answer: C
C is correct. The IIROC is described as a SRO, which sets standards, regulates members, and
is private in nature. It is a formal SRO with formal regulatory powers.

Correct Answer: A
A is correct. Financial market regulations focusing on market integrity differ from those
targeted towards market stability. The latter are more focused in their approach. To promote
market integrity, regulators may require increased disclosure to allow investors to make more
informed trading decisions, enhance transparency, and allow markets to operate.
B is incorrect. Regulation of commerce focuses on the public provision of public goods.
C is incorrect. Regulation of financial institutions focuses on reducing system-wide risks.

This will allow for the safety and soundness of financial institutions.

Correct Answer: A
A is not a valid regulatory tool. The IIROC is not a financial regulator and will not impose
capital requirements.
B is a valid regulatory tool. According to Statement 3, the IIROC set standards. Therefore, it
provides public goods by providing regulatory and investment standards for the debt and
equity investment markets.
C is a valid regulatory tool. According to Statement 3, the IIROC has the ‘power to suspend,
fire, and expel representatives.’ To discipline members it can impose conflict of interest
policies to ensure their independence.


Correct Answer: C
C is correct. A captive regulator can benefit the regulated by creating demand for products
and by acting as a barrier to entry for rivals.
A is incorrect. Encouraging competitive pricing will not allow industry participants, the
regulated, to maintain their controlling positions in the industry.
B is incorrect. Encouraging foreign competition by reducing barriers to industry entry will

not benefit existing companies (the regulated).

Reading 14 Intercorporate Investment FinQuiz.com
FinQuiz.com
Study Session 5
June 2019


Reading 14: Intercorporate Investments

Correct Answer: B
Investment in associate:
Purchase price $1,000,000,000
EI’s share of HD’s net income

$200,000,000(0.35) $70,000,000
Dividends received
$98,000,000 (0.35) ($34,300,000)
Amortization of excess purchase price

attributable to plant and equipment
($300 million (0.35) –$500,000)/10 ($10,450,000)
Investment balance $1,025,250,000

Correct Answer: C
Equity Income:
Walter’s share of Wood’s reported income 30%(975,500) $292,650
Amortization of excess purchase price (65,000/8) ($8,125)
Unrealized profit ($7,140)*
Equity Income $277,385
*Walter’s profit on sale 250,000 – 165,000 = $85,000
Wood’s sells 180,000/250,000 = 72% of the goods purchased; total unrealized profit = 85,000
(0.28) = $23,800, Walter’s share of unrealized profit = 0.30(23,800) = $7,140

Correct Answer: B
Sweeney is incorrect. There is a small difference between IFRS and U.S. GAAP in their
inclusion of contingent liabilities. IFRS include contingent liabilities if their fair values can
be reliably measured. U.S. GAAP includes only those contingent liabilities that are probable
and can be reasonably estimated.
Anderson is correct. The difference between the acquisition price and the fair value of the
acquired net assets is recognized immediately as a gain in the profit and loss under both IFRS
and the U.S. GAAP. Also, both IFRS and U.S. GAAP now require minority interests to be
reported on the consolidated balance sheet as a separate component of stockholder’s equity.


Correct Answer: A
Under the full goodwill method, goodwill on the consolidated balance sheet would be the
difference between the total fair value of the subsidiary and the fair value of the subsidiary’s
identifiable net assets: 105,500,000 – (5,350,000+47,000,000+75,500,000-45,200,000) =
$105,500,000- $82,650,000 = $22,850,000.
The value of the noncontrolling interest will equal the noncontrolling interest’s proportionate
share of the subsidiary’s fair value: 105,500,000(0.15) = $15,825,000

Correct Answer: B
Under the partial goodwill method, goodwill on the parent’s consolidated balance sheet
would be the difference between the purchase price and the parent’s proportionate share of
the subsidiary’s identifiable net assets: $85,500,000 – (0.85)(82,650,000) = $15,247,500.
The value of the non-controlling interest equals the noncontrolling interest’s proportionate
share of the fair value of the subsidiary’s identifiable net assets: 0.15(82,650,000) =
$12,397,500.

Correct Answer: C
Statement 3 is incorrect. The amount reported in other comprehensive income is net of taxes.
Statement 4 is incorrect. IFRS require that held to maturity securities be recognized initially
at fair value plus transaction costs, whereas U.S. GAAP require held to maturity securities be
initially recognized at cost including transaction costs.

Correct Answer: C
The investment in Jador Inc. will be reported as £4,500,000 at the time of purchase.
IFRS requires that investments reported as held to maturity are initially recognized at fair
value plus transaction costs. Subsequent to initial recognition, IFRS requires that held-to-
maturity investments are reported at amortized cost using the effective interest rate method.

Correct Answer: C
Subsequent to initial measurement, the investment in Jador Inc. will be reported in the
balance sheet at amortized cost. The amortized cost is calculated as follows (£’000):
(1) (2) (3) (4)

Interest Interest Amortization= Carrying
Payment Income (1) – (2) Value
1/1/2010 4,500
31/12/2010 240 157.5 82.5 4,418
(1) 8% ×par value £3,000,000 = £240,000

(2) 3.5% × carrying value £4,500,000 = £157,500

(4) £4,500,000 – (£82,500) = £4,417500

Correct Answer: B
Amounts recorded in the income statement (£’000) = changes in fair value + dividend
payments
= (£3,240 – £2,875) + (0.025 × £2,875)
= £436.875 ≈ £437
For investments recorded at held for trading, any dividends/and or interests paid on the
investment in addition to fair value changes are recorded in the income statement.

Correct Answer: C
The amount of goodwill recorded on Rigor’s balance sheet under the partial goodwill method
is + £1,292,000. This amount is calculated as follows:
£
Acquisition price* 2,825,000
Less: 70% of fair value of net assets** 1,533,000
Goodwill 1,292,000
*The fair value of Rigor’s shares exchanged for Vito’s shares is equal to the
acquisition cost in Exhibit 1, £2,825,000, which represents the acquisition
price.
** Fair value of net assets = Total Assets – Total Liabilities

= £4,001,000 – £1,811,000
= £2,190,000

Correct Answer: A
A significant influence in a corporation is classified as an investment in an associate.
Investment in associates should be accounted for by the equity method.

Correct Answer: B
The closing value of Vito’s revalued machinery, which is recorded on the consolidated
balance sheet as at December 31, 2010 is £334,800.
Since Rigor has acquired a controlling interest in Vito, Vito’s assets will be recorded in
Rigor’s balance sheet at the fair value at the date of acquisition less any subsequent
depreciation and revaluations.
• Given the machine has an original cost of £500,000 and

had a total useful life (at the time of purchase) of 8 years, annual depreciation charge
is £62,500 (£500,000 ÷ 8 years).
• Thus the net book value prior to the valuation is
£312,500 [£500,000 – (62,500 × 3*)].

• *On the date of revaluation, January 1, 2010, the

remaining useful life is 5 years. Thus 3 years (8 – 5 years) of the useful life have
elapsed.
• Increase in PPE (net) using Exhibit 2 on revaluation date
is £106,000 (£1,546,000 – £1,440,000)
• Machinery’s revalued amount = £418,500 (£312,500 +
£106,000)
• Revaluation date onwards annual depreciation charge =
£83,700 (£418,500 ÷ 5 years)
• Machinery’s net book value at December 31, 2010 is
£334,800 [£418,500 – (£83,700 × 1 year)

Correct Answer: C
Criterion 3 least likely justifies the classification of Ester Corp as a significant influence
investment as it is inconsistent with the indicators generally used to classify a significant
influence investment (see below).
Under both IFRS and US GAAP when a parent holds 20 to 50 percent of the voting rights of
the investee, it is presumed that the entity has significant influence over the investee. Since
Green Corp holds 25% of Ester Corp’s stock, this criteria has been met. In addition to
percentage ownership, the standards note that significant influence may be evidenced by:
• representation on the board of directors (this has been met by criterion 2);
• participation in the policy-making process;
• material transactions between the investor and the investee (criterion 3 is
inconsistent with this indicator as it restricts inter-corporate transactions to a
maximum immaterial amount);
• interchange of managerial personnel (criterion 1 is consistent with this indicator);
or
• technological dependency.

Correct Answer: A
Given that the acquisition price (£500 million) is less than the fair value of Poly Corp’s net
assets acquired [0.75(£770 million – £65 million) = £528.75 million], Green Corp will
immediately recognize the excess amount, £28.75 million (£528.75 million – £500 million)
as a gain in its income statement.
Green Corp is required to account for the bargain acquisition using the treatment prescribed
by IFRS. In a situation where the acquisition price is less than the fair value of the target’s net
assets, the acquisition is considered a bargain acquisition.

Correct Answer: A
The amount of net income which Green Corp will report in its 2008 income statement in
relation to Ester Corp is £2.27 million. This is calculated as follows:

Green Corp’s share of Ester Corp’s net income

€3.00000 million
(25% × €12 million)
Unrealized profit (€0.73125 million)
Equity income related to Ester Corp (2008) €2.26875 million
* Green Corp’s profit on the sale of detergents to Jason = €5 million − €0.5 million =
€4.5 million
Ester Corp sells 35% of these detergents while 65% remains unsold.
Total unrealized profit = €4.5 million × 65% = €2.925 million
Green Corp’s share of unrealized profit = €2.925 million×25% = €0.73125 million

Correct Answer: A
Assuming an acquisition price of £750 million, the amount of goodwill arising on the date of
acquisition, using the full goodwill method (mandatory under U.S. GAAP) is − £55.00
million.
The amount of goodwill arising as a result of the full goodwill method is illustrated below:
Fair value of the subsidiary* £650.00 million
Fair value of subsidiary’s identifiable

£705.00 million
net assets**
Goodwill (£55.00 million)
* Fair value of the subsidiary is equal to the market value of the subsidiary’s shares on the date
of acquisition, i.e. £650 million
**Fair value of subsidiary’s identifiable net assets =
£770 million – £65 million = £705 million

Correct Answer: B
The consolidated assets reported under the acquisition method and pooling of interest method
on Green Corp’s balance sheet, in relation to Poly Corp, on the date of its acquisition is
US$2,970 million and US$2,765 million, respectively. Thus the amount of consolidated
assets reported under the acquisition method is higher.
Under the acquisition method, the acquirer will measure the identifiable assets and liabilities
of the acquired entity at fair value at the date of acquisition. This means that the total
consolidated assets on the date of acquisition, including Green Corp’s total assets, will be
US$2,970 million (2,200 + 770).
Under the pooling of interests method, the combined companies were portrayed as if they had
always operated as a single entity. Consequently, assets and liabilities under this method were
recorded at book values. The amount of consolidated assets to be reported on Green Corp’s

balance sheet in relation to Poly Corp and on the date of acquisition is the sum of the book
values of the two corporations’ total assets, i.e. US$ 2,765 million (2,200 + 565).

Correct Answer: B
Traditionally, a special purpose entity (SPE) was consolidated if the sponsor or other entity
had control over the trust/SPE. This control was evidenced by ownership of a majority of
voting interest in the SPE. If a sponsor/other entity did not control the SPE, it did not need to
consolidate the SPE. However, with an increase in regulation, any organization with a
beneficial interest in a SPE is required to consolidate the SPE irrespective of whether it owns
a majority of voting rights in the SPE or not.
Thus Green Corp will be required to consolidate the trust even if it does not own a majority
level of voting rights in the SPE as it has a beneficial interest in the trust (see below).
Given that Green Corp bears the risk of defaults and is responsible for compensating any
defaulted interest and principal payments on the trust’s borrowings, Green Corp has a
beneficial interest in the trust. Thus the trust must be consolidated on Green Corp’s financial
statements. By leasing the asset, Green Corp receives the benefit of leasing the asset through
a residual value guarantee (the defunct factories are marketable after refurbishment) which
gives further evidence of its beneficial interest in the trust.

Correct Answer: A
Since the investment in Tire-Go will provide Fisher Corp. with board representation in
addition to the ability to participate in policy decision making matters, it will give it
significant influence over the target and thus the investment in Tire-Go should be accounted
for under the equity method of accounting accordingly.
Under the equity method of accounting, the goodwill is not reported separately in the
acquirer’s balance sheet but is incorporated as part of the cost of investment. Thus the amount
of goodwill to be reported in the balance sheet is $0.

Correct Answer: A
If the cost of the investment is less than the investor’s share of the fair value of the associate’s
net assets, the difference between them is excluded from the cost of investment and included
as income in the determination of the investor’s share of the associate’s profit or loss in the
period in which the investment is acquired.

The excess of the purchase price over the fair of Tire-Go’s net assets is calculated as follows:
$000
Purchase Price 22,000
Book Value of Net Assets ($88,000* × 30%) (26,400)
Excess Purchase Price (4,400)
Attributable to the plant [($15,000 – 8,000) × 30%] (2,100)
Goodwill (residual) (6,500)
*net assets = 150,000 – 60,000 – 2,000 = $88,000
Explanation: Firstly, Net Assets = Total Assets – Total Liabilities (1) or Total Shareholder’s
Equity (2).
• Using (1) and Tire-Go’s balance sheet, Net Assets = 150,000 – (60,000 + 2,000) or
Total Assets – (Accounts Payable + Long-Term Debt).
• Using (2), Net Assets = 60,000 + 28,000 or (Shareholder’s Equity + Retained
Earnings).
Thus Fisher Corp. should include $6,500,000 as income as part of Tire-Go’s net profit to
determine its share of profits in the associate.

Correct Answer: C
The fair value option gives the investor the option to account for an equity method investment
at fair value. Since the investment in Tire-Go is an equity method investment (see the
solution to part 1), the use of the fair value will produce the following financial statement
implications for Fisher Corp.:
Subsequent to initial recognition the investment is reported at fair value with any
unrealized gains and losses arising from changes in fair value as well as any interest
and dividends received included in Fisher Corp.’s income statement.
The investment account does not reflect Fisher Corp.’s proportionate share of Tire-
Go’s profit or loss, dividends or other distributions.
The excess of cost over the fair value of Tire-Go’s identifiable net assets is not
amortized, nor is goodwill created.

Correct Answer: C
The equity income for 2011 is as follows:
$ Millions
Fisher Corp.’s share of Tire-Go’s reported net profit
(30% × $150 million) $45.00
Unrealized Profit (30% × 0.9334*) (0.28)
Equity Income 2011 $44.72
Fisher’s profit on the sale to Tire-Go = $7.5 – $5.5 = $2 million

Tire-Go sells approximately 53.33% of the goods purchased from Fisher; 46.67% remains
unsold.
Total unrealized profit = $2 million × 46.67% = $0.9334 million

Fisher’s share of the unrealized profit = $0.9334 million × 30% = $0.28 million


Correct Answer: B
Under the pooling of interests method (permissible for periods prior to June 2001 under U.S.
GAAP), the combined companies were portrayed as if they had always operated as a single
entity. Assets and liabilities were recorded at book values and pre-combination retained
earnings were included in the balance sheet of the combined companies.
In contrast, under the purchase/acquisition method, the purchase is viewed as a purchase of

the investee’s net assets with the net assets recorded at fair values.
The total value of the shareholders’ equity of the consolidated company under the pooling of
interests method is calculated as follows:
$ ’000
Common Stock ($1 Par Value)* $52,000
Additional Paid in Capital 30,000
Retained Earnings ($55,000 + $1,500) 56,500
Total Shareholders’ Equity $138,500
* Common stock is recorded at par value = [$80,000 (see exhibit 1) – $30,000] + 2,000 (stock
issued)
= $52,000
The value of shareholder’s equity under the acquisition method is as follows:

$ ’000
Common Stock ($1 Par Value)* $52,000
Additional Paid in Capital** 38,000
Retained Earnings 55,000
Total Shareholders’ Equity $145,000
* see above
** Fisher Corp. has issued 2,000,000 shares worth $1 each or with a par value of $2 million
to acquire C.S. Corp. Under U.S. GAAP or IFRS the investment must be recorded at fair
value. Thus the consideration exchanged is 2,000,000 shares with a market value of $5 each
or $10 million.
Fisher Corp.’s common stock is increased by the par value of the common shares issued, $2
million. The acquirer’s additional paid in capital is increased by $8 million, which represents
the difference between the total market value and par value of the shares issued ($10 million
– $2 million), to a total of $38 million.
Thus the total shareholders’ equity reported under the acquisition method is higher, relative to
the total equity reported under the former method, by $6.5 million ($145 million – 138.5
million).

Correct Answer: B
Since Fisher Corp. and C.S. Corp. are situated in the U.S. the recognition of the impairment
loss will be in accordance with the U.S. GAAP rules.

Under U.S. GAAP, goodwill impairment testing is carried out as a two-step process:
1) Determination of Impairment Loss: The carrying amount of the reporting unit
including goodwill is compared to its fair value.
If the carrying amount exceeds the fair value, impairment has occurred and impairment is
measured as follows:
2) Measurement of Impairment Loss: The impairment loss is measured as the
difference between the implied fair value of the reporting unit’s goodwill and its
carrying amount.
Using the data on C.S. Corp.’s steel conversion unit, the occurrence and amount of
impairment loss is determined as follows:
1) Determination of Impairment Loss
The unit’s carrying value ($1,500,000) is greater than the fair value ($1,250,000). This
suggests that the unit has incurred an impairment loss.
2) Measurement of Impairment Loss

Fair market value of the unit $1,250,000
Less: net assets 1,180,000
Implied Goodwill $ 70,000
Current carrying value of goodwill $ 200,000

Less: Implied goodwill 70,000
Impairment loss $ 130,000

Correct Answer: B
Cost of investment = 25% × $20,000,000 × ($15 + $2) = $5,000,000 × $17
= $85,000,000.

Correct Answer: C
All figures in millions
Goodwill = COI – FV of Net Assets
= $75 - ($66 × 0.25) = $75 - $16.5 = $58.5

Correct Answer: A
Profit recognized has to offset previous unrecognized losses.
Profit= ($50*0.25) - $12 = $0.5 million.

Correct Answer: B
Under IFRS, currently exercisable or convertible warrants, call options or convertible
securities are jointly considered along with voting shares to determine the voting power of the
investor.


Correct Answer: B
Impairment losses from associates cannot be reversed under any circumstances.

Correct Answer: A
IFRS allows equity associates, which are venture capital organizations, mutual funds, unit
trusts and investment-related insurance funds to be reported under the fair value method.
Correct Answer: B
Any excess of fair value over purchase price indicated the existence of a bargain acquisition
and the gain is to be immediately reported as a gain in the investor’s income statement.

Correct Answer: A
U.S. GAAP allows goodwill to be calculated only through the full goodwill method.

Correct Answer: A
Since the acquiree’s shareholders have contractually indemnified the acquirer for the outcome
of the case, the acquirer must recognize an indemnification asset.

Correct Answer: A CoverTech owns 35% of the voting interests in The Embilon Enterprise.
However, since it is unable to exert any significant influence over the latter entity, the
investment made would be classified as an investment in financial instruments.

Correct Answer: C
Special purpose vehicle are created solely for a single purpose to meet the needs of the
sponsoring entity.
A subsidiary can be classified as a variable interest entity because subsidiary’s business
performance varies the interest of the parent.

Correct Answer: A
Under U.S. GAAP, consolidation is based on:
i. the voting interest component.
ii. the variable interest component.

Correct Answer: C
Under IFRS and U.S. GAAP, classification of financial instruments as held-to-maturity is not
allowed if in the most recent two preceding years, the entity has sold or reclassified more than
an insignificant amount of held-to-maturity securities before maturity. 22% is not an
insignificant figure.


Correct Answer: C
Under IFRS HTM securities are reported initially at fair value plus transaction costs.
Cost=$ 52,000 + $3,500= $55,500.

Correct Answer: B
Held-for trading instruments are initially recognized at their fair values.

Correct Answer: A
Any unrealized gains or losses arising from changes in fair value of an available-for-sale
security are reported in other comprehensive income with a net of tax figure.

Correct Answer: B
Any unrealized gains or losses on held-for-trading securities are reported in the income
statement.

Correct Answer: A
Unrealized Gain/Loss= Fair Value – Issuance Price – Discount + Premium
= $72,000- $80,000 + $4,800= $3,200 loss

Correct Answer: B
(All figures in $ millions)
Purchase Price (23* 50 million* 20%) 230
Entity’s Share of Net Assets (900* 20%) (180)
= Excess Purchase Price 50
Attributable to Net Assets:
P&E (35-18)*20% (3.4)
Land (15-12)*20% (0.6)
= Goodwill 46

Correct Answer: A
When the book value of investor’s share of net assets is greater than the cost of investment,
the differential amount is excluded from the cost of investment and included as income in the
income statement.

Correct Answer: B
P&E Amortization= [($35 million-$18 million)*20%]/ 6 = $3.4 million/6= $0.57 million

Correct Answer: A
Under U.S. GAAP, the fair value option is available for all entities.


Correct Answer: C
The profit will be recorded in the associate’s income statement. The investor’s share of the
unrealized profit will be included in the equity income on the investor’s income statement.

Correct Answer: B
The equity method does not increase the turnover figures in the income statements. Thus, all
margin ratios are overstated as compared to the proportionate consolidation method.

Correct Answer: A
Carrying value calculation
PV= -960, PMT= 80, N=10, FV= 1000, CPT I/Y= 8.613
Interest income = 8.613% × $960 = $82.6848 ≈ $83

Correct Answer: A
There is no capital gain to be recognized in the income statement as the investment is
classified held-to-maturity

Correct Answer: C
Carrying value calculation
PV= -960, PMT= 80, N=10, FV= 1000, CPT I/Y= 8.613
Change N to 7 to account for the three-year change.
CPT PV= -968.75.
PV of estimated future cash flows calculation
I/Y= 8.613, PMT= 0, FV= 500, N= 7, CPT PV= - 280.4
Impairment loss= CV- Recoverable Value= 968.75 – 280.4= 688.35.

Correct Answer: A
Impairment losses are recognized in the income statement.

Correct Answer: B
Cumulative loss= Acquisition Cost- Principal Repayments- Current Fair Value- Previously
charged impairment loss= 80- 68- 4= 8

Correct Answer: B
Reversals of impairment losses on AFS equity instruments are not allowed under the IFRS.
Reversals of impairment losses on AFS debt instruments are allowed under the IFRS.
Reversals of impairment losses on AFS equity instruments and debt instruments are not
allowed under U.S. GAAP.

Correct Answer: A
Subsequent to initial recognition, associate investment at fair value recognizes unrealized
gains and losses in the investor’s income statement.


Correct Answer: B
Under the fair value option, if the price paid for the target exceeds the fair value of
identifiable net assets, the excess amount is neither amortized nor recognized as goodwill.

Correct Answer: A
Impairment loss can be charged in the event of a decrease in expected future cash flows as
this qualifies as a loss event under the IFRS.

Correct Answer: C
Impairment losses cannot be reversed under the equity accounting method. IFRS prohibits the
reversal of impairment losses.

Correct Answer: B
Value in Use= Cash Flows/ Market Rate=$ 80 million/0.09= $889 million

Correct Answer: B
All figures in $ millions
Recoverable amount = higher of (fair value- costs to sell) or (value in use)
Recoverable amount = higher of (1,500-8) or (889)
Recoverable amount = higher of (1,492) or (889)
Recoverable amount = 1,492
Impairment Loss= Carrying Value- Fair Value= 1,800- 1,492= 308

Correct Answer: A
Reclassification of securities into or out of the designated at fair value category is generally
allowed under U.S. GAAP.
Reclassification of securities into or out of the designated at fair value category is generally
prohibited under the IFRS with a few exceptions.

Correct Answer: B
IFRS restricts reclassification of securities into or out of the held-for-trading category.
U.S. GAAP allows for the reclassification of securities into or out of the held-for-trading
category.


Correct Answer: B
When a security is transferred from available-to-sale to held-to-maturity category, the
cumulative amount of the unrealized gains/losses previously recognized in other
comprehensive income is recognized in the income statement over the remaining life of the
maturity.

Correct Answer: A
Since the available-for-sale category requires the security to have a measurable fair value, the
instrument could only have been classified to that category once the entity was listed.

Correct Answer: C
The disappearance of an active market for an entity’s securities is not an indicator of
impairment.

Correct Answer: C
The downgrade of an entity’s credit rating is not an indicator of impairment.

Correct Answer: A
Under U.S GAAP, calculation of the effective interest rate is based on the contractual cash
flows occurring over the asset’s contractual life.
Under the IFRS, calculation of the effective interest rate is based on the estimated cash flows
occurring over the asset’s expected life.

Correct Answer: B
Interest Revenue= Carrying Valuet-1× Market Interest Rate at date of Security purchase
= $275,000 × 10.8%= $29,700.

Correct Answer: B
Realized Gain= Sale Proceeds- Fair Value at Transaction Date
= $297,500- $282,000= $15,500.

Correct Answer: A
Any realized gains/losses on available for sale securities should be recognized in the income
statement. US GAAP states that any unrealized gains/losses arising on the sale should be
recognized in comprehensive income.

Correct Answer: B
Impairment losses on available-for-sale debt securities cannot be reversed under U.S. GAAP
guidelines.


Correct Answer: C
Realized Gain= Sale price- Fair Value + Unrealized Gain
= $310,000 - $302,000 + $15,000
= $23,000
Correct Answer: C
IFRS identify the following common characteristics of joint ventures:
1) A contractual arrangement exists between two or more parties.
2) The contractual arrangement establishes joint control.

Correct Answer: B
The IFRS requires use of the equity method to account for joint venture investments.

Correct Answer: A
A venture accounted for under the proportionate consolidation method has a higher debt
figure but the same equity amount as compared to the equity method. Thus, proportionate
consolidation would lead to a higher debt to equity ratio.

Correct Answer: B
All direct costs of the business combinations are expensed as incurred under both the IFRS
and the U.S. GAAP.

Correct Answer: C
No goodwill was calculated under the pooling of interests method, as the two entities were
treated as if they had always been a single economic entity.

Correct Answer: A
The pooling of interests method would report a lower cost of goods sold as all the assets in
this method are reported at book values.

Reading 15 Employee Compensation: Post-Employment and Share-Based FinQuiz.com
FinQuiz.com
Study Session 5
June 2019


Reading 15: Employee Compensation: Post-Employment and Share-Based

Correct Answer: A
Statement 1 is correct. Firms following IFRS would expense the entire cost immediately. Past service
costs are generated as a result of plan amendments. Under IFRS past service costs are recognized as
an expense in the P&L. In contrast, under U.S. GAAP, past service costs are reported in other
comprehensive income in the period in which the change giving rise to the cost occurs.
Statement 2 is incorrect. Under U.S. GAAP, unamortized past service costs are reported in
accumulated other comprehensive income and subsequently amortized over the average service lives
of the affected employees; the amortized amounts are included in the income statement.

Correct Answer: C
Under U.S. GAAP, actuarial gains and losses that are recognized immediately are included as a
component of pension expense. However, under IFRS, actuarial gains and losses are recognized as
part of other comprehensive income and are not subsequently amortized to P&L. If they are treated as
other comprehensive income, this can reduce the volatility of pension expense (but increase the
volatility of equity).
U.S. GAAP only allows the deferred recognition of actuarial gains and losses using either the corridor
method or the faster recognition method to determine the minimum amount to be reported on the
income statement. Park has defined only the corridor method; under the faster recognition method the
actuarial gains and losses can be amortized more quickly.

Correct Answer: A
Estimated final year’s salary: $92,736
Estimated annual payment for each of the 20 years: (92,736×0.025)(10+5) = $34,776
Value at the end of Year 5, of the estimated future payments: $383,179.6
Annual unit credit: 383,179.6/15 = $25,545.30
Benefits attributed to prior years: Annual unit credit (10) = $255,453.
Opening obligation: 255,453/(1.065)5 = $186,450.25
Interest cost = 186.450.25(0.065) = $12,119.269

Correct Answer: A
Statement 3 is correct. An increase in the assumed discount rate can increase the interest cost.
However, the interest component of the pension obligation and pension expense may decrease if the
decrease in the opening obligation more than offsets the effect of the increase in the discount rate (this
is the typical effect).
Statement 4 is incorrect. An increase in life expectancy will have no effect on the promised pension
payments because the payments are to be paid over a fixed time period.


Correct Answer: A
Total periodic pension costs = Ending funded status – contributions – beginning funded status
Total periodic pension costs = ($25,670 – $24,586) – ($19,615 – $18,956) – $65 = $360

Correct Answer: B
If Care Medicines complied with IFRS, it would report remeasurement amounts as part of net
income:
Remeasurements = net return on plan assets* - actuarial gains and losses
*Net return on plan assets = Actual return – (Plan assets × Interest rate)
Remeasurements = [$980 – (12% × $19,615)] + $1,500 = $126.20 ≈ $126

Correct Answer: A
The amount of pension liability recognized under U.S. GAAP for the year 2009 is 466 million.
Under U.S. GAAP the amount recognized under a defined benefit plan is the pension plan’s funded
status. The funded status represents the difference between the fair value of the plan assets and the
projected benefit obligation (present value of the pension liabilities). If the projected benefit
obligation exceeds the fair value of the plan assets, this suggests that the plan is underfunded.
In the case of Hewer Corporation, the projected obligation as at December 31, 2009 exceeds the fair
value of the corporation’s plan assets on the same date ($589 million vs. $123 million).

Correct Answer: B
For both the 2008 and 2009 periods, total periodic pension costs exceeded employer/employee
contributions (in 2008 periodic pension costs exceeded contributions by $54 million and in 2009
pension costs exceeded contributions by $75 million). In the event that periodic pension costs exceed
contributions, the excess can be viewed from an economic perspective as a source of financing. In the
case of both 2008 and 2009, the appropriate adjustment would be to reclassify the excess as an inflow
related to financing activities rather than to operating activities, i.e. decrease operating cash flows and
increase financing cash flows.
Since the corporation has not made these cash flow adjustments, its operating cash flows are
overstated financing flows are understated for both the periods presented.

Correct Answer: B
The actuarial loss recognized by Hewer Corporation in its 2009 income statement is $7.0 million.
Under the corridor method, the net cumulative unrecognized actuarial gains and losses at the
beginning of the reporting period are compared with defined benefit obligation and the fair value of
the plan assets at the beginning of the period.

If this cumulative unrecognized amount exceeds 10% of the greater of the PBO or the fair value of
plan assets, the excess is amortized over the expected average remaining working lives of the
employees participating in the plan and is included as a component of pension expense.
• PBO at the beginning of 2009 = $448 million

• Fair value of plan assets at the beginning of 2009 = $149 million
• Net cumulative unrecognized actuarial gains/losses at the beginning of 2009 = $150 million
• PBO balance ($448 million) > Fair value of plan assets ($149 million). Thus the PBO value is
used.
• 10% of the PBO amount = $44.8 million ($448 million × 10%)
Unamortized portion of net actuarial loss = $105.2 million ($150 million – $44.8 million)
• Amortized portion of actuarial loss (recognized in 2009’s income statement) = $7.01 million
($105.2 million ÷ 15 years)

Correct Answer: C
Amongst the actions listed, a(n):
increase in the discount rate to 12.2% in 2010 from 12.1% in 2009, will decrease the value of
the PBO being reported in 2010.
decrease in the actual return on plan assets to 8.5% will not affect the PBO amount as actual
return on plan assets are not used in the PBO computation.
increase in the rate of compensation increases to 3.8% in 2010 from 3.5% in 2009 will
increase the value of PBO being reported in 2010.

Correct Answer: C
Amongst the rate assumptions listed in Exhibit 2, the discount rate assumptions, expected return on
plan assets, and annual compensation rate increases are internally consistent. This is because these
rates are all increasing over the periods, 2008 and 2009 and thus correspond to the increase in the
expected inflation rate over the two periods. However, the actual return on plan assets is internally
inconsistent with these rates (including the expected inflation rate) as this rate of return remains
constant at 8% over the two years.

Correct Answer: B
On January 1, 2008, 2 years of the vesting period have elapsed and 1.5 years remain.
For the year 2008, the compensation expense recognized is $360 million ($540 million ÷ 1.5 years).
For the year 2009, the compensation expense recognized is $180 million ($540 million – $360
million).

Correct Answer: C
The funded status is equal to $17,236 ($87,200 – $69,964) which the difference between the ending
defined benefit obligation and fair value of plan assets,


Correct Answer: B
Net interest expense = Change in beginning of period funded status × discount rate
Net interest expense = $(54,500 – 60,000) × 12% = –$660

Correct Answer: C
Using the sponsor’s 2010 contributions of $15,425 and a $6,000 total pension costs, the sponsor’s
contributions exceed the pension expense by a pre-tax amount of $9,425 ($15,425 – $6,000). The
after-tax amount by which the sponsor company’s contributions exceed the pension costs is $7,068.75
or approximately $7,069 [$9,425 × (1 – 0.25)].
Since the sponsor’s contributions exceed the total pension costs, the excess is equivalent to a
repayment on a loan in excess of the scheduled payment (financing use of funds). This excess is
treated as an increase in cash inflow from operating activities and an increase in cash outflow from
financing activities by $7,069. Put another way, the $7,069 excess is treated as a decrease in cash
outflow from operating activities and a decrease in cash inflow from financing activities.

Correct Answer: A
Periodic pension costs are calculated as follows:
Total periodic pension costs (income) = Ending funded status – Employer contributions – beginning
funded status.
Total costs (income) = ($87,200 – $69,964) – $15,425 – ($60,000 – $54,500)

= ($3,689)

Correct Answer: B
Benefit 1: s
Stock options have payoffs, which can be characterized as asymmetric or one-sided. In other words,
the potential for profits (when the underlying stock price exceeds the option exercise price) is
unlimited on the upside and losses (when the stock price falls below the exercise price) are limited to
the option premium.
Thus the potential for risk aversion is limited and the potential for returns is unlimited on the upside.
This benefit accurately reflects a benefit of issuing stock to firm employees.
Benefit 2:
Although the issuance of stock option will dilute shareholder ownership in the future, as the options
are exercised and underlying shares are issued, the firm does not simultaneously issues shares with its
stock options issue. Regardless of whether the stock options dilute shareholdings immediately or in
the future, the firm’s existing shareholders will be affected by the issue once the options are exercised
(and associated shares issued). Thus benefit 2 does not accurately reflect a benefit of issuing stock
options to existing firm shareholders.
Benefit 3:
When stock options are issued an annual compensation expense in recorded on the firm’s income
statement thereby reducing the firm’s profitability. Additionally, stock options can dilute the firm’s

earnings per share. Thus the issuance of stock options can reduce the firm’s overall profitability as
well an individual shareholder’s share in firm profitability. Benefit 3 misrepresents the benefit as well
as effect of issuing stock options on firm profitability.

Correct Answer: B
The fair value of an option tends to decrease with a(n):
increase in underlying exercise price;
increase in assumed dividend yields; and
decrease in stock price volatilities.
Relative to current estimates for:

underlying exercise price ($52.10), selecting alternative 2 will result in a lower fair value
estimate for the option as it assumes a higher exercise price estimate ($57.45).
dividend yields (3.00%), selecting alternative 2 will result in a lower fair value estimate for
the option as it assumes a higher dividend yield estimate (3.85%) whereas alternative 1 will
lead to a higher price estimate due to the lower dividend yield estimate.
stock price volatility (23%), selecting alternative 1 will result in a lower fair value estimate as
it assumes a lower stock price volatility estimate (22%) whereas alternative 2 will lead to a
higher price estimate to the higher volatility estimate.

Correct Answer: B
Final salary= ($75,000) (1.0525)14 = $153,522

Correct Answer: C
Lump Sum Payment at Retirement = (0.025 × 161,581)15 = $60,593.

Correct Answer: A
Annual Unit Benefit = Value at Retirement/ Years of Service
= $56,553/15
= $3,770

Correct Answer: A
Benefits attributed to prior years in year 5 = Annual unit credit ($3,770) × 4
= $15,080

Correct Answer: C
Lump Sum Payment at Retirement = (0.025 × $161,581)20
= $80,791.

Correct Answer: B
Annual Unit Benefit = Value at Retirement/ Years of Service
= $20,197/20
= $1,010


Correct Answer: B
The number of employees relevant for an accumulated benefit obligation calculation for 10 years =
Currently Vested + Expected to meet Vesting Conditions in the next ten years = 25,000+ 125,000 =
150,000.

Correct Answer: C
The projected benefit obligation is based on the going concern assumption as it assumes the business
to maintain its operations for the foreseeable futures. Calculations are made using the assumed
turnover rates and salary increases in future periods.

Correct Answer: A
Interest Cost = Discount rate × Beginning pension obligation
= 9% * 48 million
= £4.32 million.

Correct Answer: B
Past service costs is the amount by which a company’s pension obligation relating to employees’
service in prior periods changes as a result of plan amendments or plan curtailments. These costs
represent an obligation of the company and are thus included within a company’s pension obligation.

Correct Answer: C
The return on plan assets does not have any effect on the benefit obligation. The return increases the
fair value of the plan assets.

Correct Answer: A
Curtailment occurs when the number of employees covered by the existing plan is reduced. This
reduction may be due to any number of reasons i.e. redundancy, restructuring etc.

Correct Answer: A
Share based payments are recorded as an expense in the income statement. Regardless of the absence
of a cash outflow, the income statement will recognize an expense according to the accrual principle.

Correct Answer: A
The compensation expense relevant to restricted stock grants is measured based on the fair value of
the stock on the grant date.

Correct Answer: B
When the option price is dependent upon future contingent events to be known after the grant date,
the compensation expense is measured at the exercise date.


Correct Answer: A
A lower assumed dividend yield would lead to an increase in the estimated fair value of a stock
option according to the option pricing model.

Correct Answer: A
In 2010, the company will recognize $187.5 million ($750 million/4) as compensation expense. After
recognizing this amount, the unrecognized non-vested compensation expense will reduce to $562.5
million ($750 million – $187.5 million) on December 31, 2010. With 3 years remaining, the
compensation expense recognized in 2011 is $187.5 million ($562.5 million/3).

Correct Answer: B
Stock appreciation rights provide the flexibility to employees to benefit from increases in stock price
without requiring them to hold shares. They require a current period cash outflow.

Correct Answer: A
It is compulsory under U.S. GAAP to make individual accounts for each participating employee.

Correct Answer: A
Under the defined contribution plan, employers are obligated only to make the designated
contribution at the required times. The return on the contributions and the overall pension benefit
received by the employees is not a responsibility of the employer.

Correct Answer: B
The defined benefit is funded in advance by the employer over the service life of the employee. Thus,
the investment risk is borne only by the employer under defined benefit plans.

Correct Answer: A
Each additional year of service gives rise to additional benefit which the employee is entitled to at
retirement.

Correct Answer: B
Theoretically, the differences between expected and actual returns arise from short term market
fluctuations’ over the long term, these returns should converge. Therefore, in the long term, actuarial
gains and losses arising from differences between actual and expected returns on the plan assets
should converge.

Correct Answer: C
The IFRS provides the flexibility of choosing between either converged disclosure of the overall
pension expense, or disclosure as separate line items.


Correct Answer: A
(All figures in $’000)
The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430)
When a company reports a surplus, the amount that can be reported as an asset is the lower of the
surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in
future contributions). Since the value of the ceiling ($54,500,000) is greater than the surplus, the asset
will be reported at the surplus amount.

Correct Answer: A
All figures in $’000
The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430)
When a company reports a surplus, the amount that can be reported as an asset is the lower of the
surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in
future contributions). Since the value of the ceiling ($54,500,000) is greater than the surplus, the asset
will be reported at the surplus amount.

Correct Answer: C
Given that the company complies with U.S. GAAP, it will include the following items in other
comprehensive income, equity:
• Past service costs

• Remeasurements:
o Difference between actual and expected return on plan assets
o Actuarial gains and losses – changes arising in a company’s pension obligation due to
changes in actuarial assumptions.
Service costs include current and past service costs. The former is immediately recognized in profit
and loss while the latter is included in other comprehensive income and subsequently amortized to
profit and loss.

Correct Answer: A
A higher discount rate reduces the PV of the defined obligation by a greater amount. This would lead
o a lower pension charge because of lower pension obligation.

Correct Answer: C
When the actual return is lower than the expected return by a significant amount, with the
significance being large enough to require amortization, the amortization would lead to a decrease in
pension expense.

Correct Answer: B
When the cumulative unrecognized actuarial gains or losses exceed 10% of either the PV of defined
obligation or the FV of the plan asset, the difference is mortised over the service life of the
employees.

Reading 16 Multinational Operations FinQuiz.com
FinQuiz.com
Study Session 5
June 2019


Reading 16: Multinational Operations

Correct Answer: A
In order to determine where foreign currency translation gains/losses are recorded, it is necessary to
determine the method to be used to translate El-Co Fiesta’s financial statements into U.S. $. This
method, in turn, is determined by the relationship of the functional currency of the subsidiary and the
presentation currency of the parent (Bernstake Ltd.).
The relevant functional currency is determined primarily by the currency in which the subsidiary
generates and expends cash; the currency which influences the sales price of goods and services; and
the currency of the country whose competitive forces and regulations mainly determine the sales price
of its goods and services.
In the case of the El-Co Fiesta, the relevant functional currency is the ARP. Since this currency
differs from the parent company’s presentation currency, the relevant translation method to use is the
current rate method. The current rate method records translation gains/losses as part of
comprehensive income, a component of stockholder’s equity.

Correct Answer: A
The appropriate translation method is the current rate method (see the solution to part 1). Under this
method all monetary and non-monetary assets are translated at the current rate (at December 31,
2009). Thus total assets, in U.S. $ terms, amount to $603,478.26 (ARP 3,470,000 ÷ ARP 5.75/U.S. $)
or approximately $603,000.

Correct Answer: B
Under the temporal method, Bernstake Ltd. would incur a foreign currency translation loss if the
subsidiary’s monetary assets were less than its monetary liabilities (or vice-versa) and foreign
currency weakened (or strengthened). The parent company would incur a translation gain if the
subsidiary’s monetary assets were greater than its monetary liabilities (or vice-versa) and foreign
currency strengthened (or weakened).
Based on the exchange rate trend, the ARP has weakened (over the year 2009) from being worth 4.45
to 5.75 for every US$. Additionally, translating El-Co Fiesta’s financial statements would result in a
translation gain as it as has a net monetary liability exposure (the monetary assets, ARP 1,420,000,
are less than the monetary liabilities, ARP 1,730,000) and the ARP has depreciated.


Correct Answer: A
The temporal method will produce an inventory turnover ratio that is identical to the pre-translation
ratio. Pre-translation ratio is 0.85 (ARP 850,000/ARP 1,000,000) and ratio under the temporal method
is 0.85 [(ARP 850,000 ÷ 4.85)/ (ARP 1,000,000 ÷ 4.85)].
The ratio produced under current rate method will be 0.96 [(ARP 850,000 ÷ 5.10)/(ARP 1,000,000 ÷
5.75)]. This ratio is higher to the one calculated from the temporal method. This is because the ARP
has depreciated relative to the dollar, resulting in a lower US$ value for the inventory figure (which is
converted at the current rate) under the current method, hence a lower denominator for the ratio. On
the other hand, inventory under the temporal method is translated by using the rate at which inventory
was acquired. As the rate at which inventory was acquired is historical, the inventory translated under
this method has a higher US$ value producing a higher denominator and decreasing the inventory
turnover ratio.
If El-Co Fiesta used the LIFO method for inventory valuation (instead of FIFO), all inventory units
on the balance sheet would have comprised of older items and thus valued at relatively older
exchange rates, resulting in higher translated inventory values. Thus LIFO method produces a higher
denominator and hence a lower inventory turnover ratio also decreasing the ratio is the lower
translated value of the cost of goods sold (translated at a newer, lower exchange rate). Current FIFO
inventory valuation method would have resulted in lower translated inventory values (relative to the
LIFO method), as the inventory would have relatively recent items with more recent rates being used.
This produces a smaller denominator and hence a higher inventory turnover ratio. Also increasing the
ratio is the higher translated value of the cost of goods sold (translated at a newer, lower exchange
rate).

Correct Answer: A
Since long-term bonds are monetary liabilities, these are translated using current exchange rates under
the temporal method. Thus the U.S. $ value of notes payable amounts to $222,608.70 (ARP
1,280,000 ÷ ARP5.75/U.S. $) or approximately $223,000.

Correct Answer: A
Under hyperinflationary periods, IFRS requires nonmonetary assets to be restated for the general
purchasing power unit of the monetary unit. These restated assets will then be translated under the
current rate method at the current exchange rate.
Inflation-adjusted inventory = ARP 1,000,000 × 130/100

= ARP 1,300,000
Translated Inventory = ARP 1,300,000 ÷ ARP 8.00/U.S. $

= $162,500


Correct Answer: C
Since France Co has a net monetary liability exposure and the Euro has appreciated relative to the
dollar (Exhibit 4), the best course of action for the subsidiary would be to finance the purchase of the
plant using equity rather than debt (long-term notes payable) since capital stock is not exposed to
foreign exchange risk under the temporal method.
The subsidiary has a net monetary liability exposure of €6,740 million as its monetary assets (cash
and accounts receivable), €3,825, are less than its monetary liabilities (total liabilities), €10,565
million.
Eliminating capital stock is not a recommended course of action since the notes payable are exposed
to foreign exchange risk under the temporal method (which is used as the translation method since the
presentation and functional currencies are identical), whereas capital stock is not.
France Co’s existing cash balance of €175 million can only partially reduce its liabilities of €10,565
million. If the parent were required to pay off France Co’s remaining liabilities of €10,390 million
(€10,565 million – €175 million), it would need to send US$ 6,754 million (€10,390 million × US$
0.65/€) on January 1, 2010. On December 31, 2010 Arioco-P would be required to send US$ 7,793
million (€10,390 million × US$ 0.75/€) to pay €10,390 million. This will result in a foreign exchange
loss of US$ 1,038 million (US$ 7793 million – US$ 6,754 million), thereby failing to eliminate
exposure.

Correct Answer: B
Given that the Euro has appreciated from 0.65 to 0.75 relative to the US dollar, France Co will report
a translation loss under the temporal method as its monetary liabilities are greater than its monetary
assets (see the previous solution) resulting in a reduction in net income and hence its total equity
balance.
On the other hand, since the current exchange rate used to translate total assets under the current
method is greater relative to the historical exchange rates used to translate assets under the temporal
method and since it has a net asset exposure of €4,566 million (€15,131 million − €10,565 million),
there will be a positive translation adjustment. Since the positive translation adjustment will increase
the total equity balance, this will result in a higher total balance being reported for the subsidiary
under the current rate method.

Correct Answer: A
A higher gross profit margin will be reported under the temporal method.
Under both methods, sales will be translated at the average rate. The rate at which cost of goods sold
is to be translated will determine the method to produce the highest gross profit margin for the
subsidiary.
Under the current rate method, cost of goods sold is translated at the average rate, i.e. US$ 0.70 per €.
The rate at which cost of goods sold is translated under the historical method will be an older and
lower rate, given the increase in the value of Euro over the 2010 period. Thus, the cost of goods sold
will be higher and gross profit lower under the current rate method, which produces a lower gross
profit margin using this method.


Correct Answer: A
Given that France Co.’s functional currency is identical to Arioco-P’s presentation currency, US$, the
temporal method is used to determine its translated retained earnings as follows:
€ (millions) Exchange rate (US$ $ (millions)

per €)
Cash 175 0.75 131.25
Accounts Receivable 3,650 0.75 2,737.50
Inventory 4,530 0.67 3,035.10
Total current assets 8,355 5,903.85
Property, plant, and
equipment 15,136 0.65 9,838.40
Less: accumulated
depreciation (8,360) 0.65 (5,434.00)
Total assets 15,131 10,308.25
Total liabilities 10,565 0.75 7,923.75
Capital stock 2,000 0.65 1,300.00
Retained earnings 2,566 to balance 1,084.50
Total 15,131 10,308.25
Since France Co was established on January 1, 2010 it has no opening retained earnings.

Correct Answer: C
Implication 1 has been inaccurately identified. Implication 2 has been inaccurately identified.
In scenarios of hyperinflation, U.S. GAAP simply requires the foreign currency financial statements
of the concerned subsidiary to be translated using the temporal method. On the other hand, IAS 21
(IFRS) requires foreign currency financial statements to be restated for inflation and then translated
using the current rate.
Under the temporal method and U.S. GAAP, liabilities will be translated at an exchange rate of AD
125.53 per US$. Under IFRS, liabilities will not be restated for inflation as they are expressed in
terms of the monetary unit current at the balance sheet date. Thus under the current rate method and
IFRS, these liabilities will be translated at the same exchange rate as used under the temporal method,
i.e. AD 125.53 per US$. Thus the translated liabilities under the two standards are identical.
Inflation in Algeria increased by 300% or by 3 times over the 2010 period. At the same time, the AD
lost about 26% [(125.53 – 100)/100] of its value. Since the decrease in currency value is not matched
by the change in local inflation, IFRS and U.S. GAAP will produce different results.

Correct Answer: A
Using the temporal method (see the solution to part 4), France Co’s closing inventory account balance
is approximately US$ 3,035 million (€4,530 million × US$ 0.67 per €).

Reading 17 Analysis of Financial Institutions FinQuiz.com
FinQuiz.com
Study Session 5
June 2019


Reading 17: Analysis of Financial Institutions

Item-set Id: 169397
1. Question:
Correct Answer: C
C is correct. Compared to other financial institutions, banks are systematically more important
compared to non-financial institutions because banks serve as intermediaries accepting deposits from
capital providers and providing capital via loans to borrowers. Their role as intermediaries between
and among providers and recipients of capital creates financial inter-linkages across all types of
entities. The network of inter-linkages means that the failure of one bank will negatively affect other
financial and non-financial entities. The risk of failure will disrupt financial services and, depending
on the size of the institution, has the potential to affect the economy as a whole.
A is incorrect. The degree to which a banking institution is regulated does not explain why banking
institutions are systemically important. On the other hand, banks are heavily regulated because they
are systemically important.
B is incorrect. This factor does not explain the systemic importance of banks.
2. Question:
Correct Answer: B
B is correct. Unlike banks, the overall insurance market has a smaller proportion of cross-border
business.
A is incorrect. The re-insurance business is largely international similar to the banking sector.
C is incorrect. Compared to L&H and P&C insurers, the re-insurance market is engaged in substantial
cross-border business.
3. Question:
Correct Answer: B
B is correct. The bank’s market risk exposure has increased as evidenced from the change in net
interest income in response to a yield curve shift; i.e. interest rate sensitivity. The sensitivity has
increased as the magnitude of the change in net interest interest income following a yield curve shift
in either direction has increased over the three years.
A is incorrect. The bank’s capital adequacy has improved as indicated by an increase in the total
capital ratio from 2015 to 2017.
C is incorrect. Short-term liquidity is measured by the coverage ratio and this trend for this ratio is
downward between 2015 and 2017. Short-term liquidity has declined between 2015 and 2017 only to
rise briefly in 2016. The long-term liquidity (as measured by the net stable funding ratio) exhibits a
downward trend indicating a decline in this measure.

4. Question:
Correct Answer: A
A is correct. The CAMELS approach analyzes capital adequacy, asset quality, management
capabilities, earnings stability, liquidity position and sensitivity to market risk. One of the factors
which is overlooked and requires attention is an entity’s corporate culture.
B is incorrect. Analyzing governance structure is not relevant to the analysis of a banking institute.
5. Question:
Correct Answer: C
C is correct. Response to Question 3: Banks are subject to minimum capital requirements which they
are legally obliged to comply with. With respect to P&C insurers, no risk-based global insurance
minimum capital standards exist. However, capital standards exist in various jurisdictions.
Nevertheless, the degree of regulation is not as extensive as that imposed on banks. Similar to P&C
companies, L&H companies are not subject to risk-based global insurance minimum capital
standards. In addition, L&H insurers can afford a lower equity cushion and lower capital
requirements than P&C insurers because L&H claims are more predictable.
Response to Question 4: As discussed above, P&C insurers’ claims are more variable because they
arise from accidents and other unpredictable events.
6. Question:
Correct Answer: C
The efficiency of the underwriting operations is determined using the combined ratio. This ratio is
calculated as follows:
Combined ratio = Underwriting expense ratio + Underwriting loss ratio
Insurer 1 Insurer 2 Insurer 3

Underwriting loss ratio 82.3 77.5 69.3
Underwriting expense ratio 22.5 20.7 18.8
Combined ratio 104.8 98.2 88.1
Based on the calculations, insurer 3 has the lowest ratio which corresponds to the greatest efficiency
in its underwriting operations.

