CFA Level II 2017 Progress Test

Transcription

1 CFA Level II 2017 Progress Test IMPORTANT INSTRUCTIONS TO CANDIDATES 1. Use the answer sheet to record your answers 2. Only complete the answer sheet using an HB or 2H pencil 3. You may make marks on the question booklet, but no marks will be awarded 4. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C calculator 5. You must stop writing immediately when instructed to do so at the conclusion of the examination 6. At the back of the paper there is space for rough working Question Topic Recommended time allocation 1 Fixed Income 18 minutes 2 Equity Valuation 18 minutes 3 Equity Valuation 18 minutes 4 Quantitative Techniques 18 minutes 5 Financial Reporting and Analysis 18 minutes 6 Financial Reporting and Analysis 18 minutes Total time permitted 1 hour, 48 minutes Tel: Fax: clientservices@fitchlearning.com

2 Copyright Fitch Learning Limited 2017 All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without the prior permission of the copyright owner. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. While every effort has been made to ensure its accuracy, Fitch Learning Limited can accept no responsibility for loss occasioned to any person, acting or refraining from action as a result of any material in this publication. 2

3 QUESTION 1: FIXED INCOME (SIX PARTS FOR A TOTAL OF 18 MINUTES) Paul Mookherjee is a new joiner at Green Lane Capital and works in their relative value, fixed income team. He has inherited a rather eclectic mix of models and research with most, only partially finished. The previous incumbent left the firm suddenly following a compliance led clamp down on personal account trading. Mookherjee s area of expertise is the valuation of embedded options within bonds. Mookherjee is looking to value a three year, 4% annual paying putable bond. Starting at year 1, this bond may be put based on a Bermudan exercise style. Before he can value an embedded option he needs to complete his benchmark model. Mookherjee has access to the files that the former analyst was working on and has found an excel file which shows the discount rates from a calibrated binomial tree based on an option free benchmark bond. His predecessor, who preferred the pathwise approach for valuation, had not completely finalized this spreadsheet. An extract from the spreadsheet is shown in Exhibit 1. Exhibit 1: PATH TIME 0 TIME 1 TIME 2 PV of Path 1 3% 4.886% 7.459% % 4.886% 7.459% % 4.886% 5.001% % 4.886% 5.001% % 3.275% 5.001% 6 3% 3.275% 5.001% 7 3% 3.275% 3.352% 8 3% 3.275% 3.352% Before Mookherjee can start on his work on valuing the putable bond he needs to identify the option adjusted spread (OAS). A colleague has advised him that an appropriate OAS to use for this particular bond would be 54bps (basis points). Using this OAS, Mockherjee estimates the price of the putable should be Amongst the files that his former colleague was working on, Mookherjee has also found some data on the key rate durations of two different bonds. They are both 15y in maturity and both pay a high coupon relative to the yield (coupon is twice as high as yield). One of the bonds is callable (at par) and the other is putable (at par). Both have a 10y lockout period. In reviewing the data on the key rate durations within the file, shown in Exhibit 2, Mookherjee believes that he has identified an error. Exhibit 2: Key rate durations Bond 2y 5y 10y 15y Callable Putable

4 The last file that Mookherjee has been able to gain access to contains information regarding a convertible bond, issued by a UK television company TV plc. The current stock price is and the convertible is offered at a price of per 100 nominal. The top left corner of the Bloomberg screen shown in Exhibit 3 includes details of the conversion rights 70, shares per 50,000 nominal value. Exhibit 3: Convertible Bond [131504] 1. Using a pathwise approach calculate the value of a 3y 4% option free bond based on $100 nominal value, using Exhibit 1. A B C Why might Mookherjee need to calculate an option adjusted spread (OAS)? [131505] A. Whenever there is an embedded option it is necessary to calculate this spread B. The putable bond may have different credit and liquidity risk to the benchmark bond C. The option within a putable bond creates higher uncertainty with regard to the forecast cash flows, which means investors need a higher return 4

