2009 Level II Mock Exam: Afternoon Session The afternoon session of the 2009 Level II Chartered Financial Analyst® Mock Examination has 60 questions. To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam.

Questions

Topic

Minutes

1-6

Ethical and Professional Standards

18

7-12

Alternative Investments

18

13-18

Financial Statement Analysis

18

19-24

Financial Statement Analysis

18

25-30

Corporate Finance

18

31-36

Equity Investments

18

37-42

Equity Investments

18

43-48

Fixed Income Investments

18

49-54

Derivative Investments

18

55-60

Portfolio Management

18

Total:

180

By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

Questions 1 through 6 relate to Ethical and Professional Standards.

SMC Case Scenario Ian Sherman, CFA, is a portfolio manager at SMC, an investment advisory firm which offers investment products and services to individual and institutional clients. SMC has adopted the CFA Institute Research Objectivity Standards and implemented policies in compliance with the Standards. All of SMC’s investment professionals have earned CFA charters. Sherman tells prospective clients, “The CFA charter is the highest credential in the global investment management industry. As charterholders we are committed to the highest ethical standards. Completion of the program has dramatically improved the team’s portfolio management knowledge and their ability to achieve better performance results.” Sherman has earned a reputation for consistently outperforming the market. Over the long run, his mutual funds have outperformed their respective market benchmarks by a wide margin. For the past 12 months the funds have slightly underperformed the benchmarks. Some clients have noticed that Sherman’s fund performance information has not been updated on the advisor’s website in the past six months. When clients inquire about fund performance, Sherman provides them with accurate updated information. Annette Martineau, CFA, works as an analyst for Sherman and presents her recently completed research report and sell recommendation on Muryan Corporation, which is held in one of Sherman’s funds to SMC’s Investment Committee. After much debate about the company and its prospects, the committee reaches a consensus recommendation that is contrary to Martineau’s. Martineau informs Sherman, “I accept that the committee’s recommendation has a reasonable basis, but I strongly believe that my recommendation is more appropriate. I have been diligent in my research and have a deeper understanding of the industry and its competitive factors.” The following week, Martineau prepares for an investment conference, open to the general public but typically attended only by investment professionals, by reviewing SMC’s policies regarding public appearances. The policies state: 1) Employees should remind audience members to judge the suitability of the investment in light of their own unique circumstances. 2) Employees should make full disclosure of all conflicts of interest, both their own and those of the firm. 3) Employees may not provide research reports to audience members. Research reports are reserved exclusively for SMC clients. During the conference, private equity firm Caruso Limited announces a takeover bid for Muryan. Immediately, Muryan shares increase 30 percent in value. Martineau is skeptical of the transaction as she doubts that the Caruso partners fully understand the changing industry By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

dynamics of the target firm. She hypothesizes that they would cancel the deal if they did. Concerned that Caruso will eventually cancel the deal, Martineau drafts an updated report and reiterates her sell recommendation on Muryan. Since SMCs Investment Committee had overturned her previous sell recommendation on Muryan she goes into great detail as to why she believes Caruso will not complete the deal. She emails the recommendation to Sherman the next afternoon. That evening, Martineau considers what action to take regarding the 5,000 shares of Muryan held in her husband’s personal account. The firm’s policy on personal investments and trading requires that Martineau receive approval from the compliance department in advance of all trades in securities in subject companies in her assigned industry. She is concerned that if Sherman accepts her recommendation to liquidate all fund holdings of Muryan, the stock price will drop before she receives approval from the compliance department. Martineau decides to use derivatives to hedge her husband’s position because these types of trades do not require advance approval from the compliance department. The next morning, on Martineau’s recommendation, Sherman’s trader sells all of SMC’s mutual fund’s entire positions of Muryan for a sizable gain. Martineau hedges her husband’s position. Several weeks later, as Martineau had hypothesized, Caruso cancels the deal and Muryan’s stock price declines 20 percent. Martineau’s derivatives position effectively hedges her husband’s position in the stock. Sherman learns that a wealthy investor in the fund might liquidate his holdings due to doubts about suitability and economic forecasts. Sherman carefully reviews the client’s investment objectives, and informs the client, “You should not sell. Our fund is still suitable for you. You have been invested with us throughout the past 12 years and I urge you to continue to stay fully invested. I was just looking at the investment record of a former client who happens to be a relative of mine, Karoll Reeves, who has traded in and out of our funds during that same period. Her returns have badly lagged yours.” The client elects to maintain his holdings in Sherman’s fund. A month later, Martineau leaves SMC and starts the Galaxy hedge fund with Anjali Shah as her partner. The first client to commit to the hedge fund instructs the Galaxy partners to direct its trades through RLB Securities. RLB charges higher-than-average fees, but provides some unique informational services to investors. In return for receiving Galaxy’s trading business, RLB promises to refer potential clients to Galaxy. Shah tells Martineau “A larger client base will create economies of scale and will eventually allow Galaxy to lower its expenses for all clients.” Martineau agrees. She and Shah explain the directed brokerage arrangement carefully to prospective clients. They require each client to sign a statement that reads, “It is not necessary for Galaxy to seek best price and execution, and I am aware of the consequence for my account. I consent to Galaxy’s trades being executed by RLB Securities.”