Reading 18 Evaluating Quality of Financial Reports FinQuiz.com
FinQuiz.com
Study Session 6
June 2019


Reading 18: Evaluating Quality of Financial Reports

Correct Answer: B
B is correct. The impact of increasing the discount rate to maintain funded status in a period
when plan assets were underperforming and subsequently decreasing the discount rate when
performance improved will result in financial statements which do not reflect economic
reality and are thus not decision useful. Lowering or increasing the discount rate merely to
maintain funded status reflects a biased accounting choice.
A is incorrect. The process of estimating the discount rate is not prescribed by GAAP and is
left to the discretion of company management. Therefore, an in appropriate estimation of this
rate is a poor representation of economic reality resulting from a biased accounting choice.
C is incorrect. The company was attempting to improve the funded status reported on its
balance sheet as opposed to earnings. Therefore, the question of whether earnings are
sustainable is not relevant in this context.

Correct Answer: C
C is correct. An understatement of financial liabilities held at fair value will result in an
overstatement of equity resulting from the overstatement of unrealized gains. Understating
the equity balance will result in an overstatement of the return-on-equity measure.


Correct Answer: C
C is correct. A possible explanation for receivables growth being faster than that of revenue
in each of the three years is that Smart-Tech may be pushing future sales into the current
period by offering favorable discounts or generous return policies. This has the effect of
encouraging customers to buy more than demanded and thus increasing the company’s
accounts receivables balance at a rate faster than the growth in sales revenues.
A is incorrect. A stringent credit policy will force customers to make timely payment of
accounts receivables and is likely to lead to a decline in outstanding account receivable
balances. This will reduce the growth of account receivables relative to sales.
B is incorrect. Again, an improvement in credit quality will lead to a decline in accounts

receivables with customers making timely payments on their outstanding accounts. This will
serve to decrease the growth in receivables relative to sales.
4. Question ID: 22259s

Correct Answer: A
A is correct. Given that the litigation claim was filed in 2012, the accrual for losses should be
recognized in the year incurred. This would mean that losses should be spread out (if Smart-
Tech incurs losses in 2013) rather than recognized fully recognized solely in the year 2013.
By not accruing losses in the previous years, Smart-Tech’s prior year’s earnings are
overstated.

Correct Answer: B
B is correct.
DEPI = Depreciation ratet-1/Depreciation ratet
A value for the DEPI variable which is greater than 1.0 indicates a decline in the depreciation
rate. A lower depreciation charge will translate into reduced depreciation charges and higher
net income.
Net profit margin will be higher relative to the previous year due to a lower depreciation
charge increasing net income.
A is incorrect. Debt-to-equity ratio will be lower relative to the previous year as higher net
income will translate into an increase in retained earnings thereby increasing the denominator
of this measure.
C is incorrect. Total debt-to-total assets will be lower relative to the previous year as a lower
depreciation charge will serve to increase the net book value of assets and thus total assets.
The denominator of the ratio will consequently increase.


Correct Answer: A
A is correct. Being less than 1.00, the value of the AQI index suggests a decline in capital
expenditures relative to the previous year.
B is incorrect. See above.
C is incorrect. The SGAI is an indicator of administrative and marketing efficiency. Based on

the value of the index in the exhibit, this indicator signals an improvement in marketing and
administrative efficiency.

Reading 19 Integration of Financial Statement Analysis Techniques FinQuiz.com
FinQuiz.com
Study Session 6
June 2019


Reading 19: Integration of Financial Statement Analysis Techniques

Correct Answer: B
Lester Corporation’s net profit margin (exclusive of associates’ performances) for the year 2010 and
the group’s total profit margin are calculated using the following formulas:
Tax burden (ex-associates) = net income – income from associates/EBT

Interest Burden = EBT/EBIT
EBIT Margin = EBIT/Revenue
Workings
Tax burden (ex-associates) $(12,232 – 3,343)/$14,856 59.83%
× Interest Burden $14,856/$15,353 96.76%
× EBIT Margin $15,353/$102,424 14.99%
= Net Profit Margin (ex-associates) 8.68%
Net Profit Margin $12,232/$102,242 11.96%
(inclusive of associates)
By including the performance of associates as part of Lester Corporation’s net profit margin, the
exclusive profit margin increases by 3.28% (11.96% – 8.68%) for the year 2010. This represents the
effect of associates’ performance on the parent corporation’s performance. In other words, Lester
Corporation’s net profit margin exclusive of associates’ investments was lower than the total net
profit margin by 3.28%.

Correct Answer: C
The total asset turnover (ex-associates) for the year 2009 is determining by subtracting the associates’
assets from the group’s assets for the years 2008 and 2009. The average of the adjusted assets for the
two years is calculated to determine the total asset turnover.
100,242
Total assets ex– associates turnover = = 0.7380
136,657 + 134,989
2
100,242
Total assets turnover (inclusive of associates) = = 0.69613
145,646 + 142,353
2
The investments in associates has decreased Lester Corporation’s total asset turnover (exclusive of
the associates) by approximately 0.042 (0.69613 – 0.73803).


Correct Answer: A
Detergents Inc.: This segment will be a cause of concern as it has the highest EBIT relative to the
other segments (35.75%). However the capital allocated to the segment has deteriorated from 2009 to
2010 (from 0.78 to 0.52). Additionally, the amount of capital expenditures relative to the total assets
has been low over these two years as a ratio of lower than 1 indicates the segment is being allocated a
smaller amount of capital expenditures relative to its total assets. All these factors may be a cause of
concern for Ali.
Lester Corp. Australia & New Zealand: This segment has the second highest EBIT margin with
capital expenditures in excess of the total assets over the three years. Additionally, the capital
expenditures are in growth mode (increasing from 2008 to 2010). All these factors indicate the
segment will not be a cause of concern for Ali.
Lester Corp. Europe: This segment has the third highest EBIT margin but the level of capital
expenditures relative to assets is considerably low (as evidenced by the lower than 1 ratios over the
three years). Additionally the decrease in capital allocation over the three years (from 0.66 to 0.69 to
0.60) may be a cause of concern for the analyst.
Mineral Extractions: This segment has the third highest ratio of capital expenditure to total assets but
has the second lowest EBIT margin. This segment is detracting capital expenditures from other
segments with higher EBIT margins such as Detergents Inc. and Lester Corp. Europe. Additionally,
capital expenditures are growing over the three year period. This segment will be a cause of concern
for Ali.
Lester Skin Care: This segment has the second highest ratio of capital expenditure to total assets but
has the lowest EBIT margin. This segment is detracting capital expenditures from other segments
with higher EBIT margins such as Detergents Inc. and Lester Corp. Europe. Additionally, capital
expenditures are growing over the three year period. This segment will be a cause of concern for Ali.

Correct Answer: B
In order to determine the earnings quality for Lester Group over the 2007 to 2010 period, the
operating cash flow before interest and taxes is compared to the profit/earnings before income and
taxes. Using the data in exhibit 3, the two figures are calculated below:
2010 2009 2008 2007

Operating cash flow 17,125 15,895 12,452 10,685
Cash taxes paid 789 598 465 325
Cash interest paid 645 558 486 315
Operating cash flow before interest and taxes 18,559 17,051 13,403 11,325
EBIT 14,856 11,453 10,473 9,856
Operating cash flow before interest and taxes/EBIT (2007) = 1.14


Since the group’s operating cash flow before interest and taxes has consistently exceeded EBIT over
the 2007-2010 period and the operating cash flow before interest and taxes/EBIT ratio has increased,
Nosov may conclude the group’s earnings quality has increased.

Correct Answer: A
The cash return on assets over the 2008 to 2010 period is calculated using the group’s operating cash
flows illustrated in exhibit 3 and the group’s total assets illustrated in exhibit 1.
$ $ $
Operating cash flows 17,125 15,895 12,452
Total assets 150,278 145,646 142,353
Cash return on assets 11.40% 10.91% 8.75%
The cash return on assets measure has increased and thus displayed a positive trend over the 2008 to
2010 period.

Correct Answer: A
The incremental assets relative to total reported assets is calculated using Nosov’s lease multiplier
and compared to total reported assets to determine whether additional assets and liabilities (related to
off-balance sheet leases) may need to be reported on the segment’s balance sheet.
2010 lease expense €9.54 million

Lease multiplier 8.52
Estimated incremental assets and debt €81.28 million
2010 total assets €500.00 million
Estimated incremental assets to total reported assets 16.26%
The estimated incremental assets to total reported assets exceeds the 6% threshold (16.26% vs. 6%).
This implies that the reported assets and liabilities do not truly reflect the financial position of the
segment and there may be off-balance sheet lease transactions which may have not been reported and
may possibly require capitalization. This implies that there are significant assets and liabilities that
could be justifiably capitalized on the segment’s balance sheet. The issue needs to be further
investigated by Nosov.

Reading 20 Capital Budgeting FinQuiz.com
FinQuiz.com
Study Session 7
June 2019


Reading 20: Capital Budgeting

Correct Answer: C
After-tax salvage value is calculated as follows:
Annual Depreciation = $175,000 – $80,000/10 = $9,500
Before-tax salvage vale = $80,000 (given)

Accumulated depreciation = $9,500 × 6 = $57,000
Net Book Value (Year 6) = $175,000 – 57,000 = $118,000
Therefore, loss on sale = $80,000 – 118,000 = –$38,000
Tax on loss = 0%
After-tax salvage value = $80,000 – 0 = $80,000

Correct Answer: A
In order to determine the EAA for both projects, it is necessary to first determine the NPV of the
project. Using your financial calculator and the 2nd CF function, the following values are input:
Event Managers Ltd.:

CF0 = –$700,000 (–$500,000 + –200,000)
CF1 = +$1,882,500 [$3,500,000 – 990,000 – ($3,500,000 – 990,000) (0.25)]
CF2 = +$1,882,500
CF3 = +$1,882,500
CF4 = +$1,882,500
The relevant discount rate is 12.50%. Using the discount rate and cash flows, the NPV of the Event
Managers Ltd. contract is $4,958,116.14.
For a four-year life and a 12.5% discount rate, the payment with an equivalent annuity is
$1,649,604.46 (PV = -$4,958,116.14; I/Y = 12.50%; N = 4; FV = 0; CPT PMT)
H.S. Creations:
CF0 = –$700,000
CF1 = +$1,882,500
CF2 = +$1,882,500
The relevant discount rate is 12.50%. Using the discount rate and cash flows, the NPV of the H.S.
Creations contract is $2,460,740.74.
For a four-year life and a 12.5% discount rate, the payment with an equivalent annuity is
$1,465,588.24 (PV = -$2,460,740.74; I/Y = 12.50%; N = 2; FV = 0; CPT PMT)
Thus the project with the highest EAA is the Event Management project.


Correct Answer: C
The optimal abandonment strategy would be to abandon the project in the second year if the
subsequent cash flows are less than the abandonment value.
If after the first year a low cash flow occurs, Music Inc. can abandon the project for $3,500,000 and
give up cash flows of $950,000 for the next four years. The present value of the $950,000 annual cash
flows discounted at 12.50% [2% + (7% × 1.5)] for 4 years is $2,855,357.42. Since the present value is
less than the abandonment value, Music Inc. should abandon the project if low cash flows occur after
the second year.
The present value of the $2,500,000 annual cash flows discounted at 12.50% for four years is
$7,514,098.46. Since the present value of the cash flows in this case is greater than the abandonment
value, Music Inc. should not abandon if the high cash flow occurs after the second year.
If a high cash flow occurs and you do not abandon, the NPV is:
଺
$2,500,000
ܸܰܲ = −200,000 + ෍ = $9,934,596.32
1.125௧
௧ୀଵ
If low cash flow occurs and you abandon, you will receive the second year cash flow and the
abandonment value. The NPV is:
950,000 950,000 + 3,500,000

NPV = – $200,000 + + = $4,160,493.83
(1.125)1 (1.125)2
The expected NPV is 0.50 ($9,934,596.32) + 0.50 ($4,160,493.83) = $7,047,545.07

Correct Answer: B
Shortfall 1: One of the shortfalls associated with capital budgeting is that it fails to taking into account
economic responses. Conditions in the market may change (such as a new competitor entering the
market and reducing profitability) which drastically change the profitability of the project. Thus
shortfall 1 has been accurately identified.
Shortfall 2: Managers may have a short-term focus and seek to increase short-term measures such as
ROE and NP margin. By doing so, they may reject projects which produce negative NPVs and
currently reduce such income and profitability measures but may generate greater shareholder value
in the long run. Thus shortfall 2 has been incorrectly identified.
Shortfall 3: Overhead costs are difficult to estimate and may be inaccurately accounted for in the
capital budgeting process. Opportunity costs and sunk costs are difficult to estimate and/or may be
excluded in capital budgets. Thus shortfall 3 has been correctly identified.


Correct Answer: C
Inflation reduces the value of depreciation tax savings and the value of the depreciation tax shelter.
Higher than expected inflation reduces the value of the depreciation tax shelter and reduces the value
of fixed payments to bondholders. Thus the real interest expenses of the corporations will decrease
decreasing the fixed payments in real terms.

Correct Answer: B
The formula for calculating economic income is cash flow + change in market value, where:
Change in market value = Ending market value- beginning market value
Alternatively, economic income = cash flow – (beginning market value – ending market value) or
cash flow – economic depreciation.
Beginning market value is the present value of the future after tax cash flows discounted at the
applicable required rate of rate
The economic income for the first two years has been calculated (in $):
Year 1 2 3
Beginning Market Value 6,395,454.55 4,690,000.00 2,579,500.00
Ending Market Value 4,690,000.00 2,579,500.00 0.00
Change in Market Value –1,705,454.55 –2,110,500.00 –2,579,500.00
After-tax cash flow 2,345,000.00 2,579,500.00 2,837,450.00
Economic Income 639,545.45 469,000.00 257,950.00
After-tax cash flow (Year 2) = $2,345,000 × 1.1 = $2,579,500
After-tax cash flow (Year 3) = $2,579,500 × 1.1 = $2,837,450
Beginning market value (Year 1) is calculated as the present value of the after tax-cash flows in years
1-3 (CF1 = $2,345,000; CF2 = $2,579,500; CF3 = $2,837,450)
Beginning market value (Year 2) is calculated as the present value of the after tax-cash flows in years
2-3 (CF1 = $2,579,500; CF2 = $2,837,450)
Beginning market value (Year 2) is calculated as the present value of the after tax-cash flows in year
3 (CF1 = $2,837,450)
In addition to the Nevada expansion project, Music Inc. is considering developing a small musical
theatre in Ohio. The estimated construction costs will be $1,500,000 which includes a fixed capital
investment of $900,000 and the remainder of the investment allocated to net working capital. These
costs will be incurred at the beginning of the project. Annual after-tax operating cash flows are
forecasted at $2,345,000 in the first year and will rise by 10% thereafter. The final year’s after tax
operating cash flow includes the equipment’s after-tax salvage value. The company will apply a 10%
discount rate to the project and the capital budget horizon is of 3 years. The applicable tax rate is
25%.


Correct Answer: A
Current NPV of the project can be found using the following relationship:
0.85 = 1 + NPV/$35 million
NPV = -$5,250,000
Increasing the NPV by $7.5 we have:

New NPV = -$5,250,000 + $7,500,000 = $2,250,000
New benefit-cost ratio (PI index):

PI = 1 + 2,250,000/35,000,000 = 1.064
Note: This can also be calculated using the other relationship: PI = PV of future cash flows/initial
investment.

Correct Answer: B
If at the end of first year the low cash flow occurs, REKE can either abandon the project and get
$315,000 or receive $70,000 for the next 4 years. $70,000 annual cash flow, discounted for four years
at 12% equals $212,614, hence REKE should abandon. Four years of the $120,000 annual cash flow
has a present value of $364,482 so REKE should not abandon.
If high cash flow occurs and REKE does not abandon:

NPV = –350,000 +∑t=1-5 120,000/1.125 = $82,573
If you abandon:
NPV = –350,000 + 70,000+315,000/1.12 = –$6,250
The expected NPV equals: 0.40(82,573) + 0.60(–$6250) = $29,279

Correct Answer: A
Boris is correct with respect to the difference between accounting income and economic income.
Accounting income is subject to accounting depreciation, which is based on the original cost of an
investment. Consequently, in contrast to economic depreciation, the accounting depreciation schedule
does not follow changes in the market value of an asset.
Boris is incorrect with respect to the flaw. Economic income ignores interest expenses. However, the
effects of financing costs are captured in the discount rate used in a capital budgeting model, and if
interest expenses are included in the cash flows (either economic income or after tax operating cash
flows), we would be double counting them.

Correct Answer: B
EBT = EAT / (1-t)
EBT = 22,748 / (1-.35)
EBT = 34,997
EBIT = EBT + Interest

EBIT = 34,997+12,904
EBIT = 47,901

NOPAT = EBIT (1- t)

NOPAT = 47,901 (1-0.35)
NOPAT = 31,136
$WACC = 0.12(67,394+153,948)
$WACC = 26,561
EP = 31,136 - 26,561 = 4,575

Correct Answer: C
PV of residual income $87,302
Debt investment $132,096
Equity investment $66,048
Total value $285,446

Correct Answer: C
Boris’s methods are incorrect. The residual income approach takes the perspective of equity investors,
so residual income should be discounted at the cost of equity. Since Company XYZ repurchases
shares sometimes, the cash flows to shareholders should include both dividends and share repurchases
(this approach is known as the claims valuation approach).

Correct Answer: C
The NPV profile does not intercept the x-axis at any point. Therefore, the IRR is indeterminable.

Correct Answer: B
All figures in ‘000
Incremental Operating Cash Flow= (∆S-∆C-∆D) (1-T) +∆D
Incremental Operating Cash Flow= ($50,000-$11,000-$9,000) (0.72) +$9,000= $21,600+$9,000=
$30,600

Correct Answer: C
All figures in $000
Total NonOperating Cash Flows:
Book Value= 160,000 – (35,000*4) = 20,000
NonOperating Cash Flows= Salvage Value+ WC Inv.- T (Salvage Value- Book value)
NonOperating Cash Flows=25,000+25,000- 0.28(25,000-20,000)
NonOperating Cash Flows=50,000-1,400= 48,600
Total Operating Cash Flows:
Operating Cash Flows= (S-C-D) (1-T) +D
Operating Cash Flows= (150,000-35,000-55,000) (0.72) +35,000
Operating Cash Flows=78,200
Total Cash Flows: 78,200+48,600= 126,800


Correct Answer: A
All figures in $000
Initial Outlay= In. Inv.= WC Inv. – Salvage Value + T (Salvage Value- Book Value)
Initial Outlay=$1,000,000+$65,000-$130,000+ (0.28) ($130,000-$115,000)
Initial Outlay=$935,000+$4,200=$939,200

Correct Answer: C
Correct Answer: C
All figures in $000
Operating Cash Flow= (S-C-D) (1-T) +D
Operating Cash Flow=$177,000(0.72) +$28,000= $155,440

Correct Answer: A
TNOCF= ∆Salvage Value + WC Inv. – T (∆Salvage Value- ∆Book Value)
TNOCF= $70,000+$65,000-(0.28) [$70,000-$0]
TNOCF= $135,000- (0.28) ($70,000)
TNOCF= $135,000-$19,600
TNOCF= $115,400

Correct Answer: C
As both the mentioned projects are not mutually exclusive and carry a positive NPV, the company
can afford to invest in both of them.

Correct Answer: C
(1+m)= (1+r) (1+i)
(1+m)= (1.12) (1.04)
m=16.48%
PV= $8,000,000, FV= 0, I/Y= 16.48, n=2, CPT PMT
PMT= $5,013,900

Correct Answer: B
Profitability Index=1+(NPV/Initial Investment)
Profitability Index= 1+($25,000,000/$53,400,000)=1.468

Correct Answer: A
Soft capital rationing addressed the situation in which the managers of the entity are reluctant to
allocate corporate funds to profitable projects despite the availability of liquid resources.


Correct Answer: C
The Tenz project needs to start commercially viable operations within two years of initial investment.
Therefore, a timing option has not been provided for this project. The expandable facility signifies an
expansion option and the flexibility in price charging indicates the presence of a price setting option.

Correct Answer: A
The beta of a stock or portfolio is a number describing the relation of its returns with those of
the financial market as a whole. It is therefore a measure of the systematic risk of an asset or a
project. A low beta indicates a low systematic risk.

Correct Answer: B
Economic Income= Net After Tax Cash Flows + Change in Market Value
Economic Income= $220,000 * (0.65) + $8,000 = $151,000

Correct Answer: B
The differential overtime is being charged by the research team currently in place, as it is being
inconvenienced by its workplace occupation by the project under scrutiny. Had this project not been
entered into, the company would not have to bear this extra cost.

Correct Answer: B
Economic Profit= NOPAT - $WACC
Economic Profit= $380,000(1-35%) – {18% x [$500,000- ($184,000/5) x 4]}
Economic Profit= $247,000 – [18% x ($500,000-$147,200)]
Economic Profit= $247,000- $63,504= $183,496

Correct Answer: C
MVA= ∑[EPt/ (1 + WACC) t]
CF Worksheet: C01= $180,000; F01= 5
NPV: I= 18%; CPT NPV= $562,890

Correct Answer: B
Total Value of Company= Fair Value of Liabilities + Fair Value of Equity = Far Value of Assets =
$18 million

Correct Answer: A
Residual Income = Net Income – (re × BV of equityt–1)
Residual Income = $190,000 – (12% × 360,000)
Residual Income = $190,000 – $43,200 = $146,800

Reading 21 Capital Structure FinQuiz.com
FinQuiz.com
Study Session 7
June 2019


Reading 21: Capital Structure

Correct Answer: C
Theory 1:
MM Proposition I (without taxes) states the value of a company is unaffected by its capital structure.
In addition the theory assumes that investors have homogenous expectations regarding the cash flows
from investments, investors can borrow and lend at the risk free rate and no agency costs or financial
distress costs exist.
Thus a change in capital structure does not affect company value. If the management-determined
capital structure is not in agreement with the capital structure desired by investors, the latter group
can borrow or lend at the risk-free rate (as opposed to a general lower rate) to create the capital
structure desired. Since the value of the company is the present value of company operating earnings,
a change in either the percentage of debt or equity will not affect company value. The value of a
leveraged company should equal to the value of an unleveraged company. Theory 1 is inaccurate with
respect to the risk-free borrowing and lending assumptions stated.
Theory 2:
MM Proposition 2 (with taxes) endorses the fact that paying interest will generate tax savings for the
corporation. Thus the value of a company should increase with the value of the tax shield (tD). With
the presence of corporate taxes, the value of a company with debt is greater than the value of an all
equity company.
As debt increases, cost of equity also rises with the rise in the cost of equity being smaller than the
rise in the no-tax case (due to the absence of tax shield benefits in the latter case). Thus as debt
increases, the overall marginal cost of capital falls and company value increases. Wright has
inaccurately described the effects of rising equity costs (from additional debt) on the company’s cost
of raising additional financing or WACC.

Correct Answer: C
D
Under MM II proposition (with taxes), re = r0 + ( r0 − rd ) (1− t )
E
r0 = 11%
rd = 5%
t = 30%
D/E (2011):
Market Value of Debt (2010) = 0.80 × $25 million = $20 million
D/E (2011) =
($20 + $3*) million = $23 million
($25 − $3*) million $22 million
* ± $3 million reflect the additional borrowing received/repurchase of common equity.

Thus, re = 11% + (11% - 5%)(1 – 30%)[23/22] = 15.3909091% ≈ 15.39%

Correct Answer: C
Factor 1: The marketability of the firm’s financial assets does affect the costs of financial
distress incurred. Firms whose assets are relatively marketable incur lower costs of
financial distress as they have more assets to liquidate in the event of financial
distress compared to firms whose assets lack marketability. Thus factor 1 has been
correctly identified.
Factor 2: The stronger the firm’s corporate governance system, the lower the probability of
bankruptcy and thus the lower the financial distress costs incurred. Thus factor 2 has
been correctly identified.
Factor 3: Bonding costs are incurred by management to ensure they are working in the best
interests of shareholders and directly affect net agency costs of equity as opposed to
costs of financial distress. Thus factor 3 is incorrectly identified and not relevant in
this context.

Correct Answer: A
When making decisions concerning the level of financial leverage they should undertake, companies
should balance the value enhancing effects of financial leverage (tax deductibility of interest) against
the value reducing costs of financial distress, asymmetric information, and debt agency costs. The
static trade-off theory of capital structure, which incorporates the costs and benefits associated with
debt, states that the optimal capital structure is one in which debt is less than 100% of its capital
structure. Optimal debt is found at the point where additional/incremental unit of debt would cause
the costs of financial distress to increase by a greater amount than the benefit of the additional tax
shield.

Correct Answer: C
Generally, agency costs are costs that arise from the conflict of interests between managers,
shareholders, and bondholders.
The smaller the stake that managers have in the company, the less is their share in bearing the cost of
executive perquisite compensation. This results in an increase in the agency costs of equity. Generally
a reduction in net agency costs of equity results from an increase in the use of debt versus equity. The
more financially leveraged a company is the less freedom managers have to take on more debt or
spend the cash unwisely (for example, through perquisite consumption). Thus debt can act as a
disciplining mechanism. This is referred to as the ‘free cash flow hypothesis’ and reflects an effort to
reduce the net agency costs of equity.


Correct Answer: C
Note: Since both countries have similar maturities, the maturities are held constant for the question.
Countries that possess efficient legal systems have a lower D/E ratio and longer debt maturity.
Relative to B, A has a lower D/E ratio (0.70 vs. 0.55) and has a more efficient legal system. Both
countries have long-term maturities (> 20 years).
Countries with a bank-based financial system have higher D/E ratios. Relative to A, B has a higher
ratio and more likely possesses a bank-based financial system. On the other hand, A possesses a
market-based financial system based on its ratio.
Countries that follow common law have lower D/E ratios and longer maturities. The converse is true
for civil law countries. Relative to B, A has a lower D/E ratio. Thus A most likely is a common law
country whereas B is a civil law country based on their respective D/E ratios.
Countries with a greater presence of information intermediaries (auditors and analysts) have lower
D/E ratios and longer debt maturities. Thus A, based on its D/E ratio, has a greater presence of
information intermediaries than B.
Countries with a greater presence of institutional investors generally have companies with lower D/E
ratios and debt with longer maturities. Based on the respective D/E ratios, country A has a greater
presence of institutions relative to B.

Correct Answer: B
Loss of customers due to deterioration of company reputation is an example of indirect cost of
financial distress.

Correct Answer: A
The specialized nature of the research assets suggests that an active market does not exist for such
products. Therefore, these assets might have to be sold at a substantial discount to their value in use in
order to attract a customer. This specialization of assets would therefore lead to an increase in costs of
financial distress.

Correct Answer: A
An increase in equity would decrease the financial leverage of the firm. This decrease in leverage will
subsequently lead to a decrease in the cost of financial distress.

Correct Answer: A
The tax paid on $10 of dividends and $10 of interest income is as follows:
Dividend:
Tax Rate=25%
Tax Amount= $10*50%*12.5%= $0.625
Interest Income
Tax Rate= 20%

Tax Amount= $10*20%= $2

Since half of the dividends received are nontaxable, and the effective tax amount paid is lower for
dividends as compared to the same amount of inflow through interest, dividend income would be
more preferable.

Correct Answer: C
WACC= [KD*(1-T)*D/V] + [Ke*E/V]
WACC= [6 %( 0.72)3/4] + [10%*1/4]
WACC= 3.2%+ 2.5%
WACC= 5.7%
Vu= EBIT (1-T)/WACC
Vu= $15million*(1-0.28)/0.057
Vu= $10.8 million/0.057=$189 million
VL= VU+ tD= $189 million + (28% x $45 million)= $202 million

Correct Answer: B
Ke= r0+ (r0-rd) (1-T) D/E
Ke= 0.08+ (0.08-0.06) (1-0.28)60/40
Ke= 0.08+ 0.0216
Ke= 10.16%

Correct Answer: A
Information asymmetry suggests that in the event of a mismatch of information between stakeholders
and the management, the costs of capital to the company increase due to a higher uncertainty of
management reliability.

Correct Answer: B
Static trade off theory dictates that the optimal capital structure lies at the point where the costs of
financial distress are exactly offset by the incremental tax benefit.

Correct Answer: B
0% Debt 50% Debt 75% Debt

Assets $45 million $45 million $45 million
Debt $0 million $22.5 million $33.75 million
Equity $45 million $22.5 million $11.25 million
Before Tax Cost of - 8% 11%
Debt
After Tax Cost of Debt - 5.76% 7.92%
Cost of Equity 12% 15% 18%
WACC 12% 10.38% 10.44%


Correct Answer: B
When the company’s WACC increases upon raising additional debt, it indicates that the capitalization
ratios have exceeded their optimal range. As a result, the costs of financial distress exceed the
additional tax benefit incurred.

Correct Answer: A
An increase in transparency would lead to a decrease in agency costs as there would be less need of
monitoring. the clear unabridged view of the company given to the stakeholders would increase their
confidence in the company.

Correct Answer: C
Raising additional debt would limit the financial flexibility of the firm because of more strict
covenants and greater payment obligations. This would not give managers room for moving corporate
funds to private holdings. Additional equity would decrease leverage and increase agency costs.
Dividends once announced are also n obligatory cash outflow.

Correct Answer: B
Common law is passed through generations due to the presence of relatable precedents. The legal
system is deemed to be more efficient for a country following common law policies. Since the equity
holders would be ensured of justice in case of management fraud, they would be prone to invest in
equity. This would lead to a lower debt to equity ratio.

Correct Answer: A
Since institutional investors would be trading large chunks of equity in the market, the cost of equity
would be relatively low as compared to a company in a market with a major composition of private
individual investors.

Correct Answer: A
In a legally efficient system, investors would be comfortable with investing for long term periods
without fear of repayment by company or manipulation by management.

Correct Answer: A
In a country with high inflation rate, investors prefer equity investments rather than debt investments.
This is because the constant stream of cash available from debt investments may not be reinvested in
a suitable project. To avoid this reinvestment risk and currency depreciation risk, investors in such a
country prefer equity investments.

Correct Answer: B
Bank based financial markets prefer debt investments as compared to equity investment. The high
concentration of tradable debt in a market would lead to a decreased cost of debt.


Correct Answer: A
The existence of a natural monopoly in a country mitigates private sector investments in that industry.
Upon the establishment of a private firm that aims to become a competition for the monopoly,
investors may be hard to come by. Hence, debt would be most likely generated.

Correct Answer: A
An increase in debt level would increase the covenant restrictions on the management. Additionally,
the company will need to payout constant interest payments as highlighted by the term of the
indenture. This cash unavailability would lead to an immediate decrease in agency costs as there
would be a lesser need to monitor the management.

Correct Answer: A
Investors are more likely to invest in a company with a well-maintained corporate governance system
in place. This is because they would qualify the management as trustworthy due to the fact that they
follow governance regulations.

Correct Answer: B
A AAA rating does not necessarily indicate absence of financial distress. The probability of financial
distress is always present, granted it may be lower for firms with high credit ratings.

Correct Answer: A
Retained earnings are the cheapest source of funds in the opinion of a company’s management.
Consequently, debt follows due to its tax saving benefits and equity is preferred only to be issued as a
last resort.

Correct Answer: B
If a stock is believed to be overvalued, the management should float additional shares in the market.
This would lead to an increased number of floating shares and a likely decrease in price.

Correct Answer: A
Since the company has recently acquired multiple companies using different mixes of debt and equity
capital, its capitalization ratio may be quite volatile at the moment. Until it gets stable, the target
capital structure should be used to calculate the WACC of the entity.

Correct Answer: A
WACC= [Kd*(1-T)*D/V] + [Ke*E/V]
WACC= [11 %*( 0.78)*75/150] + [21%*75/150]
WACC= 4.29% + 10.5%
WACC= 14.79%


Correct Answer: C
WACCL= WACCUL=11%
Value of geared company=Value of un-geared company
Value of un-geared company= EBIT/WACC
Value of un-geared company=$6million/0.11= $54 million.

Correct Answer: B
A company’s operating margin and operating income are not affected by changes in the capital
structure. Net margin and net income would change as a result of changes in capital structure due to
the accommodation of interest in the net income figure.

Correct Answer: A
Value of leveraged co= Value of unlevered company + (Tax rate*Debt)
Value of leveraged co=$450 million + (22%* $45 million)
Value of leveraged co=$450 million + $ 9.9 million= $459.9 million.

Correct Answer: C
Debt/ Equity= 70%
Value of Debt= $140 million
Value of Equity= $140 million/ 0.7= $200 million.
WACC= [KD*D/V] + [Ke*E/V]
WACC= [8%*140/340] + [15%*200/340]
WACC= 3.29%+ 8.82%
WACC= 12.11%
Ke= r0+ (r0-rd) D/E
Ke= 12.11%+ (12.11%-8%) 140/200
Ke= 14.99%

Correct Answer: A
Value= Debt + Equity= Interest/ Kd + (EBIT- Interest)/ Ke
Value= $16 million/0.08 + ($54 million-$16 million)/0.15
Value= $200 million+$253 million= $453 million.

Reading 22 Dividends and Share Repurchases: Analysis FinQuiz.com
FinQuiz.com
Study Session 7
June 2019

FinQuiz.com © 2019- All rights reserved.

Reading 22: Dividends and Share Repurchases: Analysis

Correct Answer: B
Theory 1: According to the tax argument, an investor residing in a country with higher marginal tax
rates for dividend income relative to capital gains, should prefer companies that pay lower dividends
and reinvest earnings in profitable growth opportunities. This theory has been inaccurately described
by Walters.
Theory 2: According to the bird in hand argument, investors prefer a dollar of dividends over a dollar
of capital gains as they perceive the former to have greater economic value and lower risk relative to
the latter. Thus companies that pay more dividends relative to capital gains, have lower costs of
equity capital. This theory has been accurately described by Walters.
Theory 3: According to the MM Dividend Irrelevance Proposition, investors assume capital markets
are perfect, no taxes and transaction costs exist, and investors have access to equal information. Thus
if a company’s dividend policy pays a lower level of dividend relative to the investor’s need for
income, the investor can construct their own dividend policy by selling sufficient shares to create
their own income stream. This theory has been accurately described by Walters.

Correct Answer: A
R.W. Automobiles: Based on the current and future earnings volatility, the relative riskiness of the
company’s stock will increase, thereby increasing the cost of the corporation’s equity capital and
decreasing its share price.
HealthCare Pharmaceuticals: Although a policy to resume current dividends is generally viewed as a

positive signal from a corporation to its investors that a company’s future prospects will improve
which ought to increase share price. However, based on the corporation’s future prospects, a
continuous decline in the sales trend and product demand signals future prospects are not too bright.
Thus future dividend cuts will signal a fall in corporate share price.
W.T. Manufacturing Inc.: A cut in dividends is often perceived as a strong negative signal regarding
the firm’s future prospects. Furthermore, a dividend cut following poor profitability forecasts will
lead to lower investor confidence regarding the corporation’s future and a lower share price.

Correct Answer: C
Based on Knox’s marginal tax rates, after taxes, $1 in dividends is worth $1(1 – 0.35) / (1 – 0.40) =
$1.08 in capital gains. Since $1.50 exceeds $1.08, Knox would prefer $1 in capital gains to $1 in
dividends. Alternatively, $1.50 in capital gains will give Knox ($1.50) (1 – 0.40) = $0.90 capital gains
after tax compared with $0.65 = $1 × (1 – 0.35) after tax for $1 of dividends.

Correct Answer: B
Generally agency conflicts occur because the owners of a corporation are distinct from the managers.
This agency conflict may tempt managers to engage in activities which are contrary to the owners’

best interest. One such action is investment in negative net present value (NPV) projects where
management may waste shareholder funds on projects which give them more operational control but
fail to generate shareholder value. This is known as the potential overinvestment agency problem and
may also occur when the firm has significant cash flows in excess of the potential profitable projects
available.
In order to resolve such conflicts, managers may be required to pay out all the company’s free cash
flow as dividends such that they have insufficient cash to squander.
In the case of Manufacturer A, a lack of operating cash flows relative to the potential oil supplier
contracts makes the occurrence of the overinvestment agency problem less likely. Additionally, the
presence of non-executives, although equal in number to executives, makes the occurrence of the
overinvestment agency problem less likely relative to Manufacturer B, which lacks board
independence. The presence of non-executives will bring a heightened level of monitoring and help to
reduce agency conflicts.
In the case of manufacturer B, the availability of operating cash flows relative to the profitable
projects makes the occurrence of the overinvestment agency problem more likely as management will
have access to excess funds, which they may utilize for personal benefit. Additionally, the lack of
non-executives on the firm’s board heightens the potential for the occurrence of agency conflicts due
to the lack of board independence. Thus investors are more likely to pressurize B to increase its
dividends per share due to the potential occurrence of the overinvestment agency problem. Gates has
been inaccurate with respect to A experiencing such a problem.

Correct Answer: B
The formula used to calculate dividend is:
= Earnings – (Capital budget × Equity Percent in capital structure)
Earnings $645 million

Capital Spending $850 million
Financed from new debt 0.55 × $850 million = $467.5 million
Financed from retained earnings 0.45 × $850 million = $382.5 million
Financed from new equity or debt $0
Residual cash flow/Residual dividend $645 million - $382.5 million = $262.5 million

Correct Answer: C
The benefits of a share repurchase program are:
I. a company can use share repurchases as a supplement to regular cash dividends. Thus it may
compensate for a lower level of dividends;
II. it will help to increase the firm’s EPS at the cost of increasing financial leverage (lower
denominator for both measures due to a reduction in shares outstanding) and return on equity
(due to the increase in leverage);
III. may be interpreted as a signal to investors by management that the company considers its
shares a good investment and that the firm’s future prospects are strong; and
IV. it provides managerial flexibility by not forcing management to commit to an announced
share repurchase. In contrast, when announcing the annual dividend management has a
commitment to pay the dividend promised. An announced share repurchase in the open

market is not followed by an obligation to follow through with repurchases. Management

may repurchase shares in the market at their discretion. Additionally shareholder participation
in such programs is optional, unlike the receipt of dividends, which provides shareholders
flexibility.
Gates has inaccurately identified benefits II and IV.

Correct Answer: B
Williamson’s statement does not correctly highlight the impact of the dividend payout ratio on the
firm’s per share value with respect to the clientele effect. The clientele effect suggests that when the
dividend market is in equilibrium, meaning that the demands of all clienteles for various dividend
policies are satisfied by sufficient number of companies, a company cannot affect its share value by
changing its dividend policy. With at least three competitors providing a dividend payout ratio in the
29% – 32% range (T.N. Farms, Bateson Wells Inc., and Daily Dairy) opting for the highest dividend
payout ratio (32%) will not affect Walker-Oats Corporation’s per share value.
Knight’s statement correctly highlights the impact of the dividend payout ratio on the firm’s per share
value with respect to the dividend irrelevance argument. The argument states that the firm’s dividend
policy should have no impact on its cost of capital or shareholder wealth. Furthermore the argument
states that dividend policy is irrelevant to share value. According to this proposition, if the firm
adopts a payout ratio, which shareholders do not agree with, shareholders can construct their own
policy as policy alternatives merely involve tradeoffs of different dividend streams of equal present
values.

Correct Answer: A
If the firm uses its excess free cash flow generated to pay dividends, in the event that it has a lack of
profitable investment projects available, paying dividends may help to alleviate the overinvestment
agency problem where management invest in negative NPV projects merely to enhance their span of
control. This issue may be alleviated because the payment of excess free cash flow as dividends
constrains the ability of managers to overinvest in negative NPV projects.
It is unlikely that a policy to use excess cash to pay dividends will alleviate the agency conflicts
between bondholders and shareholders. Paying dividends reduces the cash cushion available to the
company for the disbursement of fixed payments to bondholders. The payment of large dividends
could be seen as effectively transferring wealth from bondholders to shareholders.
The use of excess free cash flow to pay dividends is unlikely to alleviate or create share overhang.

Correct Answer: B
Amongst the factors that influence setting a dividend policy, the factor which has influenced
Robinson’s second suggestion is the importance to retain financially flexibility. This is because he
proposes using the excess cash to provide for a liquidity reserve, as opposed to making dividend
payments, in order to obtain financial flexibility to fund unexpected needs.
He has not proposed using the excess cash to fund profitable investment opportunities at the expense
of omitting or cutting dividend payments. Thus the factor, investment opportunities, has not
influenced his policy proposal.

Robinson has not shown any concern regarding earnings volatility. Thus the factor, expected future
earnings volatility, has not influenced his policy proposal.

Correct Answer: C
0.25
= 0.20

• The debt ratio (debt/asset) =
=
0.25 +1.00 *
0.25
*The debt/equity ratio is 0.25, which implies . Thus, total equity is 1.00.
1.00
• Thus, Equity/total assets ratio = 1 – 0.20 = 0.80
$2, 500, 000
• Total Assets = $3,125,000 =
0.8
• Thus total debt = $3,125,000 – $2,500,000 = $625,000
• The repurchase amount is $200,000 ($2,500,000 × 8%).
The debt and equity amounts as well as ratios under the ‘before buyback’, after ‘buyback using excess
cash’, and ‘after buyback using additional borrowed funds’ scenarios are compared as follows:
After Buyback
Before Buyback
All Cash All Debt
$ % $ % $ %
Debt* 625,000 20.00 625,000 21.37 825,000 26.40
Equity
2,500,000 80.00 2,300,000 78.63 2,300,000 73.60
(at market)**
Total Capitalization 3,125,000 100.00 2,925,000 100.00 3,125,000 100.00
* Under the ‘After Buyback All Debt’ strategy the value of the debt is increased by the additional
funds borrowed to finance the share repurchase, i.e. $200,000.
**Under both ‘After Buyback’ strategies, ‘All Cash’ and ‘All Debt’, the value of the equity is
decreased by the share repurchase amount, i.e. $200,000.
The share repurchase strategy should be conducted using excess cash as the debt ratio using excess
cash (21.37%) is lower relative to the debt ratio generated under a repurchase strategy using borrowed
funds (26.40%) by 5.03% (26.40% − 21.37%).

Correct Answer: A
The earnings/dividend coverage ratios (net income/dividends paid) are calculated in order to analyze
the safety of the firm’s dividend policy and/or repurchase program.
2010 2009 2008
£1,234 £993 £1,563

Earnings/dividend coverage ratio = 2.77 × = 2.72 × = 2.70 ×
£445 £365 £578

The earnings/dividend coverage ratio is increasing over the three-year period, which implies:
• The firm has sufficient earnings to pay its dividends

• A small decline in earnings will not jeopardize the payment of dividends as net income in each of
the three years exceeds the dividends paid.
Additionally, net borrowings are being increasingly used to fund share repurchases and dividend
payments over the three year period. Such a policy cannot be sustained over the long-term due to the
risks associated with increasing leverage levels. This indicates:
• Dynasty Tours does not have a sustainable policy for funding share repurchases and dividends
and
• it may need to eventually cut the dividends and/or curtail the share repurchase program.

Correct Answer: C
Amongst the three dividend policies, stable dividend policy; constant dividend payout policy; and
residual dividend policy, the ‘Most Volatile’ dividend policy is the residual dividend policy whereby
dividends may fluctuate from zero or low when capital expenditure needs are high (relative to
internally generated funds) to high when the reverse situation occurs.
The total dividends paid by Bon Appetite Cuisine for the year 2011, under this policy, are € 1.8
million.
€’000
Net income €4,000
Capital spending/budget €5,500
Financed from new debt 0.6 × €5,500 = €3,300
Financed from retained earnings 0.4 × €5,500 = €2,200
Financed from new equity or debt €0
Residual cash flow €4,000 – €2,200
= residual dividend = € 1,800

Correct Answer: A
When the marginal tax rate of the investor is less than the marginal tax rate of the corporation, the
investor receives the difference between the two rates in the form of tax credit.

Correct Answer: C
Dividend= Earnings – (Capital Expenditure x Equity percentage)
Dividend= $8 million – ($13 million x 40%)
Dividend= $8 million – ($5.2 million)
Dividend= $2.8 million


Correct Answer: A
Investors will demand a higher return from a company following a residual dividend policy as
compared to a company following a stable dividend policy. This is because they will face higher
volatility of cash flows.

Correct Answer: A
When capital gains are taxed at a lower rate than dividends, it is beneficial for the company to return
cash in the form as repurchases.

Correct Answer: A
Companies in developed countries offer higher share repurchase schemes than similar companies in
developing countries.

Correct Answer: B
FCFE Coverage Ratio= FCFE/ (Dividend + Share Repurchase)
FCFE Coverage Ratio= ($19,000,000 +$7,000,000 - $6,000,000)/ ($3,000,000 + $6.5 million)
FCFE Coverage Ratio= $20 million / $9.5 million= 2.11

Correct Answer: A
Pension funds are tax-exempt institutions, which would make them indifferent between dividend
returns and capital gain returns.

Correct Answer: A
The CFO is right in stating that investor requirements can be satisfied through sufficient capital gains.
As the second component of equity return, capital gains can also be used to return money to the
investor.

Correct Answer: A
The adverse effect in price due to the increase of supply of shares in the market after an issue is
classified as flotation costs.

Correct Answer: B
The impairment of capital rule is a legal restriction that states that the net value of a balance sheet’s
assets should not fall below a specified amount.

Correct Answer: A
As the company adheres to a stable dividend policy dictating an annual growth rate of 25%, an
earnings decline would still increase the dividend amount paid at the end of next year.


Correct Answer: C
Expected Dividend = Last Year’s Dividend + (Increase in Earnings × Adjustment Factor × Target
Payout Ratio)
Expected Dividend = $5.45 + ($100,000,000/1,000,000 x 18% x 1/6)
Expected Dividend = $5.45 + ($3)
Expected Dividend = $8.45

Correct Answer: B
Statement A is correct. Stock splits does not affect any shareholder’s equity account.
Statement B is incorrect. Generally, stock splits happen after significant rise in stock price to bring
the price down to a level not perceived too high for investors.
Statement C is correct. A two for one stock splits add one new share for every share currently held, as
a result, a shareholder’s EPS will reduce to half.

Correct Answer: C
C is correct. If a company’s shares are trading at very low price, the company will opt for reverse
stock splits. In case of reverse stock splits, decrease in number of shares outstanding, results in
increase in share price, keeping the company’s underlying fundamentals unchanged.

Correct Answer: A
The first theory explained by Hector is the Dividend Irrelevancy Theory. It states that the investor is
indifferent between return through capital gains or dividends. however, if an investor sells a portion
of his shares in one period to recognize a capital gain, he will receive a lower amount of dividend in
the next due to the reduced number of shares he is holding.

Correct Answer: A
The Clientele Effect states that the dividend market is in equilibrium. The return preferences of
different types of investors are satisfied through the diverse policies adopted by different institutions.
Therefore, the dividend policy will not affect the share price, as dictated by the Dividend Irrelevancy
Theory. A change in dividend policy may lose some shareholders of a particular niche but will, in
turn, attract shareholders from another.

Correct Answer: B
Cash Flow from Sale = Sale price – CGT on the capital gain upon sale
Cash Flow from Sale = $65- ($65-$30)18% = $65 - $6.3 = $58.7
Total Cash Flow = $58.7 × 200,000 = $11,740,000

Correct Answer: B
Cash Flow from Sale = Sale price – CGT on the capital gain upon sale+ after-tax amount of dividend
Cash Flow from Sale = $55- ($55-$30)18%+ $8(1-12%)

Cash Flow from Sale = $55- $4.5 +$7.04= $57.54

Total Cash Flow = $57.54 x 200,000= $11,508,000

Reading 23 Corporate Performance, Governance and Business Ethics FinQuiz.com
FinQuiz.com
Study Session 8
June 2019


Reading 23: Corporate Performance, Governance and Business Ethics

Correct Answer: A
A is correct. The compensation package of the senior portfolio managers highlighted in
Scenario 1 is not performance-based and so introduces a principal-agent problem. When
compensation is not based on company performance, the interests of managers may not be
aligned with those of the stockholders. In this case, senior managers may not have significant
incentive to attract new clients in order to regain business and restore firm profitability as
they are compensated despite losing their key clients.
B is incorrect. Scenario 2 does not highlight a potential principal-agent problem but rather
highlights the failure of the employer to respect the right of their employees to compensation
commensurate to their working hours.
C is incorrect. Scenario 3 may be seen as strategy to alleviate any potential principal-agent

problems. Under a ESOP program, employees are given the opportunity to become
stockowners and the value of their holdings will increase each time stock price rises.
Therefore, the interests of employees will be more aligned with those of stockholders;
maximizing stock price to increase returns on their and the owners’ holdings.

Correct Answer: A
A is correct. Scenario 2 reflects a potential ethical violation. By underpaying employees
relative to the work expected of them, Bridge & Walters has provided substandard working
conditions and so this is a clear example of unethical behavior in a corporate setting.

Correct Answer: B
B is correct. Out of the steps listed, steps 3 and 4 are not integral to stakeholder impact
analysis. The steps which are typically followed are:
Step 1: Identify stakeholders
Step 2: List down the interests and concerns of identified stakeholders.
Step 3: Identify the claims stakeholders will make on an organization based on Step 2.
Step 4: Identify the key stakeholders (most important from the organization’s perspective).
Step 6: Identify the strategic challenges in meeting claims.


Correct Answer: B
B is correct. The stakeholder impact analysis will provide managers with a useful approach
to frame any discussion of rights. Rights theories stress on the fundamental human rights and
privileges which the manager must consider when addressing stakeholder needs while
stakeholder impact analysis will allow for the framing of these rights and privileges.

Correct Answer: A
A is correct. The Friedman doctrine asserts that the only social responsibility of businesses is
to increase profits as long as the company stays within the rules of the law. Therefore, the
theory rejects any social investments which are either not required by the law or for the
efficient running of businesses. Because the company’s products have received clearance
from the concerned regulatory authority, they will not be expected to undertake further social
expenditures to satisfy the concerns of health care officials according to this doctrine.
B and C are incorrect (see above).

Correct Answer: C
C is correct. Scenario 5 most closely reflects justice theories. By implementing a
whistleblowing channel, employees have been provided with the liberty of being able to
report an unethical or otherwise illegal violation with full autonomy. This system will act to
protect their freedom to execute ethical responsibilities.
A is incorrect. Kantian ethics is concerned with treating individuals with dignity and respect.
The liberties provided to employees by the whistleblowing channel go beyond this
philosophical approach.
B is incorrect. Utilitarianism focuses on the maximizing good for the greatest number of
people. The implementation of a whistleblowing channel is not consistent with this approach
which does not consider justice and therefore will not recognize the need to implement a
channel which grants employees with the liberty to report violations in a confidential manner.

Reading 24 Corporate Governance FinQuiz.com
FinQuiz.com
Study Session 8
June 2019


Reading 24: Corporate Governance

Correct Answer: A
Corporate governance best practices recommend that at least three quarters of the board members
should be independent (or, put another way, the number of dependent members should not exceed
25%). The current composition of the board comprises of 6 executives and 7 non-executives (the non-
executives are independent and executives are generally not independent). Thus 46% of the board
comprises of executives, which is clearly more than the 25% advised.
An executive holding the dual position of a supplier and executive does not satisfy the independence
criteria (directors holding a supplier relationship with the company imply a lack of independence) set
by the provisions.
Thus the board composition is not in agreement with best practice recommendations for reasons
attributable to the proportions of executives and non-executives (dependent vs. independent
members) as well the relationship the executive holds with the company.

Correct Answer: C
The corporate governance guidelines for each policy sub-component is discussed below together with
an evaluation of whether each sub-component complies with the guidelines.
I: With respect to the qualifications of directors, best practice recommends executives to have
relevant expertise in the industry and in financial operations; legal matters; and accounting and
auditing.
By requiring all executives to have a minimum 8 years experience with the telecommunications
industry together with knowledge of the company’s product base, sub-component I is consistent
with best practice guidelines.
II: By placing a relatively lower level of importance on accounting and auditing knowledge relative
to industry experience and product knowledge, sub-component II is inconsistent with best
practice guidelines (see above).
III: Best practice guidelines recommend indications of ethical soundness by elected board members
including any public statements or writings by the executive pertaining to problems in companies
with which (s)he has been associated with in the past such as legal or other regulatory violations
involving ethical lapses. By requiring a written statement from executives of involvements in
past legal violations and/or fraudulent practices, subcomponent III is consistent with this
recommendation.
IV: Best practice guidelines recommend the chairman of the board be separate from the senior
executive. If the positions are not separate, an investor may doubt the efficiency and
effectiveness of the board’s monitoring and oversight activities. If the senior executive is
appointed as chairman, the independence of the board may be compromised as the chairman may
be influenced by the firm’s management. Thus subcomponent IV does not comply with best

practice recommendations. If the firm experiences difficulty in appointing an outsider as

chairman, the firm may appoint an individual within the firm as chairman provided they have no
affiliations (business or personal) with company management.