5 [131506] 3. Calculate the effective duration of the three year, 4% putable bond, using all relevant information provided and assuming a 25bp interest rate shock. Assume the price of the putable when rates decrease by 25 basis points has already been calculated as and the original price before any change in rates is A B C [131507] 4. With reference to Exhibit 2, which key rate duration is most likely wrong and what is the likely justification? A. 15y callable key rate is too low given that most of the cash flows come at year 15 we would expect a higher sensitivity to a change in 15y rates B. 15y putable key rate is too low given the coupon relative to the yield, it is unlikely this bond will be put and so it should behave more like an option free bond C. Both bonds appear to have the wrong durations for the early maturities given the high relative coupon we would expect the key rate durations to be negative for the tenors prior to the bonds maturity. [131508] 5. Using Exhibit 3 and the information given in the case study, calculate the conversion value of the TV plc convertible, based on 100 nominal. A. GBP43, B. GBP36.43 C. GBP86.17 [131509] 6. Using Exhibit 3 and the information given in the case study, calculate the market conversion premium ratio of the TV plc convertible, using the offer price. A % B. 40% C % 5

6 QUESTION 2: EQUITY VALUATION (SIX PARTS FOR A TOTAL OF 18 MINUTES) Megan Reyburn, an investment analyst with a large asset management company, is analyzing the latest brokerage report on a large beverage company, Koka Kola Inc. (KKL) Koka Kola Inc. is a multinational company based in the U.S. The company entered the market in the mid 1990s and after several years of losses has finally gained a foothold in the industry and is starting to pick up market share. As a result, the company is looking to a potential equity issue in the near future in order to expand its production capabilities and exploit potentially lucrative overseas markets. Currently Koka Kola Inc. has a small operation in Europe but the product has not experienced the same levels of growth overseas as it has domestically. The brokerage report suggests that the company is strong buy, citing the recent domestic growth and the likelihood of this being repeated in Europe as the main justification. Reyburn, however, is not convinced and intends to carry out her own analysis before accepting the recommendation. To assist in this analysis she has obtained extracts from the latest financial accounts as shown in Exhibits 1 and 2 and intends to calculate the company s free cash flow for the most recent period. She also intends to undertake two dividend valuation exercises as at 31 December The first will assume that the sustainable growth rate for 2013 will persist into the foreseeable future. She intends to calculate return on equity using equity at the start of the year and assume a required return on equity of 18%. In addition, she will also undertake a valuation based on the H model as some analysts have suggested that the company will only experience high growth in the short term. Her valuation will assume growth of 20% declining in a linear fashion to 5% over 5 years with a required return on equity of 18%. Exhibit 1 Koka Kola Inc. (KKL) Income Statement Extracts Year ending 31 December ($million) EBITDA Depreciation expense Operating income Interest expense Income before taxation Income tax Net income Dividend

7 Exhibit 2 Koka Kola Inc. (KKL) Balance Sheet Extracts As at 31 December ($million) Cash Accounts receivable Inventory PPE (NBV) Total assets Accounts payable Short term debt Long term debt Common stock Retained earnings Total liabilities and equity Note: There have been no disposals, impairments or revaluations of PPE during the year. Reyburn reports in to Michael Ginfarm, a senior analyst with the company. Ginfarm has concerns with the models valuation process Reyburn has used, principally concerning the calculation of the required return on equity. Reyburn had calculated the return using the CAPM model and data shown in Exhibit 3. Exhibit 3 Required return on equity using CAPM Risk free rate 5% Market return 12% Koka Kola Inc. beta 1.86 Ginfarm believes that the beta may be inaccurate and suggests using an adjusted beta to take into account the fact that the beta in future periods is likely to be closer to the beta of an average systematic risk security. Ginfarm has also been considering the possibility of calculating the required return on equity using the Fama French multi factor model. He believes that this involves taking into account a market risk factor, a market capitalization factor and book to market value factor. In addition he believes that a residual income valuation model should also be used to get a further valuation for the company. He believes the residual income method to be a better model than free cash flows for three reasons: 7