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1. In which of the following actions does Sherman most likely comply with the requirements and recommendations of the CFA Institute Standards of Professional Conduct? When he: A. references the CFA program and designation. B. provides performance information on the advisor’s website. C. references the enhanced portfolio management skills of his team.

2. According to CFA Institute Standards, Martineau’s best immediate course of action regarding her initial research report and recommendation on Muryan is to: A. leave her name on the report and take no further action. B. leave her name on the report and document her difference of opinion. C. issue her own independent recommendation since she has a reasonable basis.

3. Which of SMC’s policies regarding public appearances is least likely consistent with both the requirements and recommendations of the CFA Institute Research Objectivity Standards? A. Statement 1. B. Statement 2. C. Statement 3.

4. Martineau’s actions regarding her husband’s account most likely violate the CFA Institute Research Objectivity Standards because she: A. did not receive advance approval from the compliance department for trades in her assigned industry. B. trades within the restricted trading period of at least 5 calendar days prior to and after issuing a research report. C. should seek to ensure that trades for immediate family members are not done in advance of or disadvantage investing clients.

5. Concerning the client who wants to liquidate his holdings, which of the following CFA Institute Standards is most likely violated by Sherman? A. Confidentiality. B. Conflict of interest. C. Communication with client.

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6. Which of the following actions correctly states why Martineau’s relationship with RLB Securities would most likely violate CFA Institute Standards? A. Galaxy is prohibited from referring brokers to any client. B. Galaxy fails to explain the consequences of average quality execution. C. Galaxy should trade client accounts through RLB only if the accounts receive best price and execution.

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Questions 7 through 12 relate to Alternative Investments.

Lundberg Case Scenario John Lundberg, CFA, is a fixed income manager who is talking to a potential client, Brandy Wing, about asset backed bonds. Wing: I am new to asset backed securities (ABS) and given all of the problems lately with these securities I am trying to figure out who the players are. Excluding third parties, who is primarily involved in the securitization? Lundberg: The three main parties to the transaction are the seller or originator, the servicer, and the insurer. Wing: Can you explain the different characteristics of amortizing and non-amortizing assets in securitizations? Lundberg: Amortizing assets require periodic payments of principal and interest, while nonamortizing assets’ periodic payments consist solely of the interest due. Collateral for secured amortizing assets does not change in composition, but the composition of collateral for secured non-amortizing assets does change. All principal repayments from the collateral are distributed as received to the security holders for amortizing assets, but only after the lockout period for non-amortizing assets. Wing: Can you explain credit tranching? Lundberg: The benefit of credit tranching is that defaults are absorbed by the subordinate tranche, but any subsequent prepayments are distributed to that tranche in order to recover the loss. Wing: For many years I have invested in muni bonds and would like a bond with credit enhancement. Lundberg: With an ABS, you have three forms of protection available. Insurance provides for payment of interest and principal of a specified percentage of the par value at origination should the issuer fail to make the payments. With overcollateralization, the value of the collateral exceeds the amount of the par value of the outstanding securities issued at par. Excess spread reserves are created when cash inflows exceed payments to investors and other parties and are set aside to pay for potential future losses. Wing: Can you tell me why collateralized debt obligations (CDOs) are issued? Lundberg: CDOs are categorized based upon the motivation of the sponsor. In a balance sheet motivated transaction, the sponsor seeks to remove debt instruments from its balance sheet. By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

The motivation in an arbitrage transaction is for the sponsor to earn the spread between the yield offered on the debt obligations in the underlying pool and the payments made to the various tranches in the structure. Wing: Can you explain differences between cash and synthetic CDOs? Lundberg: Cash CDO investors have legal ownership of the underlying pool of assets. Synthetic CDO investors have only economic exposure to the underlying assets. Unlike cash CDOs, synthetic CDO structures do not have subordinate/equity tranches.