Correct Answer: B
I: Best practice codes recommend the compensation committee to be composed entirely of
independent members. This subcomponent satisfies this recommendation.
II: Best practice recommends that executive compensation should include incentives to meet long-
term goals. However the practice of setting compensation rewards based on comparison to the
levels of compensation paid by other companies may not encourage executives to work in the
best interests of shareholders as it is not related to the long-term performance of the company.
Thus the practice of determining executive compensation packages, adopted by the firm, is not
consistent with this provision.
III: Best practice guidelines recommend executive compensation package have a minimum level of
compensation unrelated to company performance such as salary and perquisites and be
dominated by stock options and restricted stocks whose payoff is related to the performance of
the firm. The firm’s existing compensation package satisfies this recommendation as it is
dominated by performance-based compensation (90% stocks options and bonuses vs. 10%
salary).

Correct Answer: B
I: The purpose of the audit committee is to provide independent oversight of the company’s
financial reporting, non-financial corporate disclosure, and internal control systems.
Subcomponent I is consistent with this purpose.
II: Best practice recommends that members have sufficient expertise in financial, accounting,
auditing, and legal matters to be able to adequately oversee and evaluate the control, risk
management, and compliance systems. Additionally it is advisable for at least two members of
the committee to have relevant accounting and auditing expertise. Thus subcomponent II
satisfies this recommendation.
III: Best practice recommends the audit committee have full access to and cooperation of
management and have authority to investigate fully any matters within its purview. Thus
subcomponent III is consistent with this recommendation.
IV: Best practice recommends that the internal audit staff should report direct to the audit committee.
A policy which requires internal auditors to report to the audit committee through an
intermediary (the senior officer) makes subcomponent IV inconsistent with best practice codes.

Correct Answer: C
Observation 1: Although granting stock options to executives and management is intended to
motivate the recipients (of such options) to work in the shareholders’ best interests, large grants of
stock options can dilute shareholders’ positions in the company and diminish the value of their
holdings. The stock option’s potential dilutive effect is measured by the share overhang (measuring
the total number of shares represented by the options relative to the total amount of stock
outstanding). A rising trend in the share overhang measure implies an erosion of the value of equity

holdings. Thus a large grant of stock options (reflecting a rising trend in the share overhang measure)
reflects a practice inconsistent with best practice provisions.
Observation 2: The board of directors should have the ability and sufficient resources to hire legal and
other experts, as required, in order to fulfill their fiduciary duties. Although board members have the
liberty to employ such experts at T.S. Telecommunications Inc., subjecting the funds to an
authorization process does not grant the board with total freedom. This is because prior to hiring the
experts, the funds must be approved by senior management. This observation reflects a practice
inconsistent with best practice recommendations.
Observation 3: It is important that directors and executives take their fiduciary responsibilities to
shareholders seriously particularly in the case of their response of shareholder votes on proxy matters.
T.S.’s merger proposal was rejected by a majority shareholder vote. However, T.S. executives
demonstrate that they are not concerned with the shareholders’ best interests as they have arranged
meetings with the competitor to discuss the proposal. This observation clearly reflects a practice
which is inconsistent with best practice recommendations.

Correct Answer: C
Accounting risk is the risk that a company’s financial statements and related disclosures, upon which
investors base their financial decisions, are incomplete, misleading, or materially misstated.
Asset risk is the risk that the firm’s assets will be misappropriated by managers or directors in the
form of excessive compensation or perquisites.
Liability risk is the risk that management will enter into excessive obligations on the shareholder’s
behalf that effectively destroy the value of shareholder’s equity.
Strategic policy risk is the risk that managers may enter into transactions that may not be in the best
long-term interests of shareholders, but may result in large payoffs for managers or directors.
Issue 1: Investing in short-term risky securities whose profits will be allocated to director personal
accounts reflects asset risk (as directors have been using shareholder funds for their benefit) and
strategic policy risk (the characteristics of the investment are unsuitable for shareholders as it exposes
the shareholders to excessive risk over a short time horizon, but results in large payoffs for directors).
Issue 2: Issue 2 reflects liability risk. Directors have entered into excessive obligations (loan
contracts) on behalf of the shareholders.

Correct Answer: B
Although it is general practice among boards to delegate responsibilities to firm management, the
board remains responsible for monitoring management activities. By failing to ensure that
Applegate’s management fulfills its loan repayment responsibilities properly, the board has not
conducted its oversight responsibilities adequately. In doing so, it has failed to ensure that the
obligations to stakeholders, in this case the bank, are met in a timely and complete manner, i.e. on
scheduled repayment dates.


Correct Answer: C
By jointly owning and managing a personal investment portfolio with Applegate’s senior portfolio
manager, Thompson, the independence of Beridze as a board member may be compromised. This is
because he may be unduly pressurized to fulfill Thompson’s favors in order to maintain the
relationship he holds with the manager outside the firm at the expense of his duties to the firm’s
shareholders. Thus, Beridze’s potential lack of independence as a board member may be a concern for
Applegate.
It is important that individual board members have relevant experience in the industry of the firm they
represent. Although Beridze has served investment advisory firms, his experience is limited to
institutional investor clients as opposed to individual investors. His lack of experience with the latter
investor category suggests a lack of relevant experience. Thus, the lack of Beridze’s experience with
such a category may be a concern for Applegate.
There has been no reference regarding past ethical lapses with which Beridze may have been
involved. Thus this factor will least likely concern Applegate relative to the other two factors.

Correct Answer: B
Suggestion 1 will not help to improve the quality of Applegate’s corporate governance system. In
general, the election of the board on a staggered basis, whereby only a portion of the board stand for
re-election each year, does not grant shareholders the power to control who will serve the board and
thus ensure the responsiveness of board members to investor concerns. Annual re-election of the
entire board ensures shareholders are able to express their views on individual member’s performance
during each period and to exercise their right to control who will represent them in the governance
and oversight of the firm. Davis’s first suggestion calls for staggered board elections.
Suggestion 2 will help to improve the quality of Applegate’s corporate governance system. Corporate
governance codes of best practice recommend boards have an audit committee comprised solely of
independent directors who have sufficient expertise in financial, auditing, accounting, and legal
matters to ensure they are able to oversee and evaluate a firm’s control, risk management and
compliance systems. Furthermore, it is advisable for at least two members of the committee to have
relevant accounting and auditing expertise.

Correct Answer: A
Codes of best practice recommend that compensation should be used as a tool to attract, retain, and
motivate talented individuals. The compensation should include incentives to meet and exceed long-
term corporate goals, rather than short-term performance targets.
Shareholders prefer that salary and perquisites constitute a relative small proportion of the
compensation package. That is, salary should be adequate but not excessive. Additionally, bonuses
should be awarded based solely on exceeding expected performance. Stock options and restricted
stock grants help to align the interest of managers with those of shareholders.
The salary component comprises 25% of the total compensation and is adequate. This component is
smaller relative to the other components, which make up a total of 75% of the total compensation.
The proposed components of compensation which focus on the long-term and/or expected
performance, i.e. stock options; restricted stock grants; and bonuses, dominate the compensation

package (consuming a proportion of 75% of the total compensation) and are thus consistent with best
practice recommendations.

Correct Answer: C
As outlined by Task 3, by determining how ‘corporate affairs are conducted’… at ‘board and annual
firm meetings’, the regulator has already planned to explore the responsiveness of the board of
directors to shareholder proxy votes, conducted at annual company meetings. This task need not be
undertaken since it has been currently planned.
As outlined by Task 2, a ‘detailed analysis of firm’s financial statements’ and accompanying

disclosures entails evaluating the quality, clarity, and completeness of financial information. This task
need not be undertaken since it has been currently planned.
Since the board has approved the executive compensation package, the regulator may need to assess
the potential for stock options to dilute potential shareholding (share overhang). This is because
following the implementation of the compensation package stock options and restricted stock grants
will be issued which have the potential to dilute shares in the future. This is a task which may need to
be undertaken in addition to the three tasks currently planned.

Correct Answer: A
Problem area 1 reflects a weakness in a core attribute of Applegate’s corporate governance system. A
core attribute of a sound corporate governance system includes fairness and equitable treatment in all
dealing between managers, directors, and shareholders. Failing to inform shareholders about company
meetings where important decisions were made and which required shareholder votes, does not
reflect fair dealing.
Problem area 2 reflects a weakness in a core attribute of Applegate’s corporate governance system. A
core attribute of a sound corporate governance system includes complete transparency and accuracy
in disclosures regarding operations, performance, risk, and financial position. Failing to disclose off-
balance sheet liabilities on its financial statements reflects a weakness in the core attributes of a sound
corporate governance system.

Correct Answer: C
The trade union discrepancy may give rise to a number of lawsuits filed against the company by
current and former employees. Thus, the company is exposed to legal risk. It is also vulnerable to
reputational risk, as widespread public knowledge of this would lead to a decrease in the entity’s
reputation and the possible loss of market value.

Correct Answer: C
As the corporate assets of the entity are being directed into the director’s personal trading account,
they are not being allocated to opportunities that would earn the maximum benefit for its
shareholders. Thus, this activity qualifies as an asset risk.
This misallocation is also a strategic policy risk as a director has entered into an activity using
corporate funds that is not in the best long-term interests of the shareholders of TBE.


Correct Answer: B
Best practice dictates minimal capitalization of interest and overhead costs and rapid write-off of all
overhead costs.

Correct Answer: B
A Statement of Government Policies and a Board Self-Assessment Report should be disclosed along
with the annual report according to the best practice under corporate governance regulations.

Correct Answer: B
According to best practice, the stock options should comprise of a major portion of the compensation
package while only a small proportion should be allocated to the actual salary payment.

Correct Answer: A
The LIFO method should be used under corporate governance guidelines as it imparts the inflated
inventory costs to the most recent time period. The inflated cost will be captured in the relevant time
period and is, therefore, the prudent way of dealing with inventory costs.

Correct Answer: C
Corporate governance disclosures are presented in the 10-K report, the annual report and the proxy
statement by companies following the US GAAP regulations.

Correct Answer: B
Dave Crosby is the most eligible candidate for the position as he is the current operating manager
and, therefore, possesses detailed knowledge of all operational information. His performance has been
exceptional during his employment tenure and there is no reason not to promote him to an executive
position.
He is, however, currently a senior manager and may have an existing and personal relationship with
existing management. Regardless of this factor, the other candidates are less eligible for the position.
Arnold Calway is a close high school friend of Crosby and this relation falls under the criteria for
related party identification. He is also the director of an automobile dealership and, thus, has a vested
interest in acquiring a directorship position in an automobile manufacturing entity.
Elizabeth Tesan also has a vested interest in the directorship position as she is the partner at a firm
currently providing outsourcing services o Allied Autos.

Correct Answer: A
The independent board members of an organization are required to have at least one annual meeting
in isolation from the executive members.


Correct Answer: A
The audit committee is to be comprised entirely of independent directors under corporate governance
guidelines.

Correct Answer: A
The nomination committee is to be comprised entirely of independent board members under corporate
governance guidelines.

Correct Answer: C
Dilutive shares = 400,000*25= 10,000,000
Total Number of Shares = 16 million
Share Overhang = Number of Dilutive Shares/ Total Number of Shares
= 10million/ 16 million = 0.625

Reading 25 Mergers and Acquisitions FinQuiz.com
FinQuiz.com
Study Session 8
June 2019


Reading 25: Mergers and Acquisitions

Correct Answer: B
Conclusion 1: One of the motives given for mergers is that they may help to increase market power.
This motive is valid in the case of horizontal and vertical mergers. Given the proposed merger
between Skyline Associates and Griston Builders Inc. is a proposed vertical merger (backwardation),
a vertical merger will help to lock in the services of the construction team, which are a critical service
to Skyline Associates. By locking in the supply of services, the real estate developer could be in a
position to influence industry outputs and/or have a measure of control over commercial real estate
developed property prices. Furthermore by merging with a foreign construction firm, Skyline
Associates will be better placed to serve clients situated in other countries. Thus this conclusion is
justified.
Conclusion 2: Diversification is sometimes quoted as a motive behind mergers. However such a

motive is relevant to a conglomerate investing in companies in industries which have a low
correlation to the industry to which the conglomerate belongs.
One motive behind cross-border mergers is that they enable companies to exploit potential market
inefficiencies by gaining access to cheaper sources of labor. Given the current economic and
unemployment situation of the developing country, local labor will be more than willing to work for
lower levels of compensation. Thus such a motive is justified.
However since the merger in question is a vertical merger in the same industry, the diversification
motive stated as part of conclusion 2 is not justified.
Conclusion 3: Foreign M&A activity has gained more popularity over the years. One of the motives
behind cross-border acquisitions is that it may help circumvent disadvantageous government policy as
the firm will be given a local identity in the local/foreign market, once and if merged with Griston
Builders Inc. Thus a merger may the only way to overcome the barriers to foreign competition
imposed by the local government. Thus conclusion 3 is justified.

Correct Answer: B
Post-merger value of the combined company (VA*) = VA + VT + S – C
VA* = $1,500 + $200 + $950 – ($8 × 50)
VA* = $2,250 million
Number of new shares issued by Skyline Associates = 0.85 × 50

= 42.5 million.
The total number of Skyline Associates’ combined shares after the merger is 100 + 42.5
= 142.5 million
The post-merger per share value given to Griston Builders Inc. is $2,250 million/142.5 million
= $15.79.

Acquirer’s Gains = Synergies – Premium = S – (PT – VT)
The total value paid to Griston Builders Inc.’s shareholders is, including the cash component of $400
million ($8 × 50 million) and a stock component of $671.08 ($15.79 × 42.5 million), is $1,071.08
million. The premium is $871.08 million ($1,071.08 million - $200 million).
Acquirer’s Gain = $950 million – $871.08 million = $78.93 million

Correct Answer: A
When stock is used as payment or offered to the target’s shareholders, the target shareholders become
part owners of the acquiring company. As part owners, these shareholders share in the post-merger
gains and losses. However when cash is paid, target shareholders no longer remain owners in the
post-merger company and thus do not share in the post-merger gains and losses.
The more confident the acquirer is that estimated synergies will be realized, the more the managers
(of the acquirer) will prefer to pay with cash and more the target managers will prefer stock. When it
is highly probable that actual synergies will be lower than the synergies predicted prior to the merger,
the acquirer’s managers will prefer to issue stock (as they would like the target shareholders to share
the losses from a lower-than-expected synergy benefits estimate) whereas target management would
prefer cash (as they would not like to share in the losses). Thus the consultant’s comments with
respect to expected synergies are incorrect.
The other factor which decides the method of payment is the counterparties’ confidence in the
companies’ relative values. The more confident the acquirer’s managers are in estimates about the
target company’s value, the more the acquirer would prefer cash and the more the target would prefer
stock. Thus the consultant’s comment with respect to confidence in target valuation is correct.

Correct Answer: B
Since K. Shaw Development Corp. has made a takeover offer any pre-takeover defenses suggested
will not be effective. Each of the proposed defenses is analyzed for effectiveness below.
Defense 1: This illustrates the post-takeover defense, ‘greenmail’. However in order for the defense to
be effective the target must agree to purchase its own shares back from the acquirer usually at a
premium to market price. A repurchase price involving a discount to market value will not be
effective as the acquirer company shareholders will not be willing to sell their holdings back to the
target at a loss, but would prefer to sell it in the market at the current market price. Additionally, the
use of greenmail as a takeover defense is extremely restricted. For these reasons, the use of this
defense will not be effective.
Defense 2: This illustrates the post-takeover defense, ‘white-knight defense’. This defense can prove
to be highly successful especially if the third party, rescuing the target, has a good strategic fit with it.
Based on such a fit, the party can justify a high bid price which may cause the bidder to withdraw its
takeover offer. Thus this defense is highly effective in the case of Skyline Associates if implemented
as described.
Defense 3: This illustrates the pre-takeover defense, ‘supermajority voting provision’. Although an
amendment to the corporate charter to provide for a supermajority approval by shareholders for
mergers may present the acquirer with significant difficulties in accumulating enough votes to

approve a merger, this defense in no longer effective once the offer has been made. Such is the case
with Skyline Associates.

Correct Answer: B
Generally there are two forms of acquisition, stock and asset purchases. Stock purchases involve the
acquirer giving the target’s shareholders some combination of cash and securities in exchange for
shares of the target company’s stock. An asset purchase involves the acquirer purchasing the target’s
assets.
In stock purchases, payments are made directly to shareholders in exchange for their shares and thus
company shareholders are taxed on their capital gains. There are no corporate-level taxes. The
consultant’s comment with respect to stock purchases is partially incorrect.
In asset purchases, the acquirer company generally avoids the assumption of liabilities. Thus this
form of acquisition is appropriate for the acquirer when it seeks to avoid the responsibility of target
liabilities. The consultant’s comments with respect to asset purchases are correct.

Correct Answer: A
n
∑

× 100

Herfindahl-Hirschman Index (HHI) =
i
The pre-merger HHI is = (35%)2 + (20%)2 + (10%)2 + (5%)2 + (4%)2 + (26%)2

= 2,442
The post-merger HHI (if the two firms are merged) = (35% + 20%)2 + (10%)2 + (5%)2 + (4%)2 +
(26%)2
= 3,842
The difference between post-merger HHI and pre-merger HHI is 1,400 (3,842 – 2,442). Since the
post-merger HHI is more than 1,800, this indicates that the real estate development industry following
the merger will become heavily concentrated. With the difference between pre- and post-merger HHI
being more than 50, the merger will evoke an antitrust challenge.

Correct Answer: A
Since the expected synergies from the merger are significantly favorable, the acquirer’s shareholders
would prefer the takeover to be settled in cash. In this way, Comodo’s shareholders will not have an
equity stake in Alcoa and Alcoa’s current shareholders would enjoy the entire future equity return
without any dilution of control.

Correct Answer: A
Since Alcoa is considering bypassing Comodo’s management and approaching its shareholders
directly, the act in itself qualifies as a hostile takeover. Through this method, the shareholders will be
asked to vote for the proposed list by Alcoa for Comodo’s directors. This process is known as a proxy
fight, through which Alcoa will be able to replace Comodo’s management.


Correct Answer: C
Due diligence is carried out by both the acquirer and the target. Alcoa will perform due diligence to
ensure that Comodo’s assets are worth approximately what they are claimed by the target. Comodo
will perform due diligence to examine whether Alcoa has the financial capacity to acquire it.

Correct Answer: B
Exchange ratio = 2 shares of Alcoa for 3 shares of Comodo
Acquirer’s Cost = Exchange Ratio × number of shares outstanding of Comodo × value of Alcoa’s
shares
Acquirer’s Cost = 2/3 × 12,000,000 × $111= $888,000,000

Correct Answer: A
Changes made to the corporate constitution to deter any takeover bids are known as shark repellants.
Since restricted voting rights require an amendment to the charter at the time of establishment, this
pre-offer takeover defense qualifies as a shark repellant.

Correct Answer: C
Fair price amendments set a floor value bid for the target company. A typical fair price amendment
would require Alcoa to pay at least as much as the highest stock price the target traded in the public
market for a certain period of time. In this vignette, that span of time is three years. Therefore, the
floor value for the minimum bid would be $63.00.

Correct Answer: C
As the two distinct entities have been merged to create a new, separate corporate entity, this merger
will be classified as consolidation.

Correct Answer: B
As Enigma is developing technology that will be used as a research input by Sensol, Sensol is
entering a backward integration.

Correct Answer: A
Conglomerates are formed as a result of unrelated diversification. Unrelated diversification assists in
the smoothing of cash flows over the long term.

Correct Answer: A
As the integration will lead to a significant increase in the economies of scale of the acquirer, the
synergies generated are cost synergies.

Correct Answer: B
The opportunity cost of time generally makes organic growth more risky than external growth.
Management’s proprietary need of building up a company themselves may result in lost opportunities
in terms of immediate sales.


Correct Answer: A
A company in its growth stage needs additional capital funds to expand existing capacity. It will most
likely reinvest the cash generated through initial sales back into the entity.

Correct Answer: B
The reconciliation activity is a right available to the target’s board. This dad-hand provision gives the
board the power to redeem or cancel the poison pills through a majority vote of the continuing
directors.

Correct Answer: B
Greenmail is the agreement entered with the acquirer in which the target agrees to buy all of its own
shares back from the acquiring company at a premium.

Correct Answer: C
The white squire defense may lead to minimal proceeds being forwarded to the target shareholders.
Without receiving their control premiums, the shareholders may get restless and Antahl would face
litigation risks.

Correct Answer: B
The Clayton Anti-Trust Act is not relevant for vertical and conglomerate mergers. As Omega is a
chief supplier of Antahl, the merger is a forward integration.

Correct Answer: C
Anti-Trust laws are subject to review by The Federal Trade Commission and The Department of
Justice.

Correct Answer: A
A HHI level of 780 indicates a market with low concentration. With minimal threat of
monopolization, anti-trust regulators will not take any action against the merger.

Correct Answer: A
Target company’s shareholders are taxed on the capital gain realized through stock acquisition. On
the other hand, there are no direct tax consequences of an asset purchase on the target’s shareholders.

Correct Answer: C
The conglomerate’s directors have adopted an aggressive strategy to increase their span of control
and in turn, raise their compensation levels. Therefore, it is apparent that the management has adopted
this strategy to favor their own personal incentives.


Correct Answer: A
A cross-border transaction can enable an entity to take advantage of market imperfections. The
compensation difference between employees in the States and employees in the Philippines is a
market imperfection.

Correct Answer: B
Since the environmental consultancy service has been accepted by the market, its sales are
experiencing exponential growth, its profit margins are high and the number of established companies
has had no effect on the demand, the industry can be classified as a rapidly accelerating growth
industry.

Correct Answer: C
One of the characteristics of an industry in its market maturity stage is that it’s growth rate is the same
as the overall economy’s growth rate.

Correct Answer: A
Assets which constitute 50% or more of a company’s balance sheets need shareholder approval
before they can be sold by the company. The Competition Council may intercede in this transaction
as the purchase of the state of the art assembly line may place Melkus’ competitor in a monopolized
assembly position.

Correct Answer: A
Low premium amounts paid would increase the realized value to the acquirer as the net benefit from
the expected synergies would be greater.

Correct Answer: B
Managerial hubris is the acquiring management’s tendency to overestimate the anticipated synergies
from the acquisition.

Correct Answer: A
Managerial hubris is the overestimation of anticipated synergies by the acquiring management. This
would lead to higher bids causing wealth to shift from the acquiring company’s shareholders to the
target shareholders.

Correct Answer: B
The value calculated through the comparable transaction method faces less scrutiny for mispricing by
stakeholders. This would lead to a decrease in litigation risk.

Correct Answer: C
Takeover Premium = (Deal Price- Current Stock Price)/Current Stock Price
Takeover Premium = ($60- $53)/$53 = $7/$53 = 13.2%


Correct Answer: C
Takeover Premium = (Deal Price- Current Stock Price)/Current Stock Price
Takeover Premium = ($60 – $53)/$53=$7/$53 = 13.2%
Estimated Takeover Price = (Estimated Stock Price based on Comparables) × (1+ Takeover
Premium)
Estimated Takeover Price = $58 × (1.132) = $65.66

Correct Answer: B
Unlevered Net Income = Net Income + Interest After Tax = 10,700 + (1,600 × 0.75) = 11,900

Correct Answer: B
NOPLAT = Unlevered Net Income + Change in Deferred Taxes
NOPLAT = 10,300 + (1,800 × 0.75) + 200 = 11,850

Correct Answer: C
Free Cash Flow = Net Income + Interest (After Tax) + Change in Deferred Taxes + Net Non Cash
Charges – Changes in Net Working Capital – Capex
Free Cash Flow = 9,000 + (1,200 × 0.75) – 200 +1,690 – 800 – 1500 = 9,090

Correct Answer: C
WACC= (0.09 × 60) + (0.20 × 40)] = 13.4%
Free Cash Flow = Net Income + Interest (After Tax) + Change in Deferred Taxes + Net Non Cash
Charges – Changes in Net Working Capital – Capex
Free Cash Flow= 8,300 + (1200 × 0.75) + 500 + 1,250 – 800 – 4,500= 5,650
PV of Free Cash Flow= 5,650 / (1.134)2= 4,394

Correct Answer: C
The data required by the discounted cash flow method includes a lot of forecasts, estimates and
assumptions. This data collected and processed by different analysts would lead to different
conclusions. Thus, reliable data is difficult to acquire.

Correct Answer: C
A split off results in the issue of shares of a newly incorporated entity to the company’s existing
shareholders in exchange for their shares of the parent company.


Correct Answer: B
The conditions of the bootstrapping effect are as follows:
i. The acquirer’s P/E ratio should not decline after the merger.
ii. The shares of the acquirer should trade at a higher P/E ratio as compared to the target’s
P/E ratio.

Correct Answer: A
Number of shares to be issued = Capitalization of the Target/ Share Price of the Acquirer
= $18,000,000/ $45= 400,000 shares

Correct Answer: C
Number of Shares Outstanding of Acquiree= $18,000,000/ $15= 1,200,000
Pre-merger EPS of Acquiree= $15/7= $2.1428
Pre-merger EPS of Acquirer= $45/16= $2.8125
Post Merger EPS = (Acquirer’s pre-merger Earnings+ Target’s pre-merger Earnings)/Post-merger
number of shares outstanding
Post Merger EPS = [($2.8125 × 15,000,000) × ($2.1428 × 1,200,000)]/ 15,400,000
Post Merger EPS = [$42,187,500 + $2,571,360]/ 15,400,000
Post Merger EPS = $2.906

Correct Answer: B
Post Merger P/E= Pre-merger stock price of Acquirer/ Post-merger EPS
Post Merger P/E= $45/$2.5= 18

Correct Answer: A
As the fair value of the net assets is greater than the capitalization of the company, an immediate gain
can be realized though acquiring the company at the capitalized amount and selling the assets at their
break-up value.

Correct Answer: B
Asset purchases in the United States do not entitle the acquirer to the target’s accumulated tax losses.
Therefore, Reffling will not be able to offset its income with the losses of the target.

Reading 26 Equity Valuation: Applications and Processes FinQuiz.com
FinQuiz.com
Study Session 9
June 2019


Reading 26: Equity Valuation: Applications and Processes

Correct Answer: B
Equity valuation tools can be used to address a range of practical problems. Some of them include
selecting stocks, rendering fairness opinions, evaluating business strategies and models,
communicating with analysts and shareholders and appraising private businesses. In addition, equity
valuation tools are also used to infer or extract market expectations by reverse engineering the value
from the model used. They can also be used to evaluate corporate events such as mergers,
acquisitions and leveraged recapitalizations. However, models cannot be used to ascertain a positive
alpha since there is no guarantee of price convergence to intrinsic value (they can only be used to
determine a stock’s intrinsic value).

Correct Answer: C
Statement 1 is incorrect. An asset based approach to valuation is an example of an absolute valuation
approach that values a company on the basis of the market value of assets it controls. An asset based
valuation can provide an independent estimate of value.
Statement 2 is incorrect. Although it is true that the inputs to a valuation model need to be accurate
and detailed, ‘quality of earnings analysis’ involves the investigation of issues related to the accuracy
of reported accounting results.

Correct Answer: A
Long depreciable lives, high pension discount rates, and low assumed rate of compensation growth
for pensions are non-conservative estimates that will lower expenses and boost reported income,
probably to mask problems with performance. Low sales per employee are not an indication of low
quality of earnings, however, they may indicate an inefficient use of human resource. Hence, longer
depreciable lives and a higher discount rate assumed by Zee Enterprises are warning signs for the
quality of its reported earnings.

Correct Answer: C
Company A has a dominant management team that sets revenue targets for employees. This indicates
excessive pressure on employees to meet targets, which may result in aggressive reporting.
Company B has management whose compensation is tied to the stock price or profitability. Such
arrangements, although desirable, can indicate a risk of aggressive reporting as well.


Correct Answer: B
Since information about the stocks actual return over the year and required return is given, only the
stocks ex post returns can be determined.
For stock A:
(38.99–33.78) + 1.78 + 2.31/33.78 = 27.53%
Alpha = 27.53–22.31 = 5.22%
For stock B:
(55.48-67.45) + 0.98 + 4.67/67.45 = –9.37%
Alpha= –9.37–2.10 = –11.47%

Correct Answer: C
Statement 3 is incorrect. Liquidation value is indeed the value of a company if it were dissolved and
its assets sold individually. However, it should be distinguished from the ‘breakup value’ or ‘private
market value’ of a company, which is the sum of the expected value of the company’s parts if the
parts were independent entities. In contrast to liquidation value, breakup value is a going-concern
concept of value because in estimating a company’s breakup value, the company’s parts are usually
valued individually as going concerns.
Statement 4 is incorrect. If the marketplace has confidence that the company’s management is acting
in the owner’s best interests, market prices should on average reflect fair value. In some situations,
however, an asset is worth more to a particular buying maybe because of potential operating
synergies. The value to a buyer taking into account these synergies and based on investor’s
expectations is termed investment value.

Reading 26: Equity Valuation: Applications and Processes

Correct Answer: A
A is correct. Being on the verge of bankruptcy, Alpha Inc. will be subject to considerable financial distress. In
this scenario, liquidation value will be most relevant to the company. Liquidation value measures the value of a
company which is dissolved and its assets are sold individually.
B is incorrect. Investment value is relevant when valuing the worth of a business to a specific buyer. This
measure of value is not relevant in the context of Alpha Inc.

Correct Answer: A
A is correct. Given that SS targets a niche market, it will have an exclusive and limited customer base. The
fewer the number of customers, the greater their negotiating power. Therefore, the buyers would represent an
inherent downward pressure on industry profitability.
B is incorrect. Based on Porter’s five forces, when there are many suppliers of input, suppliers have limited
power to raise prices and thus would not represent an inherent downward pressure on industry profitability. SS
has access to a large supplier pool and they cannot negatively influence industry profitability based on their
pricing power.
C is incorrect. A low level of competition will enhance industry profitability. The watch-making industry in
which SS operates has a low degree of intra-industry rivalry.

Correct Answer: B
B is correct. Given that SS operates in an industry with little competition, few potential substitutes will exist
thereby decreasing the threat of substitutes. A low threat of substitutes enhances industry profitability.
A is incorrect. The threat of substitutes is low. See above.
C is incorrect. Given that few potential substitutes exist, switching costs are not relevant in this regard.

Correct Answer: C
C is correct. SS is neither in financial distress nor in the process of liquidation. Therefore, the company is
assumed to be operating as a going concern and the going-concern value will be a relevant value definition.
A is incorrect. Intrinsic value is a relevant concept of value when valuing public equities.
B is incorrect. Liquidation value is appropriate for a company which is in financial distress and is used to value
a company if it were dissolved and its assets were sold individually.


Correct Answer: A
A is correct. Carlton is acquiring a minority stake in SS. Therefore, a control premium is not required to be
incorporated when adjusting Time Associate’s stock for the purposes of valuing SS’s stock.
B is incorrect. Given that the SS stock is privately traded, an illiquidity discount will required to be applied as
the shares lack the market depth associated with the publically traded stock of Time Associates.
C is incorrect. Lack of marketability discounts apply to the value of non-publically traded stocks.

Correct Answer: C
C is correct. Gains from the sale of the manufacturing plant and the income received from a positive litigation
settlement represent non-recurring sources income which is not sustainable. Therefore, Line Corporation’s
current year earning comprises unsustainable income sources.
A is incorrect. See above.
B is incorrect. The capitalization of product development costs will boost the current year’s income at the
expense of reducing income in the future years. However, this accounting treatment does not represent an
attempt to accelerate revenue.

Reading 27 Return Concepts FinQuiz.com
FinQuiz.com
Study Session 9
June 2019


Reading 27: Return Concepts

Correct Answer: B
Argument 1 fails to support the use of historical risk premium estimates for the purpose of estimating
risk premiums on Homalian equity securities. Historical estimates may be readily used when reliable
long-term records of equity returns are available. Given that local markets are not well established,
the obtaining historical data may be problematic.
Argument 2 supports the use of historical estimates. Historical estimates are based on data, rather than
forecasts, which gives then an objective quality.
Argument 3 fails to support the use of historical risk premium estimates for estimating equity risk
premiums. In using a historical estimate to represent the equity risk premium going forward, the
analyst assumes that returns are stationary and that the parameters describing the return-generating
process are constant in the past and future. This does not allow for scenario analysis to be conducted,
whereby an analyst needs to use different estimates for the parameters to arrive at a range of possible
outcomes.

Correct Answer: C
In order to develop a historical risk premium estimate, it is necessary for the analyst to select:
I. an equity index that accurately represents the returns earned by average equity investors
in the markets examined;
II. the time period of the estimate
III. the type of mean calculated
IV. the proxy for risk-free return
Vazquez has failed to select a representative market index. He should have selected Homali’s national
equity index or an emerging market African index.
Although choosing a nineteen year time period will help to increase the precision of sample data,
issues related to nonstationarity in data will need to be dealt with. Given the significant political risks
to be encountered by foreign investors investing in Homali, it is highly likely that risk premiums will
fluctuate considerably over the long term, in addition to the short-term. Thus Vazquez may have to
deal with nonstationarity in the returns data used.
Generally, a risk-free return can be represented using long-term government bond returns or short-
term government debt instrument returns. A risk premium relative to long-term government bonds is
generally preferred over the latter in a multi-period context of valuation. Using the yield on 20 year
U.S. government bonds as proxy for the risk-free rate is appropriate and does not pose any issue.


Correct Answer: C
The weighted average equity risk premium is 3.89%.
Using supply-side model, the estimated equity risk premium is calculated as follows:
[{(1 + EINFL) (1 + EGREPS) (1 + EGPE) – 1.0} + EINC] – Expected risk-free return
Equity risk premium French Manufacturer:
[{(1 + 1.45%) (1+ 0.53% + 0.10%) (1 + 3.00%) – 1.0} + (1.21% + 0.35%)] – 2.45% = 4.2618%
The GGM equity risk premium estimate is calculated as follows:
Dividend yield on the index based on year-ahead aggregate forecasted dividends and aggregate
market value
+ Consensus long-term earnings growth rate

− Current long-term government bond yield
GGM Japanese Manufacturer = (175.59 ÷ 9,556.00) + 2.54% − 1.34%

= 3.0375%
Weighted average equity risk premium = (0.7) (4.2618%) + (0.3) (3.0375%) = 3.8945%

Correct Answer: C
Espinoza’s statement accurately captures the process used to derive estimates of future beta. In order
to accurately predict future beta, the beta value in a future period needs to be adjusted closer to a
mean value of 1.0, i.e. the beta of an average-systematic-risk security.
Flynn’s statement does not accurately capture the process used to estimate raw beta. Beta equals to
the covariance of returns with the returns on the market portfolio divided by the market portfolio’s
variance of returns.

Correct Answer: A
Agatha’s estimated equity beta is 1.15.
In order to estimate the equity beta for a privately traded firm, such as Agatha, the following steps
need to be followed:
1) Unlever the benchmark’s beta

 1 
BU ≈   BE
1 + (D E )
Given a total debt ratio of 0.3, Horizon’s debt-to-equity ratio is 0.42857 (0.3/0.7).

 1 
BU ≈  1.4 = 0.98
1 + (0.3 0.7 ) 
2) Lever the beta to reflect the subject company’s leverage
BE ' ≈ 1+ ( D' E ') BU
Given a total debt ratio of 0.15, Agatha’s debt-to-equity ratio is 0.17647 (0.15/0.85)
BE ' ≈ 1+ ( 0.15 0.85) 0.98 =1.15294

Correct Answer: C
Hodge has inaccurately described both the country rating and country spread model.
The country spread model estimates the equity risk premium as the sum of the equity risk premium of
a developed market and a country premium. The country premium is equal to the yield differential
between emerging market government bonds (denominated in the currency of the developed market)
and developed market government bonds.
The country risk rating model provides a regression-based estimate of the equity risk premium based
on the empirical relationship between developed market equity returns and institutional investor’s
semi-annual risk ratings for the country. The estimated regression equation is then used with risk
ratings for less developed markets to predict the required returns for those markets.

Correct Answer: A
Using a five-year horizon for calculating beta is the most common practice. The most common
method to adjust the beta is by using the following equation:
2/3(beta) + (1/3)
For T&M, adjusted beta equals:

2/3(1.3) + (1/3) = 1.20
The required return using CAPM equals:

5.1% + 1.20(5.5%) =11.7%
To determine whether the Armstrong’s estimate implies above or below average risk, we find the
return if beta equals 1:
5.1% +1(5.5%) = 10.6%
Since Armstrong estimated a required return of 10.2%, her estimate implies below-average systematic
risk.


Correct Answer: B
Unlevering the benchmark beta:
[(1/1+(45/55)] 1.05 = 0.5775
Levering this beta:

[1+(32/68)] 0.5775 = 0.849

Correct Answer: C
Statement 1 is incorrect. Greater complexity, or a model of required return based on multiple factors,
does not ensure greater explanatory power than the CAPM for estimating required return. Any
selected model should be examined for the value it is adding (which could be greater or less).
Statement 2 is incorrect. The statement is true for the APT model. But, in the case of the Fama-French
model (a type of a multifactor model), the premiums of two factors are not stated as quantities in
excess of the risk free rate (one represents a small cap return premium and the other a value return
premium).

Correct Answer: B
Statement 3 is incorrect. The mean return to shorting large-cap shares and investing the proceeds in
small-cap shares is the small-cap premium. The exhibit shows the beta, or sensitivity to this premium,
not the premium itself. Since the size beta is negative, the company is a large-cap firm.
Statement 4 is correct. The company is a large cap, value stock high liquidity.

Correct Answer: B
EE stock is the stock of a micro-cap public company. The required return for such a company using
the build up method equals:
Risk free rate + equity risk premium + incremental premium for small size
= 4 + 5.5 + 4.21 = 13.71%
The company specific premium is added to determine the required return for a privately held
company.

Correct Answer: A
In some cases, the size premium for the smallest decile may reflect not only the premium for healthy
small-cap companies, but former large-cap companies that are in financial distress. If this is the case,
the historical estimate may not be applicable without a downward adjustment for estimating the
required return for a small but financially healthy company.


Correct Answer: A
Backfilling index returns has the effect of artificially increasing and biasing an index’s return. By
using the returns of the 15 corporations, which were in existence at 1990 and backfilling these returns
over the 1975-1989 period, the historical equity risk premium will be biased upwards.

Correct Answer: C
Both events, the opening of the Lisonian stock exchange followed by an increase in cash flow
volatility and the subsequent imposition of capital controls will produce non-stationary historical
return series. Additionally, the events have the potential to produce different equity return premiums
prior to and following the occurrence of the events.

Correct Answer: A
Under the Ibboston and Chen model, the supply side estimate of the equity return is broken down into
four components:
Expected inflation: EINFL
Expected growth rate in real earnings per share: EGREPS (sum of the labor productivity
growth and labor supply growth rate)
Expected growth in the P/E ratio: EGPE
Expected income component: EINC
Equity risk premium = [{(1 + EINFL) (1 + EGREPS) (1 + EGPE) – 1.0} + EINC] – Expected
risk-free return
= [{(1 + 0.034) (1 + 0.025 + 0.014) (1 + 0.0145) – 1.0} + (0.0176 +
0.0015)] – 0.045
= 0.064 or 6.40%

Correct Answer: C
Factor 1:
The raw beta is obtained from an ordinary least squares regression of the return on the stock on the
return on the market. However the future beta is often found to be a value closer to a mean value of
1.0, i.e. the beta of an average systematic risk security, than to the value of raw beta. Since valuation
is forward-looking it is rational to adjust the raw beta so that it may more accurately predict future
beta.
Relative to developed markets, transparency in emerging markets is often weaker and thus it may be
more difficult to obtain market data to formulate forecasts such as beta. However the beta adjustment
is rational in the case of both developed and emerging markets to obtain accurate valuation estimates.
Thus factor 1 inaccurately describes the issues involved in estimating returns for emerging markets.
Factor 2:
Models such as the Fama-French model and the Pastor Stambaugh model are generally limited to
developed countries. Historical data on the factors are publically available to 24 countries, which are
all developed countries. Although the latter model represents an extension of the former model by
including an illiquidity risk premium, either of the two models may be difficult to use in emerging

markets such as Morocco where historical data on the factors may not be readily available. Thus
factor 2 inaccurately describes the issues involved in estimating returns for emerging markets.

Correct Answer: A
The required return using the Fama-French model is calculated using the formula:
ri = RF + BimktRMRF + BisizeSMB + BivalueHML

= 3.4%* + (1.24)(6.40%) + (− 0.46)(3.50%) + (0.24)(1.80%)
= 10.158% ≈ 10.2%
* A short-term risk-free rate is used as the expected risk-free rate in the Fama-French model.

Correct Answer: B
Based on the data provided in exhibit 1, the size beta is – 0.46. The negative beta provides evidence
that the House Creations stock has a market capitalization which is higher than the average stock in
the market. The negative factor beta will reduce the cost of equity capital. A lower cost of equity
capital increases the present value of an equity security (when the cost of equity capital is used to
discount a security’s cash flow stream) and thus benefits the cost of equity capital.
A positive value premium of 0.24 provides evidence that the stock’s market price is less than the
book value of its equity, i.e. it has a high book-to-market ratio. Additionally, the positive value
premium provides evidence that the stock is a value stock.

Reading 27: Return Concepts

Correct Answer: C
In one year’s time, the stock is expected to pay dividends totaling $3.20 ($0.80 × 4).
Expected return = DH/P0 + (V0 – P0/P0) = $3.20/$38.00 + [($40.00 – $38.00)/$38.00] = 13.684%

Correct Answer: A
If the firm’s stock is correctly valued, it will return its cost of equity. Under this assumption, target
price = current price × (1 + Required return) – Dividend
Target price = $38.00 × (1.1255) – ($0.80 × 4) ≈ $39.57

Correct Answer: C
C is correct. With the exception of a flat yield curve scenario, the arithmetic mean is always higher
than the geometric mean. Therefore, the historical risk premium estimate will be higher if arithmetic
mean returns are used.
A is incorrect. Considering that the yield curve is upward sloping, the long-term government bond
return will be higher relative to the (short-term) Treasury bill return. Therefore, the historical risk
premium estimate will be higher relative to the estimate generated using T-bill returns.

Correct Answer: A
A is correct. The baseline value for the expected growth in the P/E ratio is 0 which is consistent with
an efficient market view. A negative value for this factor suggests that the analyst views the current
P/E ratio as reflecting overvaluation.

Correct Answer: A
Required return = {[(1 + EINFL)(1 + EGREPS)(1 + EGPE) – 1.0] + EINC}

.

EINFL =

− 1 =
.
− 1 = 2.0076%
EGREPS = Labor productivity growth + labor supply growth = 3.0% + 2.2% = 5.2%

Equity Risk Premium = [{(1.020076)(1.052)(0.97) – 1.0} + (0.018 + 0.0025)]-0.02 = 0.041426 or

4.14%

Correct Answer: A
A is correct. A shortcoming of applying the CAPM to estimate a stock’s required return is that the
approach solely considers one source of systematic risk – the sensitivity of the stock’s return to the
returns of the broad market index. On the other hand, the Fama-French model considers other sources
of systematic risk including value and size and is more suitable for deriving return estimates for Zitter
Inc.’s stock. The CAPM is regarded as an incomplete model for measuring risk.

Reading 28 Industry and Company Analysis FinQuiz.com
FinQuiz.com
Study Session 10
June 2019


FinQuiz Level II 2019 – Item-set Solution
Reading 28: Industry and Company Analysis

Correct Answer: B
B is correct. Pithers is using the market growth and market share approach, a top-down approach, as
he is forecasting industry growth first and considering how Hollistic Inc.’s market share will change
over time.
A is incorrect. Davis is using a hybrid approach. Projections 1, 3 and 4 represent the use of the top-
down approach; Davis starts at the overall level of the economy and uses the rate of inflation to
develop projections at the overall company level. On the other hand, Projection 2 represents the use
of the bottom-up approach to forecasting as Davis is using the company’s past cost of sales-to-sales
ratio to develop forecasts. The combination of the bottom-up and top-down approach represent a
hybrid approach.
C is incorrect. Barrett is using a hybrid approach to forecasting. She generates the short-term forecast
using a bottom-up approach by focusing on the company’s individual growth rate. However, her
long-term forecast is generated using a top-down approach as she projects sales revenue to grow at
the nominal GDP growth rate.

Correct Answer: C
C is correct. All BRL figures are in millions.
The company will pass 50% of the 2% increase in coffee beans prices to consumers; selling price per
unit should increase by 1% (2% × 0.5) per unit in 2013. Given that sales volume is projected to
decline by 8% in 2013, sales revenue is projected to total BRL 799.112 (BRL 860 × 1.01 × 0.92).
Projected cost of sales attributable to coffee beans (2013) = BRL 645 × 0.4 × 1.02 × 0.92
= BRL 242.1072
Remainder projected cost of sales (2013) = BRL 645 × 0.6 × 0.92
= BRL 356.04
Gross profit margin (2013) = [BRL 799.112 – (BRL 242.1072 + BRL 356.04)] ÷ BRL 799.112
= 25.149%


Correct Answer: A
A is correct. An inflection point will occur when the future will look considerably different from the
past. This contrasts with a perpetuity calculation which assumes a constant rate of growth into the
future. Pithers’ SG&A projection represents an inflection point as the sudden policy announcement
will alter SG&A estimates significantly.
B is incorrect. Pithers’ sales revenue forecast does not reflect an inflection point as he expects
industry revenues to grow slowly and this growth is based on its past pattern.
C is incorrect. Barrett’s revenue forecast does not represent an inflection point. Although heightened
competition will reduce Hollistic Inc.’s revenue forecast, the decline is gradual and thus does not
represent a sudden shift in future revenues.

Correct Answer: C
C is correct. Hollistic’s market share has remained constant from 2012 and is expected to remain so:
All BRL figures are in millions.
Market share (2012) = BRL 860/BRL 1,760 = 48.86%
Market share (2013) = BRL 877.2/BRL 1,795.2 = 48.86%
Industry revenue (2014) = BRL 1,795.2 × 1.02 = BRL 1,831.104
Hollistic Inc.’s revenue (2014) = BRL 1,831.104 × 0.4886 = BRL 894.68

Correct Answer: C
Part 5) C is correct.
With linear growth, it will take approximately 3 years for the revenue growth rate to equal nominal
GDP growth rate.
Yoy revenue growth (2012 – 2013) = (877.2/860.0) – 1 = 2.0%
N = number of years required for the two aforementioned growth rates to equal.
We solve for ‘N’ as follows:
2% × 1.001 × N = 6%
N = 2.997 years or ≈ 3 years


Correct Answer: B
All BRL figures are in millions.
Pithers’ SG&A Forecast (2014):
SG&A/Gross profit (2012) = BRL 43/BRL 215 = 20%
SG&A/Gross profit (2014) = 20% × 1.032
= 21.218%
Assuming that gross profit remains constant (as stated in the question), projected SG&A for 2014 is
equal to BRL 45.62 (BRL 215 × 21.218%).
Davis’ SG&A Forecast (2014):
BRL 43 × (1.02)2 = BRL 44.74


Correct Answer: B
Hailey is using the growth relative to GDP growth approach, a top-down approach, to forecast
revenues generated from the sale of generator units. This approach involves considering how the
growth rate of a specific company will compare relative to nominal GDP growth.

Correct Answer: C
The forecasted growth in Baseline Corp’s revenue is 4.8% [4% × (1 + 0.20)].

In 2018, the company’s reported revenues are forecasted to equal $1,174.04 million ($1,020 million
× 1.0483).

Correct Answer: B
All $ figures are in millions.
Current utility expenses = ($35,900 + $52,100 + $38,000) million = $126,000 million
Utility expenses per square foot = $126,000 million/35.5 million = $3,549.29578
Production area space in Year 2019 = 35.5 million × (1.01)4 = 36.9414 million square feet
Utility expenses per square foot in Year 2019 = $3,549.29578 × (1.02)4 = $3,841.87189
Total utility expenses in Year 2019 = $3,841.87189 × 36.9414 million = $141,924.13 million or ≈
$141,924 million.

Correct Answer: B
Interest rate on average cash position = Interest income/average cash position = $4,800/ ($57,600 +
$21,500) = 6.068% or 6.07%

Correct Answer: C
C is correct. The revision in tax laws will result in a decrease in the company’s income subject to
taxation because the company will recognize a higher depreciation expense in the current year as a
result of the accelerated depreciation method employed. However, the company’s effective tax rate
will not be affected if the company adopts the accelerated depreciation method for tax purposes.


Correct Answer: C
Profit before taxes $50.0

Tax payment (0.6 × 0.35 × $50) $10.5
Cash tax rate ($10.5/$50.0) 21.0%


Correct Answer: A
A is correct. Register Inc. has acquired significant economies of scale in production relative to its
competitors thereby reducing the intensity of rivalry between the manufacturer and its competitors. In
addition, the dominant market share of the manufacturer further reduces the intensity of rivalry.
Therefore, the intensity of rivalry is described as being low.

Correct Answer: A
The bargaining power of paper suppliers is low because paper is widely available as an input
resource. With a wide availability of paper suppliers, their ability to raise the price of paper is limited.

Correct Answer: B
The more fragmented the consumer base, the lower the bargaining power of an industry’s consumers
as their ability to demand lower prices and/or control the quality and quantity of end products is
limited.
On the other hand, the chain of retail outlets has higher bargaining power as it is the only retain chain
to stock the company’s products. Therefore, one would expect this buyer category to have a more
commanding position with respect to the pricing, quality and/or quantity of the company’s products.

Correct Answer: A
NAD
Sales revenue (NAD 15 × 350,000 × 1.20* × 0.84**) 5,292,000
Cost of goods sold*** 2,665,600
SG&A (NAD 4 × 350,000) 1,400,000
Operating profit 1,226,400
*The 20% increase in the price of the input will be completely passed on to customers in the form of
higher selling prices.
**The number of units sold will decline to a percentage of 84% (1 – 16%).
***Cost of goods sold reported in 2015 is equal to NAD 2,800,000 (NAD 8 × 350,000). Out of the
total figure reported, NAD 840,000 (NAD 2,800,000 × 0.30) is variable while NAD 1,960,000 (NAD
2,800,000 – NAD 840,000) is fixed.
In 2018, the fixed component will remain at NAD 1,960,000 while the variable component will
decline to NAD 705,600 (NAD 840,000 × 0.84). Total cost of goods sold will amount to NAD
2,665,600 (NAD 1,960,000 + NAD 705,600).


Correct Answer: A
A is correct. Since the demand is price elastic, a company’s efforts to pass on inflation through higher
prices can have a negative impact on volume. Therefore, in an inflationary environment, raising
prices too soon will result in volume losses.
B is incorrect. On the other hand, raising prices too late will result in a profit margin squeeze in an
inflationary environment.

Correct Answer: A
NAD
Net sales (NAD 15 × 350,000) 5,250,000
Cost of goods sold (NAD 8 × 350,000 × 1.15) 3,220,000
SG&A expenses (NAD 4 × 350,000 × 1.15) 1,610,000
Operating profit 420,000

Reading 29 Discounted Dividend Valuation FinQuiz.com
FinQuiz.com
Study Session 10
June 2019


Reading 29: Discounted Dividend Valuation

Correct Answer: B
Referring to the information in Exhibit 1, dividends do not appear to be adjusted to reflect changes in
profitability. Dividends have been relatively constant (around $1.5), whereas the EPS has
significantly fluctuated over the five-year period. Hence, the dividend discount model does not appear
to be the appropriate choice. Also, to use the residual income model for valuation, the quality of
accounting disclosures needs to be good, with the financial statements reflecting an accurate and
detailed picture of the true economic performance. As this is not the case with CT, residual income
model is also not appropriate.