8 Reason 1: Reason 2: Reason 3: The net income figure used in the calculation of residual figure is less open to manipulation than free cash flow to equity. The residual income method is not as dependent on the terminal value as dividend discount or free cash flow models. The residual income method can be used to assess the value of a controlling interest whereas the dividend valuation model and free cash flow models cannot. [126130] 7. Which of the following is closest to the value of Koka Kola Inc. using Reyburn s sustainable growth dividend discount model? A. $1,207 million B. $1,068 million C. $862 million 8. Which of the following is closest to Koka Kola Inc. s free cash flow to equity for 2013? [126131] A. $69.8 million B. $63.9 million C. $74.9 million 9. Which of the following is closest to the value of Koka Kola Inc. using Reyburn s H model assumptions? [126132] A. $585 million B. $431 million C. $739 million [126133] 10. What is the most likely impact of the adjustment to beta proposed by Ginfarm on the cost of equity for Koka Kola Inc.? A. Increase the cost of equity B. Decrease the cost of equity C. Have no impact on the cost of equity 11. Which of Ginfarm s statements regarding residual income models is most likely correct? [126134] A. Statement 1 B. Statement 2 C. Statement 3 8

9 12. Is Ginfarm most likely correct in his description of the Fama French model? [126135] A. Yes B. No, the factors that need to be used in the Fama French model are undefined C. No, the Fama French model also includes a liquidity factor 9

10 QUESTION 3: EQUITY VALUATION (SIX PARTS FOR A TOTAL OF 18 MINUTES) Terry Choker, CFA, is analysing the valuation of Chelsea Blues (CBL), a high end interior design company which is based primarily in Europe. The company is relatively young having been set up only six years ago. As a result it has not as yet paid a dividend to shareholders and has only recently started to generate significant positive cash flows. The head office and primary market is based in Paris in continental Europe and consequently the company reports in Euros. Currently the company is considering raising funds for considerable expansion into Eastern Europe. Choker has seen several brokerage reports on the company and noted that most contain a buy or strong buy recommendation. He remains unconvinced however, partly because of the lack of history of the company and partly because he cannot foresee the company s dividend policy changing in the near future. Choker is not convinced that the company is set for consistent growth and without the prospect of a change in the dividend policy he does not see that the stock will offer an adequate return for the risk profile of the business. To assess the availability of cash to pay out as a dividend, Choker intends to carry out a free cash flow to equity calculation. He intends to forecast the free cash flow to equity for next year using the assumptions given in Exhibit 1. Exhibit 1 Free Cash Flow to Equity Assumptions 2014 Sales will be 4.7m in 2014 Net profit margin is expected to remain constant at 35% Capex is expected to be 40% of sales Depreciation is expected to be 10% of sales The investment in working capital is expected to be 6% of sales The target debt to total assets ratio is 20% The tax rate is 15% Choker also wants to use one of Chelsea Blues major competitors, Parisian Groomer (PSG), as a benchmark to assess whether CBL represents good value. In order to do this he intends to carry out a valuation exercise on PSG using a free cash flow to equity model and the assumptions listed in Exhibit 2. 10

11 Exhibit 2 Free Cash Flow to Equity Valuation PSG Free cash flow to equity ,300 Net income ,480,000 Free cash flow growth for five years 30% Net Income growth for five years 30% Trailing P/E at the end of forecast horizon 20 Required return on equity 15% Number of shares in issue 20 million If Chelsea Blues does go ahead and raise funds, Choker expects it to be via a debt issue. If this is the case he anticipates that in the year of issue free cash flow to equity and free cash flow to the firm would both increase. [126136] 13. Which of the following is closest to CBL s free cash flow to equity for 2014 using the assumptions in Exhibit 1? A. 0.58m B. 0.38m C. 0.29m [126137] 14. Which of the following is closest to PSG s price per share at the end of 2013 using a free cash flow to equity model and the assumptions given in Exhibit 2? A B C [126138] 15. Is Choker most likely correct in his description of the effect of a debt issue on free cash flows? A. Yes B. No, free cash flow to equity would increase but free cash flow to the firm would be unaffected C. No, free cash flow to the firm would increase but free cash flow to equity would be unaffected 11