7. Lundberg’s statement about the parties in a securitization is incorrect with respect to: A. Insurers B. Servicers C. Originators

8. Which one of Lundberg’s comments about amortizing and non-amortizing assets is correct? A. Periodic payments B. Principal repayments C. Collateral composition

9. Is Lundberg’s explanation of credit tranching correct? A. Yes B. Only with respect to the treatment of defaults. C. Only with respect to the treatment of prepayments.

10. Which of Lundberg’s comments about the types of credit enhancements is incorrect? A. Insurance B. Excess spread C. Overcollaterization

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11. Are Lundberg’s comments about the motivations for creating CDOs correct? A. Yes B. No, only the comment concerning arbitrage transactions. C. No, only the comment concerning balance sheet transactions.

12. Which of Lundberg’s comments about differences between cash and synthetic CDOs is incorrect? A. Subordinate/equity tranches B. Legal ownership of underlying assets C. Economic exposure to underlying asset

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Questions 13 through 18 relate to Financial Statement Analysis

Bobby Lee Case Scenario Bobby Lee, CFA, is an equity analyst for the U.S. investment management firm Dumas Freres. Dumas Freres holds a substantial position in Skylark Industries, a U.S.-based company. In reviewing the position, Lee decides to look at how employee benefits and stock option compensation have affected the financial statements. In 2006, Skylark adopted SFAS No. 158 the 2006 standard on pension accounting. First he collects information regarding Skylark’s pension plan (Exhibit 1) and pension plan assumptions (Exhibit 2). Lee specifically wants to consider whether Skylark is using certain assumptions to minimize its: 1. 2.

Projected Benefit Obligation (PBO) at year-end 2008, or, pension related compensation expense for 2008. Exhibit 1 Selected Skylark Pension Plan Data as of 31 December (U.S.$ millions) Funded Status of the Plan 2008 Benefit obligation at end of the year (PBO) 972

2007 902

Fair value of plan assets at beginning of the year Actual return on plan assets Employer/Employee contributions Benefits paid Other changes to plan assets Fair value of plan assets at end of the year

514 56 78 -44

430 54 72 -42

604

514

Funded status Unrecognized net loss Unrecognized prior service cost

-368 200 7

-388 224 10

Components of net periodic benefit cost Service cost Interest cost Expected return on plan assets Other amounts recognized

60 54 -51 27

45 47 -43 13

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Net periodic benefit cost

$90

Exhibit 2 Selected Skylark Pension Plan Assumptions Pension plan assumptions and other information 2008 Expected return on assets 10.0% Discount rate for obligations 6.0% Expected rate of compensation increases 3.0% Actual return on assets 10.9% Vesting Period 4 years

$62

2007 10.0% 5.5% 2.5% 12.6% 3 years

Next Lee collects the following information about Skylark’s executive stock option compensation plan: 1. On 1 January each year, Skylark grants senior executives 1,200,000 options with a vesting period of four years. 2. The exercise price of the options is set at 140 percent of the closing stock price on the grant date. Lee is considering whether Skylark is using certain assumptions (Exhibits 3 and 4) to minimize its stock compensation expense in 2008. Exhibit 3 Selected Skylark Stock Option Data 2008 Fair value of options at grant date, 1 January 2008 $3.25 Exercise price of options 140% of closing stock price on grant date # of options granted 1,200,000 Vesting period 4 years Time to expiry 10 years Basis of option valuation Black-Scholes model

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Exhibit 4 Selected Share Price Information and Option Valuation Assumptions as at 1 January, 2008 2007 Share Price $11.15 $10.00 Dividend yield 1.85% 1.25% Volatility 34% 32% Risk-free rate 5% 4%

13. With regard to his concern about the PBO assumptions at the end of 2008 (Exhibit 2), Lee should focus on the disclosures related to the: A. discount rate. B. expected return on plan assets. C. expected rate of compensation increases.