Correct Answer: A
The dividends equal:
Year 0: 3.67 (0.40) = $1.468
Year 1: 1.468 (1.11) = $1.629
Year 2: $1.629(1.09) = $1.776
Year 3: $1.776(1.10) = $1.9537
Year 4: $1.9537(1.065) = $2.08
The required return on the stock equals: 3.75 + 1.2(5.5) = 10.35%

Value at Year 3= $2.08/0.1035-0.065 = $54.044
The value of the stock equals:

1.629/1.1035 + 1.776/(1.1035)2 +(1.9537+54.044)/(1.1035)3 = $44.607

Correct Answer: B
The expected rate of return is that rate which is implied by the market price of the stock. The
expected rate of return is the sum of the dividend yield (D1/P0) and the capital gains yield (g):
r = D1/P0 + g
= 2.34(1.055)/65.78 + 0.055
= 0.03753+0.055 = 0.092539= 9.25% (the dividend yield equals 3.75%)

Correct Answer: C
The dividend payout ratio is:
2.34/5.12 = 0.457
Required rate of return = 12%
Leading P/E = 0.45703/0.12–0.055 = 7.03125
Trailing P/E = 0.45703(1.055)/0.12–0.055 = 7.4179


Correct Answer: B
Required rate of return = 4+1.13(5.5) = 10.215%
The no-growth P/E = 1/r = 1/0.10215 = 9.7895
Growth P/E = PVGO/E1
78.05 = (1.56/0.10215) + PVGO
where (1.56/0.10215) = 15.27
PVGO = $62.778
Growth P/E = 62.778/1.56 = 40.24

Correct Answer: C
Statement 1 is correct. Gordon growth model can also be used in case of declining dividends, that is, a
negative growth rate. As long as the growth rate is less than the required return, the GGM can be
used.
Statement 2 is correct. Even though cash dividends are more predictable than share repurchases, if
applied applied, the DDM is a valid approach to common stock valuation even when the company
being analyzed engages in share repurchases.

Correct Answer: B
Since the FCFE value is negative and is expected to remain negative for the next five years of
Captura’s life, the FCFE method cannot be used for company valuation. The FCFF method can be
used in instances where the FCFE method yields negative results.
Although the company has had a long standing history of dividend payments, the recent scarcity of
cash for equity holder needs, would result in zero dividends. Thus, the DDM cannot be used.

Correct Answer: A
Dividends are less volatile than earnings. Therefore, the dividend discount model values are less
sensitive to short term input fluctuations.

Correct Answer: A
The terminal value of a project is inclusive of the operating and the non-operating cash flows in the
last period of a project’s life.

Correct Answer: B
All figures in $
Residual Income= Net Income- (BV0 of equity x cost of equity)
Residual Income= 800,000- [(4,500,000x 25%) x 12%]
Residual Income=800,000- (1,125,000 x 12%)
Residual Income= 800,000- 135,000
Residual Income= 665,000


Correct Answer: A
The residual income approach matches profits recognized to the time period in which they are earned.
Thus, the RI method characterized the matching or the accrual concept.

Correct Answer: C
Developed markets, e.g. the U.S. equity market, prefers to distribute cash to the equity holders in the
form of share repurchases rather than cash dividends.

Correct Answer: C
r= [D0(1+g)/P0] + g or [D1/P0] + g
r= [$4 x (1.06)/$65] + 6%
r= 12.5%

Correct Answer: B
Value= {[D0 x (1 +gl)]} + {[D0 x H (gs-gl)]} / (r-gl)
Value= {[$4 x (1.06)]} + {[$4 x 4 (0.29)]}/ 0.09
Value= {$4.24 + $4.64}/0.09
Value= $98.67/share

Correct Answer: B
Value= [D0 x (1 + gl)]/ (r-gl)
Value= [$4 x 1.06] / 0.09
Value= $47.91/share
Total value= $47.91 x 500,000 = 23.6 million

Correct Answer: B
Value= [D0 x H (gs-gl)]/ (r-gl)
Value= [$4 x 4 x 0.29] / [0.09]
Value= $55.56/share
Total Value= $55.56 x 500,000= $25.8 million

Correct Answer: B
Input variability is not controllable by a computer system which simply generates the results through
the information provided to it. It cannot detect false input through human error or manipulation.

Correct Answer: C
b=(Net Income- Dividends)/ Net Income
b= ($12-$4)/$12= 67%


Correct Answer: A
P0= E1/r +PVGO
$60= [$5(1.12)/0.135] +PVGO
$60= $41.48 + PVGO
PVGO= $18.52

Correct Answer: A
When the rate of return from the investment is less than the required rate of return, then despite the
increasing EPS, cash flows generated should not be reinvested in the project. The earnings should
rather be distributed in the form of cash dividends.

Correct Answer: B
PVGO is denoted by the formula= P0- (1/r)

Correct Answer: C
E1= [$6,000,000(1.08)/250,000]
No-growth value= E1/r= $25.92/0.17= $152.47

Correct Answer: C
P/E= (1/r) + (PVGO/E1)
P/E= (1/0.17) + (PVGO/E1)
$42/$25.92= 5.88 + (PVGO/E1)
1.62= 5.88 + (PVGO/E1)
(PVGO/E1) =- 4.26
Percentage= (-4.26/ 1.62) x 100= 263%

Correct Answer: C
Trailing P/E Ratio= {[D0(1+g)]/E0}/(r-g)
Trailing P/E Ratio= {[3(1.08)]/24}/(0.17-0.08)
Trailing P/E Ratio=0.135/0.09=1.50

Correct Answer: C
Factors that support the use of the GGM to value North Shore include:
• The corporation’s earnings are in line with the U.S. nominal GDP growth.
• The corporation’s profitability is stable as evidenced by its steady required return on equity.
Additionally, the steady stream of revenue from ongoing projects has secured the business and
has helped contribute to its stable profits.
• Its dividends bear an understandable and consistent relationship to its earnings as evidenced by its
policy of steadily increasing dividends.


Correct Answer: B
The Gordon growth intrinsic value of North Shore, using a required return of 10% and original
growth rate of 6.5%, is $16.74 per share.
D (1 + g ) $0.55(1 + 0.065 )
V0 = 0 = = $16 .7357 per share.
r−g 0.10 − 0.065

Correct Answer: B
The R2 measure suggests that the prediction ability of beta and the required return values using
adjusted or unadjusted beta is low. Instead, the valuation should focus on the bond-yield-plus-risk
premium approach. The estimate of the required return on equity using the bond-yield-plus-risk
premium approach is 12% (9% + 3%).
Based on a 12% required return on equity and 6.5% growth rate, the intrinsic value of North Shore’s
shares is $10.65.
D0 (1 + g ) 0.55 (1 + 0 .065 )
V0 = = = $10 .65
r−g 0.12 − 0 .065
North Shore’s shares are currently overvalued as $15.64 > $10.65.

Correct Answer: A
The contribution of North Shore’s PVGO to its P/E ratio is 8.43.
In order to calculate the contribution of PVGO to P/E, the following formula is used:
1 PVGO
P/E = +
r E1
12.46 1 PVGO
= +
0.8 0.14 E1
PVGO
= 8.43
E1


Correct Answer: A
Based on Costa’s revised estimates, the intrinsic value of North Shore’s shares is $5.86.
Based on the forecasted steady decline of North Shore’s dividends, the H-model should be used to
determine the firm’s intrinsic value.
Under the H-model, intrinsic value is calculated using the following formula:
D0 (1+ gL ) D0 H ( gs − gL )
V0 = +
r − gL r − gL
$0.55 (1.025) $0.55 ( 5) ( 0.065 − 0.025)

= +
0.14 − 0.025 0.14 − 0.025
= $5.85870 ≈ $5.86

Correct Answer: B
If North Shore adopts the policy discussed by the assistant in his query, North Shore’s intrinsic value
will be $6.92.
A three stage dividend discount model will be used to calculate the intrinsic value as follows:
Present values
Year Value Calculation Dt or Vt Dt/(1.11)t or
Vt/(1.11)t
2010 D1 $0.55(1.055) $0.58025 $0.52275
2011 D2 $0.55(1.055)(1.04) $0.60346 $0.48978
$0.55(1.055)(1.04)(1.025)/(0.
2011 V2 $7.27702 $5.90619
11 – 0.025)
Total $6.91872

Correct Answer: C
Value = BVPS + PV of RI
Value = ($16,000,000 + $11,764,708)/500,000
Value = $55.5/share

Correct Answer: C
Clean surplus accounting is denoted by the formula:
BT= BVt-1+NIt-DIvidendst


Correct Answer: C
V0 = (D1+P1)/ (1+r)
V0 = ($12+ $220)/ (1.15)
V0 = $201.73/share

Correct Answer: B
V0 = (D1)/ (1+r)1 +(D2)/(1+r)2+(D3+P3)/(1+r)3
V0 = ($7/1.15) + ($10/1.32) + ($12+220/1.52)
V0 = $166.29/share

Correct Answer: A
Growth Rate = (12/7)1/2 – 1
Growth Rate = 31%

Correct Answer: A
ROE = Net Profit Margin x Asset Turnover x Financial Leverage
ROE = $850,000/$6,000,000 x $6,000,000/$13,000,000 x 2.5
ROE = 16.4%

Correct Answer: A
The output of the Gordon’s growth model is very sensitive to small changes in the inputs i.e. assumed
growth rate and the required rate.

Correct Answer: A
Since Hiclor’s current earnings growth rate is greater than the economy’s nominal growth rate, it is
recommended to use the multistage dividend discount model instead of the Gordon’s growth model.

Correct Answer: B
Equity Risk Premium = Short Term Yield on the Market Index + Consensus Long term Earning
Growth Rate – Long Term Government Bond Yield
Equity Risk Premium = 8% + 18%- 12% = 14%

Correct Answer: C
Share repurchase at par has a neutral effect on the wealth of the existing shareholders. However,
repurchase at par does not guarantee a positive effect. This is because the cash used to repurchase the
shares could have been applied to a profitable business or investment opportunity. The opportunity
cost for share repurchase at par is not discernible with the information provided.


Correct Answer: B
The implied growth rate calculation needs the following inputs:
• actual market price

• expected dividend
• required rate of return

Correct Answer: A
As a company enters the transition phase of its lifecycle, its return on equity percentage starts falling
towards the required return.

Reading 30 Free Cash Flow Valuation FinQuiz.com
FinQuiz.com
Study Session 11
June 2019


Reading 30: Free Cash Flow Valuation

Correct Answer: C
The company WACC is:
WACC = 0.30[0.064(1 – .37)] + 0.70(.122) = 9.75%
Firm Value: FCFF1/WACC – g

= 350(1.045)/.0975 – 0.045 = $6,966.666,667 million
The value of equity is:

6,966.66 – 1,300 = $5,666.666 million
The value/share is:

5,666.666/150 = $37.7778 per share

Correct Answer: B
FCFF equals:
Net Income+ noncash charges + after tax interest expense – investment in fixed capital – investment
in working capital
Noncash charges/Depreciation = $68.75
After tax interest expense = 29.85 (1 – 0.35) = $19.4025
Investment in fixed capital = 830 – 750 = $80
Investment in working capital = [(175 – 150) + (97.55 – 86.31)] – (66 – 60) = $30.24
FCFF: 166.66 +68.75+19.4025 – 80 – 30.24 = $144.5725

Correct Answer: A
FCFE equals:
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
FCInv: 900 – 830 = $70
WCInv: [(189 – 175) + (103.4 – 97.55)] – (79 – 66) = $6.85
Net borrowing: (81 – 78) + (396 – 359) = $40

FCFE = 200.06 + 76.09 – 70 – 6.85 + 40 = $239.30


Correct Answer: B
Statement 1 is incorrect. Although it is correct that U.S. GAAP treats interest paid or received as an
operating activity, IFRS treats interest received as either an operating or an investing activity, and
interest paid as either an operating or a financing activity.
Statement 2 is correct. If WACC is calculated on a pretax basis the FCFF to be discounted should be
estimated by adding back interest paid with no tax adjustment. This ensures consistency in the
measures of WACC and FCFF.

Correct Answer: A
FCFF = Net Income+ noncash charges + after tax interest expense –investment in fixed capital –
investment in working capital
FCFF = 310,000 +(60,000 – 50,000 – 30,000+55,000) +80,000(1–.30) – (350,000 – 10,000) –45,000

= $16,000

Correct Answer: B
When using EBIT the entire depreciation amount is added back whereas when using EBITDA only
the depreciation tax savings (depreciation times the tax rate) is added back.

Correct Answer: B
North Rock’s FCFF for the year 2009 is approximately $94 million.
The incremental fixed capital investment in 2008 was 46.15%, which is calculated as follows:

−

500 − 200
= = 46.15%

650
The incremental investment in working capital in 2008 was 7.69%, which is calculated as follows:

50
= = 7.69%

650
The forecasted FCFF is calculated using the following formula:
EBIT (1 – tax rate) – Incremental Fixed Capital Investment – Incremental Working Capital
Investment
Thus the forecasted FCFF is calculated as follows (in $ millions):
$ millions
Sales 1,836.000 ($1,700 × 1.08)
EBIT 257.040 14% of sales
EBIT (1 – Tax rate) 167.076 257.040 (1 – 0.35)
Incremental fixed capital (62.764) 0.4615 × (1,700 × 0.08)*

Incremental working capital (10.458) 0.0769 × (1,700 × 0.08)*

FCFF 93.854
*Both incremental fixed capital and working capital investment are calculated based on the
respective calculated percentages in 2007 (see above) by the incremental increase in sales
which is $136 million ($1,700 million × 0.08)

Correct Answer: A
North Rock will finance incremental fixed capital and working capital investment with 40% debt (the
target debt ratio). The incremental working capital and fixed capital investment forecasted for the
year 2009 are (in millions) $62.764 and $10.458, respectively. Net borrowings (NB) are $29 million
NB = DR (Fixed Capital Investment – Depreciation) + DR (Working Capital Investment) or

= DR (Incremental Fixed Capital Investment + Incremental Working Capital Investment)
= 0.4 ($62.764 + $10.458)
= $29.2888 million

Correct Answer: C
North Rock’s forecasted FCFF for the year 2011 is approximately $82 million.
Using the formula laid out in the previous solution, forecasted FCFF is calculated as follows:
$ millions
Sales 2,141.510 ($1,700 × 1.083)
EBIT 256.981 12%* of sales
EBIT (1 – Tax rate) 167.038 256.981(1 – 0.35)
Incremental fixed capital (73.208) 46.15% of sales increase**
Incremental working capital (12.199) 7.69% of sales increase**
FCFF 81.6310
*Since the EBIT margin will decline by a total of 5% over a five-year period, starting from
2010, the decline in the EBIT margin will be 1% per annum. In 2011, EBIT margin will be
12% (14% − 2%).
**The sales increase between 2010 and 2011 is $158.630 million [(1,700 × 1.083) – (1,700 ×
1.082)]

Correct Answer: B
Out of the characteristics highlighted by Fraser, characteristic 2 decreases the usefulness of the
modified buildup model for valuing local corporations such as HL Corp. The modified build up
method involving various adjustments to the real country return is worth using when real discount
rates and growth rates can be estimated more reliably than nominal discount rates and nominal growth
rates. When the latter two rates are predictable, the model loses its usefulness.
Characteristic 1 does not decrease the usefulness of the modified buildup model for valuing
corporations such as HL Corp. The approach is particularly useful for countries with either high or

variable inflation rates. A high but steadily increasing inflation rate makes this model useful for
valuation purposes.

Correct Answer: B
The value of each HL Corp share is approximately EMA 26.9.
Using the modified buildup method, the real required rate of return is 8.32%, which is calculated as
follows:
(%)
Country return (real) 8.50
+/- Size adjustment − 0.23
+/- Industry adjustment + 0.14
+/- Leverage adjustment − 0.09
Required rate of return (real) 8.32
The real growth rate of FCFE is expected to be 2.05% (Exhibit 1), so the value each HL Corp Share
is:
FCFE଴ 1 + g ୰ୣୟ୪ 1.651.0205

V଴ = = = EMA 26.855
r୰ୣୟ୪ − g ୰ୣୟ୪ 0.0832 − 0.0205

Correct Answer: A
North Rock’s FCFE for the year 2009 is approximately $176 million.
Using EBIT, the FCFF for the year 2009 is calculated using the following formula:
FCFF = EBIT (1 – Tax rate) + Dep – FCInv – WCInv

= $350 (1 – 0.35) + 35.74 – 25.50 – (58.53)*
= $179.21 million
*WCInv = Increase (decrease) in accounts receivable + increase (decrease) in inventory + decrease

(increase) in accounts payable + decrease (increase) in accrued expenses
WCInv (in millions) = $15.80 + $10.25 + $17.98 + 14.50 = $58.53
Using the FCFF value, FCFE is calculated using the following formula:
FCFE = FCFF – Interest (1 – tax rate) + Net Borrowing

= $179.21 – $8.45(1 – 0.35) + ($4.67 – $2.25)
= $176.1375 million


Correct Answer: B
B is correct. The FCFF model is more suitable for valuing a levered company with a
changing capital structure because FCFF estimation may be computed more easily compared
to FCFE estimation in these circumstances.
A is incorrect. The advantage of FCFE and FCFF approaches over earnings-based measures
is that the latter do not account for the reinvestment in working capital and capital assets
which a company makes to maintain or maximize the value of the firm. Therefore, the latter
approach is not consistent with the shareholder perspective which focuses on long-term value
maximization.

Correct Answer: B
FCFF = Net income + non-cash charges + Interest(1 – tax rate) – Fixed capital investment –
working capital investment
All $ figures are in thousands.
Fixed capital investment = $1,410 – $1,390 = $20

Working capital investment:
2014 2013
Accounts receivable $150 $110
Inventory $85 $100
Total current assets excluding cash $235 $210
Accounts payable $70 $70

Accrued taxes and expenses $85 $130
Current liabilities excluding current
portion of long-term debt $155 $200
Working capital $80 $10
Increase/(Decrease) in working capital $70 -
FCFF = $206 + $105(1 – 0.3) + $320 – $20 – $70 = $509.50


Correct Answer: A

FCFE = CFO – FCInv. + Net borrowing = $466 – ($1,410 – $1,390) + [($25+$480) – (90+
$500)] = $361.00

Correct Answer: C
C is correct. EBITDA is a poor proxy for FCFF because it fails to consider depreciation tax
shield and the investment in fixed capital and working capital. The measure is also a poor
proxy for FCFE as it fails to consider cash flow from new borrowings or debt repayments
which otherwise feature in a company’s FCFE computation.
A is incorrect. Even though EBITDA is a pre-tax measure, this fact does not justify why
EBITDA is a poor proxy for FCFF and FCFE.
B is incorrect. EBITDA is a before-tax measure and so the discount rate applied to it would
be a before-tax rate.

Correct Answer: C
The two-stage FCFE model will be used to value the Ceta Inc. stock:
Year FCFE PV of FCFE

1 $1,004(1.25) = $1,255.0000 $1,255.0000/1.125 = $1,115.5556
2 $1,004(1.25)2 = $1,568.7500 $1,568.75000/1.1252 = $1,239.5062
3 $1,004(1.25)3 = $1,960.9375 $1,960.9375/1.1253 = $1,377.2291
4 $1,004(1.25)3(1.08)/(0.125 – $47,062.50/1.1253 = $33,053.4979
0.08) = $47,062.50
Total $36,785.7880
Forecasted intrinsic value = $36,785,788.0/1,800,000 = $20.4365 or $20.44

Correct Answer: B
FCFE = FCFF – Int.(1 – Tax rate) + Net borrowing
FCFF = $1,004 + $105 (1 – 0.30) – ($527 – $480) = $1,030.50


Correct Answer: C
Wayne’s opening statement is relevant for calculating FCFF from both EBIT and EBITDA.
This is because many noncash charges are made after computing EBIT or EBITDA and do
not need to be added back when calculating FCFF and/or FCFE from either of the two. An
example of a noncash charge which is not made before computing EBITDA is depreciation.
Therefore, it is not added back to EBITDA when computing FCFF/FCFE. However, because
depreciation is tax-deductible, the effect of taxes must be accounted for when calculating
FCFF. This is done by adding the product of the depreciation expense and tax charge to
EBITDA.

Correct Answer: C
C is correct. The equation for calculating FCFF from EBITDA is as follows:
FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.
Based on this equation, the:
• product of the depreciation charge and tax rate is added (Option C is correct while
option A is incorrect) and
• after-tax interest expense does not feature in the equation as EBITDA is
calculating prior to the inclusion of interest expense (Option B is incorrect).

Correct Answer: A
The amount of Wayne Corporation’s FCFF is computed below:

In Millions
Increase in cash balance ($40 – $25) million $15.0
Plus: Interest expense × (1 – tax rate) = $12 million (1 – 0.30) $8.4
Plus: Repayment of principal – borrowings = ($10 – $8) million $2.0
Plus: Cash dividends $15.0
Less: New share issuances in excess of repurchases ($20 – $15) million $5.0
Uses of FCFF $35.4


Correct Answer: B
Wayne Corporation’s FCFF is computed below (All $ figures are in millions):

Sales $450 × 1.10 $495.0
EBIT $495 × 0.20 $99.0
EBIT (1 – tax rate) $99 (1 – 0.30) $69.3
Incremental FC 88.89%* × $450 × 0.10 ($40.0)
Incremental WC 8.89%** × $450 × 0.10 ($4.0)
FCFF $25.3

$$
*Incremental fixed capital investment = = $×. =

88.89%

$$
**Incremental working capital investment =

= $×. = 8.89%

Correct Answer: A
Net borrowing = (Fixed capital investment + working capital investment) × debt ratio
Net borrowing = ($27.00 + $6.75) × 0.30 = $10.13
Fixed capital investment = 60% × $450 × 0.10 = $27.00
Working capital investment = 15% × $450 × 0.10 = $6.75

Correct Answer: B
Based on the data in Exhibit 2, the required return on equity should be calculated using
CAPM.
r = E(Ri) = RF + Bi[E(RM) – RF] = 3.80% + 1.30[7.35%] = 13.355% ≈ 13.4%


Correct Answer: B
FCFE0 (1 + g ) 23.5(1 + 0.015*)

V0 = = = VER256.478
r−g 0.108 * * − 0.015
*Brach Tech’s real required return is 1.2% lower that Venezuela’s real GDP growth,
therefore, the company’s real required return is 1.5% (2.7% - 1.2%).
**The real required return for Brach Tech is equal to 10.8%. See below:
Country return (real) 10.5%

Industry adjustment +
1.8%
Size adjustment - 1.0%
Leverage adjustment - 0.5%
Required rate of return 10.8%


Correct Answer: B
The reconciliation has been accurately presented with respect to:
• decrease in trade receivable – represents a source of cash and the amount of decrease
should be added to net income;
• increase in other current assets – represents a use of cash and the amount of decrease
should be deducted from net income;
• increase in interest receivable represents a use of cash and should be deducted; and
• decrease in notes payable – should not feature in the reconciliation and should be
omitted.
Based on these three adjustments, the correct figure for operating cash flows is VER 3,587
million. Note: Relevant corrections are highlighted in bold and all figures are in millions.
Net income VER

3,550
Adjustments to reconcile net income to operating cash flows
Depreciation + 80
Loss on disposal property plant and equipment +2
Increase in inventories - 14
Decrease in trade receivables + 10
Increase in other current assets - 20
Increase in accrued expenses + 15
Decrease in interest payable -8
Increase in interest receivable -6
Income tax paid - 22
Net cash provided/(used in) operating activities VER
3,587
Correct Answer: A
A is correct. An increase in depreciation expense is positive for future cash flow from
operations (CFO). Net income is reduced by depreciation × (1 – tax rate) while the full
amount of depreciation expense is added back when calculating CFO. Therefore, the
difference between the depreciation expense – the amount added back to net income to
calculate CFO - and the amount by which net income is reduced by depreciation expense is:
(tax rate) × (depreciation expense) which represents a positive increment to CFO.
Therefore, the CFO reported in reading will increase by VER 24.48 million (VER 80 million
× 1.02 × 0.30).


Correct Answer: A
FCFE is not affected by divided payments to common shareholders. The reason is that FCFE
represent the cash flows available to a company’s shareholders while dividends represent
uses of these cash flows. Therefore, the company’s decision to cut its dividend per share
should not affect its FCFE.
On the other hand, an increase in leverage will increase FCFE in the year the debt is issued
by the amount of issuance proceeds.

Correct Answer: B
B is correct. Dividend payments are made at the discretion of the corporation’s board of
directors and therefore, they may imperfectly signal the company’s long-run profitability.
A is incorrect. Dividends represent uses of available cash whereas FCFE represent the cash
flow that will be distributed to a company’s shareholders without impairing the company
value.
C is incorrect. As long as a company’s growth rate is lower than its required rate of return, a
declining rate can be used in the dividend discount model.

Correct Answer: C
FCFE forecasted for the year 2018 is equal to VER 24.8 million/2.5 million = VER 9.92
2018
Expected
(In VER
millions)
Earnings VER 52.0
Net fixed capital investment - VER 22.0
Net working capital investment - VER 12.0
Debt financing [(VER 22 + VER 12) × + VER 6.80
0.20]
Forecasted FCFE VER 24.8

Reading 31 Market-Based Valuation: Price and Enterprise Value Multiples FinQuiz.com
FinQuiz.com
Study Session 11
June 2019


Reading 31: Market-Based Valuation: Price and Enterprise Value Multiples

Correct Answer: B
Statement 1 is incorrect. A justified price multiple is an estimated fair value of the multiple, which
can be justified either on the basis of the method of forecasted fundamentals or on the basis of the
method of comparables. In either case, the multiple will be called a justified multiple (it is not
necessarily based on forecasted fundamentals).
Statement 2 is correct. Of all the accounting adjustments, the potential dilution of EPS generally
makes the least demands on analysts’ accounting expertise because companies are themselves
required to present both basic EPS and diluted EPS. Because companies present both EPS numbers,
the analyst does not need to make the computation.

Correct Answer: C
Since the firm’s P/E has been negatively related to the recent earnings growth rate and positively
related to the future growth rate (the Molodovsky effect), this is most likely due to rebounds in
earnings. Hence earnings are cyclical. For cyclical firms, normalized P/Es most closely reflect long-
term earning power of the business. Also, since the company has been expanding, and as seen from
Exhibit 1, its book value per share has risen significantly. Therefore, the normalized EPS from the
average ROE method will better reflect the effect of the current size of the company. The estimation
is as follows:
(6.7+5.5+14.5+23.5+21.1)/5 = 14.26%
Based on current BVPS of $6.95, the normalized EPS equals:

(.1426×6.95) = $0.99
The P/E based on this estimate equals:

14.32/0.99 = 14.449

Correct Answer: A
As of 1st October, three months remained in year 2009. The EPS equals:
[(3/12)(0.18*) + (9/12)(0.47)] = $0.3975 *0.02+0.07+(0.03)+0.12 = 0.18
The NTM P/E would be: 9.84/0.3975 = 24.75
The EPS based on a fiscal year definition and next year’s forecasted EPS equals:
0.09 + (0.05) + 0.21 + 0.22 = 0.47
P/E equals: 9.84/0.47 = 20.94


Correct Answer: B
Stock A appears to be undervalued when compared to the index. Stock A and B are both trading at
the same P/E of 14.67, versus a P/E of 16.15 for the index. But the last column indicates that Stock A
has historically traded at a premium to the index whereas stock B has traded at a discount. Based on
the current level, this would imply a P/E for stock B of 0.89×16.15 = 14.37. Stock A should have a
P/E of 1.1 × 16.15 = 17.765, hence it is undervalued.

Correct Answer: C
P/BV = (ROE–g)/(r–g) = .15–.085/.12–.085 = 1.857
The statement is correct with respect to residual income. If the present value of expected future
residual earnings is zero, that is, the business earns its required return on investment in every period,
the justified P/BV will equal 1.

Correct Answer: C
PEG does not factor in differences in risk, an important determinant of P/E. Also, PEG does not
account for differences in the duration of growth (short-term growth forecasts vs. long-term growth
prospects). PEG assumes a linear relationship between P/E and growth, which is another limitation of
the ratio, hence, option C is incorrect.

Correct Answer: C
According to the Fed Model, the justified P/E ratios for the indices are:
Euro Index: 1/0.0564 = 17.73

German Index: 1/0.0785 = 12.7388

Correct Answer: A
According to the Yardeni Model, the justified P/E ratio equals:
P/E = 1/CBY – b(LTEG)
In this case:
P/E = 1/6.7% – 0.10(11.5%) = 14.91

Correct Answer: A
Mahard is correct with respect to the drawback. A drawback of the Fed Model is that the relationship
between interest rates and earnings yields is not a linear one. This drawback is most noticeable at low
interest rates.
Mahard is incorrect with respect to the benefit. A drawback of the Fed Model is that it inadequately
reflects the effects of inflation and incorrectly incorporates the differential effects of inflation on
earnings and interest payments.


Correct Answer: C
Cloff is incorrect. In using T-Wires own historical P/E as a benchmark, Cloff has overlooked the fact
that the company has undergone shifts in the use of financial leverage. This will impair comparability
based on past P/Es, and the method is prone to error. Also, T-Wires is able to fully pass through cost
increases to customers, and in case of complete cost pass-through, the justified P/E should not be
affected by inflation.

Correct Answer: B
Because of share repurchases and growth in treasury stock, shareholders equity would grow at a low
rate even if retained earnings are growing fast. Also, when a company repurchases shares at a price
higher than the current book value per share, it lowers the overall book value per share for the
company. This will have the effect of increasing the P/BV. In addition, if the firm has shifted to a JIT
inventory system, the amount of inventory it holds will decrease, and the P/BV will increase.

Correct Answer: C
For two stocks with the same P/B, the one with the higher ROE is relatively undervalued, all else
equal. If the present value of expected future residual earnings is positive, the justified P/B will be
greater than 1. Option C is correct.

Correct Answer: B
Normalized Earnings = Total Recent Cyclical Earnings/ Number of Years in Cycle
Normalized Earnings = $93.83/7
= $13.40

Correct Answer: B
Normalized Earnings = Avg. ROE × Current Book Value per share
Normalized Earnings = 16% × $103.00 = $16.48

Correct Answer: C
If Armadillo had reported a loss in the current year, the most appropriate formulae to be used for the
normalized earnings calculation would be:
Average ROA × Total Assets

or
Average ROE × Total Shareholders’ Equity


Correct Answer: C
Earnings yield may be used when:
• earnings are negative.

• earnings are extremely low.

Correct Answer: C
The earnings yield of the index = 1/34 = 2.9%
As the earning yield is lower than the 10 year Treasury bonds yield, the decision rule of the Fed
Model dictates that the index is overvalued.

Correct Answer: A
The Fed Model does not incorporate the differential effects of inflation on earnings and interest
payments. The other two options are correct.

Correct Answer: B
As the objective is to calculate share price, price multiples must be used. Earnings Yield is
appropriate as well, as it is the inverse of the price to earnings ratio. Enterprise value multiples are to
be used to calculate the total market value of all sources of capital.

Correct Answer: A
Value in year n = (Benchmark trailing P/E ratio) × (Forecasted earnings in year n)
Forecasted Earnings per Share of Aberdour = $42 *million/8 million= $5.25/share
Value = 34 × $5.25 = $178.5/share
*Valuation is a forward looking process, so analysts usually focus on forward EPS when earnings
forecasts are available; when earnings are not readily predictable, a trailing EPS may be more
appropriate than Forward EPS.

Correct Answer: B
Tighter credit controls would increase the cost of money. This increase in interest rates would be
reflected through an increase in the equity returns demanded by the residual stakeholders. The
increase in earning yields would be translated as an effective decrease in the P/E ratio.

Correct Answer: C
As the character of Carnell’s management is questionable, the earnings reported by the company
cannot be expected as reliable and transparent. It is, therefore, more prudent to use the price to sales
or the price to book value ratios to arrive at a relevant value.


Correct Answer: B
Current EPS = $60 million/ $12 million = $5/share
Leading P/E = Current Market Price/ Next Year’s Expected Earnings
Current Market Price = $5 × 34 = $170.00
Next Year’s Expected Earnings = $57 million/12 million = $4.75
Leading P/E = $170/$4.75 = 36

Correct Answer: C
Non-recurring items are excluded from the earnings to arrive at a figure which is sustainable in the
future. The cash flow component of earnings is assigned a greater weight than the accrual component
of earnings in the valuation.

Correct Answer: B
Sales per share = ($16,000,000 – $1,200,000 – $500,000)/ 600,000
= $14,300,000/600,000
= $23.83/share
b = (NI – Div)/NI = ($16.00 – $1.80)/$16.00 = 88.7%

g = b × r= 88.7% × 18% = 16%
Justified Price to Sales = [(E0/ S0) (1 – b) (1+g)]/ (r – g)

Justified Price to Sales = [($16.00/ $23.83) (1 – 0.887) (1+16)]/ (0.18 – 0.16)
Justified Price to Sales = [0.67 × 0.113 × 1.16] / 0.02= 4.39

Correct Answer: B
Sales per share = ($18,000,000 – $1,500,000 – $800,000)/ 650,000
= $15,700,000/650,000
= $24.15/share
b = (NI-Div)/NI = ($14.00 – $1.40)/$14.00 = 90%

g = b × r = 90% × 20% = 18%
Justified Price to Sales = [(E0/ S0) (1 – b) (1+g)]/ (r-g)

Justified Price to Sales = [($14.00/ $24.15) (1– 0.90) (1+18)]/ (0.20 – 0.18)
Justified Price to Sales = [0.58 x 0.10 x 1.18] / 0.02 = 3.42

Correct Answer: B
In cases where stocks have similar P/E ratios, actual or forecasted net profit margin can be calculated
through:
(P/S)/ (P/E)
Zeg’s NP Margin:
(P/S)/ (P/E) = 4.39/ 12.5 = 35%

Skive’s Net Profit Margin:

(P/S)/ (P/E) = 3.42/ 12.5 = 27%

Correct Answer: A
A low payout ratio as compared to competitors is sustainable income. However, high dividend
payouts as compared to industry average figures may be unsustainable in the long term.

Correct Answer: B
ROIC = Operating Earnings after Tax/ Invested Capital
= ($22,000,000 × 0.82)/ $102,000,000 = $18,040,000/ $102,000,000
= 17.70%

Correct Answer: A
EV = MV of Equity + MV of Preferred Stock + MV of Debt – Cash and Cash Equivalents
EV = ($225x 600,000) + $13,000,000 + $25,000,000 – $14,000,000

= $159 million

Correct Answer: B
CEY = CBY – (b × LTEG)
CEY = 8.0% – (0.1 × 4.5%)
CEY = 7.55%
P/E = 1/CEY = 13.20

Correct Answer: A
Book Value per Share for Equity Holders = (Total Assets-Total Liabilities- Preferred Stock- Arrears
on Preferred Stock)/ Number of Shares Outstanding
Book Value per Share for Equity Holders = ($256,000 – $103,000 – $23,000 – $6,000)/8,000
= $15.50 per share

Correct Answer: A
The approach uses collectable market data in valuation rather than the Gordon Growth Model which
uses forecasted values for its calculation. The other two options are correct.

Correct Answer: A
A share repurchase at a premium to the current book value per share would decrease the overall book
value per share for the company. This is because the value of the equity would be reduced by a
greater amount than the number of shares purchased through the through the transaction.


Correct Answer: B
All financial assets are reported at fair value for the purpose of calculating the price to book ratio.
However, investments classified as held-to-maturity are reported on a historical cost basis.

Correct Answer: C
b = (NI – Div)/NI = ($4.60 – $1.20)/$4.60 = 74%
g = b × r = 74% × 18% = 13.3%
Justified P/B = (ROE – g)/ (RR – g)

= (0.18 – 0.133)/ (0.15 – 0.133)= 0.047/0.017
= 2.76

Correct Answer: C
As Postet is an automobile manufacture, it is a cyclical business affected by the ups and downs of the
economic lifecycle. The trailing EPS is an inappropriate measure of determining company
performance as it is often negative at the bottom of a cycle and positive at the top of the cycle. This is
known as the Molodovsky effect.

Correct Answer: A
b = (Net Income- Dividends)/Net Income
g = b x ROE
Micro Milli Macro

b 72% 80% 65%
g 14.4% 14.4% 14.3%
As the growth rates of all three companies are similar, and Micro is in the growth stage of the
industry life cycle, we may safely assume the other two companies to also lie in the growth stage of
the lifecycle.

Correct Answer: B
b = (Net Income – Dividends)/Net Income
g = b × ROE
Justified Trailing P/E = [(1 – b) × (1+g)]/(r-g)
Micro Milli Macro

b 72% 80% 65%
g 14.4% 14.4% 14.3%
Justified Trailing P/E 53.38 8.80 57.15


Correct Answer: C
Regression does take into account differences in the duration of growth. The other two options are
correct limitations.

Correct Answer: C
b = (Net Income- Dividends)/Net Income
g = b × ROE
Justified Forward P/E = (1 – b)/(r – g)
Micro Milli Macro

B 72% 80% 65%
G 14.4% 14.4% 14.3%
Justified Forward P/E 46.67 7.69 50.00
Forward P/E (Market) 50.00 30.00 48.00
Overvalued Overvalued Undervalued

Correct Answer: B
PEG Ratio = (Stock’s P/E)/ Expected Earnings Growth Rate
Micro:
PEG Ratio = 50.0/7 = 7.1
Milli:
PEG Ratio = 30/9 = 3.3
Macro:
PEG Ratio = 48/12 = 4.0
Decision Rule: The lower the PEG ratio, the more attractive is the investment.

Reading 32 Residual Income Valuation FinQuiz.com
FinQuiz.com
Study Session 11
June 2019


Reading 32: Residual Income Valuation

Correct Answer: A
Following is the company’s analysis:
EBIT $1,500,000
Less Interest expense $480,000 (20 million × 0.30 × 0.08)
Pretax Income $1,020,000
Less Income tax $306,000 (at 30%)
Net Income $714,000
NOPAT $1,050,000 (1,500,000 – 30% taxes)
Equity Charge $1,820,000 (20 million × 0.70 × 0.13)
Debt Charge $336,000 [20 million × 0.30 × (1-0.30)0.08)]
Total Capital Charge $2,156,000 (equity charge + debt charge)
Residual income $(1,106,000) (NI less equity charge or NOPAT less total
charge)
Effective capital Charge 10.78% (Total capital charge/20 million)
After tax net operating return 5.25% (NOPAT/20 million)
So the after tax net operating return on total assets is 5.53% less than the effective capital charge.

Correct Answer: B
Year 1 2 3
Beg. BVPS $7.50 $9.45 $11.44
NI/share $3.45 $4.00 $4.79
Less DPS $1.5 $2.01 $16.23
Change in RE $1.95 $1.99 –$11.44
End. BVPS $9.45 $11.44 $0
NI/share $3.45 $4.00 $4.79
Less equity charge $0.90 $1.134 $1.3728
Residual Income $2.55 $2.866 $3.4172
V0 = 7.50 + 2.55/(1.12) + 2.866/(1.12)2 + 3.4172/(1.12)3 = $14.4938


Correct Answer: C
Statement 1 is incorrect. It is true that the higher the persistence factor the higher the stream of
expected residual income. However, the persistence factor is only related to the continuing residual
income, and determines the residual income in the final stage of the company’s operations. Hence, a
higher persistence factor does not mean high residual income over the entire life of a security; RI
before the final stage is unaffected.
Statement 2 is also incorrect. Lower residual income persistence is associated with extreme
accounting rates of return.

Correct Answer: B
Since Scott is not sure about the future demand and profitability of energy stocks, the terminal value
will be subject to huge uncertainty. In residual income valuation, the current book value captures a
large portion of total value and the terminal value is not a large component. However, this contrasts
with other multistage approaches, like DDM and FCFF (DCF), in which the present value of the
terminal value is frequently a significant portion of the total value. Also, a lower persistence factor
will result in a lower terminal value, a conservative estimate, and is better to use in this case (which
will again reduce the TV’s weight in total value).

Correct Answer: C
Using CAPM, the return on equity is: 4 + 1.3(11) = 18.3%
According to the single-stage residual income model, the value of the stock is:
V0 = 25.5 + (.205–0.183)/(0.183–0.093)25.5 = $31.74
Since the stock’s intrinsic value is $7.967 less than the current market price of $39.7, the stock is
overvalued and should not be bought.

Correct Answer: A
Year 1 2
BVPS $8.15 $10.61
EPS $4.56 $5.43
Less DPS $2.1 $2.43
End. BVPS $10.61 $13.61
Abnormal rate of return(ROE-r) 21.3% 27.9%
× beg. BVPS ×8.15 ×10.61
Residual Income $1.736 $2.960


Correct Answer: A
A residual income model is appropriate in the following situations:
• the company does not pay dividends or the dividends are unpredictable;
• the company’s expected free cash flows are negative within the analyst’s forecast horizon;
• the terminal value is uncertain and is thus unpredictable using an alternative present value
approach.
HM’s uncertain dividend payment stream and its negative free cash flow generation pattern, expected
over the foreseeable horizon, make the residual income model the most appropriate model to use for
valuing HM.

Correct Answer: A
Benefit 1:
The residual income model uses accounting data to produce valuations. The benefit of using
accounting data is that is readily available. However, the drawback associated with accounting data is
that it may be subject to manipulation by management and may require the use of adjustments. This
complicates the use of the model and implies that accounting data may not always be directly/readily
usable. Thus benefit 1 fails to accurately capture the benefit of using accounting data as part of the
model.
Benefit 2:
Residual income models focus on economic profitability, which reflects the profits available to
shareholders after deducting the cost of providing equity capital by equity shareholders. Thus the
model takes the perspective of shareholders by focusing on the profits available to them. On the other
hand, measures based on net income may not be as useful to shareholders as they reflect the profits
available to all the providers of capital, debt holders and equity holders, as opposed to exclusively to
the equity holders. Benefit 2 accurately captures this benefit.
Benefit 3:
As outlined in the solution to Part 1, the model is most appropriate when forecasted terminal values
are highly uncertain making this model beneficial to use in the event of uncertain terminal values.
Benefit 3 accurately addresses this benefit.


Correct Answer: A
Residual income = (ROE – r) × BVt-1 or EPSt – (r × BVt-1)
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Year Book Projected Dividend Forecasted Cost Cost Residual Present
Value Income $* $* ROE of of Income Value
$* (Beginning Equity Equity (RI) of RI
Equity %) (%) $ $* $
2005 28.85 28.85
2006 33.89 7.54 2.50 26.14 13.00 3.7505 3.7895 3.35
2007 38.64 7.63 2.88 22.51 13.00 4.4057 3.2243 2.53
2008 46.37 9.66 1.93 25.00 13.00 5.0232 4.6368 3.21
2009 55.64 11.59 2.32 25.00 13.00 6.0281 5.5644 3.41
2010 66.77 13.91 2.78 25.00 13.00 7.2332 6.6768 3.62
Total 44.97
* Stated as $ per share
Workings:
(2) = (3) – (4) – BVt-1
(3) = (5) ÷ BVt-1
(4) = (3) × 0.20
(5) = (3) ÷ BVt-1
(7) = (6) × BVt-1
(8) = [(5) – (6)] × BVt-1
Using the persistence factor, 0.75, the present value of the terminal value is calculated using the
following formula:
−
1 + − 1 +
T=6
2011 residual income = $8.01216 ($6.6768 × 1.20).
The growth factor of 1.20 reflects a 20% growth rate where the growth rate is the retention rate
multiplied by the ROE: (0.80) (25%) = 0.20
$8.01216
= $11.443893 $11.44
1 + 0.13 − 0.751.13
The current value is thus equal to $56.41 ($44.97 + $11.44) or approximately $56.00.


Correct Answer: C
The residual income model can be re-written as follows:
P0 ROE − r
= 1+
B0 r−g
Should the return on equity (ROE) equal to the cost of equity, the extreme right hand side of the
equation, following the ‘+’ sign, equals to zero and the justified price-to-book ratio will equal to 1.
Additionally, if the return on equity equals the cost of equity, residual income will equal to zero as
demonstrated by the formula below:
Residual income = (ROE – r) × BVt-1

Correct Answer: B
Violations of the clean surplus relationship may occur when accounting standards permit changes
directly to the shareholder’s equity account, bypassing the income statement. Items that commonly
bypass the income statement include:
• foreign currency translation adjustments;

• certain pension adjustments; and
• fair value changes of some financial instruments.
Under both U.S. GAAP, which is applicable to HM, and IFRS, foreign currency translation
adjustments bypass the income statement and are recorded as a component of shareholder’s equity. In
the case of H.M., these adjustments will be recorded as part of comprehensive income (i.e.
component of equity).
As a result, these adjustments will distort net income, ROE, and hence residual income. However
since the adjustments are recorded as a component of equity, the book value of equity is accurately
stated.
Wade’s statement is inaccurate with respect to the effects of a violation on the book value of equity
but is accurate with respect to the fact that foreign currency translation adjustments may be a source
of violation.

Correct Answer: C
The rate of residual income decay will be slower the greater the level of residual income persistence,
following the initial income forecast horizon, and:
• the lower dividend payout/the higher the retention rate;

• should the firm hold a high historical presence or secure a strong competitive position in the
industry;
• the lower the level of special items (nonrecurring items) and accounting accruals being recorded;
• and the less extreme the accounting rates of return.


Correct Answer: A
EVA = NOPAT – (Cost of capital × Total capital)
EVA = [($32,580,450 × (1 – 0.35)] – (0.15 × $5,425,800*) = $20,363,422.50 ≈ $20,363,000.
*Total capital = Total liabilities + total equity = $2,345,100 + $3,080,700 = $5,425,800

Correct Answer: B
B is correct. An increase in the LIFO reserve is added in when calculating NOPAT.

Correct Answer: B
B is correct. When calculating NOPAT, an analyst should eliminate deferred taxes such that only cash
taxes remain.

Correct Answer: A
To determine whether Monoline Constructors’ shares are fairly valued or not, a single-stage residual
income model will be applied to the data in Exhibit 1 to determine intrinsic value.
ROE − r 0.12 − 0.10

V0 = B0 + B0 = $65.80 + ($65.80) = $109.67
r−g 0.10 − 0.07
Based on a current share price of $115.20, Monoline’s shares are overvalued.


Correct Answer: B
The formula for calculating intrinsic value per share using the multi-stage residual income model is as
follows:
T −1
Et − rBt −1 (PT − BT )
V0 = B0 + ∑ +
t =1 (1 + r )t (1 + r )T
2015 2018 2018 2018
Beginning book value per $10.80 $10.80 + $16.35 + $20.45 +
share $8.80 – $6.50 - $5.30 -
$3.25 = $2.40 = $1.85 =
$16.35 $20.45 $23.90
ROE $8.80/$10.80 $6.50/$16.35 $5.30/$20.45 0.10
= 0.81 = 0.40 = 0.26 (given)
Equity charge per share (0.08 × (0.08 × (0.08 × (0.08 ×
$10.80) = $16.35) = $20.45) = $23.90)
$0.86 $1.31 $1.64 = $1.91
Residual income per share $7.94 $5.19 $3.66 (0.10 –
0.08) ×
$23.90 =
$0.48
Given that price will equal book value per share at the end of 2018, the second term of the equation
(to the right hand side of the plus sign) reduces to zero.
$7.94 $5.19 $3.66 $0.48

Intrinsic value = $10.80 + + + + = $25.86
1.08 1.082 1.083 1.084

Correct Answer: C
The single stage residual income model is provided by the following expression:
ROE − r
V0 = B0 + B0
r−g
If the ROE is lower than the cost of equity, the company would have negative residual income and
would be valued at less than its book value.


Correct Answer: A
A is correct. Terminal value will equal zero on the maturity date of the Ace Limited investment as
return on equity declines to cost of equity. In this scenario, the residual income valuation will not be
sensitive to terminal value estimates.
On the other hand, a large fraction of the stock’s present value in either the discounted dividend or
free cash flow models is represented by the present value of the expected terminal value.
B is incorrect. A high persistence factor will mean that residual income will be higher in the final
stage and the valuation will be higher. However, this fact does not help answer Question 1.
C is incorrect. Although residual income is a highly suitable technique when free cash flows are
negative, there is no information to indicate Ace Limited is generating negative free cash flows.

Correct Answer: B
The multi-stage residual income model will be used to calculate residual income.
V0 = B0 + ∑
T
(EPSt − rBt −1 ) + EPST − rBT −1
t =1 (1 + r )t (1 + r − ω )(1 + r )T −1
Given that ROE will decline to the cost of equity after 2018, the third term on the right-hand side will
be zero.
Beginning book value per share2015 = EPS2015/ROE2015 = $7.45/0.2129 = $34.993
Sum of present value of residual income=

($7.450 − $4.200 ) + ($8.965 − $4.800 ) + ($10.320 − $5.522 ) = $9.6372
(1.12 ) (1.12 )2 (1.12 )3
V0 = $34.993 + $9.6372 = $44.630 or $44.63


Correct Answer: A
Lowering the dividend payout will increase residual income persistence as the annual amount of
deduction (for dividends) from a company’s earnings will be lower leading to a higher stream of
residual income in the final stage.

Correct Answer: A
A is correct. Residual income models are not appropriate for valuation purposes when a company’s
ROE is not predictable. Given that Nixing Inc.’s earnings are unpredictable; its ROE cannot be
forecasted with a reasonable degree of accuracy.
B is incorrect. Residual income models are appropriate when a company does not pay dividends or if
its dividends are not predictable. The fact that Nixing Inc. does not currently pay dividends makes the
use of the residual income model appropriate for valuation.
C is incorrect. The appropriateness of the residual income model is not determined based on how
established a company’s revenue base is.

Correct Answer: C
C is correct. The residual income approach is not appropriate when the clean surplus relationship does
not hold. The equation which determines whether this relationship holds is as follows: Bt = Bt-1 + Et –
Dt.
Based on the calculations below, the residual income model can only be used to value Howard’s stock
as the clean surplus relationship holds only for the company.
Based of clean surplus relationship:

Bt of Lars Plc. = £74.50 + £8.55 – £2.30 = £80.75
Bt of Oron = £87.95 + £10.30 –£3.80 = £94.45
Bt of Howard Corp. = £95.00 +£12.90 – £4.35 =£103.55

Correct Answer: B
B is correct. In applying a residual income model it is necessary to develop a forecast of future

residual income based on recurring items. Litigation expenses related to product quality reflects an
unusual charge and the event is unlikely to occur from one period to the next. Therefore, the most
suitable course of action is to re-classify the expenses and any associated losses as non-recurring.


Correct Answer: C
Based on the relationship between the justified price-to-book (P/B) ratio and the residual income
model (see below), if the cost of equity (represented by ‘r’) is below the company’s required return on
equity (represented by ‘ROE’), the company’s expression to right of the plus sign is positive resulting
in a ratio which is greater than 1.0.
P0 ROE − r
= 1+
B0 r−g

Correct Answer: B
Based on the single-stage residual income model (see below):
• Observation 2 will increase residual income as a decline in ‘g’ will increase the
expression on the right hand side of the plus sign.
• Observation 3 will increase the intrinsic value estimate as a lower ‘r’ will increase the
expression on the right hand side of the plus sign.
ROE − r
Single-stage residual income model = V0 = B0 + B0
r−g

Correct Answer: A
Market value added = Market value of the company – Accounting book value of total capital =
(1,200,000 × $8.50) – $8,240,300 = $1,959,700

Correct Answer: B
Tobin’s q is a measure of the productivity of a company’s assets.

$,, !,,×$".#$
Tobin’s q =

= = 3.7817 ≈ 3.78
$%,#",
Based on the expression for Tobin’s q, the replacement cost takes into account the effects of inflation.
Therefore, a projected increase in inflation will increase the replacement cost of assets, decrease the
Tobin’s q measure, and lower the productivity of a company’s assets.


Correct Answer: C
Forecasted Ending ROE Equity Residual PV of

NI BV ($) (%) Charge Income RI ($)
Year ($) ($) –RI ($)
2015 25.00
2018 5.00 30.00 20 1.50 3.50 3.30
2018 6.00 36.00 20 1.80 4.20 3.74
2018 7.20 43.20 20 2.16 5.04 4.23
11.27
The intrinsic value of the company’s shares of stock is calculated using the following expression: V0
= B0 + Sum of discounted RIs + Discounted Premium
V0 = $25.00 + $11.27 + (0.15)($43.20)/1.063 = $41.71

Correct Answer: A
A is correct. Under US GAAP, R&D expenditures, with the exception of expenses related to software
development, are expensed directly to the income statement. Unproductive R&D expenditures will
lower residual income through the expenditures made. ROE should reflect the productivity of
expenditures without any adjustments. Therefore, Mathews should adjust the company’s earnings to
reflect these unproductive R&D expenditures.

Reading 33 Private Company Valuation FinQuiz.com
FinQuiz.com
Study Session 11
June 2019


Reading 33: Private Company Valuation

Correct Answer: C
Since Vibrant Manufacturers Inc. has just begun producing its product, it is most likely in the
developmental stages of the lifecycle. This also means that the company is still small, and since the
future of the firm is uncertain, the going concern premise of value may also be doubtful. This means
that future cash flows are difficult to estimate and hence, the income approach is not appropriate.
Also, the firm’s product is unique so similar public firms may not be present. Hence, in the earliest
stages of development, when the going concern premise may be uncertain, future cash flows are
difficult to establish and competitors are not present, the asset based approach is most appropriate.