12 16. Assuming a FCFF figure for year 1 is 0.5m, for the items below calculate how a 200,000 increase in each item below would impact on FCFF. Assume where relevant a tax rate of 20% [126139] 1. Depreciation (assuming it is tax deductible) 2. Accounts receivables 3. Interest expense A. +40,000; 200,000; no impact B. +40,000; 200,000; 80,000 C. +200,000; 200,000; no impact [126140] 17. Which of the following is an advantage to using Residual Income valuation approach rather than FCF to value a share? A. Useful when looking from a controlling perspective B. Useful when dividends are variable C. Useful if the company has a very large capital expenditure causing free cash flow to be negative 18. When adjusting net income for non cash items which of the following would not be a subtraction from net income when calculating FCFF? [126141] A. Gains from disposals of assets B. The tax benefit from offering stock options to employees that is not expected to be an ongoing event C. Amortization of a bond premium 12

13 QUESTION 4: QUANTITATIVE METHODS (SIX PARTS FOR A TOTAL OF 18 MINUTES) Jonathan Board is a research analyst within the retail section at Jasons Investment House. He is evaluating the performance of Shrew & Company, a large discount retail chain. He divides the company performance by regions and picks up one of the regions for detailed analysis. Here he finds that some stores seem to perform much better than others. Jonathan feels that three factors are related to sales: the number of competitors in the region, the population in the surrounding areas, and the amount spent on advertising. He gathers the following information for each store: Y = total sales last year ($ thousands) A = number of competitors in the region B = population around the store vicinity (in millions) C = advertising expense ($ thousands) Based upon the collected data, Jonathan uses a statistical package to regress sales against the number of competitors, population and advertising expense. The results are shown below in Exhibit 1. Exhibit 1 Regression Model Output Predictor Coefficient Standard error t stat Constant A B C Analysis of variance (ANOVA) Table Source DF SS MS Regression Error 2200 Total

14 The data for two stores is as follows: Store 1 Store 2 Number of competitors 4 0 Population 400, ,000 Advertising US $30, What is the Coefficient of Determination and the Standard Error of the Estimate (SEE)? [126142] Coefficient of Determination SEE A B C [126143] 20. Jonathan wants to find out if the independent variables as a whole have an explanatory power in relation to sales. Determine the appropriate test statistic and the correct interpretation. Assume a 5% level of significance. Please assume that using a 5% F table the critical stat is 2.99, and using a 2.5% table the critical stat is Interpretation Value of test statistic A Do not reject null 1.38 B Do not reject null 9.01 C Reject the null

15 [126144] 21. Jonathan wants to determine if he can eliminate any of the independent variables from his equation by a t test. Which of the statements below is closest to the correct conclusions Jonathan should reach? (You can assume a critical t stat of 2) A. All of the gradient coefficients are significant B. Advertising coefficient is 0.2. Given the closeness to zero, it is likely that this coefficient is not significant C. The coefficient for variable A is likely not to be significant [126145] 22. Jonathan uses out of sample data for two years to determine if his model is robust or not. Based upon the results he is concerned with the fact that the error terms (i.e. difference between the predicted sales values and the actual sales value) seem to be correlated. Identify the problem that is caused by correlation between error terms and the consequences of such a problem. Problem Consequences A Multicollinearity Incorrect standard errors B Serial correlation Incorrect standard errors C Serial correlation High R 2 and low t statistics 23. Which of the following tests is appropriate to assist Jonathan in deciding whether there is conditional heteroskedasticity and multicollinearity present in his test? [126146] Conditional heteroskedasticity Multicollinearity A. Durbin Watson statistic Breusch Pagan test B. Breusch Pagan test High R 2 with low t statistics C. Breusch Pagan test Durbin Watson statistic 15

