Free CFA Institute CFA-Level-II Exam Questions
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Page No. 1 of 143
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Question 1
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Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.
Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts.O'Connor's annual dividend history is shown in Exhibit 1.
De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.
The output from the regression appears in Exhibit 2.
De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:
* Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
* The accuracy of the beta estimate.
* Whether or not the model is the appropriate one to use.
De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.
De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of .
She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.
Is De Jong correct with respect to her conclusions regarding the causes of the differences between her beta estimate for O'Connor and the published beta estimates, and her strategy for adjusting her beta estimate to more quickly approach the mean reverting level of beta?
Answer: B
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Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.
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Question 2
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Lauren Jacobs, CFA, is an equity analyst for DF Investments. She is evaluating Iron Parts Inc. Iron Parts is a manufacturer of interior systems and components for automobiles. The company is the world's second largest original equipment auto parts supplier, with a market capitalization of $1.8 billion. Based on Iron Parts's low price-to-book value ratio of 0.9* and low price-to-sales ratio of 0.15x, Jacobs believes the stock could be an interesting investment. However, she wants to review the disclosures found in the company's financial footnotes. In particular, Jacobs is concerned about Iron Parts's defined benefit pension plan. The following information for 2007 and 2008 is provided.
Iron Parts has adopted SFAS No. 158, Employers' Accounting for Defined Benefit Pensions and Other Postretirement Plans.
Jacobs wants to fully understand the impact of changing pension assumptions on Iron Parts's balance sheet and income statement. In addition, she would like to compute Iron Parts's economic pension expense.
Which of the following best describes the effect(s) of the change in Iron Part's expected return on the plan assets, all else equal?
Answer: C
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Question 3
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Mary Andrews and Drew McClure are economists for Gasden Econometrics. Gasden provides economic consulting and forecasting services for governments, corporations and small businesses. Andrews and McClure are currently consulting for the developing country of Wakulla, which is considering imposing new regulations on its businesses.
Due to increases in industrial production in the country, the demand for electricity has increased. Unfortunately the cost of electricity has increased as well, and the Wakullian government is considering regulating the electrical utility industry by limiting the amount producers can charge. The price limits would be established so that the utilities can set their own prices as long as they do not earn a return on invested capital that is higher than the average Wakullian business.
The Wakullian government has also proposed stiffer environmental regulations on its firms because the level of air quality has declined in its largest cities. Andrews advises that this regulation is likely to increase production costs that will burden smaller businesses more than larger businesses, and thus can adversely affect competition within an industry. The higher production cost from the environmental regulation will ultimately be borne by consumers, she asserts.
One of the concerns of the Wakullian government is that previous regulation of the economy has been ineffective. For example, when the automobile industry was required to increase the fuel efficiency of passenger vehicles, they increased the weight of some vehicles so more could be classified as trucks, instead of passenger vehicles. The trucks were not subject to the regulation and as a result, fuel efficiency actually declined in the country due to the heavier weight of trucks. McClure comments that the regulation should have been written so that the regulation would be more effective.
McClure gives another example of an ineffective regulation from the automobile industry. When airbags were required in automobiles, consumers started wearing their seat belt less often and driving at higher speeds because the airbags gave them a feeling of greater safety. Consequently, driving fatalities and injuries did not decline as much as expected.
Some regulation, Andrews states, is limited in effectiveness when the regulators are chosen from the industry that is regulated. For example, Andrews states that, due to the level of scientific knowledge needed, many regulatory bodies for the pharmaceutical industry are dominated by former drug company executives and scientists. She states that, according to the share-the-gains, share-the-pains theory, regulatory decisions tend to favor the drug industry because of the close relationship between the industry and the regulator.
McClure adds that another example of regulatory ineffectiveness is when telephone companies go before their regulatory bodies to ask for rate increases. He states ihat according to the capture hypothesis, telephone companies will have greater economic resources and more at stake than individual consumers. As a result, the regulatory decisions tend to favor the telephone industry.The Wakullian government is considering some of the country's industries. To illustrate the potential costs and benefits of deregulation to the Wakullian government, Andrews and McClure compose a matrix of the potential consequences of deregulation. In the matrix, three scenarios of possible economic consequences are presented in Exhibit 1
Regarding the statements made by Andrews and McClure on regulation in the drug industry and the telephone industry, are both statements correct?
Answer: B
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Mary Andrews and Drew McClure are economists for Gasden Econometrics. Gasden provides economic consulting and forecasting services for governments, corporations and small businesses. Andrews and McClure are currently consulting for the developing country of Wakulla, which is considering imposing new regulations on its businesses.
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Question 4
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Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.
Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the 'neglected firm effect,' in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be 'neglected.'
Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:
Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei
where:
Ri = the rate of return on stock i
COVERAGEi = one if there are three or fewer analysts covering stock
i, and equals zero otherwise
LN(SIZEi) = the natural logarithm of the market capitalization
(stock price times shares outstanding) for stock i,
units in millions
FORECASTi = the 1-year consensus earnings growth rate forecast for stock iPilchard derives the following results from her cross-sectional regression:
The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.
Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.
Pilchard derives the ANOVA table for her regression. In her ANOVA table, the degrees of freedom for the regression sum of squares and total sum of squares should equal:
Answer: C
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Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.
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Question 5
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Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1.
The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides detail about the Alpha Fund with a vintage year of 2006 and committed capital of SI95 million.
The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's new drug pipeline, a company value of $300 million is reasonable in five years. Management at Alpha Fund views Targus Company as a risky investment and is using a discount rate of 40%. After a thorough analysis of Targus's future prospects, Alpha Fund's management believes that there is a possible 15% risk of failure for the company.
Using Exhibit 2 and assuming a 20?rried interest, the Alpha Fund's 2008 dollar amount of carried interest is closest to:
Answer: B
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