Correct Answer: C
First, the SG&A expenses should be reduced by (2,500,000–1,050,000) + 100,000.
Second, the land and commercial property are nonoperating assets, so expenses and income related to
them should be removed from the income statement. The SG&A expenses should be reduced by
$500,000, depreciation should be reduced by $300,000, and operating income should be reduced by
$450,000. Overall, the operating income after taxes (at 40%) will increase by:
ሺ1,450,000 + 100,000 + 500,000 + 300,000ሻ൫1– 0.40൯– 450,000൫1– 0.40൯ = $1,140,000.

Correct Answer: A
Dynamic Manufacturers, Next year’s FCFF
Revenues ($80,000,000 × 1.04) $83,200,000
COGS $36,400,000
Gross Profit (0.5625 × 83,200,000) $46,800,000
SG&A (10,500,000 × 1.05) $11,025,000
Pro Forma EBITDA $35,775,000
Depreciation (0.03125 × 83,200,000) $2,600,000
Pro forma EBIT $33,175,000
Pro forma taxes (37%) $12,274,750
Operating income after taxes $20,900,250
Plus Depreciation $2,600,000
Less capital expenditures* $2,824,000
Less increase in working capital** $416,000
FCFF $20,260,250
*= $2,600,000 + 0.07(3,200,000) = $2,824,000
**= 0.13(3,200,000) = $416,000


Correct Answer: A
According to the CAPM, the required rate of return is:
3.25 + 1.21(5.5) = 9.905%
According to the expanded CAPM:

3.25+1.21(5.5)+3.5+0.67 = 14.075%

Correct Answer: B
Since Wilshire is using FCFF as cash flows, the appropriate discount rate is the cost of capital, or the
firm’s WACC.
The cost of equity using the build-up method equals:

3.25+5.5+3.5+0.67+1.5% = 14.42%
The after tax cost of debt = 9.45(1-0.37) = 5.9535%

WACC equals:
0.15(0.059535) + 0.85(0.1442) = 13.15%

Correct Answer: C
Statement 1 is incorrect. Even though nonoperating assets are assets not necessary to the ongoing
operations of a business enterprise, in principle, the value of a company is the sum of the value of
operating assets and the value of nonoperating assets. Thus, nonoperating assets should be included in
the valuation of an enterprise regardless of the valuation approach or method being used.
Statement 2 is incorrect. For companies with highly leveraged financial conditions and/or significant
volatility expected in future financial performance, the valuation of equity as the residual obtained by
subtracting the face value of debt form the value of the enterprise is not appropriate. Estimates of
market value based on debt characteristics, known as matrix prices, are an alternative in such cases.

Correct Answer: C
Given Time Corporation is privately owned it will least likely face the same pressure from external
investors as public companies. For that reason, private company management may be able to take a
longer term perspective in their decisions and not face the pressure to achieve above-average returns.
Due to the concentration of ownership in firm management, Time Corporation will suffer less from
issues such as monitoring costs arising from a separation of management and ownership commonly
faced amongst public corporations.
Being privately traded, the stock of Time Corporation will, as a privately traded stock, has a reduced
level of marketability.


Correct Answer: B
Based on Time Corporation’s stage of development and maturity, a market approach is most suitable
for valuing the established watchmaker.
At the earliest stages of development, the company may be best valued using an asset-based
approach. With progress to a development stage company in a high growth mode, the company might
be valued using an income approach.

Correct Answer: C
Given the fact that investors are divided over the likelihood of an IPO, the investment value is the
most appropriate definition of value for Time Corporation. The value of the corporation may differ as
a result of the different perspectives of investors, making this definition of value appropriate.
A lack of comparable firms in the market makes the use of fair market values to define value for Time
inappropriate. Given the diversity in expectations, with respect to the IPO, the intrinsic value is an
inappropriate value definition.

Correct Answer: B
Time Corporation’s forecasted FCFF (in ‘000) for the year 2011 is $9,561. This is calculated as
follows:
Revenues ($35,000,000 × 1.03) $36,050,000

Cost of goods sold 18,025,000
Gross profit margin (50% × $36,050,000) 18,025,000
SG&A Expense (maintained at 2010 level) 2,420,000
Pro forma EBITDA 15,605,000
Depreciation and amortization ($36,050,000 × 1.5%) 540,750
Pro forma earnings before interest and taxes 15,064,250
Pro forma taxes on EBIT (at 35%) 5,272,488
Operating income after tax 9,791,763
Plus depreciation and amortization 540,750
Less: Capital expenditures* (614,250)
Less: Increase in working capital** (157,500)
Free cash flow to the firm $9,560,763
*Incremental revenues (revenue generated) = $35,000,000 × 0.03 = $1,050,000

Capital expenditures = $540,750 (projected depreciation) + 0.07($1,050,000)
= $614,250
**Increase in working capital = $0.15 additional working capital for every $1 of revenue
generated.
$1,050,000
= $0.15 × = $157,500
$1


Correct Answer: A
Factor 1 fails to address the factors to consider when using the FCFF approach to value a firm. A
FCFF model is more robust relative to a FCFE model when substantial capital structure changes are
in view as WACC, the discount rate used in a FCFF valuation approach, is less sensitive than the
cost of equity, used in a FCFE approach, to changes in financial leverage.
Factor 2 correctly addresses the factors to consider when using the FCFF approach to value a firm. In
calculating a WACC for a valuation based on FCFF, analysts need to consider that a private
company has less access to debt financing than a similar publically traded corporation. The lesser
access means that the company will need to rely more on equity financing, which would increase its
WACC and consequentially result in a lower firm valuation.

Correct Answer: B
The value of Emerson’s 15% equity interest is $306,788. This is calculated as follows:
Indicated value of equity assuming IPO materializes

$2,530,000
Interest appraised 15%
Pro rata value of 15% equity interest $379,500
Less: Lack of control discount of 14% $53,130
Value assuming ready marketability $326,370
Less: Lack of marketability discount of 6% $19,582
Indicated value of Emerson’s 15% equity interest $306,788


Correct Answer: C
C is correct. The analysts’ main reason for valuing BRIC Limited is transaction-related.
A is incorrect. Litigation-related valuations require effective presentations in a legal setting. There is

no evidence of the company being positioned in a legal proceeding setting.
B is incorrect. Compliance encompasses actions required by law or regulations. Financial reporting

and tax reporting are the primary focuses of this type of valuation.

Correct Answer: C
C is correct. Given that Zeta is in its early stages of development with significant uncertainty
regarding the future success of the company’s products, the asset-based approach is most suitable for
valuation. The free-cash flow approach may not be suitable as future cash flows may be extremely
difficult to predict at this stage of development.

Correct Answer: B
B is correct. The high growth phase in which Quanto operates makes the application of the FCF
approach appropriate. The analysts will make discrete cash flow forecasts until cash flows are
expected to stabilize at a constant growth rate.
A is incorrect. Once the initial high growth phase is over, the analysts should opt for either the
capitalized cash flow method or market approach.
C is incorrect. Using market multiples to estimate terminal value in high growth industries would not
be appropriate as rapid growth will be incorporated twice: once in the cash flow projections over the
projection period and also in the market multiple used in calculating the residual enterprise multiple.


Correct Answer: A
Normalized earnings are defined as “economic benefits adjusted for nonrecurring, non-economic, or
other unusual items to eliminate anomalies and/or facilitate comparisons.” Quanto’s normalized
earnings should reflect compensation expense which is in line with that offered in the market. In
addition, earnings should not reflect the life insurance premium paid by the company on behalf of its
shareholders.
As
Reported Adjusted
Revenue $58,000 $58,000
Cost of goods sold $37,700 $37,700
Gross profit $20,300 $20,300
Selling, general and $3,900 $3,150
administrative expenses (SG&A)
Earnings before interest, tax,
depreciation and amortization $16,400 $17,150
(EBITDA)
Depreciation and amortization $9,900 $9,900
Earnings before interest and taxes $6,500 $7,250
(EBIT)
Taxes (@ 30%) $1,950 $2,175
Operating income after taxes $4,550 $5,075

Correct Answer: B
Revenue ($58,000 × 1.05) $60,900

Gross profit ($60,900 × 0.35) $21,315
SG&A ($3,900 × 1.02) $3,978
EBITDA $17,337
Depreciation and amortization ($60,900 × 0.02) $1,218
EBIT $16,119
Taxes (@ 30%) $4,836
Operating income after taxes $11,283
Add: Depreciation and amortization $1,218
Less: Working capital investment (0.10 × 0.05 × $58,000) $290
Less: Fixed capital investment – current operations $650
Less: Fixed capital investment – future operations (0.08 × 0.05 × $58,000)
$232
FCF 11,329


Correct Answer: C
C is correct. Analysts believe that The FCFF approach is more robust when there are substantial
capital structure changes because the weighted average cost of capital, which represents the discount
rate used in a FCFF valuation, is less sensitive than the cost of equity, which is used in a FCFE
valuation, to changes in financial leverage.
A is incorrect. The cost of equity used in a FCFE valuation is more sensitive to changes in financial
leverage.


Correct Answer: A
A is incorrect. In evaluating an acquisition, the finance theory indicates that the cost of capital used
should be based on the target company’s capital structure and the riskiness of the target company’s
cash flows.

Correct Answer: C
C is correct. In general, the CAPM approach is least appropriate when guideline public companies are
not available or are of questionable comparability. Based on ‘O Conner’s analysis of the industry,
publically traded comparables do not exist resulting in the CAPM approach being an inappropriate
tool for deriving required returns.
A and B are incorrect. The CAPM can be applied to derive required return estimates for privately
traded companies as long as public company comparables for the company being valued are available
and comparable. The CAPM approach adds a premium for small size and company-specific risk when
deriving required returns for private companies.

Correct Answer: A
Initial MVIC to EBITDA from transactions 9.5

Relative risk and growth adjustment for Prac (9.5 × 0.16) (1.52)
Indicated multiple 7.98
EBITDA $1,280,000
Indicated value of invested capital $10,214,400
Less: Debt capital $625,000
Indicated value of equity $9,589,400

Correct Answer: B
Indicated MVIC to EBITDA 9.5000

from transaction
Relative risk and growth (1.5200)
adjustment for Prac (9.5 × 0.16)
Regulatory changes adjustment 0.6384
factor (7.98 × 0.08)
Indicated multiple 8.6184
The indicated multiple is approximately 8.62.


Correct Answer: B
The individual discounts are multiplicative rather than additive and are applied in sequence. Total
discount is equal to 54.5% [(1 – (1 – 30%)(1 – 35%)].

Correct Answer: B
B is correct. The GTM considers transactions involving the acquisition of the total equity of
companies and thus the pricing multiple reflects the value of total companies. On the other hand,
pricing multiples from guideline public companies reflect trading in small blocks of stock and may
not reflect the total value of the public companies. The fact that SnT is taking over Prac is indicative
that the acquirer is purchasing a controlling interest in the latter.
A is incorrect. There is no evidence that SnT’s acquisition of Prac will generate synergistic benefits
for the former. SnT is not in the software development industry and, therefore, the purchase of a
private company in an unrelated industry is an example of a financial transaction.
C is incorrect. The composition of a company’s asset base does not drive the decision of which
valuation method to use.


Correct Answer: B
B is correct. The value assigned to Gatco’s stock of £35 by Peterson reflects intrinsic value. Intrinsic
value is defined as the value the investor considers after an evaluation of facts. Peterson arrives at the
value of the stock after evaluating earnings projections and the forecasted dividend payout ratio
which provides further evidence of the use of this approach.
A is incorrect. Fair value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between marketplace participants at the transaction date.
Data concerning an arm’s length transaction between a buyer and seller is not provided and so stock
value does not represent fair value.
C is incorrect. Investment value is defined as value to a particular investor based on investor’s

investment requirements and expectations. Given that the information collected by Peterson does not
reflect his expectations, but that of market analysts’, the value derived cannot be classified as
investment value.

Correct Answer: A
A is correct. For companies that are not expected to grow at a constant rate, FCF using a series of
discrete cash flow projections is theoretically preferred to the CCM.
B is incorrect. A CCM approach is suitable for valuing a private company in which no projections are
available and an expectation of stable future operations exists.
C is incorrect. If market pricing evidence from public companies or transactions is limited, a CCM
approach may be a suitable approach.

Correct Answer: A
Required return on equity based on buildup method:
Risk-free rate 2.5%

Company-specific risk premium 3.5%
Industry risk premium 1.0%
Small stock premium 4.3%
Equity risk premium 6.2%
Indicated return on equity 17.5%
Value of Gatco = FCFE1/(r –g) = £1,800,000/(17.5% - 3.5%) = £12,857,142.9 or £12.9 million


Correct Answer: B
The EEM is used to value Spidex. Application of this approach is discussed below:
In the current year, residual income = £145,000 – 0.04(£250,000) – 0.12(£770,000) = £42,600
Intangible assets are valued using the formula for a growing perpetuity. The total value of intangible
assets is (1.03) (£42,600) / (0.10 – 0.03) = £626,828.57
The total value of working capital, fixed capital, and intangible assets equals to the value of the
business according to the EEM. This value is equal to £250,000 + £770,000 + £626,828.57 =
£1,646,828.57 or £1.65 million.

Correct Answer: A
Net assets = Total assets – total liabilities = £13,582,500 – £7,750,000 = £5,832,500
Fair value of inventory = £350,000 × 0.95 = £332,500
Fair value of property, plant, and equipment = £8,200,000 + (£3,500,000 – £2,750,000) – £800,000 =
£8,150,000
Fair value of assets = £13,650,000 – £350,000 – £8,200,000 + £332,500 + £8,150,000 = £13,582,500

Correct Answer: B
Indicated value of equity in operations £23.500 million

Interest appraised 15%
Pro-rata value of 15% £3.525 million
Less: Lack of control discount 0
Value assuming ready marketability £3.525 million
Less: Lack of marketability discount of 20% £0.705 million
Indicated value of Reed’s 15% equity interest £2.820 million

Reading 34 The Term Structure and Interest Rate Dynamics FinQuiz.com
FinQuiz.com
Study Session 12
June 2019

FinQuiz.com © 2019 - All rights reserved

Reading 34: The Term Structure and Interest Rate Dynamics

Correct Answer: B
B is correct. The forward contract value will increase during Year 2 as the expected future
spot rate is lower than that implied from the forward rate curve (2.139% and 2.684%
respectively).
A is incorrect. The forward contract value will decline in Year 1 as the expected future spot
rates are higher than that implied by the forward curve (1.994% and 1.954% respectively).
C is incorrect. Since the expected and implied spot rates are equal in year 3, the forward
contract value will remain unchanged.

Correct Answer: C
C is correct. Lev can ride down the yield curve when the yield curve is upward sloping which
is the case if the future spot rates expected by investors are realized. If the yield curve does
not change its shape and level, an investor with a two-year investment horizon can buy bonds
with maturity greater than two years. With the passage of time and assuming an upward
sloping yield curve, the bond will be valued at successively lower yields and higher prices as
long as yields do not change. In summary, the bond’s total return will exceed that of a bond
whose maturity is equal to that of the investment horizon.
A is incorrect. Buying a bond with a maturity equal to the investment horizon will earn a
lower return in contrast to buying bonds whose maturity exceeds the investor’s investment
horizon.
B is incorrect. An upward sloping yield curve will allow the trader to generate profit from the
strategy as long as the yields do not change.


Correct Answer: B
B is correct. The yield curve is downward sloping as the four-year spot rate is lower than the
three-year spot rate, which in turn is lower than the two- and one-year spot rates. A
downward sloping yield curve implies that forward rates will decline with the passage of
time. Therefore the one-year rate for a bond to be delivered three years from today will be
lower than the one-year rate for a bond to be delivered two years from today.
A is incorrect. Given that the spot curve is not flat, one-period forward rates will not equal to
the current spot rate but will be lower.
C is incorrect. A downward sloping yield curve will result in expectations for the long-term
rate, r(T*+T), being lower than that of the short-term rate r(T*).

Correct Answer: B
B is correct. The forward model is used to derive the forward rate f(1,2):
f(1,2) = [(1 + 0.025)3/(1 + 0.035)]1/2 – 1 = 0.020036 or 2.00%.

Correct Answer: C
C is correct. White is incorrect with respect to his opinions regarding both of the statements.
The liquidity preference theory can produce an upward sloping yield curve even when
interest rates are declining or flat if the rising liquidity premium is sufficient to offset
declining or flat interest rates. Rising spot rates will be consistent with an upward sloping
yield curve in any case.
Statement 2 reflects the preferred habitat theory which asserts that investors may be willing
to move out of their preferred habitat as long as they have incentive. This incentive may be in
the form of higher returns or reduced risk.

Correct Answer: B
B is correct. Equilibrium models such as the Cox-Ingersoll-Ross (CIR) and Vasicek models
assume that short-term rates are mean reverting. That is, they tend to move in a bounded
range and show a tendency to revert to a long-run value, b.


Correct Answer: A
A is correct. The spot curve represents the term structure for zero-coupon securities. Given the
absence of a coupon on the underlying securities, construction of this curve avoids the complications
associated with the reinvestment rate assumption.
C is incorrect. The par curve represents the yields to maturity on coupon-paying government bonds.
Construction of this curve requires a consideration of the reinvestment rate assumption.

Correct Answer: A
Hawke is incorrect regarding Statement 2. The shape and level of the spot yield curve is dynamic
because the spot curve depends on the market pricing of option-free zero-coupon bonds.
Hawke is incorrect regarding Statement 3. The yield on zero-coupon bond maturing in T years is
regarded as the most accurate representation of the T-year spot rate. In the absence of default risk, the
T-year spot rate is equal to the yield-to-maturity of a zero-coupon bond.

Correct Answer: B
The forward rate model will be used to determine the presence of the arbitrage opportunities. If the
return earned on trading the 3-year bond issue exceeds the geometric mean of one-period forward
rates, the trader was able to exploit an arbitrage opportunity.
r (5) = {[1 + r (1)][1 + f (1,1)][1 + f (2,1)][1 + f (3,1)][1 + f (4,1)]} −1

1/ 5
r (5) = {[1 + 2.0%][1 + 3.8%][1 + 4.6%][1 + 5.1%][1 + 5.9%]} − 1 = 4.27%

1/ 5
According to the forward rate model, the spot rate for a security with a 5-year maturity should be
4.27%. However, the trader’s return (6.0%) is greater than this geometric mean of one-period forward
rates. Therefore, he has successfully exploited an arbitrage opportunity.

Correct Answer: C
As evident from Exhibit 1, the forward curve is upward sloping. Therefore, Hawke should expect the
five-year spot rate to be higher than the forward rate on a contract to purchase a 4-year zero-coupon
bond one year from today. In other words, f(1, 4) < r (5)


Correct Answer: B
Given that the yields have declined at all maturity points; the yield curve has experienced a parallel
downward shift. Furthermore, given that the short-term rates have declined more than the long-term
rates, the slope of the yield curve has steepened.

Correct Answer: B
A decline in yields will increase the value of the bond portfolio.

Change in the value of the portfolio = (- 0.10)(- 0.016) + (- 0.30)(- 0.012) + (- 0.60)(- 0.005) + (-
0.90)(- 0.003) = + 1.09%
The value of the portfolio has increased to $202,180 ($200,000)(1.109).


Correct Answer: C
C is correct. The swap rate represents the interest rate quoted on the fixed rate leg of the swap.

Correct Answer: C
C is correct. Abdul is valuing the bond on behalf of County House, which is a wholesale bank. These
organizations employ the swap curve to value assets and liabilities because they hedge many items on
their balance sheet with swaps.
A is incorrect. While it is true that swap contracts are non-standardized and customized, this does not
explain why the swap rate will be preferred over Treasury spot rates for valuation.
B is incorrect. The swap and Treasury markets are both active in the US. This factor will not serve to
influence the choice of benchmark.

Correct Answer: C
I-spread = Bond rate – swap rate of same maturity as bond = 7.99% - 4.55% = 3.44%
TED spread = LIBOR – T-bill yield of matching maturity = 3.00% - 1.25% = 1.75%

Correct Answer: A
A is correct. While the swap spreads provide a convenient way to measure credit and liquidity risk, a
more accurate measure is the Z-spread.

Correct Answer: B
Discount factor = P(t,T) = P(2,4)
1/P(2,4) = [1 + 0.03][1 + 0.04][1 + 0.05][1 + 0.07] = 1.203493
P(2,4) = 1/1.203493 = 0.8309


Correct Answer: A
Abdul is correct with respect to Conclusion 1 but incorrect with respect to Conclusion 2. The local
and pure expectations theories both assert that the one-period return is equal to the risk-free rate.
Therefore, the one-year holding period return should equal to the 1-year risk-free rate of 3%.
The local expectations theory asserts that the expected return for bonds over longer-time periods is
higher than the risk-free rate due to the existence of a premium.


Correct Answer: A
A is correct. Given that callable bonds include embedded options, the yield curve is sloping steeply
upwards and the fact that interest rates are volatile, the callable bond’s YTM is a poor estimate of its
expected return. Even though default-free zero-coupon bonds do not include embedded options, the
assumptions concerning yield curve slope and volatility will result in the zero-coupon bond issue’s
YTM being a poor estimate of its expected return.

Correct Answer: B
Since the forward rates are the assumed reinvestment rates, Mathews’ first step will involve
determining the forward rates.
f (1,1) = 1.082/1.12 – 1 = 4.1429%

f (2,1) = 1.063/1.082 – 1 = 2.1104%
f (3,1) = 1.044/1.063 – 1 = - 1.7764%
Expected cash flow at the end of Year 4 =

5(1 + 0.041429) (1 + 0.021104) (1 – 0.017764) + 5(1 + 0.021104) (1 – 0.017764) + 5(1 – 0.017764) +
105 = 120.14859
Expected bond return = (120.14859 – 102.70) /102.70 = 16.9899%

Expected annualized return = (1 + 0.169899)1/4 = 4.00%

Correct Answer: A
Mathew expects the spot rate curve to be sloping steeply downwards. In this scenario, the forward
rate curve will be below the spot rate curve.

Correct Answer: A
A is correct. Lester’s comments are accurate with respect to modern term structure models but
inaccurate with respect to equilibrium term structure models. Modern term structure models provide
quantitative descriptions of how interest rates evolve and attempt to capture the statistical properties
of interest rate movements.
The CIR model cannot be calibrated to market data because it has a finite number of parameters and
therefore it is not possible to specify the parameter values in such a way that model prices coincide
with observed market prices.


Correct Answer: C
C is correct. Mathews is inaccurate regarding Feature 3. The standard deviation makes volatility
proportional to the square root of the short-term rate which allows for volatility to increase with the
level of interest rates. It also avoids the possibility of non-positive interest rates.
Mathews is accurate regarding Feature 1. The CIR model is a single factor model. The short-term
interest rate can determine the entire term structure.
Mathews is accurate regarding Feature 2. The deterministic or drift term of the model ensures the
mean reversion of interest rates towards a long-run value.

Correct Answer: A
A is correct. Lester’s conclusion concerning the CIR model is appropriate. Because the model
requires the short-term rate to follow a certain process, which features mean reversion to a long-term
value (deterministic part) and a random normal distribution with a mean of 1 and standard deviation
of 0 (stochastic term), the estimated yield curve may not match the observed yield curve.

Reading 35 The Arbitrage-Free Valuation Framework FinQuiz.com
FinQuiz.com
Study Session 12
June 2019


Reading 35: The Arbitrage-Free Valuation Framework

Correct Answer: A
A is correct. Discounting cash flows at their relevant spot rates is inappropriate for bonds
with embedded options such as the Joyce Borde Inc. issue. This is because the framework
assumes constant interest rates and is inappropriate for valuing bonds with embedded
options. Changes in interest rates will impact the size and timing of cash flows of this bond
category.
B and C are incorrect. The binomial model is appropriate for valuing zero-coupon issues
such as Vox Limited while the Monte Carlo method is suitable for valuing bonds with
embedded options whose cash flows are path dependent. The Monte Carlo method is suitable
because it allows for changing interest rates by making a volatility assumption. In this way,
the model incorporates impact of changing interest rates on the size and timing of cash flows.

Correct Answer: C
C is correct. Keeping in mind that the bond is valued at par at maturity, the value of the bond
is $100 at Time 3. The value of the bond issue at Node 1-2 is derived using the value of the
bond at nodes 2-2 and 2-3 (see the table below for the aforementioned nodes).
Value of bond issue at Node 2-2 = 0.5 × (100/1.05215 + 100/1.05215) = 95.04348
Value of bond issue at Node 2-3 = 0.5 × (100/1.04102 + 100/1.04102) = 96.05963
Value of bond issue at Node 1-2 = 0.5 × (95.04348/1.03752 + 96.05963/1.03752) = 92.0961
Time 0 Time 1 Time 2 Time 3

Node 1 Node 1-1 Node 2-1 Node 3-1
Node 1-2 Node 2-2 Node 3-2
Node 2-3 Node 3-3
Node 3-4


Correct Answer: A
A is correct. The Monte Carlo simulation model is well calibrated if it is arbitrage-free. A

model is rendered arbitrage-free if it generates a value for the benchmark bond, which is
equal to its market price. In order to ensure the Monte Carlo model generates arbitrage-free
values for benchmark bonds and fits the current spot rate curve, a constant will need to be
added to all short-term rates on all paths.
B is incorrect. Increasing the number of paths will only serve to enhance the statistical
accuracy of the value estimate. However, this does not mean that the model value of the
security is closer to its fundamental value or in other words, the model is well-calibrated.
C is incorrect. Stripping and reconstitution allows dealers to separate or recombine the

bond’s individual cash flows such that trading activities will eliminate any arbitrage profits.
However, the process does not ensure that the Monte Carlo simulation model is well
calibrated.

Correct Answer: A
A is correct. In order to determine which trade offers the maximum potential for arbitrage
profits, the issue’s market price is compared to its arbitrage-free value.
Arbitrage-free value of the issue (PV) = 103.6299
FV = 100
I/Y = 4%
PMT = 5
N=4
The arbitrage profit realized if the issue is purchased in NYSE, at a price of 103.6214, and
sold at its arbitrage-free price of 103.6299 is equal to 0.0085 per 100 par (103.6299 –
103.6214). The trader can maximize arbitrage profits by executing this trade.
B is incorrect. The arbitrage profit realized if the issue is purchased in ASE, at a price of
103.6245, and sold at its arbitrage-free price is equal to 0.0054 per 100 par (103.6299 –
103.6245). The realized profit is lower than if the trade is undertaken in NYSE.
C is incorrect. The arbitrage profit realized if the issue is purchased at its arbitrage-free price
and sold in LSE a price of 103.6311 is equal to 0.0012 per 100 par (103.6311 – 103.6299).
The trader realizes the lowest arbitrage profit in this trade.


Correct Answer: B
B is correct. To determine the arbitrage-free valuation of a bond with embedded options,

individual cash flows are discounted at forward rates implied from the benchmark spot rate
curve. Implied forward rates are most suitable for this purpose because they account for
volatility, which is necessary given that the size and timing of the cash flows generated by
bonds with embedded options are sensitive to interest rate volatility.
A is incorrect. Benchmark spot rates cannot be directly used to discount cash flows of a bond
with embedded options. The reason for this is that the rates do not incorporate a volatility
assumption.
C is incorrect. Discounting the early coupons on a bond at the security’s yield-to-maturity

will give too much discounting and an upward sloping yield curve and too little discounting
for a downward sloping yield curve making the yield to maturity inappropriate as a discount
rate. Furthermore, using this rate involves making the unrealistic assumption that all cash
flows are reinvested at the yield-to-maturity, which is unrealistic given interest rate volatility
and its impact on the size and timing of cash flows.

Correct Answer: A
A is correct. The law of one price applies to the price of a product trading in more than one
market and specifies that the prices of otherwise two identical products trading in different
markets should be the same. However, this law is not relevant to the generation of implied
forward rates from the benchmark spot rate curve.
Both options B and C are incorrect. Implied forward rates generated from the benchmark
spot rate curve need to be consistent with 1) an assumed level of interest rate volatility, 2) an
interest rate model that governs the random process of interest rates, and 3) the current
benchmark yield curve.


Correct Answer: B
Greene is incorrect with respect to his statement. Regardless of the complexity of the bond, each
component must have an arbitrage-free value.
Parker is correct with respect to her statement.

Correct Answer: A
A is correct. A higher volatility assumption results in the forward rates spreading out on the tree. On
the other hand, a lower volatility assumption will result in the rates collapsing to the implied forward
rates from the current yield curve.

Correct Answer: A
The process of bootstrapping will be used to derive the spot rates necessary for discounting the cash
flows.
Year 1 spot rate = 2%

3 103
Year 2 spot rate = 100 = + ; x = 3.0152 %
1.02 (1 + x )2
5 5 105
Year 3 spot rate = 100 = + + ; x = 5.1224%
1.02 (1.030152 ) 2
(1 + x )3
5 5 105
Value of bond issue = + + = 100 .00
1.02 (1.030152 ) 2
(1.051224 )3
Correct Answer: A
A is correct. The rate at Node 6, 6.356%, can be derived using by multiplying the rate at Node 5,
9.467%, by e-2 × 0.20.


Correct Answer: C
C is correct. Mean reversion is implemented by implementing upper and lower bounds on the random
process generating future interest rates. Mean reversion has the effect of moving interest rates toward
the implied forward rates from the yield curve.
B is incorrect. Mean reversion does not allow interest rates to get too high or too low and achieves
this by implementing upper and lower bounds. Therefore, the process helps in reducing interest rate
volatility.

Correct Answer: C
The present value of the bond at Path 4 is calculated as follows:
105
Year 3 Present Value = = 95 .9193
1.09467
Year 2 Present Value =
(95.9193 + 5) = 96.1732
1.04935
Year 1 Present Value =
(96.1732 + 5) = 99.1894
1.02


Correct Answer: A
The process of bootstrapping is used to generate spot rates from the benchmark par yield
curve. This process employs linear interpolation to generate the relevant rates.

Correct Answer: B
B is correct. Lone believes that the law of one price is being violated; this is because the
three issues are believed to be mispriced.
When assets are mispriced, there exists an opportunity for arbitrage profits. Therefore, assets
are no longer valued under the principal of no arbitrage which otherwise validates arbitrage-
free valuation. This principal is based on the law of one price and therefore arbitrage
opportunities arise as a result of a violation of the law of one price.
A is incorrect. The non-negativity of interest rates is a property of the lognormal model of

interest rates, which provides structure to the randomness of interest rates in a binomial
interest rate tree.
C is incorrect. The existence of arbitrage opportunities will increase the demand of mispriced
securities. Prices will adjust until opportunities disappear. Therefore, the existence of such
opportunities is never permanent.

Correct Answer: C
To determine the amount of mispricing, it is first necessary to determine the arbitrage-free

value. This value is derived using spot rates which are calculated using the par yields
provided in Exhibit 2.
5 105
100 = + ; z 2 = 5.051%
1.03 (1 + z 2 )2
7 7 107
100 = + + ; z3 = 7.198%
1.03 (1.05051) (1 + z3 )3
2
7 7 107
Arbitrage-free value = + + = 99.9999 or 100.00
1.03 1.05051 1.071983
2
Therefore, the Sliver Inc. issue is mispriced by $5 per 100 of par value.


Correct Answer: C
C is correct. Using spot rates to discount the cash flows for callable bonds ignores one key
aspect of these securities – that is, cash flows are dependent on the path of interest rates.
Changes in future interest rates will affect the likelihood that the option will be exercised
which, in turn, will impact the cash flows.
A is incorrect. The process of discounting cash flows using spot rates considers the time
value of money and so this is not a valid argument.
B is incorrect. Mean reversion in interest rates is a concept which is specifically considered

for Monte Carlo simulation. It is unlikely to constitute a limitation of Lone’s preliminary
analysis.

Correct Answer: B
B is correct. The process of calibration allows for the resulting bond values to be arbitrage-
free or, in other words, equal to the current observable market price.
A is incorrect. Incorporating mean reversion in Monte Carlo simulation ensures that interest
rates never get too high or too low.

Correct Answer: A
The value of the Gary-Tills issue at each of the three nodes is presented below:
 100.000   100 .000 

Node 1-1: 0.5  + 0.5  = 92.684
 1.07984   1.07984 
 100.000   100 .000 
Node 1-2: 0.5  + 0.5  = 93.929
 1.06463   1.06463 
 92.684   93.929 
Node 1-0: 0.5  + 0.5  = 90.589
 1.03   1.03 
The value of the issue is calculated incorrect at Node 1-0.


Correct Answer: C
C is correct. The attendee’s explanation of the arbitrage-free valuation is inaccurate because the
process is based on the no-arbitrage principal which implies that identical assets should sell at the
same price. This results in an absence of arbitrage opportunities or, in other words, an inability to
earn riskless profits with a zero net investment of money. Although arbitrage-free valuation values a
bond as a portfolio of zero-coupon securities, the approach does not allow a market participant to
realize an arbitrage profit through stripping and reconstitution.

Correct Answer: B
The value additivity principal states that the value of the whole is equal to the sum of its parts. A
violation of this principal results in riskless profits. The individual strategies in the options are
analyzed to determine profits today.
Option A Option B Option C

Today’s (102 × 0.9804) – (102 × 0.9804) – $95 – $100 = - $5.00
profit $100 = $0.00 $95 = $5
The strategy listed on option B is the only strategy to generate arbitrage-free profits based on the
value additivity principal.

Correct Answer: A
Statement 1 is correct. Arbitrage-free valuation is based on the no-arbitrage principal, which implies
that two otherwise identical assets should sell at the same price. Similarly, two cash flows with the
same maturity and identical risks but attached to different bonds should be discounted at the same
rate.
Statement 2 is incorrect. To derive an arbitrage-free value of an option-free bond, the YTMs on on-
the-run Treasury securities represent the benchmark rates. Spot rates need to be derived from the
benchmark rates using bootstrapping which in turn is used to discount the bond’s cash flows to derive
the arbitrage-free value.


Correct Answer: C
C is correct. Gloethe is inaccurate regarding Step 4. Determining the present value or arbitrage-free
value using the binomial interest rate tree involves discounting the cash flows at the one year forward
rate at the higher and lower nodes and averaging the two present values. This procedure is repeated
while working from the right to left (backwards) of the binomial interest rate tree. The value at the
root of the tree (leftmost node) represents the arbitrage-free value. In short, backward induction is
used to derive the arbitrage-free value.
A is incorrect. The first step in constructing a binomial tree involves the specification of a benchmark
par curve by using bonds of a particular country or currency.
B is incorrect. The second step in constructing the tree is to determine the rates at each node using an
interest rate model, a volatility assumption and the benchmark par curve.

Correct Answer: B
B is correct. The volatility assumption is estimated using implied volatility as it is based on the
observed market prices of an interest rate derivative – the swaption.

Correct Answer: B
Gloethe is inaccurate regarding both his statements.
The Monte Carlo method simulates a large number of interest rate paths based on a probability
distribution and assumed volatility. Spot rates are generated from the simulated one-month interest
rates which are in turn used to calculate the present value of cash flows across interest rate paths. In
short, simulated interest rates are not directly used to discount the security’s cash flows.
Statement 4 is also inaccurate. To ensure that the model fits the current spot rate curve and is well
calibrated, modelers will want to ensure that the model produces benchmark bond values equal to
market prices. The model will be drift adjusted by adding a constant to all interest rate paths such that
the average present value for each benchmark bond equal to its current market price. Adjusting the
model for drift will ensure that the model fits the current spot rate curve and is well calibrated.

Reading 36 Valuation and Analysis: Bonds with Embedded Options FinQuiz.com
FinQuiz.com
Study Session 13
June 2019


Reading 36: Valuation and Analysis: Bonds with Embedded Options

Correct Answer: A
Putable bonds are the most effective hedges against rising interest rates. A rise in interest rates will
decrease the value of the straight bond. However, an increase in the value of the embedded put option
will partially offset this decline. Therefore, putable bonds are more valuable when interest rates
decline. A rise in interest rates will give the option holder to put the bond back to the issuer and
reinvest the proceeds of the retired bond in a higher-yielding bond.
On the other hand, the value of the callable bond declines similarly to the underlying straight bond.
The embedded call option is out of the money and does not help to offset the decline. Therefore, a
callable bond is not considered a hedge against rising interest rates.

Correct Answer: C
C is correct. The current yield-to-maturity is higher relative to bond A’s and C’s coupon rates (5.7%
vs. 3% and 4%, respectively.) The call option is out of the money as it is unlikely to be called.
Therefore, the effect of a shift in interest rates will have a similar effect on the prices of a callable and
option-free issue. Both Bond C and the option-free bond have similar effective durations, 2.7.
A is incorrect. The effective duration of a callable bond declines relative to that of the straight bond
when current yields decline below coupon rates. This is when the call option is in the money.
B is incorrect. The effective duration of a putable bond cannot exceed that of the straight bond
regardless of the relationship between current yields and coupon rates.

Correct Answer: C
C is correct. The option-free bond changes very little in response to interest rate movements. On the
other hand, the value of a callable bond decreases and putable bond increases with an increase in
interest rate volatility.


Correct Answer: A
The calculated bond values at each node using the binomial tree are illustrated in the exhibit below:
Year 0 Year 1 Year 2 Year 3
R = 4.098% C = 105.000
V = 100.867
Coupon = 5
R = 1.500% R = 2.777% R = 3.355%

V = 104.433 V = 103.072 V = 101.592 C = 105.000
Callable at 101.00 Coupon = 5 Coupon = 5
Callable at 101.000 Callable at 101.000
R = 2.273% R = 2.747%
V = 103.644 V = 102.193
Coupon = 5 Coupon = 5 C = 105.000
Callable at 101.000 Callable at 101.000
C = 105.000
Given that Bond B is currently callable the value of the bond is equal to 101 per 100 of par value.

Correct Answer: B
A higher volatility assumption will decrease the OAS of a callable bond.

Correct Answer: C
The effective convexity of the bonds is calculated using the formula:
Effective convexity =
(PV− ) + (PV+ ) − [2 × (PV0 )]
(∆Curve)2 × (PV0 )
101.632 + 100.765 − [2 × 101.156]
Effective convexity (Bond A) = = 52.52
(0.004 )2 × (101.156)
101.149 + 99.893 − [2 × 100.207]
Effective convexity (Bond C) = = 391.69
(0.004)2 × (100.207 )


Correct Answer: A
Using the spot rates, the forward rates are determined using linear interpolation:
F(0,1) = 1.50%
F(1,1) = 1.02252/1.015 – 1 = 3.0055%
F(2,1) = 1.0313/1.02252 – 1 = 4.8213%
Today Year 1 Year 2 Year 3

Cash flow 5.000 5.000 105.000
Discount 1.500% 3.006% 4.821%
rate
Value of 101.936 100.171
callable 103.448 Called at Called at
bond 100 100

Correct Answer: A
A is correct. The advantage which the key rate duration measure has over the effective duration
measure is that the former considers shaping risk – the bond’s sensitivity to changes in the shape of
the yield curve.
B is incorrect. Both duration measures consider parallel shifts in the yield curve.
C is incorrect. Both the effective and key rate duration measures are appropriate for measuring the
price sensitivity of bonds whose cash flows are sensitive to the path of interest rates. The exercise of
the embedded call option depends on where the interest rate stands relative to the coupon rate.
Consequently, the cash flows and the value of callable bonds depend on the path which interest rates
follow.

Correct Answer: A
The price of the bond will respond primarily to the movements in the ten-year par rate when the
coupon rate is 2%. When the coupon rate is 2%, the 10-year key rate is the highest while the other
key rates are close to zero. This indicates that the callable bond behaves similarly to a ten-year
option-free bond at this coupon rate.


Correct Answer: C
The issue is first callable five years from today. Because of the virtual certainty of being called at a
coupon rate of 8%, the callable bond behaves similarly to 5-year option-free bond; the 10-year key
rate duration is negligible (0.15) relative to the 5-year key rate duration (1.64).

Correct Answer: A
A is correct. When interest rates decline, putable bonds exhibit greater upside price potential relative
to callable bonds. While both bonds increase in value, negative convexity will compress the price
appreciation potential of callable bonds.
B is incorrect. Although the embedded call option increases with a decline in interest rates, Davis
should not opt for a callable bond issue because of the price compression resulting from negative
convexity (see above).
C is incorrect. The value of the embedded put option decreases with a decline in interest rates.

Correct Answer: B
To determine whether the issue is influenced by stock- or bond-related factors, Davis will need to
determine whether the issue exhibits stock risk-return characteristics or is a busted convertible and
exhibits bond-like characteristics. A comparison between the underlying share price and conversion
price will reveal this.
Conversion price = Par value/Conversion ratio = $100,000/90,000 = $1.11

Given that the current market price exceeds the conversion price ($2.50 > $1.11), the convertible
bond exhibits stock risk-return characteristics. Therefore, share price volatility will have the greatest
influence on the value of the convertible issue.


Correct Answer: A
A is correct. Given that interest rates are forecasted to rise to a level which
significantly exceeds the coupon rate, the embedded call option will have a very low
value and the callable bond will exhibit positive convexity. In this scenario, the
increase in rate will have a similar effect on the prices of callable and option-free
bonds which both exhibit positive convexity.

Correct Answer: C
The minimum value of the convertible is known as the floor value and is calculated as
the greater of the conversion value and the value of the underlying option-free bond.
Conversion value = Underlying share price × Conversion ratio = $5.80 × 200 =

$1,160
Straight bond value = $1,500
Minimum value = Greater of $1,160 and $1,500
Therefore, the floor value is equal to $1,500


Correct Answer: C
C is correct. The market conversion premium per share limits downside risk to the
straight value. However, the exact amount of downside risk cannot be known by
buyers of convertible bonds. Investors know only that the most they can lose is the
difference between the convertible bond price and straight bond value. However, the
latter is not fixed and so the amount of loss cannot be known with certainty
beforehand.
A is incorrect. Scholes has correctly calculated the market conversion premium per
share.
Market conversion price = Convertible bond price/conversion ratio = $1,200/200 =

$6.00
Market conversion premium per share = Market conversion price – underlying share
price = $6.00 – $5.80 = $0.20

Correct Answer: C
Conclusion 2 is most accurate regarding share price movements. The upside potential
of a convertible bond issue primarily depends on the prospects of the underlying
common stock.

Correct Answer: A
A is correct. The value of the convertible bond ($1,200) is lower than the greater of
the conversion value ($5.80 × 200 = $1,160) and straight value ($1,500) which
indicates that an arbitrage opportunity exists.
Investors can purchase the convertible bond at a price of $1,200 and secure a profit of
$ ($1,500 – $1,200 = $300).


Correct Answer: B
The convertible bond is trading similar to a hybrid instrument as the current share
price ($5.80) exceeds the convertible bond price ($5.00) and is expected to decline
towards the latter. In this scenario, the change in the convertible bond price will be
lower than the change in the underlying share price as the issue has a floor. Therefore,
the decline in the convertible bond price will be less than 13.79% [($5.80 –
$5.00)/$5.80], which is equal to the decline in the share price.

Reading 37 Credit Analysis Models FinQuiz.com
FinQuiz.com
Study Session 13
June 2019


Reading 37: Credit Analysis Models

Correct Answer: C
C is correct. Yamada is inaccurate with respect to his justification because traditional credit models
such as credit ratings rank the credit risk of an entity but do not provide an estimate of a loan’s default
probability. On the other hand, reduced form models use hazard estimation procedures to estimate
default intensity (probability) and loss given default.
B is incorrect. Reduced form models use hazard estimation procedures. Estimating default
probabilities using these procedures is very flexible as they incorporate changes in the business cycle
and are independent of balance sheet structure.

Correct Answer: C
C is correct. Reduced form models use hazard estimation procedures to estimate default probabilities.
These procedures incorporate changes in the business cycle and are independent of the balance sheet
structure allowing for model flexibility. On the other hand, structural models assume that asset return
volatility will remain constant over time, independent of changing business conditions and economic
cycles.
A is incorrect. Both structural and reduced form models assume markets are frictionless.
B is incorrect. The structural model allows for an understanding of default probability based on
option analogy. Reduced form models allow for an understanding of default probability based on
business cycle conditions and company circumstances. Therefore, this does reflect not an advantage
of reduced form models over structural models.

Correct Answer: B
B is correct. The 3-year issue has a lower loss given default (see below).
Expected loss = loss given default × default probability

Loss given default (3-year) = $1.245*/0.035
= $35.571
Loss given default (4-year) = $0.939*/0.025
= $37.560
*The calculations below represent $1,000 of par value.
A is incorrect. The sum of the recovery rate and loss given default equals to 100%. Based on the
calculated loss given default for the two issues, the 4-year issue has a lower recovery rate.
Recovery rate = 1 – loss given default

Recovery rate (3-year issue) = 1 – [($35.571 × $1,000)/$100,000] = 64.43%

Recovery rate (4-year issue) = 1 – [($37.560 × $1,000)/$100,000] = 62.44%
C is incorrect. Expected loss represents the loss expected in the event a bond defaults prior to
maturity; that is, the loss figure is undiscounted and therefore does not reflect the time value of
money. Furthermore, the default probability is simply multiplied by the loss given default. With no
adjustment for the risk of cash flows, expected loss does not reflect a risk premium.

Correct Answer: C
C is correct. The expected loss amounts to $1,245 ($1.245 × $1,000).
The maximum amount an investor is willing to pay to at third party to convert the issue to a default-
free bond (remove the credit risk) is equal to 154.775 ($912.393 – $757.618), the present value of
expected loss.
Given that the expected loss is $1,090.225 ($1,245 – $154.775) higher than the present value of
expected loss, the premium for credit risk is dominated by the discount for the time value of money.
A is incorrect. The present value of expected loss reflects the time value of money and credit risk
premium. Therefore, it is incorrect to state either of the two components is not reflected by the
measure.
B is incorrect (see above).

Correct Answer: A
A is correct. The present value of expected loss due to credit risk is $1.039; equal to the difference
between the credit-adjusted and risk-free values on June 30, 2014 ($45.722 – $44.683).

Correct Answer: A
A is correct. Thomas and Yamada are inaccurate with respect to Fact 1. The cash flow structure of
ABS is complex and includes prepayments, principal repayments and coupon interest. Furthermore
different special purpose vehicles (SPVs) have different waterfall structures. In this situation, Monte
Carlo simulation procedures are often used. However, the two individuals have incorrectly pointed
out that these procedures are also applied to corporate bonds.
B is incorrect. Thomas and Yamada are accurate with respect to Fact 2. Credit risk measures used for
corporate or sovereign bonds can be applied to ABS bonds: probability of loss, expected loss, and the
present value of expected loss. The probability of default does not apply to ABS and is replaced by a
probability of loss given that a default in the collateral pool does not cause a default to either the SPV
or a bond tranche.
C is incorrect. Thomas and Yamada are accurate with respect to Fact 3. Given the fact that ABS is
structured debt and its complexity, the use of the same credit-rating scales (as that used for corporate
or sovereign bonds) may at times be inappropriate.


Correct Answer: C
C is correct. The present value of expected loss includes the probability of default, the loss
given default, the time value of money and the risk premium in its computation. This
measure is the present value of the product of default probability and loss given default, both
of which depend on the health of the economy.
A is incorrect. Credit scores are not a suitable measure of credit risk as they do not explicitly
depend on current economic conditions. Furthermore, the measure merely ranks a borrower’s
credit riskiness and does not provide an estimate of a borrower’s default probability. In this
way, credit scores are an incomplete measure of risk. Furthermore, the time value of money
is not considered.
B is incorrect. Even though the loss given default measure depends on the current health of
the economy and incorporates the riskiness of a corporation’s cash flows, it is not suitable
given Engle’s objectives. This is because the loss given default does not consider the time
value of money.

Correct Answer: B
B is correct. The cost of removing credit risk is greatest for the Smithson Manufacturing
issue as evidenced by the present value of expected loss. This measure represents the largest
price one would be willing to pay to remove the credit risk of purchasing and holding the
bond.
A is incorrect. Credit scores provide ordinal ranking, ordering borrowers’ riskiness from
highest to lowest. Therefore, they do not provide cardinal ranking – which determines the
riskiness of one borrower relative to another in multiples.
C is incorrect. The recovery rate is measured as: ‘1 – loss given default (in %)’. The loss
given default is often expressed as a percentage of the position or exposure.
Smithson Manufacturing’s recovery rate = 1 – 0.20 = 0.80
Carl Jones plc = 1 – 0.25 = 0.75
Alpha Ltd = 1 – 0.50 = 0.50
Given that the recovery rate is the highest, a corporate lender should expect to receive the
most from the Smithson Manufacturing issue.


Correct Answer: A
Concern 1 does not accurately represent a concern of using credit scores while Concern 2
does. Credit scores change as the borrower’s behavioral or financial circumstances change.
Given that credit scores are updated to reflect this change in circumstances, Jefferson should
not have a problem with this feature of credit scores.
On the other hand, there is some pressure on credit rating agencies to maintain stability in the
scores generated by lenders. This may serve to distort the objectivity of the credit risk
measure.

Correct Answer: C
The debt option analogy is based on the notion that holding the company’s equity is
economically equivalent to owning a European call option on the company’s assets with
strike price K and maturity T.
C is correct. What the debt option analogy implies for debt holders is: the time T value of the
company’s debt is equal to K (the face value of debt) if the value of a company’s assets is
greater than K. On the other hand, the value of debt is equal to the time T value of the
company’s assets if the value of the company’s asset base falls below K.
A is incorrect. The debt option analogy states that debt holders lend equity holders K dollars
and simultaneously sell them an insurance policy for K dollars on the value of their assets.
B is incorrect. A company’s shareholders have limited liability; that is, in the event that the
asset value declines below K, debt holders can only claim the value of a company’s assets. In
other words, the value of debt holder’s claims does not extend to the assets of a company.

Correct Answer: A
D(t, T) = AtN(-d1) + Ke-r(T-t) N(d2)
D(0,3) = $1,200(0.097) + $850e-0.025(3 – 0)(0.1451*) = $230.823 ≈ $231
*Probability asset value 3 years from today is ≥ face value of debt = 0.1451


Correct Answer: A
A is correct. Gavin is recommending the use of the structural model to generate credit
ratings. This model relies on a number of assumptions including that the risk-free rate is
constant over time.
B is incorrect. The structural model only assumes that a company’s assets trade in
frictionless markets. The model does not make any assumption with respect to a company’s
debt.
C is incorrect. The probability of default depends exclusively on a company’s assumed

liability structure.


Correct Answer: A
Reason 1 does not accurately reflect one of the strengths of using credit ratings. The accuracy of
externally generated credit ratings may be distorted if agencies are compensated on the basis of an
issuer-pays model. To obtain more business, credit rating agencies may have an incentive to give a
higher rating than may be deserved.
Reason 2 does not accurately reflect one of the strengths of credit ratings. Ratings create an ordinal
ranking of borrowers. This type of ranking cannot be used as a basis to compare the relative riskiness
of two borrowers.
Reason 3 does not accurately reflect one of the strengths of credit ratings. Although the motivation
to maintain stable ratings reduces unnecessary volatility in debt market prices, this comes at a cost of
reduced accuracy. Stable ratings can only be accurate on average because they change infrequently
while information on the business cycle arrives continuously. Furthermore, stability in ratings will
reduce the correspondence to a debt offering’s default probability.

Correct Answer: B
B is correct. Reduced form which models rely on historical estimation to estimate parameters
introduce flexibility into the estimation process. Historical estimation is an application of hazard rate
procedures. These procedures incorporate business cycle changes and are independent of the
requirement to specify a particular balance sheet structure.
C is incorrect. Reduced form models using historical estimation employ past observations of bond
prices to predict the future.

Correct Answer: A
A is correct. Jarrow’s application of the model is inappropriate because there are more maturity points
and therefore more variables to estimate (unknowns) than the number of bonds in the data set.
B is incorrect. Even though default probabilities and loss given defaults are not constants in reality,
the expected percentage loss per year implied by the credit spread can be roughly estimated by
assuming otherwise.
C is incorrect. The reduced form model can be used to estimate risky zero-coupon bond yields from
coupon bond prices.