16 [126147] 24. Jonathan is considering running a new regression, this time regressing sales against previous sales figures using a one lag period. He asks some of his colleagues for advice in forming this new model. Below are some of their replies. Which one is most likely to be true? A. Using an AR(1) model is unlikely to be covariance stationary if you have a unit root problem. For the model to work you need the lag coefficient to be statistically significantly less than one. You can test for this using the Dickey Fuller test B. Using an AR(1) model is likely to be covariance stationary unless you have a unit root problem. For the model to work you need the lag coefficient to be statistically significantly different from one. You can test for this using the Engle Granger test C. When using an AR model you would expect the t stats for the autocorrelations to be significant and then to suddenly drop this is how you know how many lags you need in your model 16

17 QUESTION 5: FINANCIAL REPORTING AND ANALYSIS (SIX PARTS FOR A TOTAL OF 18 MINUTES) On 1 st January Oak Inc. acquired 80% of Elm Inc. The consideration was $440,000 and was funded $128,000 in cash and the balance by the issuance of new Oak Inc. shares. These shares had a market value of $5.20 when issued to fund the acquisition but have since fallen in value and one year later trade at $4.80 per share. Unless otherwise told, please use US GAAP. Details of the two companies balance sheets at 1 st January are shown below in Exhibit 1 Exhibit 1 Balance Sheet Extracts Oak Inc. Elm Inc. $ (000 s) $ (000 s) Cash Receivables Inventory Total current assets Land Plant and equipment (net) Total assets Current liabilities Non current liabilities Total liabilities Common stock Additional paid in capital 200 Retained earnings Total liabilities and equity

18 Points to note: 1) No adjustments have been made for the acquisition 2) The fair value of Elm Inc. s freehold land, on the open market is $180,000. Neither Elm Inc. nor Oak Inc. currently depreciate freehold land as they view it as an asset with a perpetual value 3) Elm Inc. s non current liabilities are overstated by $25,000 4) Elm Inc. s depreciable plant and equipment has a fair value that exceeds its book value by $40,000. This plant has a remaining useful life of ten years and will be depreciated on a straight line basis 5) Oak Inc. will treat any excess consideration, after taking the above points into account, as goodwill arising on acquisition. 6) Both Oak Inc. s and Elm Inc. s shares have a nominal value of $1. Abbreviated income statements for the year following the acquisition are shown below in Exhibit 2. Exhibit 2 Income Statement Extracts Oak Inc. Elm Inc. $ (000 s) $ (000 s) Revenue COGS (35) (12) Gross profit Expenses (15) (8) Depreciation (10) (3) Net income

19 Points to note i. These are before any consolidation adjustments. ii. All revenues, COGS and expenses were received/paid for in cash. iii. Neither company bought or sold any fixed assets during the year. iv. Neither company paid a dividend. 25. What is the value of Plant and Equipment (P&E) and Minority Interest in the consolidated balance sheet immediately following the acquisition if it is accounted for using the Acquisition method (to the nearest $000)? [126148] P&E Minority Interest A B C Which of the following is the best estimate for the consolidated Net Income for the year immediately following the acquisition under the Acquisition and the Pooling methods of consolidation (in $000s) [126149] Acquisition method Pooling method A B C [126150] 27. If, despite owning 80%, it was determined that Oak Inc. did not have control and that the investment in Elm Inc. should be accounted for under the equity method, which of the following is closest to the total asset figure upon acquisition of the stake. Answers are in $000s. A. 3,812 B. 3,420 C. 3,292 19