Correct Answer: A
Expected percentage loss per year implied by the yields = Average yield spread
Zero-coupon government bond Yield (%)=
(2.50 + 2.55 + 2.60 + 2.60 + 2.63)% = 2.576%
5
Zero-coupon AM bond yield =
(3.84 + 3.90 + 4.00 + 4.01 + 4.11)% = 3.972%
5
Expected percentage loss per year = 0.03972 – 0.02576 = 0.01396

Correct Answer: B
The credit risk-adjusted valuation is derived using the continuously compounded total yield which is
used to compute the discount factor.
Credit risk-adjusted value = $120 × 0.9725 = $116.70

Correct Answer: B
A limitation of using both reduced and structural models in decomposing the credit spread is that the
assumption of frictionless markets implies that there is no quantity impact of a purchase or sale on the
price of the security. The presence of a quantity impact introduces liquidity risk. In reality, markets
are not frictionless and liquidity risk is very much present.
The true credit spread consists of both the expected percentage loss (derived from either the reduced
form or structural model) and a liquidity risk premium.


Correct Answer: A
Although Monte Carlo simulation procedures are often used in practice, both the structural
and reduced form model can be used to value ABS.

Correct Answer: B
B is correct. Historical estimation cannot be used to estimate a structural model’s parameters

because the assets of an SPV, represented by the collateral loan pool, do not trade in
frictionless markets and hence its value is not observable. Therefore, one cannot use standard
statistics to compute a mean return or the asset’s return standard deviation. Historical
estimation relies on past time-series observations of the underlying asset’s price and standard
statistical procedures to estimate the parameters and therefore relies on past observations of
security prices.
C is incorrect. Calibration or implicit estimation procedures should be used when estimating

the structural model’s parameters. Based on the data presented in the framework, Lewis is
relying on historical estimation procedures.

Correct Answer: B
When measuring the credit risk of ABS, the probability of loss is used as opposed to the
probability of default. Unlike corporate debt, an ABS does not default when an interest
payment is missed but the ABS continues to trade until either its maturity date or its face
value is eliminated because of accumulated losses in the collateral pool or through early loan
prepayments. In addition, a default in the collateral pool does not cause a default to the SPV
or a bond tranche. Therefore, the probability of default is not a relevant measure of credit
risk.

Correct Answer: B
Although credit-rating agencies use the same rating scale as that used for corporate and
sovereign debt, the complexity of ABS may make use of the same scales inappropriate. The
alleged mis-ratings of structured products in the recent past have resulted in credit rating
agencies revising their rating methodologies.


Correct Answer: B
Gabrielle has the highest credit score and thus lower credit riskiness. Therefore, she is the
most eligible candidate for the loan based on credit standing.

Correct Answer: B
B is correct. If a borrower borrows from many institutions and in many forms, his/her credit
score may have different implications for default probability on different types of loans. This
is because there are no cross-default clauses for retail borrowers and so it is possible for the
borrower to be more likely to default on one type of loan than on another.
Given that Walters is the only borrower to borrow one form of loan, there will be less
disparity between his credit score and individual loan default probability compared to Selena
and Gabrielle who have more than one form of borrowing.

Reading 38 Credit Default Swaps FinQuiz.com
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Study Session 13
June 2019


Reading 38: Credit Default Swaps

Correct Answer: B
B is correct. CDS B’s credit spread is higher than its standard rate (6.0% vs. 1.0%, respectively)
which will result in the payment of an upfront premium from the protection buyer to the protection
seller. This is because the coupon is insufficient to cover the credit risk associated with the swap and
an upfront premium payment will make up for this discrepancy.
The standard rate may not always equal the CDS credit spread. This discrepancy is accounted for by
an upfront premium. A credit spread less (greater) than the standard rate will result in a payment from
the protection seller (buyer) to the protection buyer (seller).
A is incorrect. CDS A’s credit spread is lower than its standard rate (3.5% vs. 5.0%, respectively)
resulting in the payment of an upfront premium from the protection seller to the protection buyer.
C is incorrect. CDS C’s credit spread is equal to its standard rate; therefore, there is no upfront
premium payment.

Correct Answer: C
C is correct. TM will receive the highest proceeds, $13.5 million, from settling CDS C (see below). In
the case of cash settlement, the payout ratio is based on the cheapest-to-deliver defaulted debt. Since
CDS A and C require cash settlements, the contract’s recovery rate is 80% and 25% respectively.
The CDS’s payout ratio is determined using the formula, [(1 – recovery rate %) × Notional].
TM can cash settle CDS A for $2 million [(1 – 0.80) × $10 million] and sell its bonds for $8 million
(0.8 × $10 million) receiving total proceeds of $10 million.
TM will receive the face amount of the bond, $12 million, in the case of CDS B.
TM can cash settle CDS C for $7.5 million [(1 – 0.25) × $10 million] and sell its bonds for $6 (0.6 ×
$10 million) receiving total proceeds of $13.5 million.


Correct Answer: A
A is correct.
Gross index CDS notional principle = $350 million

Hedge protection sold = 20%
Notional amount of entity B in CDS index (purchased)
= $7 million/0.20
= $35 million
Net notional principal on the CDS index trade (excluding entity B)

= ($350 – $35) million
= $315 million

Correct Answer: A
A is correct. Based on the CDS trade undertaken by TM’s management, it believes that long-term
credit risk will increase relative to short-term credit risk. By going short a long-term CDS and long a
short-term CDS, this curve steepening trade reflects short-term bullish views on credit risk.

Correct Answer: A
A is correct.
Coupon payment = $10 million × 0.05/4
= $0.125 million
Recovery rate is based on the cheapest-to-deliver bond, which is the issue selling at 25% par. Thus,
the recovery rate is 25%.
The sum of the first three loan payments total $0.375 million ($0.125 million × 3). If default occurs,
loss given default on the first three loan payments only is equal to $0.28125 million [$0.375 million ×
(1 – 0.25)] or approximately $0.3 million.


Correct Answer: C
C is correct. As a protection buyer, TM is economically short the reference obligation and benefits
from an increase in the company’s credit spread. A widening of the credit spread will imply that the
TM will pay the same fixed coupon to cover a larger credit risk. TM can offset its position by
entering into a new CDS with the same terms as the original CDS, but with higher premium, as
protection seller. Therefore, the entity can sell protection for a higher premium.
A is incorrect. Based on Greene’s forecast, the bond’s credit spread will widen to 6.7% (5.0% +
1.7%). Given that the spread in the CDS market will still be higher relative to the bond market (6.9%
vs. 6.7%, respectively), the basis is positive.
B is incorrect. Credit risk will continue be more expensive in the CDS market (6.9%). relative to the
bond market (5.0% + 1.7% = 6.7%) despite the widening of credit spread. TM can take advantage of
this opportunity by selling protection in the CDS market and going short the bond, paying 6.7% for
transferring credit risk.


Correct Answer: C
The recovery rate is based on the cheapest-to-deliver issue. A debt obligation issued by the borrower
which is ranked equivalently or higher in priority of claims to the reference obligation is covered.
Given that the subordinated issue is not ranked pari passu to the reference obligation, the senior
unsecured issue is classified as the cheapest-to-deliver issue.

Correct Answer: C
Given that the CDS spread is lower than the issue’s credit spread (5% and 7%, respectively), the
protection buyer is paying a standard rate (CDS spread) which is insufficient to cover the risk of the
bond. Therefore, the protection buyer will make a cash upfront payment to the seller.

Correct Answer: B
A long position in a CDS is equivalent to a package of long put options. Put options enable the option
holder to sell (put) the underlying to the seller if the underlying performs poorly relative to the
exercise price. Thus, the option holder is compensated for the poor performance of the underlying. A
CDS performs in a similar manner. Poor performance of the bond or loan results in the protection
seller compensating the protection buyer.

Correct Answer: B
A CDS does not eliminate credit risk but simply substitutes the credit risk of the reference entity with
the CDS seller.


Correct Answer: C
Expected loss = Loss given default × Probability of default

If the borrower defaults on the first loan payment, the amount lost is ($5 × 70%) = $3.50
If the borrower defaults on the second loan payment, the amount lost is ($105 × 70%) = $73.50
Probability of default on first and second loan payments = 4%
Probability of default on second loan payment = 96% × 4% = 3.84%
There is a 4% chance of losing $77.00 ($3.50 + $73.50) and a 3.84% chance of losing $73.50.
Expected loss = ($77.00 × 4%) + ($73.50 × 3.84%) = $5.9024 ≈ $5.90

Correct Answer: B
Sigma Corp can cash settle for $21.0 million (1 – 0.30)($30 million) and sell the issue for $10.5
million (35%)($30 million) for total proceeds of $31.5 million. Alternatively, the company can
physically deliver the entire $30 million of the issue. Physical settlement will be the preferred option
due to its lower cost.


Correct Answer: C
Observation 2 qualifies as a potential credit event. Failure to pay on a scheduled interest payment
after a grace period may trigger a payment from the credit protection seller to protection buyer.
Observation 1 is defined as a potential succession event as there is a plan to change the corporate
structure of the reference entity.
Observation 3 is does not qualify as a potential credit event. Restructuring includes a number of
possible events including reduction or deferral of principal or interest which is forced on the
borrower by creditors and is thus involuntary. Given that the borrower has requested a reduction, the
event does not classify as a restructuring event.

Correct Answer: C
The present value of the protection leg is greater than the present value of the premium leg ($150 vs.
$146, respectively) indicating that the protection buyer has a greater claim on the CDS payoff and
will make an upfront payment to the protection seller.
The present value of the protection leg is the present value of the contingent obligation that the credit
protection seller will have to make to the credit protection buyer.

Correct Answer: C
An increasing hazard rate implies a greater probability of default in the later years which in turn will
result in an upward sloping credit curve.

Correct Answer: C
Credit spread = Upfront premium*/Duration + Fixed coupon = (83.3333 + 98) basis points = 181.33
basis points
*Value of upfront premium = 5%/6 = 0.0083333 × 100 × 100 = 83.3333 basis points


Correct Answer: A
A is correct. Given that the credit spread has narrowed, the protection buyer continues to pay a fixed
coupon of 98 basis points to receive coverage on a company whose risk justifies a reduced level of
coupons. Therefore, the protection buyer (seller) will incur a loss (profit) and the amount of that loss
is calculated below:
Loss for the protection buyer = (- 0.25%)(5)($2,500,000) = - $31,250
C is incorrect. The profit to the protection seller is $31,250.

Correct Answer: A
Credit spread of the bond issue is the excess of the yield over LIBOR. Given that the credit spread of
the issue (7.0% - 2.5% = 4.5%) is lower than the credit spread of the CDS (7.0%), its premium is
lower relative to the CDS market which means its price is too high. The CDS is pricing too much
credit risk and bond market is pricing too little credit risk. To capture arbitrage profits, the basis trade
would involve selling the CDS (protection) and the underlying bond issue.

Reading 39 Pricing & Valuation of Forward Commitments FinQuiz.com
FinQuiz.com
Study Session 14
June 2019


Reading 39: Pricing & Valuation of Forward Commitments

Correct Answer: A
Three months after initiation, the current value of the original 6 x 9 FRA is determined using
the 90- and 180-day LIBOR rates. The following steps will be followed to determine the
current value of the FRA:
Step 1: Calculate the new FRA rate of a contract which initiates today and expires at the
same time as the original FRA. The relevant rates to use are the 90- and 180-day LIBOR.
FRA (90, 180 – 90, 90) = {[1 + (0.0438 × 180/360)]/[1 + (0.0425 × 90/360)] – 1} ÷ (90/360
= 0.044626 or 4.46%
Step 2: Calculate the current value of the FRA as the difference between the initial FRA
price and the FRA price determined in step 2 discounted at the provided rate of 5.60% over a
period of 180 days.
Value of the FRA = {[(4.46% - 4.50%) × 90/360] × SEK 50,000,000}/[1 + (0.056 ×

180/360)] = - SEK 6,534.5333 ≈ - SEK 4,549
Because the FRA rate has declined, the value of the FRA will be negative to Macro Limited.

Correct Answer: C
Because the original FRA contract is a 6 x 9 FRA, the relevant rates to use are the 180- and
270-day LIBOR for determining the potential for arbitrage profits. The FRA rate using the
hypothetical market LIBOR rates is calculated as follows:
FRA (0, 180, 90) = {1 + (0.0568 × 270/360)]/[1 + (0.056 × 180/360)] – 1}/(90/360) =

0.05681 or 5.68%
Comparing the initial FRA rate of 4.50% to the market rate of 5.68%, the original contract
would have been underpriced if the hypothetical rates actually existed at time 0.


Correct Answer: C
C is correct. Unlike a fixed-rate swap, a floating rate swap in general is not priced because a
single coupon rate is not designated to the swap. At each reset date, the coupon rate will be
re-established according to the LIBOR prevailing at the time. The same holds true for a
floating rate bond which is used to price the swap; the coupon rate is reset at each reset date.
A is incorrect. The statement holds true for fixed-for-fixed currency swaps in which the
coupon rates on fixed-rate bonds are selected to match the fixed swap rates resulting in future
net cash flows equaling zero.
B is incorrect. The value of the swap is equal to par on each reset date.

Correct Answer: B
The notional principal paid by Macro Limited at contract initiation is equal to SEK
54,347,826.09 (£5,000,000/0.092).
Using the rates provided in the exhibit, the SEK present value factors are determined as
follows:
SEK Spot Present Value

Days to Interest Rates Factors
Maturity (%)
180 3.0 0.98522
360 3.5 0.96618
540 4.1 0.94206
The annualized SEK swap fixed rate is determined as follows:
1 − 0.9426 360
rFIX,SEK = × = 3.968%
0.98522 + 0.96618 + 0.94206 180
Annual swap fixed payment = SEK 54,347,826.09 × 0.03968 × 180/360 = SEK 1,078,260.87
or ≈ SEK 1.09 million


Correct Answer: A
At the initiation of the swap, Macro Limited will receive £5 million from and pay SEK
54,347,826.09 (£5,000,000/0.092) to the swap counterparty.

Correct Answer: A
A is correct. Based on the formula for calculating forward iron ore prices (see below), an
increase in the risk-free rate, ‘r’, will increase forward prices relative to spot prices.
B is incorrect. Carry benefits, represented by the symbol γ0 in the formula, decrease the
burden of carrying the underlying instrument through time and so an increase in carry
benefits will decrease the forward price relative to the spot price.
C is incorrect. Expectations of the future underlying price have no bearing on the forward
price. Therefore, an expectation that the underlying will increase in value has no impact on
the forward price.
Forward price formula: F0(T) = (S0 + θ0 – γ0)(1 + r)T

Correct Answer: C
The formula used to calculate the no-arbitrage forward price at contract initiation is as follows:
F (0,T ) = S 0 (1 + r )
T
F (0, T ) = AUD1,000(1 + 5%) = AUD1,028.8698 ≈ AUD1,029

7 12

Correct Answer: C
Since the actual forward price is AUD 1,500 while the forward price determined as part of the no-
arbitrage formula (solution to Part 1) is AUD 1,029, the forward contract is overpriced. Thus Cohen
should undertake a short position in the wheat forward contract. Using the spot price of wheat and the
forward price (AUD 1,500), the rate of return will be:
AUD1,500
− 1 = 0.50
AUD1,000
The risk –free return for seven months is 50%. The annualized return is 100.4% which is calculated as
follows:
(1.5)12 7 − 1 = 1.003875


Correct Answer: A
Since Cohen already holds a corporate bond investment in Test Manufacturing, he will undertake a
short position in a forward contract in which the underlying is the manufacturer’s corporate bond. The
formula to calculate the value of a corporate bond forward contract at time T is:
Vt (0,T ) = Bt (T + Y ) − PV (CI , t ,T ) − F (0,T ) (1 + r )

C T +t
200 days into the forward contract, the first coupon date (181 days) has already passed. The second
and third coupon payments are 165 days (365 – 200) and 347 days (547 – 200), respectively, away.
 85 
The present value of the second coupon payment is AUD 83.14578 =  
 (1.05 )(365− 200 )365 
 
 85 
The present value of the third coupon payment is AUD 81.14739 =  
 (1.05 )(547−200 )365 
 
Since the forward contract will expire a day after the third coupon payment, the time to maturity is
348 days [(547 + 1) – 200].
Thus, Vt (0, T ) = AUD1,250.50 − 83.14578 − 81.14739 − 1,075.45

(1.05)548−200 365
= AUD
59.63858831 or AUD 59.64
Since Cohen already holds the corporate bonds, he is short the forward contract, thus the value of the
forward contract to Cohen is - AUD 59.64 and the value to the manufacturer is + AUD 59.64

Correct Answer: B
The duration of an FRA agreement beginning in 2 months time covering a loan to be taken out in
eight months time is 6 months (8 – 2 months) or 180 days (30 days × 6).
Since Test Manufacturing would like to protect against increase in borrowing costs, it should
undertake a long position in an FRA agreement. The formula to calculate the initial FRA rate is:
 h+m 
1 + L0 (h + m ) 360   360 
FRA(0, h, m) =    − 1
 
 1 + L (h )  h   m 
 0   
 360 
FRA (0,30,180) = 
(
 1 + 14% × 240  )
360 − 1 360  = 0.159671 or 15.97%

(
1 + 7.50% × 60
360
)
 180 



Correct Answer: B
The formula to calculate the value of the FRA on day g is:
 m 
1 + FRA(0, h, m) 
( )
Vg 0, h, m =
1
−  360 
h−g  h+m− g 
1 + Lg (h − g )  1 + Lg (h + m − g ) 
 360   360 
  180 
11 + 15.971× 
1   360 
= − = AUD0.99366538 − AUD0.99297011 = AUD0.00069527
 30   210 
1 + (7.65%)  1 + 15.00% × 
 360   360 
Based on the AUD 2.5 million notional principal (AUD 5 million × 50%), the value of the forward
contract after 30 days is approximately AUD 1,738 (AUD 2,500,000 × 0.00069527).

Correct Answer: A
Since Howell’s clients already own Australian investments Howell will need to undertake a short
position in a forward contract that will allow her to sell AUD for USD. However prior to determining
the value of the forward contract after one month, it is necessary to determine the forward price at the
initiation of the contract. Using continuous compounding, the formula used to calculate the initial
forward price of a forward currency contract is:
(
F (0, T ) = S 0 e − r
fc
T
)e r CT
F (0, T) = F (0, T ) =  0.98e e 3.50%× 312 = USD0.97633188 per AUD

−5%× 3
12
 
Using the initial forward price and current spot price (ST = USD 1.10 per AUD), the formula used to
calculate the value of a forward currency contract at time T (using continuous compounding) is:
[
VT (0,T ) = ST e − r
fc
(T −t )
]− F (0,T )e − r C (T −t )
VT (0, T ) = 1.10e  − 0.97633188e −3.50%×212 = 0.12021823 ≈ USD 0.12 per AUD.

−5%× 2
12
 
Since Howell is short the currency forward, the value of the forward contract is USD – 0.12 per AUD.


Correct Answer: B
No-arbitrage forward price of the equity forward is determined by the following formula:
்
F(0,T) = (ܵ଴,் ݁ ିఋ ் )݁ ௥ = (3,250݁ ି଴.଴ଵ଻ ×ଵ.ହ )݁ ଴.଴ସଽଷଵ×ଵ.ହ = 3,411.39

Correct Answer: B
The forward contract is overpriced. Therefore, the most suitable strategy would involve
selling a forward contract on the index and, since the investor does not own index stocks,
borrowing funds to buy the underlying index stocks at the spot price today (S0).

Correct Answer: C
Value of the forward contract = Vt (0,T) =

S t e −δ (T −t ) − F (0, T )e − r (T −t ) = 3,700 e −0.017 [1.5−(2 12 )] − 3,600 e −0.04931[1.5−(2 12 )] = 246 .15
c c

Correct Answer: A
Marshall is correct with respect to Analysis 1. The forward price is calculated by

compounding the spot price at the risk-free rate. Therefore, the pricing of the forward
contract assumes that S0 units of currency are invested in the asset which is designed to earn
the risk-free rate.
Marshall is also correct with respect to Analysis 2. The sale of a forward contract on an asset
position is priced assuming that the spot price is invested in a risk-free bond that pays F(0,T)
at time T.

Correct Answer: A
The forward contract on the ABC Inc. stock is an off-market FRA as the initial value if
intentionally set at a nonzero value. The forward contract price on off-market forwards is
determined in the process of negotiation between two parties and not by discounting the price
of the asset at the risk-free rate.

Correct Answer: A
Miller’s statement 1 is correct and statement 2 is incorrect.

Eurodollar time deposits are dollar loans made by one bank to another. Although the term Eurodollars
refers to dollar denominated loans, similar loans exist in other currencies. The primary Eurodollar rate
is called Libor.
Correct Answer: C
The formula used to calculate the futures price of a futures bond contract is:
B C 0 (T + Y )[1 + r0 (T )] − FV (CI ,0, T )
T
f 0 (T ) =
CF (T )
Where T = 2.25
FV (CI ,0, T ) = $45(1.0525) + $45(1.0525) + $45(1.0525) + $45(1.0525) = $189.5275 ≈ $189.53
1.75 1.25 0.75 0.25
BC0 (T + Y) = $1,127.95 [N = 10 (5×2); I/Y = 3% (6%/2); PMT = $45 (9%/2 × $1,000); FV = $1,000;
PV = X)
$1,127.95(1 + 5.25% ) − $189.53

2.25
f 0 (2.25) = = $614.8857 ≈ $614.89
1.75

Correct Answer: B
Observation 1:
If the futures price for a bond futures contract is higher than the no-arbitrage futures price,
opportunities for arbitrage profits exist. The investor can buy the bond and sell futures to earn more
than the risk free rate. On the other hand when the futures price is lower than the no-arbitrage price,
investors can sell short the bond and undertake a long position in futures. However, the latter
transaction may become difficult unless the bond underlying the long futures contract (from which
the arbitrage was computed) remains the cheapest to deliver. If that is not the case, the short
(counterparty to the long) will not deliver the bond and the arbitrage will not be successful. Thus
there is no guarantee that the short will deliver the same cheapest to deliver bond (cheapest at the time
of contract initiation) and this situation constrains the arbitrage transaction. Melton is inaccurate with
respect to observation 1.
Observation 2:
If a futures contract has many deliverable bonds and the bond underlying such a contract is delivered,
the long pays an amount equal to the futures price multiplied by the conversion factor. The
conversion factor adjustment does not add risk to the risk-free transaction. Melton is accurate with
respect to observation 2.


Correct Answer: C
The unusual construction of the Euro-dollar futures contract relative to the Euro-dollar spot market
means that no-risk free combination of a Euro-dollar time deposit and a Euro-dollar futures contract
can be constructed. The Euro-dollar is a time deposit and an add-on instrument whereas the Euro-
dollar futures contract is structured like a T-bill. Thus Melton is correct with respect to this comment.
Although the mismatch of the design of the spot and futures instruments in the Euro-dollar market
make the contract difficult to use for hedging purposes, but the Eurodollar futures can still be used a
hedging instrument. This is because an increase (decrease) in interest rates will decrease (increase)
the value of the time deposit but increase (decrease) the payoff from the Euro-dollar futures contract.
Thus the hedge can be quite effective even if it is not perfect. Melton has incorrectly stated that
hedging using Euro-dollar futures will be ineffective.

Correct Answer: C
The formula used to calculate the continuously compounded dividend yield is δ = ln(1 + δ ) . Since
C
the information given on the S&P 500 concerns discrete dividends, the formula used to calculate δ is:
1 FV (D,0, T )
= 1−
(1 + δ )T
S 0 (1 + r )
T
To obtain δ , the following formula is used: δ C = (1 T )ln(1 + δ )

C T
Using the information on Sweeney’s futures investment, the contnuousy compounded dividend yield
is calculated below.
T = 0.3479 (127/365)
1 $2.54
= 1− = 0.998374 ≈ 0.9984
(1 + δ )T
1,534.65(1 + 5.25% )
0.3479
The inverse of this will produce (1 + δ ) . Thus 1/0.9984 = 1.0016

T
ln(1.0016)
δC = = 0.004595 ≈ 0.460%
0.3479

Correct Answer: A
Prior to determining the optimal strategy to follow, it is necessary to determine the no-arbitrage
futures price for the pound sterling futures contract. The general formula used is:
 S0 
f 0 (T ) =  (1 + r )T
(
 1+ r C
 )
T 

T = 56/365 = 0.1534
f 0 (0.1534) = (1.05)0.1534 = $1.5977 (the no-arbitrage futures price)
$1.60
(1.06)0.1534

The current futures price is $1.78. Thus the futures contract is overpriced and if Swanson wishes to
engage in a risk-free arbitrage, the contract should be sold. However prior to selling the futures
contract the number of currency units, which need to be purchased, should be determined. The
number of currency units to purchase is:
1
= 0.9911 which will cost 0.9911($1.60) = $1.5858. Thus $1.5856 units are purchased
(1.06)0.1534
and the futures contract is sold at $1.78. During the life of the contract, 0.9911 currency units will
grow to 1 currency unit as the futures price converges to the spot price and equals it during expiration.
At expiration, the pounds are converted to dollars at the futures rate, $1.78. Thus the return per dollar
1.78
invested is = 1.1225
1.5856
Thus a return of 1.1225 is earned on each dollar invested over the 56-day period. In contrast, the risk-
free return earned on a risk-free investment (the no-arbitrage return on a futures contract) over the 56-
day period 1.0075 = (1.05)0.1534. Thus the return earned over the 56-day period is 0.1150 (1.1225 –
1.0075) or 11.50% higher and Swanson should undertake the arbitrage strategy.

Correct Answer: A
In general, if interest rates are positively correlated with futures prices, traders with long positions
will prefer futures over forwards because they will generate gains when interest rate are going up, and
traders can invest those gains for higher returns. Thus the marking to market of futures become more
attractive. Conversely, when interest rates go down investors can borrow to cover the losses at lower
rates.
In contrast when futures prices are negatively correlated with interest rates, traders will not prefer to
mark to market so forward contracts will carry higher prices.
Since Swanson has only held a long position in Dutch equity futures over quarters 5 and 6, the data
over the quarters 1-4 is not necessary for analysis in this context.
The correlations between interest rates and equity futures prices have been positive over Q5 and Q6
(0.04 and 0.35, respectively). Being long in the Dutch equity futures, Swanson would continue to
prefer futures over forwards as the rising futures prices imply a gain upon the marking to market of
her futures position and the rising rates imply that these gains are reinvested at higher rates.

Correct Answer: C
Osborne’s opening statement is only correct with respect to the equivalence of futures to a spot
transaction. Because the futures price converges to the spot price on expiration date, the purchase of a
futures contract which expires immediately is equivalent to purchasing the underlying in the spot
market.
Osborne is incorrect in stating that the futures price converges to the spot price each time the account
is marked to market. Convergence only takes place on the expiration date.


Correct Answer: C
The value of a futures contract before it has been market to market is the gain or loss accumulated
since the account was last market to market. At 12:00 hours on Day 2, the futures contract is in
between two marked to market days. Therefore, the value of the futures contract at this time is equal
to the difference in prices on Day 1 on market close (at 17:00 hours) and on Day 2 at 12:00, $50 –
$46 = $4.

Correct Answer: C
Based on a current spot price of $48, the no-arbitrage price of a 3-month futures contract should equal
to $48.3560 ($48 × 1.030.25). At $49, the futures contract is overpriced. To exploit the arbitrage
opportunity, the futures contract should be sold and the underlying asset purchased. At the expiration
of the contract, $0.36 ($48 × 0.03 × 3/12) represents interest lost from the $48 tied in the asset.
On expiration date:
Profit on futures = ST – $49
Total profit = $49 – $48 – $0.36 = $0.64

Correct Answer: A
A is correct. The future value difference between storage costs and the convenience yield is indicative
of either backwardation or contango. If this difference is positive, storage costs exceed the
convenience yield thereby increasing the futures price relative to the current spot price and indicating
that the futures market is in contango.
C is incorrect. The relationship between the futures price and expected spot price is indicative of the
existence of normal backwardation or normal contango.

Correct Answer: A
Given that the transaction is assumed to be risk-free, the risk premium is zero and the current spot
price is calculated using the following formula:
S T − FV (CB ,0, T ) $ 39 .24 − 12 .60

S0 = = = $ 26 .249 or $26.25
(1 + r )T (1.03 )0.5


Correct Answer: B
Osborne is correct with respect to her statement while Lester is incorrect with respect to his statement.
Eurodollar futures serve as imperfect hedges because they are structured like a T-bill contract - as
though the underlying were a discount instrument. On the other hand, the Eurodollar time deposit is
an add-on instrument. A mismatch between the spot market and futures contract results in an
imperfect hedge between the two. However, this does not mean that Eurodollars futures are an
ineffective hedging tool.

Correct Answer: C
The currency futures contract is overpriced based on a comparison between the current and
no-arbitrage futures prices (€0.9398 vs. €0.9262). Therefore, an arbitrage strategy would
involve selling the USD currency futures and buying the underlying USD.

Correct Answer: B
Given that the current futures price exceeds the no-arbitrage price, the following steps need
to be followed as part of a strategy to earn a risk-free profit:
Step 1:
Buy 1/(1.042)165/360 = 0.98132 units today which should cost 0.98132(€0.92) = €0.902814
Step 2:
Invest the 0.98132 units at the US risk-free rate of 4.2% for 165 days. The amount will grow
to 1.00000 units.
Step 3:
Enter into currency futures to convert the USD to EUR at a rate of €0.9398.
Return per € invested over 165 days is 0.9398/0.902814 – 1 = 0.040967 or 4.0967%. The
domestic risk-free rate over 165 days is (1.0575)165/360 – 1 = 2.596%. The arbitrage
transaction is much better as the return exceeds the domestic risk-free rate by 1.500%.

Correct Answer: B
The bond pays coupons semi-annually (6 months apart) at a rate of 4.75%. Four coupon
payments will be received over the maturity of the 1.75-years futures contract. The
accumulated interest on these coupon payments is:
€4.75(1.04)1.25 + €4.75(1.04)0.75 + €4.75(1.04)0.25 = €14.67728
f(2) = €102.72(1.0575)1.75 – €14.67728 = €98.60


Correct Answer: B
The amount which the long must pay the short when the underlying bond is delivered is
equal to the product of the futures price and conversion factor, f(0) × CF.

Correct Answer: B
B is correct. The delivery option permits the party holding the short position with the
flexibility in deciding which bond to deliver.

Correct Answer: B
If the arbitrageur buys the futures contract and sells short the underlying, (s) he must be
reasonably assured that the short will deliver the bond from which the potential arbitrage
profit is computed. The CTD bond has a tendency to change over the course of time and if
the bond on which the profit was computed is no longer the CTD bond, the short will not
deliver this bond and the arbitrage will not be successful.

Reading 40 Valuation of Contingent Claims FinQuiz.com
FinQuiz.com
Study Session 14
June 2019


Reading 40: Valuation of Contingent Claims

Correct Answer: A
Rogers is accurate regarding Statement 1 and inaccurate regarding Statement 2. The

probability used in the expectations approach is determined objectively and is not based on
an investor’s personal views regarding risk preferences. The expectations approach
discounts all cash flows using an estimated risk-free interest rate.

Correct Answer: B
B is correct. Knight is incorrect regarding his analysis of how option values are derived
when the expectations approach is used within the binomial model framework to determine
call option values at each node. The formula for deriving call option value at each node
using the expectations approach is:
c = PV[πc+ + (1 – π)c-]
This formula demonstrates that the call option value at Time 0 is equal to the present value
of the cash flows or call option payoffs at Time 1 using a risk-neutral probability (π).
C is incorrect. The statement summarizes how option values are estimated when the no-
arbitrage approach is used within a binomial model framework.

Correct Answer: B
B is correct. The formula for deriving the call option value at Time 0 using the expectations
approach is:
c = PV[π2c++ + 2π(1 – π)c+– + (1 – π)2c– –]

π = (1 + r – d)/(u – d) = (1 + 0.10 – 0.65)/(1.50 – 0.65) = 0.5294
c++ = Max(0, Su2 – X) = Max[0, $180 – $80] = $100.00
c+- = Max(0, Sud – X) = Max[0, ($80 × 1.50 × 0.65) – $80] = $0
c-- = Max(0, Sd2 – X) = Max [0, ($80 × 0.652) – $80] = $0
c = 1/(1.10)2[(0.52942 × $100) + 2(0.5294)(1 – 0.5294)($0) + (1 – 0.5294)2($0) = $23.1623
≈ $23.16

Correct Answer: C
C is correct. An American call option will give the option holder the right to exercise early,
purchase the underlying before it goes ex-dividend, and capture the dividend payment. Note
that the call option is only in the money at Node 2 and therefore the value of the call option at
Node 3 is ignored.
The present value of the dividend payment at Time 0 is $4.5455 ($5/1.10). The value of the
stock without dividends at Node 2 is $113.1818 [($80 – $4.5455) × 1.50]. The exercise value
of the call option including dividends at Node 2 is $38.1818 [Max 0, ($113.1818 + $5) –
$80] ≈ $38.18.

Correct Answer: C
The carry benefit is equal to the foreign currency risk-free rate, which in this case is the US$
risk-free rate of 0.50%.

Correct Answer: C
C is correct. The term N(d2) is interpreted as the probability that the call option expires in the
money and is calculated as N(d2) = 1 – N(-d2). Therefore, the probability that the ¥ call
option will expire in the money is 51.70% [(1 – 0.4830) × 100].


Correct Answer: A
In order to determine the intrinsic value of the call option, the following steps need to be followed:
Step 1: Determine u & d.

u = 1.45 (1+ 45%)
d = 0.75 (1 – 25%)
Step 2: Determine S+ and S-.

S+ = €65 (1.45) = €94.25
S- = €65 (0.75) = €48.75
Step 3: Determine c+ and c- (values of the option at expiration)

c+ = Max(0,94.25 – 70) = €24.25
c- = Max(0,48.75 – 70) = €0
Step 4: Determine the risk-neutral probability.

1.05 − 0.75
π= = 0.428571 ≈ 0.4286
1.45 − 0.75
1 – π = 0.5714
Step 5: Determine the price of the call today (c).

0.4286(24.25) + 0.5714(0)
c= = 9.89619 ≈ 9.90
1.05

Correct Answer: C
At €13, the call is overpriced (relative to €9.90). Thus, the calls will need to be sold. The number of
calls which need to be sold for 1 unit of the underlying stock (n) is determined by the following
formula:
c+ − c− 24 .25 − 0
n= + −
= = 0.532967 ≈ 0.5330
S −S 94 .25 − 48 .75
Reginald should purchase 533 (0.5330 × 1,000) units of Jasper Inc.’s stocks and sell 1,000 calls. The
outlay/net cash flow is:
Sell 1,000 calls at €13 +13,000

Buy 533 units of Jasper Inc.’s stocks at €65 –34,650
Net cash flow –21,645
The initial outlay is €21,645. The value of the investment at expiration will be
If ST = 94.25
533(94.25) – 1,000(24.25) = €25,985.25
If ST = 48.75
533(48.75) – 1,000(0) = €25,983.75
The rate of return is thus 20.05% = (25,985.25/21,645 – 1)


Correct Answer: B
Based on Ramirez’s expectations regarding the acceptance of E&E Agriculture and the projected drop
in stock price, Ramirez should purchase a put option on Jasper Inc.’s stock holdings. This will protect
the stock investment from a fall in stock price and give Ramirez the flexibility to benefit from an
increase in stock price (by letting the option expire).
Buying a call option is not the best course of action as it will provide a limited payoff if stock prices
rise above the exercise price (ST – X), whereas the put option will provide unlimited payoff.
Additionally, the call will not provide adequate protection if the stock price falls below the exercise
price.
Selling a call option is not the best course of action because if the stock price falls below the exercise,
the counterparty will not exercise the option leaving Ramirez (as the option writer) with the option
premium as profit (which will be insufficient to cover the loss on the stock investment). If price rises
above the exercise price, the counterparty will exercise the call and Ramirez will be responsible for
paying the difference between the stock price and exercise price.

Correct Answer: A
Assumption 1: The Black-Scholes-Merton model assumes that the risk-free rate is not random and is
constant. Thus assumption 1 is partially incorrect.
Assumption 2: The basic model does not take into account the cash flows generate by the underlying
asset but the model can be modified by adjusting the spot price of the underlying asset. Assumption 2
is accurate.

Correct Answer: B
Volatility is the only variable in the option pricing model which cannot be directly observed and
easily obtained. Thus Ramirez is correct with respect to this statement.
The benefit of using the historical method to estimate volatility is that is based on factual data (what
happened in the past). However in order to get the estimate, a large amount of data is required. This
means some of the data needs to be obtained by going far back into the past. The drawback of doing
so is that the data loses its relevance and the volatility estimate becomes less reliable. Thus Ramirez
has inaccurately pointed out the ability of this method to produce reliable estimates.
The drawback of using the implied volatility method to estimate volatility is that it assumes that the
market correctly prices the options, which makes it difficult to identify mispriced options. Thus the
drawback of the implied volatility method has been accurately illustrated.


Correct Answer: B
The formula to calculate the put option value using the put-call-forward parity is:
p0 = c0 + [X − F (0,T )]/(1 + r )
T
P0 = 70.50 + [70 – 100.89]/(1.05)1.5 = 41.789949 ≈ €41.79
The current put price is €65.45. Relative to the price of the put obtained from the put-call-forward
parity, the put is overpriced. The appropriate (arbitrage) strategy is to sell the put and purchase the
synthetic put. To buy the synthetic put it is necessary go long the call, short the forward contract and
hold a bond with a face value of X – F (0,T). The payoff from the transaction at the start of the
contract is:
Sell put + 65.45

Buy call (70.50)
Buy Bond – (70 – 100.89)/(1.05)1.5
€23.66

Correct Answer: B
The speaker is inaccurate with respect to technique 1. A synthetic bond position is created by
combining a long put (buying a put option), a long position in the underlying asset (purchasing the
underlying stock), and a short call position (selling a call option). Although this technique is easily
applicable to European options, put-call parity with respect to American options is considerably more
complex. The resulting parity equation is a complex combination of inequalities. Thus, it cannot be
concluded that a given combination exactly equals another combination.
X/(1+r)T = p0+S0–c0
The speaker is accurate with respect to technique 2. A pay-fixed, receive-equity swap can be
replicated by issuing a fixed-rate bond and using the issuance proceeds to purchase either stock or an
index portfolio.

Correct Answer: A
The most appropriate strategy would be buying the synthetic call or selling the synthetic put.
Using the put-call parity, the synthetic call and put prices are calculated as follows:
c0 = p0 + S0 – X/(1+r)T
= $5.15 + $68.60 – $65/(1.025)150/365
= $9.4063
p0 = c0 + X/(1+r)T – S0
= $9.66 + $65/(1.025)150/365 – $68.60
= $5.4037

The actual call is worth $9.66 while the synthetic call is worth $9.41. The appropriate strategy would
be to buy the synthetic call.
The actual put is worth $5.15 while the synthetic put is worth $5.40. The appropriate strategy would
be to sell the synthetic put.

Correct Answer: A
The put option with the lowest put price is option J. The put option price, using the Black-Scholes-
Merton model is calculated using the following formula:
‫ ݁ܺ = ݌‬ሾ1 − ܰሺ݀ ሻሿ − ܵ ሾ1 − ܰሺ݀ ሻሿ

೎
The continuously compounded risk-free rate, rC, is 2.469% [In (1 .025)].
ܲ
= $54.00݁ .×/ ሾ1 − 0.5714ሿ − 55.25ሾ1 − 0.6293ሿ
= $2.29
.×
ఴ
ܲ
= $55.25݁ భమ ሾ1 − 0.5120ሿ − 55.25ሾ1 − 0.5714ሿ
= $2.84

Correct Answer: C
If BC’s share price declines by $15, the approximate new put option price of an option identical to M
is $65.45.
Delta can be obtained approximately from the Black-Scholes-Merton formula as N(d1) for calls and
N(d1) – 1 for puts.
Given that option M’s call option delta N(d1), is 0.6368, the put option delta is approximately –
0.3632 (0.6368 – 1).
The relation between the change in underlying asset price, delta, and change in option price is
captured by the following equation:
Change in option price = Delta × change in underlying asset price
For a $15 decline in BC’s share price, the approximate new put option price is $65.45;
Change in put option price = − 0.3632 × − $15
= $5.448
Approximate new put option price = $60.00 + $5.448

= $65.448


Correct Answer: B
Greene has correctly identified implication 1. As the options on BC’s shares are European options,
the price of European options on assets such as corporate shares are not very sensitive to the risk-free
rate. Therefore, a change in the risk-free rate (either increase or decrease) should not have much
impact on the price of the option identified by Greene.
Greene has incorrectly identified implication 2. With respect to call option, longer the time to
expiration, higher will be the option price. Extending the expiration date of call option L from eight to
ten months should increase the price.

Correct Answer: C
In order to estimate historical volatility, recent past stock price data is obtained. This price data is
converted into returns then compounded continuously. Next, continuous returns’ variation is
calculated. Since price data is on monthly basis, the variance is multiplied by 12 to convert into
annual standard deviation.
This is a technique that may be used as a starting point to estimate future volatility. It is a valid
volatility estimation technique.

Correct Answer: B
P++ = [Min (0, Strike Rate – Reference rate)]/ (1+r)
= Min (0, 0.1412-0.1200)/1.1412=0
P+-/P-+ = [Min (0, Strike Rate – Reference rate)]/ (1+r)

= Min (0, 0.1150-0.1200)/1.1150 = 0.004484
P-- = [Min (0, Strike Rate – Reference rate)]/ (1+r)

= Min (0, 0.0810-0.1200)/1.081= 0.0361
P+ = [ProbA(P++ Value) + ProbB(P+-Value)]/(1+r)

= [0.5(0.0) + 0.5 (0.004484)/1.1305 = 0.002242/1.1305 = 0.001983
P– = [ProbA(P++ Value) + ProbB(P-+Value)]/(1+r)= [0.5(0.004484) + 0.5(0.0361)]/1.0905

= 0.020292/1.0905
= 0.018608
Option price at T0 = {0.5(0.001983) + 0.5(0.018608)}/1.1225

= 0.010296/1.1225= 0.009172


Correct Answer: A
P+ = [Min (0, Strike Rate – Reference rate)]/ (1+r)
= Min (0, 0.1305 – 0.1200)/ 1.1305 = 0
P– = [Min (0, Strike Rate – Reference rate)]/ (1+r)

= Min (0, 0.0905 – 0.1200)/ 1.0905 = 0.0295/1.0905 = 0.027052
T0 price of 1 year floorlet = {ProbA(P+Value) + ProbB(P-Value)}/(1+r)
= {0.5(0) + 0.5(0.027052)}/ 1.1225 = 0.01205
T0 price of floor = T0 price of one-year floorlet+ T0 price of two-year floorlet = 0.01205 + 0.0092
= 0.02125

Correct Answer: A
Fundamental Price Market Price Conclusion

One Year Floorlet 1.21% 1.00% Underpriced
Two Year Floorlet 0.92% 0.60% Underpriced
Two Year Floor 2.13% 2.36% Overpriced

Correct Answer: B
American options are worth more as they would be able to lock in prices in case of future default.
European Options do not carry that added feature of early exercise and are therefore lower in price.

Correct Answer: A
Effective hedging nets off trading costs against benefits derived through risk reduction. This trade-off
is necessary to generate an overall positive return.

Correct Answer: A
The exercise price of the call option, the put option and the face value of the risk-free bond are the
same.

Correct Answer: A
A higher payout ratio will decrease the value of the underlying asset which will subsequently increase
the value of a put option.

Correct Answer: B
Options are not solely standardized contracts. They may be standardized or customized.


Correct Answer: B
S0 × e–(D × T) = 235 × e (–0.55) = $222.42

Correct Answer: A
The option price derived through the BSM model is relatively overvalued as compared to the market.
Through backward calculations on the current market price, calculate the implied volatility rate. To
calculate a lower option price, use a lower volatility rate; as volatility rates and option prices are
positively correlated.

Correct Answer: B
P/E = D/Y × [(1+g)/Ke-g]
A lower p/e ratio is the only deduction which results from a reduced growth rate. Reduced growth
rates would lead to an increase in payout ratios.

Correct Answer: A
The Black Model on forward and future contracts is applicable only to European Options.

Correct Answer: A
p0 = c + [(X – F)/ (1 + R)T]
p0 = 20 + [(92.50 – 105.25)/(1.07)3]
p0 = 20 + [–10.41] = $9.60
Currently trading at $6.00

Underpriced by $3.40

Correct Answer: A
F = (P0 – C0)(1+ R)T + X
Ft = (6 – 20) (1.07)3 + (92.5)
Ft = $75.35

Correct Answer: A
As the forward is underpriced, Hall would advise the firm to buy the forward and sell the synthetic
forward.


Correct Answer: A
If St<$92.50 St>$92.50
Short Call 0 -(St-$92.50)
Long Put $92.50-St 0
Short Bond $105.25-$92.50 $105.25-$92.50
Long Forward St-$105.25 St-$105.25
Payoff at Expiration 0 0

Correct Answer: A
The constant rebalancing necessary for dynamic hedging helps hedge the fluctuations in value. When
the dynamic hedging is not applied, greater fluctuations in value are allowed without any action being
taken.

Correct Answer: A
When the trading option and the value derived through the BSM rate are equal, it is assumed that the
hedging portfolio is earning the risk-free rate.

Correct Answer: C
Time decay is unfavorable for the buyer of the option as he generates decreased opportunity savings
from his position. The seller of the option, in turn, is positively affected through decreased time
remaining as he has to pay less opportunity cost.

Correct Answer: C
A gamma value that is relatively smaller than other options helps in hedging a larger amount of the
underlying asset, as a small gamma value indicates a stable delta.
A large gamma value effectively points towards a volatile option delta. This highly fluctuating delta
would not be able to hedge a large price change in the underlying stock and would require frequent
portfolio rebalancing

Correct Answer: C
Vega is highest for at the money options, but the first excerpt does not touch upon the moneyness
concept at all. Vega is not linked to either increase or decrease in an option’s price, but its moneyness
at the particular price.


Correct Answer: B
Call Option Delta = 0.75/5 = 0.15

Correct Answer: B
Number of Put Options Needed = 500000/0.85 = 588235

Correct Answer: A
An arbitrage opportunity exists if the underlying asset performs better than the risk-free rate. This
opportunity can be availed through buying the underlying and financing this investment through
borrowing at the risk-free rate. This makes it possible to generate an unlimited amount of money.

Correct Answer: C
An increase in volatility results in the increase in both call and put option values.

Correct Answer: B
The underlying asset’s price will decrease by the PV of cash flows. A decrease in the underlying
asset’s price leads to an increase in put option value.

Correct Answer: B
European put options may either be higher or lower with greater time remaining to expiration.

Correct Answer: C
The volatility is assumed to be constant to facilitate its inclusion in the model. The concept that this
reason is why only European Options can be valued through the BSM is baseless.

Correct Answer: B
The BSM calls for unrestricted selling of stock, with freedom of full use of short sale proceeds.
Derivative prices would not be affected by short selling of underlying stock.

Correct Answer: A
The existence of cash flows from the underlying asset give the holder sufficient reason to exercise the
option early. The holder of an option on a stock would prefer the right to exercise just before the
stock goes ex-dividend. Through this process, the holder foregoes the time value but captures the
dividend.


Correct Answer: A
Gamma values of both call and put options are at their maximum when the options are at-the-money
and close to expiration.

Correct Answer: C
Only at-the-money options have a high gamma value. Deep-in-the-money options have low gamma
ratios.

Correct Answer: B
Deep-in-the-money put options have a positive theta given that they are characterized by:
• low time remaining to maturity, so that there are less chances of the option decreasing in value.
• high interest rates, so that the money generated through options can be reinvested at a high rate to
generate greater income.
• low volatility rates, so that there are less chances of fluctuations that will take the option to an at-
the- money or out-of-the-money scenario.

Correct Answer: C
The time decay of an option leads to a decrease in the option value. However, an increase in the time
to maturity results in an increase in option value.

Correct Answer: C
The risk free rate for a put option is negative as it signifies the lost interest because of the delayed
availability of cash.

Correct Answer: B
A fiduciary call is the greater of the exercise price of the option or the price of the underlying asset.
If St < X, the call value is zero and the bond would be worth X.
If St > X, the call is worth St-X and the bond is


Correct Answer: C
Fact 1: Swap contracts can be thought of as equivalent to forwards and futures. In the case of
forwards, swaps are different from forward contracts in that swaps call for a series of equal payments
whereas forward contracts are almost always priced at different fixed rates. It is common to think of
swaps as a series of forward rate agreements all priced at the swap fixed rate and not the rate they
would normally be priced in the market. Thus forwards can be used to construct swaps.
Swaps can be thought of as equivalent to futures contracts if the future interest rates are certain
(which makes them equivalent to forward contracts). However, this is not typically the case as future
interest rate are almost always uncertain. Futures can be used to construct swaps provided interest
rates are certain.
Thus fact 1 has been accurately outlined.
Fact 2: A swap can be constructed from a combination of options with expiration dates corresponding
to the settlement dates of the swap. A pay fixed swap can be thought of as equivalent to buying a call
option and selling a put option. This is because if interest rates rise, the call option holder receives the
difference between the strike rate and current market rate. Similarly the pay-fixed party in the swap
receives a payment equal to the difference between the floating payment and fixed rate in the swap. If
interest rates go down, the seller of a put option pays the difference. Similarly the pay-fixed side pays
the floating side of the swap the difference between the floating and fixed rate.
Thus fact 2 has been accurately outlined.

Correct Answer: C
Based on the CEO’s statement, “We need a strategy which will protect us from the effects of rising
interest rates on borrowing costs”, the best course of action will be to enter into a transaction that will
allow the party to pay a fixed rate of interest regardless of the movements in interest rates. The best
swap contract for Furnace Works Ltd. to undertake is a pay fixed/receive floating swap which ensures
the company pays a fixed rate of interest and compensates it if interest rates rise above the fixed rate
(by making a net payment).
The value of the swap at contract initiation is always zero. Since the swap transaction recommended
by the executive has not yet begun, it will have a market value of zero.


Correct Answer: B
In order to value the swap, the following steps will be followed:
Step 1: Determine the Euro discount factors

1
B180€ =
(
1 + 3% ×180
360
) = 0.98522167
1
B360€ =
(
1 + 3.12% × 360
360
) = 0.96974399
1
B540€ =
(
1 + 3.25% × 540
360
) = 0.95351609
Step 2: Determine the present value (PV) of the fixed payments in Euros.
The fixed rate (given) paid by Beta Build on the swap is 3.45%. The non-annualized rate is 1.725%
(3.45%/2).
Thus, PV Fixed Payments = €0.01725(0.98522167 + 0.96974399 + 0.95351609) + €1.0(0.95351609)

= €1.00368740.
Step 3: Determine the total PV of fixed payment in $.
The euro notional principal established at the start of the swap is calculated as $25 million/0.85
The total euro fixed payments are converted to $ at the new exchange rate. Thus the total PV of fixed
payments paid by Beta Build is $26,568,195.89 (€1.00368740)($25,000,000/0.85)($0.90)
Step 4: Determine the total PV of floating payments paid by Alpha Corp. in U.S. $.
The PV of floating rate payments is simply $1.0 multiplied by the notional principal as floating rate
bonds re-set at each swap payment date (which corresponds to the 180th day in this case). Thus the
total PV of floating payments is $25,000,000.
Step 5: Determine the value of the swap.
Since Beta Build pays the fixed rate and receives the floating rate, the value of the swap to Beta Build
will be $25,000,000 – $26,568,195.89 = –$1,568,195.89 ≈ –$1,600,000


Correct Answer: A
The motives behind using a swaption include:
• they are used to terminate an existing swap – a party holding a pay floating/receive fixed swap
will enter into a payer swaption, and not a receiver swaption, to terminate the existing swap.
• they are used by parties who anticipate the need for a swap at a future date but wish to secure a
fixed rate today, while retaining the flexibility to not engage in the swap at a later date or engage
in a swap at a more favorable rate in the market. Thus a corporation may want to secure its
borrowing costs today by securing a fixed rate on a swap, which may be needed in the future.
• they are used by parties to speculate on interest rates.

Correct Answer: B
In order to determine the best course of action to take the expiration of the receiver swaption, the
swap’s market rate will need to be calculated and compared to the exercise rate. If the exercise rate is
greater than the market rate, the swap should be exercised. This is because the swap will allow for the
receipt of a greater amount fixed payments relative to the rate achievable in the market.
1
(
1 + 4.55% + 90
360
) = 0.98875294
1
(
1 + 4.88% + 180
360
) = 0.97618118
1
(
1 + 4.90% + 270
360
) = 0.96455269
1
(
1 + 5.00% + 360
360
) = 0.95238095
1 − 0 .95238095
= 0.01226705
Market/Fixed rate = 0.98875294 + 097618118 + 0.96455269 + 0.95238095 or
1.23%.
Annualized market rate = 1.23% (360/90) = 4.92%
Compared to the exercise rate of 3%, the annualized market fixed rate is much higher. Thus the best
course of action would be to let the swaption expire at enter into a new swap at the current market
rate of 4.92% to receive a higher fixed rate.
Entering into the present swaption at a swap rate of 3% is not optimal as it will result in the receipt of
fixed payments at a rate lower than current annualized market swap rates (3% vs. 4.92%).
Rolling the present swaption into a new receiver swaption at the market rate is not optimal for the
same reasons and such a transaction may not exist (depending on local market factors).


Correct Answer: A
1
= 0.97549079
(
1+ 10.05% + 90
360 )
1
= 0.92732120
(
1+ 10.45% + 270
360 )
1
= 0.88368497
(
1+ 10.53% + 450
360 )
1− 0.88368497
= 0.0417424 or 4.17424%
0.97549079 + 092732120 + 0.88368497
The annual fixed rate is 8.35% (4.17424% × 360/180).

Correct Answer: A
Only the counterparty to which the greater amount is owed is exposed to credit risk in a swap.

Correct Answer: A
The payoffs from an interest bearing swaptions are similar to coupon bearing bonds.

Correct Answer: B
Change in Price of Call = Delta × Change in Price of Underlying

Correct Answer: A
Division of the expiration date into smaller units would lead to an increase in pricing accuracy as the
spreads will tighten.

Correct Answer: C
Similar to its use for European options on forwards and futures. The Black model can also be used for
the valuation of European options on interest rates. This is done through replacing the forward price
in the model by the forward interest rate.

Correct Answer: A
The statement is a detailed explanation of second generation derivatives based on the put-call-parity.


Correct Answer: C
Invoice price paid by the buyer to the seller = (Contract Size × Future Settlement Price × Conversion
Factor) + Accrued Interest
= ($100,000 × 92 18/32 × 2.8) + $5200 = $264,375

Correct Answer: B
Future Price = Converted Price/ Conversion Factor = $90.80/ 0.9421 = $96.38.

Correct Answer: C
Commercial banks occupy the largest segment in the CDS market.
Hedge funds are the largest growing participants of the CDS market.
Fund managers use the positions created by the CDS market to exploit mispricings.

Correct Answer: C
Fixed rate payer Swap is suitable as a hedging instrument for a floating rate borrower to hedge
interest rate risk.

Correct Answer: B
A fixed rate receiver swap is equivalent to a long interest rate put and a short interest rate call.
A fixed rate payer swap is equivalent to a long interest rate call and a short interest rate put.

Correct Answer: A
One of the reasons behind the referral of a swap as a series of off-market forward contracts is because
the swap fixed rate applied to the fixed leg of the calculation is equal to the average rate of on-market
FRAs.

Correct Answer: B
Currency swaps exchange notional principals at the end of the swap’s life and therefore, credit risk is
concentrated towards the middle and end of the swap’s life. Credit risk at contract initiation, which is
the current risk at the time of entry, is low otherwise parties would not be willing to enter into the
contract. Therefore, potential credit risk is higher relative to the current credit risk.

Correct Answer: A
While it is fairly common to view swaps as being equivalent to options and swaps, the equality of
swaps to futures contracts holds true only in very limited cases.

Correct Answer: B
Quarterly dollar swap fixed payment = 0.03/4 × $1 = $0.0075

Present value of dollar swap payments = $0.0075(0.99494 + 0.98945 + 0.97816 + 0.96823) +
$1(0.96823) = $0.997711
The dollar notional principal established at the start of the swap is $1.3333 (1/€0.75).
The current value of the fixed rate leg of the swap in Euros is $1.3333 × €0.80 × $0.997711 =
€1.064198
Present value of Euro swap payments = [€1 + (0.025 × 90/360)] × 0.99215 = €0.998351
Value of the pay $ fixed, receive € floating = €0.998351 – €1.064198 = - €0.065848 ≈ €0.0658

Correct Answer: A
The swap spread is not a measure of the credit risk of a given swap but a reflection of the credit risk
in the global economy. Therefore, one would expect swap spreads to widen as a result of economic
recession and remain unaffected by the credit risk of individual swap counterparties.

Correct Answer: B
Sports IMEX wants to protect its future investment from a loss in income which will result from a
decline in interest rates. To hedge against a decline in interest rates, the company should enter into a
receiver swaption which will allow the company to receive a fixed rate of interest and require it to
pay the floating rate.


Correct Answer: A
To calculate the swap fixed rate at day 360 (swaption expiration date), the discount factors are
calculated for the three years of the underlying swap’s tenor:
1
L (360) = = 0.966184
1 + (0.035)(360 / 360)
1
L (720) = = 0.926784
1 + (0.0395)(720 / 360)
1
L (1,080) = = 0.888099
1 + (0.042)(1,080 / 360)
1 − 0.888099
Swap fixed rate = = 0.040237 or 4.02%
(0.966184 + 0.926784 + 0.888099)
Maturity Rate (%)

(Days)
360 3.50
720 3.95
1,080 4.20
1,440 4.75

Correct Answer: C
Fixed Rate = [1–{1/ (1+360-day LIBOR)}]/ [{1/ (1+ 180-day LIBOR (n/360))} + {1/(1+ 360-day
LIBOR (n/360))}]
Fixed Rate = [1-{1/ (1.055}]/ [{1/ (1+0.052(180/360))} + {1/ (1+ 0.055(360/360))}]

= 0.027117
Annual Fixed Rate = 0.027117 × 2 = 5.4234%

Correct Answer: A
A plain vanilla currency swap pays floating on dollars and fixed on foreign. The floating rate cash
flows on the settlement date are based on the previous period’s ending floating interest rate.
Floating Rate Cash Flows = 0.06 × $2,000,000 = $120,000


Correct Answer: B
Fixed Rate Payments = 0.05 × (180/360) × $20,000,000 = $500,000
PV of remaining payments = $500,000/ (1+ 0.05 × (90/360)) + $20,500,000/ (1+ 0.054 × (270/360))
= $20,195,893
Floating payment in 90 days = 0.048 × (180/360) × $20,000,000 = $480,000
PV of floating payment = $480,000/ (1.0125) = $474,074
The second floating-rate payment combined with 1 at the end of the swap has a present value of 1 on
the first payment date. The present value of 1 is 1/ (1 + 0.05 × (90/360)) = 0.987654321 so the present
value of the second floating rate payment combined with the principal amount is
= 0.987654321 × $20,000,000
= $19,753,086
Total value = 19,753,086 + 474,074 = $20,227,159
The value of the swap to the fixed-rate payer is $20,227,159 – $20,195,893

= $31,266.

Correct Answer: B
A payer swaption will give Andrex the right to pay a lower fixed price if market rates increase.

Correct Answer: B
PV of fixed payments (CHF) = [(0.048(180/360))/ (1+0.048(90/360)] + [(1+0.048(180/360))/
(1+0.054(270/360)]
= 0.02372 + 0.98414
= 1.00786
Current exchange rate value = 1.00786 × 0.35

= $ 0.35275
Notional amount = 1,000,000/0.34

= CHF 2,941,176
$ value of CHF payments = $0.35275 × CHF 2,941,176

= $ 1,037,500
PV of fixed payments (USD) = [(0.052(180/360))/ (1+0.052(90/360)] + [(1+0.052(180/360))/

(1+0.054(270/360)]
= 0.02567 + 0.98606= 1.01173
Value = 1.01173 x 1,000,000 = 1,011,730

The value of the swap to the dollar payer is 1,037,500 – 1,011,730 = $25,770


Correct Answer: A
A swaption is like an option on a bond with payments equal to the fixed payments on the swap. It
can be used to hedge the rate on an anticipated swap transaction and can be used to offset a current
position in the swap.

Reading 41 Derivative Strategies FinQuiz.com
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Study Session 14
June 2019


Reading 41: Derivative Strategies

Correct Answer: B
An equity swap does not involve any initial outlay but involves an agreement by one party to
trade the return on a stock portfolio for the return of another asset. Therefore, this type of
agreement is the cheapest in terms of required initial investment amount.
Strategy 1 is relatively expensive compared to Strategy 2 as WLC will need to pay option
premium to purchase call options. Initial investment outlay = $0.85/call × 1,000
calls/contract × 125 contracts = $106,250
Strategy 3 is the most expensive out of the three as the initial investment cost is $2.5 million.

Correct Answer: A
A synthetic long call position is replicated from a long stock and long put position.

Correct Answer: A
Under the equity swap, WLC will receive the total return on the equity stock and pay the six-
month LIBOR.
Total stock return = [($21.00 – $20.00) + $0.30]/$20.00 = 0.065 or 6.50%
LIBOR return for the six-month period = 0.80%/2 = 0.40%
WLC will receive a net payment from the swap counterparty which amounts to (6.50% -
0.40%) × $2,500,000 = $152,500. Put another way, WLC will make a net payment of –
$152,500 to the swap counterparty.

Correct Answer: C
The put strategy executed by Rubin is described as a bear spread strategy as this position is
constructed by buying a put option with the higher exercise price of $40 and writing another
put option at the lower exercise price of $38.


Correct Answer: B
The maximum profit will occur when the underlying price is equal to or lower than the put
option with the lowest exercise price. If the underlying price is $38, the profit on each option
is as follows:
38-Put = - Max (0, X – ST) + premium = - Max [0, (38 – 38)] + $2.05 = $2.05
40-Put = Max (0, X – ST) + premium = Max [0, (40 – 38)] – $2.33 = - $0.33
Maximum gain = $2.05 – $0.33 = $1.72

Correct Answer: C
C is correct. A longer time to expiration would mean that there is a greater chance that the
option will move in the money, resulting in the option being exercised by the buyer and the
stock being called away from the writer.
A is incorrect. Based on the option prices in Exhibit 3 it is clearly evident that the option
writer can earn greater income from writing the longer-term option.
B is incorrect. Exercise value is the difference between the underlying price and exercise
price. Given that the underlying is expected to remain relatively constant, the exercise value
will also remain constant for the at-the-money call option under consideration.

Reading 42 Private Real Estate Investments FinQuiz.com
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Study Session 15
June 2019


Reading 42: Private Real Estate Investments

Correct Answer: B
Because they facilitate owner divisibility, publically traded real estate securities are relatively liquid
in contrast to their private counterparts.
However real estate performance has not been highly correlated with the performance of asset classes
such as stocks and bonds, so adding real estate helps to lower the risk of the portfolio (provide
diversification). This is true with regard to both publically and privately traded real estate and justifies
the addition of the asset class to existing client portfolios.
Private real estate is traded less often and is not publically traded. Therefore, there are an insufficient
amount of transactions from which prices can be determined. Thus privately traded real estate often
exhibits ‘stale’ prices, which do not reflect their actual values. On the other hand, because publically
traded real estate trade on formal exchanges, their prices are readily determinable.

Correct Answer: A
Hotels require the most day-to-day management. While shopping centers are relatively management
intensive, the level of active management required is relatively lower in comparison to hotels.

Correct Answer: C
For a property to make the highest and best possible use of its location, the value of the existing
building (excluding land value) should exceed the land value.
Property 1 Property 2 Property 3

Selling price $1,800,000 $25,000,000 $3,200,000
Vacant land value 1,000,000 14,850,000 $3,300,000
Value under existing use (building only) $800,000 $10,150,000 $(100,000)
Property 3 is not making the highest and best possible use as the value under existing use is
$(100,000). Thus Property 3 should be considered for demolition.

Correct Answer: A
The property is being valued using a rate of 13% discount rate. The implied 5% (13% – 8%) growth
rate being used is 3% higher than the rate at which NOI and property values are increasing. Holding
the discount rate constant, the denominator ‘r – g’ used to capitalize each year‘s NOI before resale is
lower when a 5% growth rate is used. This implies the appraiser is overvaluing the property.


Correct Answer: C
The implied going-in cap rate is 2% lower than the terminal cap rate. A lower going-in cap rate
implies:
• The markets are expected to be weaker in the future with lower expectations for rental growth
than in the current market. Investors are willing to pay a higher price for a property with greater
growth potential and therefore the current implied growth rate will be higher and going-in cap
rate lower in this scenario; or
• interest rates are expected to be higher in the future resulting in a higher terminal cap rate
therefore pushing up discount rates; and
• there is uncertainty of what NOI will be in the future which may result in the selection of a higher
terminal cap rate.

Correct Answer: A
The following steps need to be followed to determine the implied going-in cap rate:
Step 1: Estimate resale price after four years.

Resale or terminal cap rate = 15% – 4% = 11%
Resale value = $330,000/0.11 = $3,000,000
Step 2: Discount the level NOI for the first three years and the resale price:
PMT = $200,000
FV = $3,000,000
n=3
i = 15%
Solving for PV, the current value of the property is $2,429,194 and using the formula, going-in cap
rate = NOI/Market value, the implied going-cap rate is $200,000/$2,429,194 = 8.23%


Correct Answer: A
A is correct. The most appropriate form of real estate investment is REIT shares as management of
the underlying property is professionally managed and requires no real estate expertise on the part of
the investor in shares of REITs (Concern 1 is addressed). In addition, the shares of publically traded
REITs are traded in public markets and thus have greater liquidity making the asset class suitable for
Richards who has liquidity concerns (Concern 2 is addressed). REITs are a type of publically traded
equity investment. REIT shares are typically liquid and active trading results in prices that are more
likely to reflect market value (Concern 3 is addressed).

Correct Answer: B
Sheffield is accurate with respect to Drawback 1. Equity investors have a residual claim on real estate
and this value is equal to the value of the real estate less the amount owed to the mortgage lender.
C is incorrect. Equity investors are entitled to two income streams: an income stream resulting from
such activities as renting the property and a capital appreciation component resulting from changes in
the value of the underlying asset.

Correct Answer: C
C is correct. Sheffield is inaccurate with respect to drawback 2 because he has incorrectly stated that
equity real estate investments bring little to no diversification opportunities to a portfolio. Real estate
equity offers diversification benefits as it is less than perfectly correlated with stocks and bonds.
B is incorrect. Real estate investment returns are influenced by factors affecting the profitability of
companies leasing the space and the strength of the overall economy.

Correct Answer: B
Rental income at full occupancy (€45,860/0.50) €91,720

- Vacancy and collection losses €7,800
- Operating expenses €6,540
- Property management expenses €2,220
= NOI €75,160


Correct Answer: B
Value of property if renovated = [Stabilized NOI/(Discount rate – long-term growth rate)] - PV of

loss in income
= [€19,880/(0.10 – 0.06)] – €5,750 = €491,250

Correct Answer: B
If the value of a site under existing use (with the constructed property) is more than the land value,
the office complex should remain on site. Otherwise, the complex should be demolished.
Property 1 Property 2 Property 3

Value under existing use €400,000 €740,050 €185,100
Implied land value €380,000 €750,000 €181,050
Value of office complex €20,000 - €9,950 €4,050
The value of Property 2 has a negative implied building value indicating that the building should be
demolished.


Correct Answer: A
GIM = Sales price/gross income
GIM (Comparable 1) = $1,200,000/$750,000 = 1.60

GIM (Comparable 2) = $890,000/$428,080 = 2.08
GIM (Comparable 3) = $970,500/$576,050 = 1.68
GIM (Comparable 4) = $420,000/$380,900 = 1.10
Average GIM = (1.60 + 2.08 + 1.68 + 1.10)/4 = 1.615
Sales prices = 1.615 × $1,580,000 = $2,551,700 ≈ $2,552,000

Correct Answer: C
The GIM method does not consider explicitly vacancy rates and operating expenses and thus
implicitly assumes that the ratio of vacancy and expenses to gross income is similar for the
comparable and subject properties.

Correct Answer: C
C is correct. Unlike public equity real estate investments, privately traded equity investments do not
trade in public markets and are less likely to behave like the stock market. Therefore, one would
expect the individual correlations between private equity real estate and stocks and bonds to be lower
relative to the former type of equity real estate.
A is incorrect. A private equity investment in a hotel chain will require the investor to incur higher
property management expenses. In general, private equity real estate is more management intensive
compared to a public real estate equity investment. In the case of the latter, the underlying real estate
is professionally managed.
B is incorrect. Private real estate investments may receive a favorable tax treatment. Similarly,
publically traded REITs may also have some tax benefits in some countries. Therefore, there is no
distinct tax advantage of investing in private equity real estate.


Correct Answer: A
Stone has observed the terminal cap rate to be higher relative to the going-in cap rate. When this is
the case, the following holds true:
• interest rates are expected to be higher pushing up discount rates; therefore, the future
discount rates are expected to be higher or
• growth is expected to be lower as the property is older at the time of sale and the market
may not be competitive or
• there is greater uncertainty of what the NOI will be in the future compared to today.

Correct Answer: B
The following steps will be followed to estimate the current value of the real estate:
Step 1: Estimate resale price after four years:
Resale price = $250,000/(0.07) = $3,571,429
Step 2: Discount the level NOI for the first four years and the resale price:
PMT = $190,000
FV = $3,571,429
n=4
i = 10%
The current (present) value of the property is estimated to be $3,041,608.

Correct Answer: A
When the growth rate is equal to zero, the value of the property is calculated as: NOI/Discount rate.
Value = $190,000/0.10 = $1,900,000


Correct Answer: B
B is correct. The sales comparison approach cannot be used when there is a lack of comparable
properties being sold in the market. This makes the use of the cost approach more appropriate as it
does not rely on the sale of comparables.
C is incorrect. The cost approach relies on the replacement cost of property, which assumes it is built
today using current construction costs and standards. Therefore, when construction is no longer
feasible, the replacement cost will be difficult to determine, which in turn will make it difficult to
employ the cost approach for valuation.
A is incorrect. The discount rate is not used when valuing a property using the cost approach. Failing
to fully consider a property’s risk in the discount rate will result in the income approach producing an
incorrect value.

Correct Answer: C
$1,400,000
Replacement cost
Curable physical deterioration - $50,000
$1,350,000
Incurable deterioration [(8 – 6)/8] × $1,350,000 - $337,500
Economic obsolescence - $35,000
Incurable functional obsolescence ($4,950/0.10) - $49,500
Locational obsolescence ($320,000 – $30,000) - $290,000
Land value + $80,000
Final appraised value (land and building) $718,000
In addition to the data collected in Exhibit 1, Emmanuel makes the following observations:

Correct Answer: C
Observation 1 mandates that an environmental inspection should be conducted to determine the

impact of the contamination on property and land values.
Observation 2 mandates a property survey be done to determine whether the conversion activity is
conducted within the premises of the property.


Correct Answer: B
Subject Property 1 Property 2 Property 3

Property
Annual rental income per unit (p.u.) $1,200 $2,800 $3,000
Adjusted rental income p.u. $1,209.60 $2,954.00 $3,123
Average rental income p.u. $2,428.87
× Number of units 500
Appraised value $1,214,433

Correct Answer: C
C is correct. When a property is older, estimating depreciation and obsolescence becomes more
difficult. The cost approach will generate an unreliable estimate of value. Therefore, the approach will
be more reliable for newer properties that have a relatively modern design in a stable market.
B is incorrect. The sales comparison assumes that investors make rational purchase decisions.
Therefore, the sales comparison approach will be appropriate when this assumption holds.

Correct Answer: B
Since the loan will be advanced in accordance with a maximum loan to value ratio, the mortgage loan
amount is first calculated and then used to determine the loan to value ratio.
Return on equity = Cash flow/equity

Equity = $30,000/0.12 = $250,000
Equity = Price – Mortgage
Mortgage = $3,375,000 – $250,000 = $3,125,000
Loan-to-value ratio = $3,125,000/$3,375,000 = 0.9259 or 92.6%

Reading 43 Publicly Traded Real Estate Securities FinQuiz.com
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Study Session 15
June 2019


Reading 43: Publicly Traded Real Estate Securities

Correct Answer: B
The contractual nature of REITs' rental income combined with high income payout rates makes
REITs the most stable and highest yielding of publically traded equities.
A is incorrect. In general, publically traded real estate securities (equity REITs and REOCs) provide
the ability to trade on stock exchanges. Thus REITs and REOCs both provide liquidity.
C is incorrect. Because REITs are constrained in their operations, investment choices and
distributions, REITs are prevented from maximizing their returns.

Correct Answer: C
The most appropriate response to Concern 1 is Yes. The stock market value of publically traded
REITs is more volatile than the appraised net asset value of privately traded REITs. Net asset values
based on appraised values rather than actual transaction prices tend to underestimate volatility.
The most appropriate response to Concern 2 is No. Investments in publically traded REITs are not
suitable for investors seeking control over property-level investment decisions. Investors desiring
control should opt for a direct investment in the underlying property.

Correct Answer: C
NOI is a figure calculated before the deduction of general and administrative expenses.
A is incorrect. Insurance costs are incorporated in the NOI calculation and are thus an element of
AFFO.
B is incorrect. Straight-line rent is an element of NOI and AFFO. It is the average contractual rent
over a lease term. Subtracting cash rent paid from straight-line rent produces non-cash rent; thus
straight-line rent is the sum of cash rent paid and non-cash rent, in other words it is equivalent to the
gross rental revenue.


Correct Answer: C
Total NAV = $25.40 × 5,000,000 = $127,000,000
Total NAV = $25.40 × 5,000,000 $127,000,000

Plus: debt and other liabilities $2,345,000
Less: Prepaid and other assets $760,000
Less: Land held for future development $9,000,000
Less: Accounts receivable $2,125,000
Less: Cash and equivalents $120,000
Estimated value of operating real estate (1) $117,340,000
Assumed cap rate (2) 7%
Estimated next 12 months cash NOI (1 × 2) $8,213,800
Less: General and administration expenses $200,000
Less: interest expense $45,000
FFO $7,968,800
FFO per share ($7,968,800/5,000,000) $1.59376
P/FFO ($33.50/1.59376) 21.02x

Correct Answer: B
Residential REITs are most undervalued relative to their average subsector P/AFFO multiple.
To determine which type of REITs is most undervalued, it is necessary to determine the level of
discount to the average subsector P/AFFO:
Office Residential Healthcare

REITs' P/AFFO* 16.8x 15.3x 21.6x
Average subsector P/AFFO (given) 18.9x 17.7x 22.4x
REITs (Discount)/Premium to average subsector REITs (11.1%) (13.6%) (3.57%)
P/AFFO = Current share price/AFFO per share


Correct Answer: C
Healthcare REITs are the least desirable from an investment perspective.
Given that the economy is in an expansionary phase, short remaining lease terms provide mark-to-
market opportunities on term rent. All three properties have lease terms exceeding a year and are thus
almost equivalent in this respect; the three REITs do not provide attractive mark-to-market
opportunities.
Low-in place rents provide upside potential to cash flows upon lease re-negotiation while high in-
place rents represent additional risk to maintaining current cash flows. Office REITs and residential
REITs have low-in place rents and are desirable from this perspective while healthcare REITs are
least desirable.
The properties underlying office REITs have the highest percentage of tenant occupancy while
healthcare REITs' properties have the lowest percentage occupancy. Thus healthcare REITs are
undesirable from this perspective.
Based on in-place vs. market rent and percentage of occupied space, healthcare REITs are the least
desirable form of investment.


Correct Answer: A
A is correct. REIT shares can be traded on the stock exchange and therefore they provide greater
liquidity than buying and selling real estate in property markets. Due to their large lot sizes, a direct
investment in real estate represents a relatively illiquid form of investment.
B is incorrect. The maintenance of a REIT structure is costly and may not be offset by the benefits.
C is incorrect. The stock market of a REIT is more volatile than the appraised value of a REIT.
Therefore, one would expect the REIT shares to have higher price and return volatility.

Correct Answer: B
B is correct. Investment in REITs allows investors to diversify their real estate portfolios by
geography and property type. This type of diversification is hard to achieve in direct property
investing because of the large size and value of each property.
A is incorrect. Because REITs are associated with high dividend yields, there is less income available
for reinvestment. This low rate of reinvestment will reduce income growth potential.
C is incorrect. Because investors in REITs have their interests managed by professional managers,
control over property-level investment decisions no longer remains in their hands. This contrasts with
investors acquiring a direct investment in real estate; the latter are actively involved in the
management of the underlying property.

Correct Answer: B
B is correct. Trends in government funding influences the value of an investment in a health care
REIT and is not relevant for the purposes of analysis.
A is incorrect. Job creation will lead to an increase in the use of storage space as personal and small
businesses need space to rise.


Correct Answer: C
To determine whether the warehouse property is mispriced, the P/AFFO multiple of the property
relative to the average industry needs to be calculated and compared.
P/AFFO = Market price per share/[(NOI – General and administrative expenses – interest expense –
non-cash rent – maintenance-type capital expenditures)/Shares outstanding]
*Non-cash rent = Straight-line rent – cash rent
P/AFFO (Warehouse) = $47.56/[{$175,000 – $4,250 – $2,250 – ($40,000 – $35,000) –

$1,080}/52,000] = $15.23
P/AFFO (Average Industry) = $52.09/[{$180,000 – $4,780 – $1,890 – ($45,000 – $25,000) –

$2,010}/50,000] = $17.21
The warehouse appears to be relatively undervalued as it has a lower P/AFFO multiple compared to
the average industry.

Correct Answer: B
NAV = NOI/Market cap rate = $175,000/0.08 = $2,187,500
NAVPS = $2,187,500/52,000 = $42.07

Correct Answer: B
Lewis is inaccurate regarding to Reason 1. FFO estimates are readily available through market data
providers.
Lewis is accurate regarding Reason 2. Applying a multiple to the FFO and AFFO may not capture the
intrinsic value of real estate assets held by the REIT or REOC. An example of this includes a parcel
of land and empty building which do not produce current income and thus do not contribute to FFO
but have value.
Lewis is accurate regarding Reason 3. The recent increase in one-time items such as gains as well as
new revenue recognition rules have affected the income statement making the P/FFO and P/AFFO
multiples more difficult to compute and complicating comparisons between companies.


Correct Answer: A
The repositioning strategy will be dilutive to earnings because the cap rate at which the properties
will be sold is higher than yields at which they are reinvested reflecting lower risk premiums.
Therefore, the REIT will most likely face cash flow growth pressures in the near term as a material
portion of the portfolio is reinvested into higher-quality properties.

Correct Answer: B
Prior to discounting the dividends, the required rate of return will need to be determined
using CAPM:
Required rate of return = 2.20% + 0.65(6.85%) = 6.6525% = 6.6525%
Present value (PV) of Divided (2015) = $0.85/(1.066525) = $0.7970

PV of Dividend (2018) = $1.10/(1.066525)2 = $0.9671
PV of Dividend (2018) = $2.50/(1.066525)3 = $2.0608
PV of perpetual dividend in 2018 = $2.5(1.05)/(0.066525 – 0.05) = $158.85
PV of perpetual dividend today = $158.85/(1.066525)3 = $130.94
Current value of office REIT share = $0.7970 + $0.9671 + $2.0608 + $130.94 = $134.76

Correct Answer: A
A is correct. A higher long-term growth rate will decrease the cap rate and a lower cap rate will
increase the current value of each REIT share.

Intrinsic Value =
=
C is incorrect. Parking income (other income) increases the net operating income, which eventually
increases the intrinsic value of the property.


Correct Answer: B
B is correct. Observation 1 will have an indeterminate impact on NAVPS while Observation 2 will
increase NAVPS. A higher future rental income stream will increase NOI and thus NAVPS; the latter
includes the next 12 months’ expected NOI as a component. On the other hand, a higher cap rate
resulting from a higher rental income stream will reduce the NAVPS. The dividend growth rate does
not affect the NAVPS calculation. Therefore, the observation does not have a clear cut impact on the
NAVPS measure.
Observation 2 will serve to increase NAVPS. Land held for future development is added to the
estimated value of operating real estate to arrive at net asset value. Therefore, an increase in the land
value will serve to increase NAVPS.
A is incorrect. The NAVPS includes the next 12 months’ growth in NOI as a component in its
calculation.
C is incorrect. NAVPS includes the value of land as a component. Where the market value of land
cannot be reliably estimated, book value is used instead.

Correct Answer: C
C is correct. National GDP growth is one of the main drivers influencing the value of an office REIT
as businesses are prepared to pay more rent as well as demand office space to accommodate more
business in a stronger economy.
A and B are incorrect. The value of an office REIT is least affected by retail sales growth and
population growth.

Correct Answer: A
REITs are characterized by high dividend yields often paying a significant portion of their income as
dividends. Therefore, this makes the dividend discount model an appropriate valuation tool.


Correct Answer: B
Penn should invest in either the REIT or REOC to achieve diversification. On the other hand,
diversification is hard to achieve in direct property investing because of the large size and value of the
property.
Unlike REITs, REOCs as well as direct property investors are free to invest in any kind of real estate
subject only to the limitations that may be imposed by their articles of incorporation and/or the
market. In contrast to REOCs, REITs are constrained in their investments, operations, and
distributions.
REOCs are free to use a wider range of capital structures and degrees of financial leverage.

Correct Answer: C
For his personal investment portfolio, Penn should select either a REOC or REIT investment. Both
types of structures permit investors to purchase shares that represent fractional interests with a much
lower investment than a single commercial property. On the other hand, large lot sizes of real estate
considerably increase the cost of investment making it difficult for investors such as Penn to
purchase.

Correct Answer: B
B is correct. Equity markets of most countries have shown a preference for the tax advantages, high-
income distributions and stringent operating and financial mandates that come with the REIT status.
Therefore, REOCs have less access to equity capital and lower market valuations relative to REITs.
C is incorrect. REOCs are ordinary taxable corporations thus subjecting investors to the taxation of
their dividend income.


Correct Answer: C
C is correct. Given that the management of the underlying properties is delegated to subsidiary
REITs, due diligence of senior management serving the parent REIT is not relevant.
A is incorrect. Because the income of a hotel REIT is variable and demand is cyclical, analysts need
to be wary of structures that use a high degree of financial leverage. Therefore, a review of the
REIT’s balance sheet and leverage levels need to be examined.
B is incorrect. Compared to other real estate, hotels have the shortest lease terms. Short-term leases
are a positive consideration in an expansionary economy and/or rental market and a negative
consideration in a declining economy and/rental market.

Correct Answer: A
Estimated next 12 months cash NOI $325,280

Assumed cap rate 10%
Estimated value of operating real estate $3,252,800
Cash and cash equivalents + $50,088
Land held for future development + $30,100
Prepaid assets + $19,200
Total debt - $1,560,500
Other liabilities - $150,780
Net asset value $1,640,908
Shares outstanding ÷ 60,000
Net asset value per share $27.35

Correct Answer: B
Penn is accurate with respect to Reason 1 but inaccurate with respect to Reason 2.
One of the main reasons of why REIT shares trade at a premium or discount relative to their NAV is
that public equity market investors ascribe a different value to the REIT relative to the private buyers.
When the value ascribed by the public equity market is lower relative to private buyers, REIT shares
trade at a discount to their NAV.
When the underlying property market is illiquid, estimating a NAV becomes difficult as the estimates
can become quite subjective.

Reading 44 Private Equity Valuation FinQuiz.com
FinQuiz.com
Study Session 15
June 2019


Reading 44: Private Equity Valuation

Correct Answer: A
With a $20 million investment in D.S. Associates and an investment value of $25 million in three
years time, the IRR on the investment is 7.72%. Since the investment’s IRR does not exceed the
specified hurdle rate (8%) the theoretical carried interest of $1 million ($5 million × 20%) will not be
paid to the managers until and unless the fund generates a value which results in its IRR exceeding
the hurdle rate.

Correct Answer: C
Fact 1:
The general partner of a buyout investment is paid variable revenue comprising of carried interest,
transaction fees, and monitoring fees. While carried interest is the main source of variable revenue to
the general partner of a venture capital firm, transaction and monitoring fees are rare in practice. Thus
the GP of a buyout fund earns revenue which may not be earned by the GP of venture capital firms.
Fact 1 has been correctly identified.
Fact 2:
In context of the variability of returns on investment portfolios comprising of buyout funds, the
underlying investments are characterized by lower variances across investment returns. Additionally,
bankruptcies are of rare occurrence. In contrast, the variability of venture capital fund portfolios are
characterized by very high returns from a limited number of investments and a significant number of
write-offs from low performing investments or failures. Thus fact 2 does not accurately address the
level of write-offs and success rates of the latter investment type.
Fact 3:
A venture capital firm requires a significant cash burn rate to ensure company development and
commercial viability. This contrasts with buyout funds which offer the investor restructuring and cost
reduction potentiality. Fact 3 does not accurately address the purpose of the high cash burn rate.

Correct Answer: B
Management fees represent the percentage of committed capital paid annually to the GP over the
fund’s lifetime. Neither provision 1 nor 2 make reference to management fees.
Transaction fees are paid to GPs in their advisory capacity when providing investment banking
services for transactions such as merger and acquisitions or IPOs. These fees may be subject to a
sharing agreement between the GP and limited partners. Provision 2 makes reference to this economic
term.
Rachet is a mechanism which helps to determine the allocation of equity between shareholders and
the management team of the private equity controlled company. Provision 1 makes reference to this
economic term.

A placement fee is an upfront or a trailer fee fundraising fee charged by the fund raiser. Neither
provision 1 nor 2 make reference to this type of fee.

Correct Answer: C
The exit value, twelve years following the investment is $94 million (18.8 × $5 million). Initially the
proportion of initial investment attributable to the private equity (PE) fund, preference shares, and the
management are as follows:
Preference Shares = $10 million(0.4)(0.05) = $0.2 million
PE fund = $10 million (0.4)(0.85) = $3.40 million

• 65% of the senior bonds have been paid, reducing the debt from $6 million to $2.1 million [$6
million − (0.65) ($6 million)]. The senior bond holders will be paid $2.10 million.
• Preference shareholders are paid a 15% return for 12 years, so they receive $0.20(1.15)12 = $1.07
million.
• The PE equity fund receives 90% of the terminal equity value, or 0.90[94 – (2.10 + 1.07) =
$81.747 million.
Using the initial total value (share of the initial investment) of the PE equity fund and the preference
shares of $3.60 million ($0.20 million + $3.40 million) and the final total value upon termination of
$82.82 million ($81.75 million + $1.07 million), the annual IRR earned by the private equity fund is
approximately 29.86%.

Correct Answer: B
Factor 1:
Market risk reflects the change in the general market conditions (interest rates or currency exchange
rates) which adversely affects private equity investments. The impact of market risk is long-term in
nature and temporary short-term market fluctuations are generally irrelevant. Fact 1 does not correctly
address market risk as it refers to this risk affecting investments over the short-term (temporary) and
long-term as opposed to the long-term only.
Factor 2:
Lack of diversification arises from investment portfolios being highly concentrated in investments of
the same vintage year and/or at the same stages of development. This exposes the portfolio to
significant losses (possibly during a market downturn producing simultaneous losses for these highly
correlated investments). Factor 2 correctly addresses this risk exposure/factor.
Factor 3:
Government regulations can pose significant risks to private equity funds if the underlying investee
companies’ product and services are subject to changes in governmental regulations that adversely
impair their business model. The exposure of company practices to evolving and consequentially
more stringent measures correctly addresses this risk exposure/factor.


Correct Answer: B
In order to determine the per-share value after the first round of financing, the following steps are
followed:
Step 1: Determine the post-money valuation at the time of the second round of financing
(POST2)
POST2 = V/(1 + R2) = $50/(1.10)2 ≈ $41.32
Step 2: Determine the pre-money valuation at the time of the second round of financing (PRE2)
PRE2 = POST2 – I2 = $41.32 – 3 = $38.32
Step 3: Determine the post-money valuation at the time of the first round of financing (POST1)
POST1 = PRE2/(1 + R1) = 38.32/(1.12)3 ≈ $27.28
Step 4: Determine the pre-money valuation at the time of the first round of financing (PRE1)
PRE1 = POST1 – I1 = $27.28 – 4 = $23.28
Step 5: Determine the required ownership fraction for the investors in the first round (F1)
F1 = I1/POST1 = $4/27.28 ≈ 0.146628
Step 6: Determine the number of shares required by the investors in the first round to achieve
their desired ownership fraction (y1)
y1 = x1[F1/(1 – F1)] = 2[0.1466276/1 – 0.1466276)] ≈ 0.3436427
Step 7: Determine the price per share in the first round (p1)
p1 = I1/y1 = $4/0.3436427 ≈ $11.64 per share

Correct Answer: A
The percentage of fees paid to SPVIII’s managers is inconsistent with the percentage of management
fees typically paid to the general partner of private equity funds. Fees are typically in the range of
1.5% to 2.5% of committed capital.
Private equity funds tend to have durations of 10 to 12 years, which may be extendable to an
additional 2 to 3 years. SPVII’s duration (13 years) is consistent with typical fund structures.
Vintage year is the year when the private equity fund was launched. There is nothing indicating that
either of the three funds’ vintage years is inconsistent with the typical fund structure.

Correct Answer: B
The amount of carried interest paid in 2010 is C$3.16 million.
The first year that NAV is higher than committed capital, carried interest is 20% of the excess.
Thereafter, provided that NAV before distribution exceeds the committed capital, carried interest
equals (20%)(increase in NAV before distributions).

Since NAV before distributions exceeded the fund’s committed capital (C$200 million) for the first
time in 2010, carried interest is C$3.16 million [20% × (C$215.8 millions – C$200 millions)].

Correct Answer: C
The TVPI of the SPV I fund at December 31, 2010 is 2.13.
TVPI is the portfolio company’s distributed and undistributed value as a proportion of the cumulative
invested capital. It is presented net of management fees and carried interest. It is calculated as the sum
of ‘the residual value to paid-in capital (RVPI) and distributions to paid-in capital (DPI)’.
Paid in capital (in C$ millions) = 35 + 15+ 40 + 10 = 100

DPI = (C$0 + C$0 + C$20) / C$100 = 0.20
RVPI = C$192.64* / C$100 = 1.9264
*NAV after distributions in 2010 (in C$ millions)= 215.8 – 3.16 –20 = 192.64
TVPI = 0.20 + 1.9264
= 2.1264

Correct Answer: A
Net IRR of the SPV III fund during the 2008 to 2010 period is – 9.26%
Net IRR is estimated by calculating the internal rate of return between the following cash flows:
called-down capital + operating results – management fees – carried interest

or
cash flows for calculating gross IRR – management fees – carried interest
Cash flows 2007 (In C$ million) = − 65
Cash flows 2008 = − 35 – 0.3 = − 35.3
Cash flows 2009 = 0 – 0.4 = − 0.4
Cash flows 2010 = 80 – 0.6 – 1.4 = 78.0
Net IRR = − 9.26%

Correct Answer: A
The executives are correct with respect to the benefit, to LPs, of adopting the co-investment clause.
The co-investment clause grants LPs the first right of investing along with the general partner. The
advantage of co-investment clause for LPs is that fees are likely to be lower (or zero) on co-invested
capital.
The executives are incorrect with respect to the benefit to LPs, of adopting the key man clause. The
key man clause will ensure that in the event a certain number of key named executives leave the fund,
or devote insufficient time to the fund management, the GP may be prohibited from making any new
investments until a new key name executive is employed.


Correct Answer: A
SPVIII’s gross IRR is − 8.10% (see below). SPV III has demonstrated very modest returns based on
the gross IRR measure. A negative gross IRR indicates that SPV III is still experiencing the J-curve
effect.
The J-curve effect refers to the typical time profile of reported returns by private equity funds,
whereby low or negative returns are reported in the early years of a private equity fund. This period of
low returns is followed by increased returns thereafter, as the private equity firm manages portfolio
companies toward exit.
Gross IRR is estimated by calculating the IRR between the called down capital at the beginning of the
period and operating results.
Using the following cash flows IRR is calculated as – 8.10%:

CF0 = − C$65;
C01 = − C$35;
C02 = C$0;
C03 = C$80


Correct Answer: A
The alignment of interests between private equity managers and the management of the companies
they control is possible because the former do not suffer from the short-termism prevailing in public
companies. Short-termism prevails in public companies as a result of the pressure on managers to
meet quarterly earnings targets. On the other hand, private equity firms have a longer time horizon to
manage their equity investments. Therefore, firms manage their investment in a way which
maximizes the value of investor holdings as well their (fee) income resulting in an alignment of
economic interests.
B is incorrect. The payment of cash generated to shareholders does not assist in the alignment of
interests.
C is incorrect. Private equity firms are not the sole catalysts of change in a large organization.

Correct Answer: A
A is correct. Evidence suggests that many public companies have established a long track record of
creating value. Therefore, only a part of the value added comes from superior reorganization and
reengineering capabilities while financial leverage and alignment of interests between private equity
firm owners and the managers of the firms they control also play a role in value creation.

Correct Answer: B
B is correct. Given that the private equity fund managed by Lex Associates invests in mature
companies, the earnings multiple approach is suitable for valuation. This approach applies to
companies with a significant operating history which have a predictable stream of cash flows making
it suitable for the Lex Fund.
A is incorrect. The replacement cost approach rarely applies to mature companies as it is difficult to
estimate the cost of recreating a company with a long operating history.
C is incorrect. The real option approach generally applies to companies operating at the seed or start-
up stage where management or shareholders have significant flexibility in making radically different
strategic decisions.


Correct Answer: B
Policy 1 is an example of a non compete clause which restricts company founders from starting the
same activity during a predefined time period.
Policy 2 is an example of the earn-outs clause which links the acquisition price paid by the private
equity firm to the firm’s future financial performance over a predetermined time horizon.
Policy 3 is an example of the reserved matters clause which requires certain areas of strategic
importance to be subject to approval or veto of the private equity firm.

Correct Answer: C
At the terminal year, preference shares receive €3,221,020 [€2,200,000(1.10)4] on their investment
while debt holders receive €1,000,000.
The private equity fund receives 0.80[€12,500,000 – (€1,000,000 + €3,221,020)] = €6,623,184 on

their €800,000 investment which gives an IRR of 60.42%.

Correct Answer: C
When using the income approach for valuing LBO transactions, the initial high and declining
financial leverage is the main technical issue that needs to be factored into the approach.


Correct Answer: B
B is correct. The discounted cash flow approach is not a good starting point for valuing a VC
investment because there is uncertainty surrounding the projected future cash flows. The approach
depends on a predictable cash flow stream to generate value.

Correct Answer: B
B is correct. A clawback provision will require Romero Associates (the general partner, GP) to return
capital to limited partners (LPs), including Oregon Associates, in excess of the agreed profit split
between the GPs and LPs. This provision ensures that, when a private equity firm exits from a highly
profitable investment early in the fund’s life but subsequent performances are less profitable, the GP
will pay back capital contributions, fees and expenses back to LPs in line with the fund’s prospectus.
A is incorrect. A co-investment clause grants LPs the first right to co-invest with the GP. This allows
for fees and profit share to be lower on co-invested capital.
C is incorrect. A distribution waterfall is a payment mechanism which ensures that distributions are
made to LPs before the GP receives carried interest.

Correct Answer: B
B is correct. In contrast to buyout funds, which require full blown due diligence (financial, strategic,
commercial, legal, tax and environmental), venture capital firms tend to conduct primarily
commercial and technological due diligence before investing. Since the portfolio companies have a
very short operating history, VC firms do not conduct extensive financial due diligence.
A is correct. See above.
C is incorrect. VC firms are primarily equity funded with use of leverage being very rare and limited.


Correct Answer: A

NAV after distributions = NAV before distributions – Carried interest – Distributions
NAV before distributions = NAV after distributions t – 1 + call-down capital – management fees +
operating results
NAV before distributions = $0 + $75 – (0.02 × $75) – $10 = $63.5
NAV after distributions = $63.5 – $0* – $0 = $63.5
*In the first year, NAV is lower than committed capital ($63.5 million versus $405 million).
Therefore, carried interest is $0.

Correct Answer: A

Realized return on investment (Distributions to Paid in Capital) = $5/($75 + $30) = 0.0476x or 0.05x

Correct Answer: B
B is correct. A closed end fund structure restricts existing investors from redeeming their shares
during the lifetime of the fund.
A is incorrect. A closed end fund structure limits the entry of new investors to predefined time
periods, at the discretion of the GP.


Correct Answer: C
C is correct. One of the challenges associated with exit via an IPO is that the private company must
have an established operating history with excellent growth prospects. Being a startup, there is
uncertainty surrounding Rita Robotics’ ability to build a reasonable amount of operating history in
five years’ time.
A is incorrect. Going public offers significant advantages including high valuation multiples as result
of enhanced liquidity. An enhancement of liquidity is the result of private company shares being
traded on an established trading platform.
B is incorrect. Although exit via an IPO has numerous benefits, it comes at an expense of less
flexibility for managers who are now subject to the scrutiny of analysts, investors and the public
market at large. However, it is incorrect to attribute the reduced flexibility to excessive leverage.

Correct Answer: A
To determine the price per share, two variables are required – Stone Tech’s 1) initial investment
amount (given as $5 million) and 2) the number of shares needed to acquire a 58.7% stake in Rita
Robotics (denoted y).
Given that the founders own 1,800,000 shares, the number of shares required by Stone Tech is
y = 1,800,000[0.587/(1 – 0.587)] = 2,558,354

Price per share = $5,000,000/2,558,354 = $1.95

Correct Answer: B
B is correct. Prior to determining the pre-money valuation, it is necessary to determine the post-
money valuation. Based on the data in the exhibit, an investment of $5 million buys 58.7% of the
company. Therefore 58.7% × post-money valuation = $5 million.
Post-money valuation = $5 million/0.587 = $8.5179 million
Pre-money valuation = $8.5179 million – $5 million = $3.5179 million or $3.5 million


Correct Answer: A
A is correct. Investors in the Stone Tech fund will not experience a dilution of ownership interests if
the fund is used to finance both stages. This is because the same fund is merely expanding its
investment in Rita Robotics while ownership is retained by fund investors.
B is incorrect. Given the challenges surrounding exit via an IPO, it is unlikely that Stone Tech
agreeing to finance both rounds will help avoid this uncertainty.

Correct Answer: C
The required investment for the second round is $2 million while the post-money valuation at the
beginning of the second round is $5,340,576 ($35,000,000/1.64).
The additional ownership fraction required by Stone Tech is equal to 37.4% ($2,000,000/$5,340,576).

Correct Answer: A
The post-money valuation in the second financing round is equal to $35,000,000/1.454 = $7,917,645.
The ownership stake demanded by the second round of investors would equal $2,000,000/$7,917,645
= 25.26% or 25.3%

Reading 45 Commodities & Commodity Derivatives: An Introduction FinQuiz.com
FinQuiz.com
Study Session 15
June 2019

Reading 46: Commodities & Commodity Derivatives: An Introduction

Correct Answer: C
C is correct. By capitalizing on Orme’s expectations, Sun Capital will participate in the
commodities futures markets as an informed investor. This is because the firm will believe it
has an information advantage with respect to volatility and it will seek to profit from this by
trading futures.
A is incorrect. Arbitrageurs who have the ability to inventory physical commodities can
capitalize on mispricing between the commodity futures price and spot price. However, Sun
Capital does not possess this capacity.
B is incorrect. A liquidity provider will provide insurance to hedgers in exchange for an

expected profit. By acting on Orme’s expectations, Sun Capital will not be playing the role of
a liquidity provider as its objectives will differ from the motives of this commodity
participant.

Correct Answer: B
B is incorrect. Since live cattle is consumed by individuals and used to make food products
year round, the demand for this commodity is not seasonal.
A is incorrect. Grain is used by ranchers as an input to feed livestock. Therefore, fluctuations

in grain prices will directly affect the cost of raising an animal and the final selling price.
B is incorrect. With a growing middle class in emerging and frontier markets, consumers
capable of purchasing meat protein as part of their regular diet increases. This will result in a
higher demand for livestock and increased investment in the livestock and meatpacking
industries.

Correct Answer: C
C is correct. The storage costs of livestock such as live cattle are tied to grain prices. If grain
prices increase, then animals are slaughtered more quickly to avoid the higher cost of feeding
them. This will pull supply forward in the near term leading to an excess supply and lower
prices. However, an increase in storage costs will not produce the same effect on natural gas
supply.
A is incorrect. Natural gas can easily be transported via ships. Slaughtered meat is usually
frozen and advances in freezing technologies means that products are moving from one part
of the world to another in response to differences in production costs and demand. Therefore,
the advancement of technology has allowed slaughtered meat to become more transportable.
B is incorrect. Weather has a surprising impact on animal health and weights. In the winter
cattle suffer more than hogs and chickens because of their height. Winter is a key driver of
the demand for natural gas with colder months driving up the demand for natural gas.

Correct Answer: A
A is correct. A commodity futures market is said to be in contango when long-term futures
prices are higher than the near-term futures prices or futures prices are higher than the spot
price. The opposite occurs in backwardation. Based on the trend in live cattle futures prices
and the relation between the spot and futures prices, this sector is in a state of contango. On
the contrary, the natural gas sector is in a state of backwardation.
B is incorrect. Positive calendar spreads can only be earned when futures markets are in
backwardation. Negative calendar spreads are associated with futures markets in contango.
As established above, the live cattle market is in a state of contango and therefore an investor
can only earn a negative calendar spread.
C is incorrect. As commodity futures markets shift from being in a state of contango to

backwardation, the roll returns will fluctuate accordingly. Therefore, it is impossible for an
investor to earn roll returns in perpetuity.

Correct Answer: A
A is correct. Orme is relying on the insurance theory to explain the trend in futures prices.
This is because he assumes that the hedging pressure of commodity sellers has lead to the
present state of backwardation in the natural gas sector. This coincides with the insurance
theory which assumes that the futures market is in backwardation as a result of the demand
for commodity sellers to seek price insurance.
B is incorrect. The theory of storage attempts to explain how the level of commodity storage
influences commodity futures price curves. Orme is not considering the level of natural gas
storage and is therefore not relying on this theory.
C is incorrect. Hedging pressure hypothesis compares the demand of commodity producers

and consumers for price insurance. Orme does not address commodity consumers when
analyzing the futures price trend and is therefore not relying on this theory of commodity
futures returns.

Correct Answer: C
C is correct. If Sun Capital is seeking to capitalize on the difference between expected versus
observed volatility for a reference price commodity, it should employ a volatility swap.
Under this arrangement, both parties speculate on how volatile prices will be versus
expectations.
A is incorrect. A basis swap exchanges periodic payments based on the values of two related
references prices which are not perfectly correlated. This type of swap will not be relevant
for exploiting the volatility expectation.
B is incorrect. A variance swap involves two buyers periodically exchanging payments based
on the proportional difference between an actual variance in price levels and a fixed amount
of variance established at the outset of the contract. However, this type of swap will not be
relevant for Sun Capital which seeks to exploit the difference between actual and expected
volatility in price levels.
Reading 46 The Portfolio Management Process & the investment policy statement FinQuiz.com
FinQuiz.com
Study Session 16
June 2019


Reading 46: The Portfolio Management Process

Correct Answer: C
The planning stage of the portfolio management process includes the following steps:
1. Determine the client’s objectives and constraints.

2. Create the IPS which generally details the reporting requirements, rebalancing guidelines,
frequency and format of investment communication, manager fees, investment strategy, and the
desired investment styles of the managers. Investment strategies include passive, active and risk-
controlled active strategies.
3. The third stage involves formulating capital market expectations which are long-run forecasts of
the risk and return characteristics for various asset classes.
4. The final stage involves determining the strategic asset allocation. This stage combines the IPS
and capital market expectations to determine target asset class weights, maximum and
minimum permissible asset class weights.
The newsletter has incorrectly addressed the fourth stage of the planning process.

Correct Answer: B
The execution stage incorporate the following steps:
1. The ‘portfolio selection/composition decision’: this decision involves the integration of

investment strategies with capital market expectations to select specific assets for the portfolio.
2. The ‘portfolio implementation decision, which involves initiating portfolio decisions using
analysts’ input and trading desks to implement these decisions.
3. The portfolio is revised as investor circumstances or capital market expectations change. Fixing
the portfolio revisions to one year is not appropriate as client circumstances or market
expectations may change more frequently than the stipulated frequency.
Thus the newsletter has incorrectly addressed the third step of the execution process.

Correct Answer: B
Generally portfolios may require rebalancing when:
• investor circumstances (objectives and/or constraints) change;

• capital market expectations change; and
• deviations from strategic asset allocation as specified by the IPS.
Frequent investment officer changes are not a factor which would dictate portfolio revisions. Such
changes generally do not affect investor circumstances or capital market expectations.