20 28. Calculate the amount of goodwill that would have been recognised at the time of the acquisition. [126151] A. $155,000 B. $124,000 C. $5,000 [126152] 29. If the investment was accounted for under the equity method, what is closest to the value for the investment at the end of the first year? A. $448,000 B. $440,000 C. $444,800 [126153] 30. Which of the following statements is most likely to be accurate when considering the treatment for the impairment of goodwill? A. Once impaired US GAAP does not permit goodwill to be restored whereas IFRS does permit the reversal of goodwill impairment B. Under US GAAP impairment losses are taken directly to equity (other comprehensive income) C. Under IFRS, once goodwill has been reduced to zero, any remaining amount of the impairment is then allocated to other non cash assets on a pro rata basis 20

21 QUESTION 6: FINANCIAL REPORTING AND ANALYSIS (SIX PARTS FOR A TOTAL OF 18 MINUTES) A German based car manufacturer company, BWM has recently established a US subsidiary, BWM USA. The presentation currency is the EUR and the functional currency of the subsidiary is USD. Upon setting up BWM USA, there was an initial equity investment of EUR 1000m made on 1 st January. The subsidiary immediately takes out a loan in USD for 500m, buys some plant and machinery and also some inventory. The exchange rate at the time of the investment was 1.56 (USD per 1EUR). Below is the inaugural balance sheet of BWM USA. Please note all values have been rounded to nearest whole numbers. BWM USA balance sheet on 1 st January (USD millions) CASH 550 INVENTORY 260 PP&E 1,250 TOTAL ASSETS 2,060 NOTES PAYABLE 500 COMMON STOCK 1,560 TOTAL FINANCING 2,060 After the first year of operations the subsidiary has the following income statement: BWM USA income statement for first year (USD millions) SALES 1,200 COGS (725) SG&A (210) DEPRECIATION (62.5) EBIT 203 INTEREST (55) TAX (45) NET INCOME

22 BWM USA uses LIFO inventory accounting and has maintained stable levels of inventory over the year. You can assume inventory purchases occurred evenly throughout the year and that the average rate approximates to the weighted average rate for purchases. The year end exchange rate is now 1.37 and the average rate for the year was Below is the year end balance sheet for BWM USA. No dividends were paid. BWM balance sheet on 31 st December (USD millions) CASH 715 INVENTORY 260 PP&E 1,188 TOTAL ASSETS 2,163 NOTES PAYABLE 500 COMMON STOCK 1,560 RETAINED EARNINGS 103 TOTAL FINANCING 2,163 [126154] 31. Using just the opening balance sheet, assume exchange rates have just changed to 1.46, i.e. on day 1 of establishing the subsidiary. Calculate the gain/loss from translation using the all current and also the temporal method All current Temporal A B. (31) 13 C Calculate the translation gain/loss for the first year assuming the scenario given. [126155] A. 213 B. 141 C. 2 22

23 [126156] 33. If we now assume the subsidiary s functional currency is the Euro, what would be the translation gain/loss? A. 9 B. 13 C. 141 [126157] 34. Which of the following items would be classified as a non monetary item under the Temporal method? A. Cash B. Deferred revenue C. Receivables [126158] 35. Which of the following best describes the treatment with regard to dealing with hyper inflation? A. Under IFRS foreign accounts are first restated for local inflation and then translated using the temporal method B. Under US GAAP the foreign accounts are not adjusted for inflation but you must use the all current method to ensure local values are most accurately converted into the presentation currency C. US GAAP requires that the temporal method is used whereas IFRS uses current exchange rates [126159] 36. The issue of converting inventory can be problematic. Assume a US Parent company owns a water treatment plant in Abu Dhabi. Assuming the reporting currency (presentation currency) and the functional currency of the Abu Dhabi company is the USD, then which of the following most accurately describes the correct treatment for calculating COGS? A. COGS should be calculated by converting opening inventory, closing inventory and purchases at the rates when the underlying transactions occurred B. COGS should be converted using an average rate for the year C. If the company is using FIFO then we would use year end rates for the closing inventory, opening rates for the opening inventory and average rates for purchases 23

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