Correct Answer: C
Assertion 1:
In context of pension plans, the return requirements and risk tolerances are contingent upon whether
the plan in question is a defined benefit or defined contribution plan.
Defined benefit plans state their return requirements in terms of the return that will adequately fund
liabilities on an inflation-adjusted basis. The risk tolerance of such plans depend upon the plan and
sponsor characteristics, plan features, funding status, and workforce characteristics.
Defined contribution plans’ return requirements depend on the stage of life of the individual
participants. The risk tolerance of such plans varies with the risk tolerance of individual participants.
Thus assertion 1 has inaccurately addressed the return requirements and risk tolerances of pension
plans by failing to make a distinction between the two categories.
Assertion 2:
The risk tolerances of individual investors; defined contribution plans; and banks, as institutional
investors, vary according to the type of investor. Thus assertion 2 has incorrectly pointed out that
individuals are the only investor category whose risk tolerance varies.

Correct Answer: A
With sufficient pre-retirement (salary) and post-retirement income (pension) to cover her current and
post-retirement living expenses, Lance has a low level of liquidity needs.
Since her current and future needs (living expenses) are secured, Lance is capable of taking risks.
There is nothing to indicate that her spending needs are extravagant. Additionally at 47 years of age,
her risk taking ability is high. Together these factors demonstrate an above average ability to take
risk.

Correct Answer: A
Harper is currently 35 years of age and has 15 (50 – 35) years left to retirement. Thus her time
horizon can be defined as being long-term.
Harper has a multi-stage horizon, which includes:
1. the current period till the time of his mother’s death (she is terminally ill);
2. from her death to the date of his retirement;
3. retirement onwards.


Correct Answer: C
C is correct. The portfolio perspective is based on the concept that an asset class should not be
evaluated from a stand-alone perspective, but from a portfolio perspective. This means that portfolio
managers should consider the interrelationship between the asset classes and how much risk each
asset class brings to the portfolio.
B is incorrect. The portfolio perspective does not address how portfolio management should be
viewed and dealt with – as a process or random set of individual procedures.

Correct Answer: C
The ‘Ethical Responsibilities’ excerpt accurately presents the concept with respect to all three points
discussed. Ethical conduct is the foundation requirement for managing investment portfolios. In
addition, the conduct of a manager affects the well-being of clients and thus looking after their
welfare is crucial. Furthermore, portfolio managers must keep in mind that they are in a position of
trust as reflected by the Code of Ethics and Standards of Professional Conduct.

Correct Answer: C
Lee retired 25 years ago when his investable asset base was $95,000. Given that he withdrew $25,000
each year for 25 years and built a $1 million investment portfolio at the end of this time period, his
post-tax required rate of return was 26.97% (see below). Given a 30% tax rate, his pre-tax required
rate of return was 38.53% [26.97%/(1 – 0.3)].
N = 25; PV = - 95,000; PMT = 25,000; FV = 1,000,000

I/Y = 26.9737%

Correct Answer: B
Lee has significant liquidity concerns as is evident from his desire to hold cash in reserves and his
dependence on the investment portfolio as a source of liquidity. Hector can modify the payoff
structure of a risky portfolio to address liquidity requirements using derivative strategies.

Correct Answer: A
Concern 2 addresses a tax constraint only. The increase in estate tax rates may influence Lee’s
decision to transfer his investment portfolio upon his death. Therefore, tax concerns will influence
any investment decisions made on behalf of his portfolio.


Correct Answer: C
C is correct. Performance appraisal is an evaluation of a manager’s performance relative to his or her

stated benchmark. The portfolio performance can be examined in terms of absolute returns via three
distinct sources – decisions from strategic asset allocation, market timing (returns attributable to
short-term deviations from the strategic asset allocation, and security selection.
A is incorrect. The policy has incorrect described returns from market timing as security selection
returns.
B is incorrect. Residual returns are not stated as a source of absolute returns.


Correct Answer: A
If the impact of the occurrence of an event on the financial circumstances of the investor is significant
enough, an additional time horizon stage is warranted. The receipt of the $0.5 million will increase
Redel’s ability to take risk and will therefore require an additional time horizon stage.

Correct Answer: A
A is correct. The receipt of the $0.5 million will increase the size of Redel’s financial asset base.
Therefore, she will be able to tolerate greater volatility in her asset base as a result of employing
riskier investment strategies. In conclusion, Redel’s ability to take risk will increase.
B is incorrect. An increase in the inflation rate will not have an impact on her ability to take risk.
C is incorrect. The impact of an increase in tax rates should be reflected in the tax constraints section
of Redel’s IPS. Therefore, Note 3 will not have an influence on her risk taking ability.

Correct Answer: A
Both notes 1 and 4 combined indicate that a revision in Redel’s liquidity requirements is warranted.
Redel is required to spend $500,000 in three months which reflects a demand on portfolio liquidity
(given that her earnings are only sufficient to offset her living expenses). The receipt of the
inheritance sum will reduce the demand on portfolio liquidity as Redel can employ the amount
received towards the boat purchase.

Correct Answer: B
Out of the three statements made by Redel, only Statement 2 reflects a unique circumstances
constraint. These circumstances are internal factors (other than a liquidity requirement, time horizon,
or tax concern) that may constrain portfolio choices. The requirement to avoid tobacco stocks
constrains Knight’s investment choices with respect to his client’s portfolio and does not constitute a
constraint which may classify in any of the aforementioned categories.


Correct Answer: C
C is correct. Note 7 reflects a legal and regulatory constraint which will not have an impact on the
investment account’s risk tolerance.
A is incorrect. The plan sponsor will need to arrange for the payment of benefit payments for the
employees who have elected to retire early. This will put a strain on portfolio liquidity and decrease
the plan’s risk tolerance (Note 5).
B is incorrect. The risk tolerance of the plan will decrease as a result of the deficit reported in the
current year (Note 6).

Correct Answer: C
The return requirement for a foundation’s investment account should reflect compensation for
investment expenses and expected inflation.
Required return = 3.5% + 0.9% + 1.3% = 5.7%


Correct Answer: A
Boyle’s ability to take risk is classified as average. She has a long-time horizon and has no plans for
retirement; both these factors serve to increase her risk-taking ability. However, she has significant
liquidity needs including funding for her children’s university education, paying installments on the
residential mortgage loan and car lease agreement. Since her salary does not cover her living
expenses, she will heavily depend on her portfolio to meet these requirements. Therefore, the liquidity
constraint serves to decrease her risk-taking ability. Her overall risk-taking ability is average.

Correct Answer: A
Boyle’s liquidity constraints are significant. She depends on her portfolio to pay for installments on
both the mortgage and automobile loan as well as fund her children’s university education. In
addition, she will need to rely on her portfolio to fund her living expenses which significantly exceeds
her current income.
Boyle’s current income and capital gains are subject to taxes. Therefore, the tax constraints on her
portfolio are significant.

Correct Answer: B
Boyle’s willingness to take risk should be dictated by the investment portfolio details as opposed to
her opinion on risk taking.
Her opinion on risk taking is in clear conflict with her portfolio holdings given that the former
indicates a below average willingness whereas the latter indicates an above average willingness.
Boyle’s allocation to high-yield bonds, venture capital equity funds, and small-cap equities indicates
an above average willingness to bear risk.

Correct Answer: A
Emerson is correct with respect to Statement 1 and incorrect with respect to Statement 2. The
planning process involves an elaboration of the investment strategy – the manager’s approach to
investment analysis and security selection.
Emerson is incorrect with respect to Statement 2. The formulation of the investment strategy is a key
component of the planning process.


Correct Answer: A
A is correct. An advantage of the adopting the single-period perspective in the risk and return
characteristics of asset allocations is its simplicity.
Options B and C are incorrect. A multiperiod perspective can address the liquidity and tax
considerations that arise from rebalancing portfolios over time, as well as serial correlations in
returns.

Correct Answer: A
A is correct. The ‘Asset Allocation’ Policy correctly addresses what triggers a permanent revision in
the strategic asset allocation. The asset allocation may temporarily drift from the strategic asset
allocation to reflect a change in investor’s circumstances. However, if the change in circumstances
becomes permanent, the manager is required to update the IPS and the temporary asset allocation will
become the new revised strategic asset allocation.
On the other hand, tactical asset allocation strategies respond to changes in short-term capital market
expectations rather than to investor circumstances.

Reading 47 An Introduction to Multifactor Models FinQuiz.com
FinQuiz.com
Study Session 16
June 2019


Reading 47: An Introduction to Multifactor Models

Correct Answer: B
Based on the equation for the one-factor model, expected portfolio returns should be equal to the
following:
Portfolio A (Expected Return) = 0.0764 + (0.0560 × 0.18) = 0.08648
Portfolio B (Expected Return) = 0.0764 + (0.0560 × 1.05) = 0.13520
Portfolio C (Expected Return) = 0.0764 + (0.0560 × 1.96) = 0.18616
Compared to the expected return calculated by the one-factor model, Portfolio B is offering a
relatively lower return. Portfolio B is overvalued. An arbitrage opportunity exists which can be
exploited by selling portfolio B and investing the proceeds in portfolios A and C. The arbitrage profit
earned per dollar shorted is equal to $0.1352 – $0.0924 = $0.0428

Correct Answer: A
Emerson is using arbitrage pricing theory (APT) to derive the one-factor model as evidenced by the
assumption undertaken with respect to arbitrage opportunities. However, she is inaccurate with
respect to Assumption 1 which implies that financial markets are highly liquid. However, APT does
not make any assumptions with respect to market liquidity.
Emerson is accurate with respect to Assumption 2. A key assumption of APT is that there are many
assets so investors can form well-diversified portfolios that eliminate asset-specific risk.

Correct Answer: B
The contribution of each factor to active returns needs to be calculated.
K
Total active return = ∑
i =1
[(Portfolio sensitivity)k – (Benchmark sensitivity)k] × (Factor return)k +
Security selection
Or Total active return = Factor return + Security selection
Factor return = [(0.90 – 1.70) × 0.105] + [- 1.85 – (- 2.50) × 0.258] + [(0.08 –

1.00) × - 0.095] + [(0.60 – 0.60) × 0.008] = 0.1711
Active return = 0.1711 – 0.0640 = 0.1071
Contribution of SMB to active return = [(0.90 – 1.70) × 0.105]/0.1071 = - 0.7843
Contribution of HML to active return = [- 1.85 – (- 2.50) × 0.258]/0.1071 = 1.5658

Contribution of WML to active return = [(0.60 – 0.60) × 0.008]/0.1071 = 0
HML has the greatest contribution to active return in absolute and non-absolute terms.

Correct Answer: C
Boyle has a negative active exposure to the HML (value) factor of – 0.92 (0.08 – 1.00). Value stocks
should have a positive active exposure while growth stocks should have a negative active exposure.
This implies that he has adopted a growth mandate. His portfolio exposure is inconsistent with the
investment mandate and benchmark.
The negative sensitivity to the SMB (size) factor of – 2.50 in the benchmark indicates a large-cap
orientation and that Boyle’s performance benchmark is appropriate given his investment mandate.
However, Boyle has adopted a positive active exposure of 0.70 [- 1.80 – (- 2.50)] to this factor.
Therefore, his portfolio exposure is inconsistent with the investment mandate in this regard.

Correct Answer: B
Total residual risk is measured by active specific risk. This risk can be calculated using the following
equation:
∑ (w ) σ
n
a 2 2
Active specific risk = i εi
i =1
where w a i represents the active weight (All $ figures are in millions)
Active specific risk = ($1.0/$2.0)2(0.2010)2 + ($0.4/$2.0)2(0.1540)2 + ($0.5/$2.0)2(0.0130)2 +

($0.1/$2.0)2(0.610)2 = 0.01199 or 11.99%

Correct Answer: A
Emerson is inaccurate with respect to Statement 1; accurate with respect to Statement 2.
Non-systematic risk may feature in the macroeconomic model and for a stock it might represent the
return from an unanticipated company-specific event or nonsystematic risk. However, this risk is
represented by the residual term. The intercept of the model represents an asset’s expected return.
A distinction between macroeconomic multifactor models and fundamental factor models is the
specification of variables. In case of the former, the factor (surprise) series is developed first and then
the factor sensitivities are estimated through regression. In case of the latter, the factor sensitivities
(attributes) are specified first and then the factor returns are estimated through regression. Both
models differ with respect to how statistical techniques are used to specify model variables.


Correct Answer: A
A is correct. Jing’s conclusion concerning statistical factor models is correct. In this model, the
factors are portfolios of securities in the group under study where the factors are defined by portfolio
weights. A portfolio of Polish stocks would be represented by a weight of 57% ($5.7 million/$10.0
million) and a portfolio of Turkish stocks would be represented by a weight of 25% ($2.5
million/$10.0 million).

Correct Answer: B
B is correct. Weidman has incorrectly asserted that statistical factor models require substantial
assumptions. In reality, these models make minimal assumptions.
C is incorrect. Weidman has correctly asserted that the model does not lend itself to the economic
analysis of the factors. Associating a statistical factor with economic meaning is generally not
possible with this model.

Correct Answer: C
C is correct. To determine whether the manager has passive risk exposure to any of the factors,
information concerning the benchmark and portfolio factor exposures should be provided.

Correct Answer: C
Using a macroeconomic factor model, the expected fund return is equal to - 1.50% (calculated
below). A benchmark expected return of 1.05% will yield a zero active return, which in turn implies a
passive risk exposure.
Expected Fund Return = 2.20% + (0%)(1.5) + (- 2%)(0.8) + (1.5%)(- 1.1) + (1.0%)(0.0) = -1.05%

Correct Answer: B
To speculate on an expansion in money supply, Portfolio B is the most optimal choice because it has
a sensitivity of 1.00 to the money supply factor and 0.00 to all other factors. This portfolio is therefore
the most efficient in placing a pure bet on an expansion in money supply. A long position should be
taken in portfolio B to bet on the positive growth in money supply.


Correct Answer: A
The analysis in Exhibit 3 demonstrates the employment of multi-factor models in portfolio

construction. These models permit portfolio managers to make focused bets or control portfolio risk
relative to the benchmark’s risk. Therefore, Weidman is using multi-factor models to establish a
specific desired risk profile for a portfolio.


Correct Answer: C
Emerging market stocks are often characterized by high share price volatility. Davis’ portfolio has the
most significantly positive active exposure (1.60 – 0.00 = 1.60) to this factor.
Both Thornton’s and Segal’s portfolios do not have active exposure to the share price volatility factor.

Correct Answer: B
Value stocks are characterized by high book-to-market ratios and low earnings yield.
B is correct. Segal’s portfolio has an active exposure of - 0.70 (1.10 – 1.80) and 1.55 (1.55 – 0.00) to
the earnings yield and book-to-market ratio factors, respectively. The negative active exposure to the
earnings yield factor suggests that he his portfolio has an exposure to (low earnings yield) value
stocks. Both exposures clearly indicate that Segal’s portfolio has a value bias.
Thornton has a positive active exposure of 0.05 (1.85 – 1.80) and 1.50 (1.50 – 0.00) to the earnings
yield and book-to-market ratio factors, respectively. Thornton’s exposure to the earnings yield factor
suggests that his portfolio does not have a value/growth bias while his exposure to the book-to-
market ratio factor suggests his portfolio has a value bias. Therefore, the value bias conclusion is
indeterminate.
C is incorrect. Davis has an active exposure of 0.00 (1.80 – 1.80) and – 0.80 (- 0.80 – 0.00) to the
earnings yield and book-to-market ratio factors, respectively. Based on his exposure to earnings
yield, he has no value/growth bias while his exposure to the book-to-market factor indicates he has a
growth bias.

Correct Answer: C
The decision of which manager to select will solely be based on the return from factor tilts. Davis’
portfolio has generated the highest return from factor tilts (see below) and will be the preferred
candidate.
Thornton = (1.85 – 1.80)(6.74%) + (1.00 – 1.00)(3.33%) + (1.50 – 0.00)( 3.28%) + (0.04 –

0.00)(12.50%) = 5.7570%
Segal = (1.10 – 1.80)(6.74%) + (0.00 – 1.00)(3.33%) + (1.55 – 0.00)(3.28%) + (0.08 –

0.00)(12.50%) = - 1.964%
Davis = (1.80 – 1.80)(6.74%) + (1.35 – 1.00)(3.33%) + (- 0.80 – 0.00)(3.28%) + (1.60 –

0.00)(12.50%) = 18.5415%


Correct Answer: B
The decision of which manager to select will be based on the information ratio(IR) calculated for
each manager:
Thornton’s IR = 1.93%/5.42% = 0.3561

Segal’s IR = 5.45%/11.30% = 0.4823
Davis’ IR = 2.47%/8.56% = 0.2886
Segal is projected to generate the highest information ratio for his portfolio and should be selected.

Correct Answer: A
Allen is correct with respect to both advantages. Multifactor models have the ability to decompose
and attribute sources of total and active risk.
Allen is correct with respect to the second advantage. Allen is employing a fundamental factor model
as is evident by his choice of factors. When decomposing the sources of tracking error, an analyst’s
first choice is the fundamental factor model because the model can decompose the sources of active
risk and directly relate them to the manager’s portfolio decisions.

Correct Answer: B
Use 1 is classified as rules-based active management. These strategies tilt specific systematic risk
factors when constructing portfolios. The objective of this approach is to capture systematic risk
exposures traditionally attributed to a manager’s skill or alpha in a rules-based manner at low cost.
Use 2 is classified as passive management. Analysts seeking to construct a fund which tracks an index
with many component securities will rely on a multifactor model to replicate the index’s fund
exposures, mirroring those of the index tracked.


Correct Answer: A
The sensitivity of each stock to dividend yield is calculated as follows:

bik =

ARC Corp Skim Ltd

bearnings growth .%.% 8.8% − 10.4%
.%
= 0.1355 = −0.1032
15.5%
bDividend yield 1.8% − 1.0% 1.5% − 1.0%
= 0.6154 = 0.3846
1.3% 1.3%
Based on the calculations, the ARC Corp stock has the greatest sensitivity to the two factors.

Correct Answer: C
Fundamental factor models employ scaling, which permits model users to interpret all factor
sensitivities similarly despite different units of measure and scale in the variables.

Correct Answer: B
Unlike macroeconomic models, the factors in a fundamental factor model are stated as
returns rather than return surprises, in relation to their predicted values. Therefore, the factors
do not generally have expected values of zero.
A is incorrect. Although factor sensitivities are attributes of a security in a fundamental factor

model, this does not explain why factors do not have expected values of zero.
C is incorrect. The factors in macroeconomic models are defined as surprises, which refer to
the difference between the actual and predicted values of variables. Therefore, it is incorrect
to state that factor surprises are calculated as the difference between actual and unpredicted
values.


Correct Answer: A
Lone is accurate with respect to Conclusion 2; inaccurate with respect to Conclusion 3.
The intercept of the macroeconomic factor model reflects the effect of the predicted values of
the macroeconomic variables on expected stock returns. Therefore, the intercept reflects
expected stock returns.
Although analysts prefer the fundamental factor model in return attribution as they allow the
sources of a portfolio’s performance to be described using commonly understood terms,
macroeconomic models (although a less preferred option) may also be used.

Correct Answer: C
The ability to generate active returns based on portfolio holdings is measured using the
security selection return. This return is calculated as the difference between the active return
of 5% and the factor return.
Lone was unable to generate a security selection return with respect to the ARC Corp stock.
Active return attributable to ARC Corp stock = (5%)(0.20) = 1%

Total factor return = [0.85 – (- 1.03 )](1.50%) + (0.40 – 1.00)(2.85) = 1.11%
Security selection return = 1.00% - 1.11% = - 0.11%.
Lone was able to generate a 2.3275% security selection return due to his above average
ability to select shares of the Skim Ltd stock.
Active return attributable to Skim Ltd stock = (5%)(0.80) = 4%

Total factor return = [0.75 – (- 1.03 )](1.50%) + (0.65 – 1.00)(2.85) = 1.6725%
Security selection return = 4% - 1.6725% = 2.3275%.

Correct Answer: B
A pure earnings growth factor portfolio has an exposure of 1.00 to the earnings growth factor
and zero to the dividend yield factor.
ARC Corp Factor return (Earnings growth) = [0.85 – (- 1.03)](1.50%) = 2.82%

Skim Ltd Factor return (Earnings growth) = [0.75 – (- 1.03)](1.50%) = 2.67%
Total active return* = (2.82%)(0.50) + (2.67%)(0.50) = 2.745%

*Return from individual security selection decisions is 0%.

Reading 48 Measuring & Managing Market Risk FinQuiz.com
FinQuiz.com
Study Session 16
June 2019


Reading 48: Measuring & Managing Market Risk

Correct Answer: C
C is correct. The reliability of the VAR estimate is verified using a process known as
backtesting. This involves comparing the frequency of losses implied by VAR with the actual
frequency of loss occurrence.
Based on an average of 22 trading days in a typical month, a 16% one-month VAR would
imply that the minimum losses (as stated by VAR) are expected to occur on 16% of the
trading days or on 3.52 (16% × 22 days) days in a month. Based on the data in the exhibit,
the actual loss frequency of Portfolio C (4 days) exceeds that implied by the 16% VAR.

Correct Answer: B
B is correct. VAR can be interpreted as the level of confidence that portfolio losses will not
exceed the VAR amount of $2.5 million, 84%* of the time over a period of one month.
A is incorrect. VAR is not a worst-case scenario. Portfolio losses can and will exceed VAR.
C is incorrect. The interpretation of VAR is incorrect because VAR is stated in terms of a

minimum loss and loss frequency; these essential elements are missing in option C’s
statement.

Correct Answer: C
C is correct. The Monte Carlo simulation method is capable of handling any complex
distribution. This will allow the method to be readily used to analyze the riskiness of
embedded options which are characterized by a non-normal return distribution.
A is incorrect. The parametric method is difficult to use when the investment portfolio
contains options. Although adjustments can be made to render options more responsive to the
parametric method, these adjustments are not perfect which limits the usefulness of the
parametric method when there are options in the portfolio.
B is incorrect. The maximum drawdown is not a method used to estimate VAR.


Correct Answer: A
A is correct. Mendes is accurate regarding Reason 1 and inaccurate regarding Reason 2.
Historical simulation uses the distribution implied by the historical prices of the risk factors
which eliminates the need to assume a return distribution.
The method constructs a return distribution using actual prices for the risk factors. However,
the biggest assumption which underlies the historical simulation method and the return
distribution of the parameters is that history will repeat itself. Another assumption is that
each day in the time series carries an equal weight which can be a potential problem if there
is a trend in volatility – lower in earlier periods and higher in later periods or vice versa.

Correct Answer: A
A is correct. Based on the facts presented, Mendes is applying historical simulation to

determine how risk sensitivities will react if current market events were to reoccur. Historical
scenarios have the advantage that they are uncontroversial because there is historical
evidence to prove that the events did occur.
B is incorrect. A limitation of applying historical simulation to the risk factor sensitivities

gamma and delta is that the measures are not suitable for handling the type of extreme
movements typically associated with stress tests.
C is incorrect. A drawback of historical simulation is that it assumes that history will repeat
itself. Therefore, any correlation behavior observed in the past is expected to continue into
the foreseeable future. However, correlations do not necessarily remain constant as assumed
and can break down in periods of market stress.

Correct Answer: C
C is correct. Ex-ante tracking error measures the volatility of the performance of a portfolio
with respect to its benchmark. Hedge funds are typically absolute-return strategies for which
a benchmark does not always exist. In this scenario, a benchmark-relative measure such as
relative VAR will not be used in the risk analysis.
Both banks are long-only asset managers can use ex-ante tracking error with the latter
frequently employing ex-ante tracking error as a key risk metric to estimate the degree to
which the current portfolio could outperform its benchmark.

Reading 49 Economics and Investment Markets FinQuiz.com
FinQuiz.com
Study Session 17
June 2019


Reading 49: Economics and Investment Markets

Correct Answer: B
B is correct. BEI rates reflect investors’ expectations concerning inflation as well as a premium to
compensate investors for the uncertainty concerning inflation. BEI rates are calculated by subtracting
real yields from nominal yields.
Bond Issue BEI Rate

3-month 0.5%
1-year 0.4%
4-year 0.4%
8-year 1.7%
15-year 2.9%
An increase in the BEI rates from the 4-year issue and onwards indicates an expectation that
inflationary pressures will be rising which in turn will lead to an increase in the cost of goods and
services. High inflationary pressures arise from higher demand for resources so that cost and prices
rise as fast.
C is incorrect. BEI rates do not help conclude whether bonds have been effective as hedges against
bad consumption outcomes.

Correct Answer: B
B is correct. An upward sloping yield curve suggests that shorter-maturity bonds carry lower expected
returns (and thus lower premiums) relative to higher-maturity bonds. Shorter-maturity bonds are seen
as being more effective as an inflation hedge which implies that during bad economic times these
instruments will generate payoffs. Therefore, investors are willing to pay a high price for them
leading to a decline in the expected return and bond risk premiums relative to long-maturity bonds.
A is incorrect. An inverted yield curve is viewed as a predictor of an economic recession.
C is incorrect. The nominal yields are increasing with maturity. This indicates that bond risk
premiums are increasing with maturity.


Correct Answer: B
B is correct. The interpretation of an upward sloping yield curve is often ambiguous. The positive
relationship between bond risk premiums and maturity does not necessarily embody expectations of
future rate increases. Conversely it could imply a combination of expected rate increases and risk
premiums or even rate cuts that are more than offset by the existence of positive risk premiums.
C is incorrect. The limited supply of short-term default-free government bonds will drive down short-
term yields. However, they will not explain the shape of the entire yield curve.

Correct Answer: B
Both credit risky and default-free bonds are exposed to interest rate risk. A parallel upward shift in
the yield curve will have an identical proportionate impact on the prices of the four-year default-free
issue and the comparable Aa2 corporate issue.
If investors are risk-neural, they will demand a return on their corporate bond investments which is
sufficient to compensate them for the possible loss they would incur from holding a corporate bond.
This expected loss will depend on the probability of default and expected recovery rate in the event
of default. The expected loss on the 8-year government bond will equal to the loss adjusted expected
return of the Aa1 corporate issue.
Expected loss = 5%
Loss-adjusted return = (11.8%)(1 – 0.05) = 11.21% or 11.2%

Correct Answer: A
When an economy enters into the recessionary phase of the business cycle, credit spreads will widen
as there is a general increase in issuer defaults and thus credit risk. In this scenario, the spreads on
bonds with a low rating and/or that are part of a cyclical sector will widen the most and in turn will
experience the greatest percentage price decline.
Out of the two lowest rated issues (A1 and Baa1), the A1 issue is part of the cyclical sector. The
credit spreads on bond issues belonging to this sector are highly sensitive to fluctuations in the
business cycle. Although, the Baa1 issue carries the lowest rating, it is part of the non-cyclical sector
and is less sensitive to fluctuations in business cycle activity.


Correct Answer: A
Campbell is correct with respect to his statement while Burns is incorrect with respect to his statement.
The expected returns on equity investments will decline when the economy takes a downturn. In such a
scenario, companies suffer a decline in profitability. Therefore, expected equity returns and profitability
are pro-cyclical.
Burns is correct in pointing out that risk-averse investors will seek to avoid equities when the economy
takes a downturn; this is because equities are a poor hedge against bad consumption outcomes. However,
he has incorrectly pointed out the positive covariance relationship. During bad economic times, expected
future consumption is low (inter-temporal rate of substitution is high) and equities decline in price. This
results in a decline in equity returns and produces a negative covariance relationship between the inter-
temporal rate and equity returns which, in turn, causes investors to demand a positive risk premium.


Correct Answer: A
Given the volatility in economic growth and inflation, 1-year nominal zero-coupon bonds will serve
as the best hedge against bad consumption outcomes. The relative payoff from a short-term issue and
thus the relative certainty about the amount of consumption that the investor will be able to undertake
with the payoff suggests that this issue will be a good hedge against bad consumption outcomes.
Furthermore, the negative correlation between asset payout and economic growth suggests that the
asset will generate a payoff when there is weak economic growth.
B is incorrect. On the other hand, the payoff from the 12-year government bond is only certain in
nominal terms. Investors will have less confidence in their ability to form views about future inflation
resulting in less certainty about the real value of the bond’s payoff.
C is incorrect. Credit risky corporate bonds will be more sensitive to shifts in the economic cycle
relative to the two government issues. Spreads will tend to widen as the business cycle takes a
downturn at the same time as the risk of default increases. The relationship between the economic
cycle and defaults mean that credit risky bonds will tend to perform poorly in bad economic times.

Correct Answer: C
C is correct. In addition to the premium demanded for inflation and inflation uncertainty, investors of
credit risky bonds demand a credit premium. The total premium quoted for this bond issue will be the
highest.
A is incorrect. The risk premium demanded for 1-year zero-coupon government bonds will be the
lowest because of the negative correlation between bond payoffs and economic growth. The issue
provides a good hedge against bad consumption outcomes (when marginal utility of consumption is
high) and so will bear a negative risk premium.
B is incorrect. While the premium demanded on 12-year zero-coupon government bonds is higher
than the 1-year government bonds, it is lower than that quoted on corporate bonds. This is because the
returns on default-free coupon bonds do not incorporate a credit spread.


Correct Answer: A
A is correct. The difference in yield between the 12-year corporate and default-free issue reflects
credit spread.
B is incorrect. The BEI rate is equal to the difference between a zero-coupon nominal default-free
bond and a zero-coupon default-free real bond of the same maturity.
C is incorrect. A premium for inflation uncertainty will be included in the yields of the two 12-year
issues.

Correct Answer: C
Edmond has short-listed value stocks for his portfolio. Value stocks tend to outperform growth stocks
when the economy is in a state of recession. In addition, large-cap stocks tend to outperform small-
cap stocks during bad economic times. Therefore, Edmond stock selection suggests that he most
likely anticipates a recession.

Correct Answer: B
According to the Taylor rule (see below), the policy rate is equal to 1.55%.
prt = lt + it + 0.5(it − i *t ) + 0.5(Yt − Y *t ) = 2.0% + 1.5% + 0.5(1.5% − 2.2% ) + 0.5(− 3.2% ) = 1.55%
Given that inflation is below the target level and the output gap is negative, the policy rate should be
below the neutral interest rate.

Correct Answer: A
A is correct. A downward-sloping yield curve implies that short-term interest rates are expected to
decline. In addition, bond risk premiums are expected to decline. A decline in bond risk premiums
implies that investors are willing to pay a high price of the consumption hedging properties on
government bonds.
B is incorrect. The expected change in short-term interest rates is ambiguous when the yield curve is
upward-sloping.
C is incorrect. A decline in risk premiums suggests that investors place more value of the
consumption-hedging properties of government bonds.


Correct Answer: A
Real yields are positive correlated to real GDP growth and volatility. Therefore, real GDP growth will
be the lowest in Yugoslavia corresponding to the low real yield on 1-year default-free government
bonds. When real GDP growth is low, investors worry more about their future and their consumption
abilities in the future indicating that their inter-temporal rate of substitution is high. Therefore,
Peterson should expect that the investor’s willingness to trade current consumption for future wealth
(inter-temporal rate of substitution) to be the highest for Yugoslavia.

Correct Answer: A
A is correct. Real yields or inflation-adjusted yields are not affected by inflation expectations.
B is incorrect. High (low) GDP growth volatility will translate into high (real) yields.
C is incorrect. The policy rate of central banks has an influence on the real yields of default-free
government bonds. The former rate should fluctuate around the neutral policy rate as central banks
respond to changes in the output gap.


Correct Answer: C
The yield curve in Peru is expected to be sloping steeply upwards and so 1-year default-free
government bonds should bear the lowest risk premium. This contrasts with Yugoslavia, where the
yield curve is expected to invert and the premium demanded on short-term bonds should be higher.
An upward sloping yield curve can be interpreted as the yields on short-dated bonds beings less
positively correlated with bad times than are long-dated bonds. The less positive or more negative
correlation will make short-dated bonds more reliable as hedges against bad consumption outcomes
than long-dated bonds. This, in turn, implies that the premium should be higher for the latter. The
yield curve should be upward sloping to reflect the differences in premium.
When the yield curve is inverted, short-dated bonds will quote a higher premium relative to long-
dated bonds.
In addition, a steeply sloping yield curve will correspond to high inflation expectations. An inverted
yield curve will signal a decline in inflation once a peak has been reached during the late stages of a
business expansion.

Correct Answer: B
Based on the calculations below, bond risk premiums are projected to increase. An increase in
premiums implies that investors place less value on the consumption-hedging properties of
government bonds. Therefore, the demand for such bonds is projected to decline.
The bond risk premiums (BRP) for each of the five issues are calculated as follows:
Bond risk premium = Projected yield on conventional government bond – Projected yield on
inflation-indexed government bond – Expected inflation rate
BRP (3-month) = 3.8% – 2.4% - 0.9% = 0.5%

BRP (12-month) = 4.5% – 2.1% - 1.1% = 1.3%
BRP (15-month) = 5.9% – 1.9% - 1.4% = 2.6%
BRP (18-month) = 6.8% – 1.5% - 1.5% = 6.8%

Correct Answer: B
Based on the maturity schedule, inflation risk premiums increase with maturity. Therefore, Peterson
should expect domestic interest rates to increase with inflation.


Correct Answer: C
C is correct. When credit spreads are narrowing, lower-rated corporate bonds will outperform
higher-rated bonds. This is because the latter are associated with a higher credit spread and thus the
increase in price as a result of narrowing in spread will be greater for this issue. Therefore, relative to
the higher-rated Issue 2, Issue 3 is the most attractive from an investment perspective.
A is incorrect. When credit spreads are narrowing, corporate bonds will outperform government
bonds making Issue 1 the least attractive from an investment perspective.


Correct Answer: B
Since the local government has proposed to pay rental income that is indexed to inflation, the
discount rate that would apply to the investment in commercial property would include
liquidity and equity risk premium in addition to the real risk-free rate.
On the other hand, the discount rate on the investment in which ATC Services is the
borrower would equal to the sum of the real risk-free rate, liquidity risk premium, equity risk
premium, credit risk premium, premium for expected inflation, and premium for inflation
uncertainty. Therefore, the difference between the two rates is equal to the sum of the credit
risk premium, premium for expected inflation, and premium for inflation uncertainty. The
discount rate on an investment in which ATC Services is the borrower is higher by 3.00% +
0.75% + 1.80% = 5.55%

Correct Answer: A
The equity risk premium compensates investors for the uncertainty related to the value of the
property at the end of the lease.


Correct Answer: A
The discount rate used for the investment is equal to 1.40% + 3.00% + 0.75% + 1.80% +
1.20% + 0.90% = 9.05%
Using a financial calculator, the implied property value is equal to:
$6,131,406.58.
CF1-7: $250,000
CF8: $9,750,000
I/Y = 9.05%
NPV = 6,131,406.58
Given that the asking price of $9.5 million is greater than the implied property value, the
return would be less than the implied hurdle rate of 9.05%. Therefore, the investment would
not be worthwhile for Train Inc.

Correct Answer: B
Young is incorrect with respect to Reason 1. Rental income has been found to be relatively
stable in nominal terms and almost immune to the business cycle. Young has incorrectly
pointed out this fact.
On the other hand, Young has correctly stated that commercial property capital values are
sensitive to business cycle fluctuations.

Correct Answer: B
In general, commercial real estate has been found to be an ineffective hedge against bad
consumption outcomes. The reason for this is that commercial real estate prices are
procyclical, declining during recessionary periods and rising during periods of economic
growth. During recessionary periods, current income and consumption will be low and so the
marginal utility derived from an additional unit of consumption increases which decreases
the inter-temporal rate of substitution. Therefore, the correlation between the two variables is
positive.


Correct Answer: B
Young is incorrect regarding Conclusion 1; correct regarding Conclusion 2. Property risk

premiums are positively correlated with equity risk premiums. Both premiums tend to rise
during bad economic times.
Young is correct regarding Conclusion 2. Because commercial real estates are privately
traded, they are relatively illiquid. Therefore, investors will experience difficulty in easily
converting this asset class to cash during bad economic times. On the other hand, equity is a
relatively liquid asset class and conversion to cash during bad economic times is easier.

Reading 50 Analysis of Active Portfolio Management FinQuiz.com
FinQuiz.com
Study Session 17
June 2019


Reading 50: Analysis of Active Portfolio Management

Correct Answer: C
Based on the calculations below, Wright is expected to generate the most positive returns by
underweighting Japanese stocks as this decision is expected to generate the highest value added
return.
Value added return = (Portfolio weight – Benchmark weight)(Portfolio return – benchmark return)
Value added return (Swedish stocks) = (0.3050 – 0.2580)(12.50% - 13.70%) = - 0.0564%
Value added return (UK stocks) = (0.2760 – 0.2385)(15.91% - 11.89%) = 0.15075%
Value added return (Japanese stocks) = (0.2185 – 0.3260)(29.77% - 39.00%) = 0.9923%

Correct Answer: B
Security selection return = wp ,i RA,i + ∆wp , j RA, j + ....∆wp , x RA, x
Security selection return = (0.305)(12.50% - 13.70%) + (0.276)(15.91% - 11.89%) +

(0.2185)(29.77% - 39.00%) + (0.2005)(25.03% - 27.54%) = - 1.77649 or - 1.776%

Correct Answer: A
To calculate the information coefficient using the basic fundamental law of active management,
optimal portfolio active risk and return needs to be determined.
Portfolio active risk = [(3.66%)2 (0.305 – 0.258)2 + (4.50%)2 (0.2760 – 0.2385)2 + (6.80%)2(0.2185 –
0.3260)2 + (2.77%)2(0.2005 – 0.1775)2]0.5 = 0.77233%
Portfolio active return = (0.305 – 0.258)(12.50% – 13.70%) + (0.2760 – 0.2385)(15.91% – 11.89%) +

(0.2185 – 0.3260)(29.77% – 39.00%) + (0.2005 – 0.1775)(25.03% – 27.54%) = 1.0288%
Basic fundamental law: E(RA) = IC BRσ A
1.0288% = IC 4 × 0.77233%
IC = 0.666045


Correct Answer: B
B is correct. A consequence of the two country stocks being positively correlated is that the breadth
of the investment strategy will be lower than the number of securities in the portfolio; this is because
part of the manager’s forecast will be higher or lower based on the perspective the investor has about
the industry. This will considerably reduce the number of independent decisions a manager has about
an industry. Since the breadth of the investment strategy will remain overstated, Ali’s proposed
strategy will not contribute positively towards increasing the information ratio of the investment
account; IR = IC BR .
B is incorrect. The transfer coefficient is not affected by the correlation between stock returns or an
improvement in forecasting accuracy.
C is incorrect. Ali’s suggestion will not help in increasing the expected information ratio of the
portfolio because the information ratio can only increase if the active return decisions are independent
over time and the information coefficient can be maintained. In the case of the client’s investment
account, active return decisions are not independent. A policy aiming to increase managerial skill will
increase the information coefficient but will not serve to increase the information ratio when
rebalancing decisions are accounted for.

Correct Answer: C
Active return based on the Grinold rule: E(RA) = Expected IC × σA × Score

= 0.25 × 3.80% × 2.20 = 2.09%
The transfer coefficient is less than 1.0 which provides evidence that the portfolio manager’s ability
to translate active return forecasts into actual active returns is restricted due to portfolio constraints.
With limits on active risk, the percentage of successful and unsuccessful market calls cannot be used
to calculate the expected active return.

Correct Answer: A
Gregory is incorrect with respect to Statement 1. While the variance in performance due to constraint-
induced is equal to TC2 = 0.372 = 0.1369 or 13.7%, this value is a component of realized (and not
expected) variation.
Gregory is also incorrect with respect to Statement 2. The maximum possible Sharpe ratio of a
constrained portfolio is equal to the sum of the squared Sharpe ratio of the benchmark and the product
of the squared information ratio of an unconstrained portfolio and squared transfer coefficient.


Correct Answer: C
Statement 1 is inaccurate. While active security return can be defined as the residual return in a
single-factor statistical model, RAi = Ri – βiRB, the benchmark return does not necessarily need to be
the market return as the fundamental law does not require the empirical validity of any equilibrium
theory of required returns. Evans has correctly pointed out that active security return can be defined
as benchmark excess return or the actively managed portfolio’s excess return, RAi – RB.

Correct Answer: C
When the TC = 0, there would be no correspondence between the active return forecasts and active
weights and thus expectation of value added from active management. In this case, one would expect
the manager to follow a passive risk management mandate. Manager C is therefore following a
mandate which is inconsistent with the stated active mandate.

Correct Answer: A
Evans is correct with respect to Observation 1. Manager A’s constrained portfolio’s active risk is
higher than the optimal active risk. According to the full fundamental law of active management,
optimal active risk is calculated as:
IR * 0.78
σ A = TC σ B = 0.90 × × 0.13 = 0.1404 or 14.04%
SR B 0.65
The portfolio’s actual active risk is higher than the optimal active risk (15.50% and 14.04%,
respectively). Manager A can reduce his portfolio risk by mixing 9.42% (1 – 14.04/15.50) in the
benchmark and 90.58% in the actively managed fund.
Evans is incorrect with respect to Observation 2. Manager B’s actual active risk of 12.85% is lower
than the optimal active risk of 13.71% (see below).
IR * 0.65
σ A = TC σ B = 1.00 × × 0.1856 = 0.1371
SR B 0.88


Correct Answer: B
The Sharpe ratio of each managed portfolio is calculated using the formula:
SR2P = SR2B + (TC)2(IR*)2

SR2P (Portfolio A) = 0.652 + (0.90)2(0.78)2 = 0.9153
SR2P (Portfolio B) = 0.882 + (1.00)2(0.65)2 = 1.1969
SR2P (Portfolio D) = 0.732 + (0.75)2(0.20)2 = 0.5554
The portfolio with the highest squared Sharpe ratio will have the highest Sharpe ratio and that
portfolio is B.

Correct Answer: C
Marshall’s statement is inaccurate as the risk being mentioned is strategy risk. Strategy risk reduces
expected and average realized information ratios. The higher the uncertainty about forecasting ability
(IC), the smaller the expected value added is likely to be. An overestimated IC will lead to a smaller
expected value added.

Correct Answer: A
In an absence of portfolio constraints, the transfer coefficient is equal to 1.00. In this scenario, the
expected active return for managers A, B and C after incorporating the uncertainty of the information
coefficient is:
IC 0.05
E(RA) – Manager A: σA = × 15 .50% = 5.032 %
σ IC 0.1540
0.04
E(RA) – Manager B = × 12.85% = 4.283%
0.1200
0.07
E(RA) – Manager D = × 5.11% = 1.5827%
0.2260
After incorporating the lower information coefficients, Manager A generates the highest expected
active return on his portfolio.


Correct Answer: C
The basic fundamental law states that the expected active return is E(RA) = IC BRσ A
There is no information to indicate that the returns of the bond issues in Forecast 1 are correlated.
Therefore, the breadth of the strategy is equal to 40. Given that the forecasts are made semi-annually,
expected active return is equal to 15.74% = ( 0.20 × (40 × 2) × 8.8% ).
In contrast, the breadth for Forecast 2 will not equal to the number of securities in question (10)
because active return forecasts relate to GDP growth expectations, which is fairly stable. Therefore,
(
expected active return returns will not equal 5.56% 0.20 × 10 × 8.8% . )
The breadth for forecast will be lower than the number of securities in question (20) as the returns of
stocks constituting the fund are positively correlated. Therefore, Adams should expect the expected
(
active returns to be lower than 7.87% 0.20 × 20 × 8.8% . )
Correct Answer: A
Adams is correct with respect to the limitation he has outlined. Unlike equity securities, for which the
risk factors can be decomposed and systematic risk factors removed, almost all bonds represent a
combination of duration risk, credit risk and optionality. Therefore, returns are highly correlated in
subtle ways which complicates the process of determining breadth.


Correct Answer: A
Based on the calculations below, Gilbert appears to enjoy the higher information ratio.
STD (R A ) = STD (RB )

IR
SRB
Rearranging this equation, we can determine the information ratio for each fund manager:
IR (Gilbert) = (12.90%/20.88%) × 0.75 = 0.4634

IR (Cohen) = (9.15%/14.60%) × 0.40 = 0.2507

Correct Answer: B
Considering the leverage levels and the expected active risk provided in the exhibit, the optimal risk
is calculated for the two managers:
(Optimal active risk/actual active risk) – 1 = leverage
Gilbert’s optimal level of aggressiveness = (0.2 + 1) × 12.90% = 15.480%
Cohen’s optimal level of aggressiveness = (0.5 + 1) × 9.15% = 13.725%
Based on the above calculations, the following conclusions can be made:
• B is correct. Gilbert has a higher optimal level of aggressiveness as indicated by a higher

risk figure (15.480% vs. 13.725%).
• A is incorrect. Leverage serves to increase the level of aggressiveness for the two
managers. Gilbert’s active risk level will increase from its current level of 12.90% to
15.480% while Cohen’s active risk level will increase from its current level of 9.15% to
13.725%.
• C is incorrect. See the above calculations.


Correct Answer: B
Given that both the Domestic Equity fund’s Sharpe ratio and active risk is higher than its benchmark,
the objective will be to maintain the fund Sharpe ratio while minimize risk.
B is correct. The initial expected excess return of the fund is 23.75% (0.95 × 25.00%). The strategy
will decrease the expected excess return to 19.84% (0.95 × 20.88%).
A is incorrect. The fund’s Sharpe ratio will not be affected by the active risk reduction strategy.

Correct Answer: A
Increasing or decreasing the level of aggressiveness has no impact of the information ratio of an
unconstrained portfolio because active risk and active return will increase proportionally. There is no
evidence to indicate that the Fund is subject to investment constraints. Therefore, the information
ratio will remain unchanged.


Correct Answer: B
Since ex post value added returns are being calculated, the realized or the ex post information
coefficient will be used.
E (R A IC R ) = (TC )(IC R ) BRσ A
Gayle’s realized active returns = (0.50)(0.25) 2 × 8.85% = 1.564%

Paul’s realized active returns = (1.00)(0.15) 2 × 8.60% = 1.824%
Lee’s realized active returns = (0.97)(0.18) 2 × 5.78% = 1.427%
Based on the value added returns calculated, Paul has generated the highest value added
returns during the period.

Correct Answer: B
The variation in the performance over time, which is attributable to the success of the
forecasting process, is calculated as TC2. Based on this measure, Paul has reported the
highest transfer coefficient and thus the highest TC2 measure.


Correct Answer: A
A is correct. Conclusion 1 is based on the mean variance theory which assumes that portfolio
with the highest Sharpe ratio is the one with the highest information ratio:
SR2P = SR2B + IR2
However, given that the value of Gayle’s TC is less than 1.0, this conclusion is not correct.
SR2P = SR2B + (TC)2(IR*)2
Gayle’s unconstrained portfolio’s information ratio = IR =

SR 2 P − SR 2 B = 0.952 − 0.622 = 0.71979
Gayle’s portfolio’s Sharpe ratio based on constraints = SRP =

0.62 2 + (0.50 ) (0.71979) = 0.71689
2 2
Immediately after considering portfolio constraints, her portfolio’s Sharpe ratio declines
below that of Paul’s portfolio. The latter’s portfolio is not subject to portfolio constraints and
will thus maintain a Sharpe ratio of 0.86.

Correct Answer: A
A is correct. Weaver is correct with respect to Conclusion 2 because the ex post IC for all
four managers is lower relative to their ex ante IC. The difference between the two values
can be attributable to an overestimated forecasting ability resulting from overconfidence.
C is incorrect. The transfer coefficient measures the correlation between forecasted active
returns and optimal active weights.


Correct Answer: A
A is correct. Conclusion 3 can be directly implemented for Paul without influencing her
existing information ratio. Based on a TC of 1.00, Paul’s portfolio is not subject to any
constraints and, therefore, she can increase her aggressiveness without changing the overall
information ratio. Increasing the aggressiveness of an unconstrained portfolio will increase
active return and risk by the same magnitude leaving the overall information ratio
unchanged.
B is incorrect. As evident from the TC and his portfolio’s active risk, Jacobs has adopted a
passive management approach. Increasing his aggressiveness will change his investment
mandate as well as the zero or near-zero information ratio reported for his investment
portfolio.
C is incorrect. Based on a TC of less than 1.00, Lee’s portfolio is subject to constraints and
therefore increasing the aggressiveness of the active weights will influence his reported
information ratio.

Correct Answer: A
Asset allocation return = (0.35 – 0.50)(10.5%) + (0.65 – 0.50)(7.0%) = - 0.525%

Reading 51 Algorithmic Trading & High-Frequency Trading FinQuiz.com
FinQuiz.com
Study Session 17
June 2019


Reading 51: Algorithmic Trading & High-Frequency Trading

Correct Answer: C
C is correct. The trading strategy most appropriate for the pension fund is volume-weighted
average price. The volume-weighted average price uses the historical trading volume
distribution for a security over the course of the day dividing the order into slices in a way
which is proportioned to the distribution. This technique is an example of the execution
algorithm which has a goal of achieving a benchmarked (fair) price.
The HFT strategy most appropriate for the bank is mean reversion. The difference between
the current price of $50 and the mean price of $40 presents an arbitrage opportunity to sell
the underlying bonds of the issue.

Correct Answer: A
The order submitted by Twain is classified as a child order which represents a subset of the
overall parent order. The instructions sent by the pension fund manager to Twain represents a
parent order. The parent order specifies whether the order is a buy or a sell order, the
quantity, and the algorithm to use.

Correct Answer: B
B is correct. While the use of algorithms has helped to bring down the cost of execution, this
positive impact of algorithmic trading does not underlie Twain’s beliefs with respect to the
need for trading strategies to evolve.
A and C are incorrect. The scenario presented by Twain is an example of a market

fragmentation strategy in which an instrument trades in multiple trading venues at different
prices and liquidities and traders aggregate the liquidity and send the order to the venue with
the greatest price and liquidity. The increased fragmentation of markets has made it
necessary for trading strategies to evolve such that they can operate more effectively in an
environment with fragmented liquidity and avoid the intensifying market impact of a large
trade. Furthermore, low latency and rapid update is important to avoid trading on stale
liquidity information.


Correct Answer: B
Fat finger trades are trades in which order entry mistakes are made. By entering an order to
sell 100 bonds instead of 1,000 bonds, BMC has engaged in fat finger trading.

Correct Answer: A
Twain is correct with respect to Comment 1 and Comment 2. Although trading venues have
had real-time surveillance technologies for a long time, there is a lack of consistency across
the market. The monitoring and surveillance role of regulators is also challenged by the
multitude of high-frequency algorithms, market fragmentation, cross-asset trading, and dark
pools (where trading venues do not publish their liquidity and are only open to selected
clients).

Correct Answer: B
B is correct. Although HFT techniques as well as the market and news event data purchased
by HFTs are available to any firm, these techniques are quite costly to develop and run, and
many investors cannot afford them, creating unequal access to information.
C is incorrect. HFT research literature strongly supports the assertion that HFT has led to
narrowing of bid-ask spreads, lower transaction costs, and an increase in liquidity and price
efficiency. All these developments have taken place without an increase in volatility.

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Reading 1 Code of Ethics & Standards of Professional Conduct FinQuiz.

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FinQuiz Level II 2019 – Item-sets Solution

Reading 1: Code of Ethics & Standard of Professional Conduct

Please download item-sets file Reading 2.

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FinQuiz Level II 2019 – Item-sets Solution

Reading 2: Guidance for Standard I-VII

1. Question ID: 10536

2. Question ID: 10537

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3. Question ID: 10538

Additionally by sending out the recommendation to existing clients only as opposed to

4. Question ID: 10539

5. Question ID: 10540

By presenting the performance attained by Emerson at Denver Associates as being attained at

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6. Question ID: 10541

The requirement that members and candidates/investment professionals must exercise

7. Question ID: 10550

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8. Question ID: 10551

Additionally standard VI (B) Priority of Transactions requires members and candidates to

9. Question ID: 10552

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Standard IV (B) Additional Compensation Arrangements requires members and candidates

10. Question ID: 10553

11. Question ID: 10554

Additionally, Brewer has not violated III (B) Fair Dealing.

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12. Question ID: 10555

13. Question ID: 10564

Standard IV (C) Responsibility of Supervisors requires members and candidates to make

14. Question ID: 10565

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15. Question ID: 10566

16. Question ID: 10567

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17. Question ID: 10568

18. Question ID: 10569

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19. Question ID: 10578

20. Question ID: 10579

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21. Question ID: 10580

22. Question ID: 10581

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23. Question ID: 10582

Standard IV (B) Additional Compensation Arrangements prohibits member and candidates

24. Question ID: 10583

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25. Question ID: 10592

26. Question ID: 10593

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27. Question ID: 10594

28. Question ID: 10595

29. Question ID: 10596

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30. Question ID: 10597

Standard IV (B) Additional Compensation Arrangements requires members and candidates