14. Under SFAS No.158, the pension liability recognized on the balance sheet ($ millions) at 31 December 2008 is closest to: A. 161. B. 368. C. 972.

15. Which of the following would best support Lee’s concern about the pension related compensation expense in 2008? The change in the: A. discount rate. B. vesting period. C. actual return on assets.

16. The 2008 economic pension expense ($ millions) is closest to: A. 58. B. 63. C. 85.

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17. The 2008 compensation expense ($ millions) related to the stock options issued in 2008 is closest to: A. 0.390 B. 0.975. C. 1.338.

18. Which of the following would best support Lee’s concern about the stock related compensation expense in 2008? A. The risk-free rate. B. The dividend yield. C. The share price volatility

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Questions 19 through 24 relate to Financial Statement Analysis

Ebba Nyberg Case Scenario Ebba Nyberg is a fixed income analyst with a Swedish investment firm. Nyberg is analyzing the financial statements of Sweet Home A/B, a Swedish home furniture manufacturer and retailer. Sweet Home is listed on both the Stockholm and New York stock exchanges and prepares its financial statements in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP). Nyberg’s supervisor, Ander Gustafson, asks Nyberg to continue his preliminary evaluation of Sweet Home’s creditworthiness and quality of earnings. He asks her to examine Sweet Home’s liquidity by calculating its free cash flow to the firm and the quality of earnings by using the cash-flow-statement-based accrual ratios. His initial analysis is contained in Exhibit 1. Nyberg uses the unadjusted financial statements in her initial calculations. Sweet Home’s financial statements are summarized in Exhibits 2 to 4. Nyberg also uses information from the management discussion and analysis (MD&A) section of Sweet Home’s 2007/8 annual report to adjust Sweet Home’s reported debt, modify its working capital and assess its quality of earnings. The MD&A states: 1.

2. 3. 4.

“During 2007/8 Sweet Home guaranteed bank loans of non-consolidated subsidiaries, sold receivables with partial recourse, and took advance payments from large customers when possible.” “Despite overall worsening economic conditions the allowance for doubtful accounts was significantly reduced by SEK 150 million.” “Sweet Home uses the last-in, first-out (LIFO) method for inventories resulting in a reserve of SEK 83 million compared to a first-in, first-out (FIFO) valuation.” “Sweet Home uses declining balance depreciation for all fixed assets except for leasehold improvements which are amortized straight-line over the lease term.” Exhibit 1 Gustafson’s Preliminary Accrual Analysis of Sweet Home A/B’s Financial Statements For the Fiscal Years ended 31 March in SEK millions

Net Operating Assets Cash flow statement based accruals ratio

2007/8 8,136

2006/7 7,213

?

0.18

Exhibit 2 Condensed Balance Sheet of Sweet Home A/B For the Fiscal Years ended 31 March in SEK millions By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

Assets Cash and cash equivalents Trade accounts receivable (net of allowances) Inventories Property, plant, and equipment (net of accumulated depreciation) Total assets Liabilities and Shareholders’ Equity Trade accounts payable Convertible bond Shareholders' equity Total liabilities and shareholders' equity

2007/8 71 948 4,238

2006/7 31 590 3,821

5,493

4,534

10,750

8,976

2,543 4,000 4,207 10,750

1,732 4,000 3,244 8,976

Exhibit 3 Condensed Income Statement of Sweet Home A/B For the Fiscal Years ended 31 March in SEK millions 2007/8 Net sales 26,832 Cost of goods sold (COGS) (19,228) Selling, general & administrative expenses (5,462) (SG&A) Interest expense (net of interest income) (290) Income taxes @35% (648) Net income 1,204

2006/7 23,201 (16,556) (4,796) (295) (544) 1,010

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Exhibit 4 Condensed Cash Flow Statement of Sweet Home A/B For the Fiscal Years ended 31 March in SEK millions 2007/8 Net income 1,204 Depreciation and amortization 293 (Increase) decrease in working capital 36 Cash flow from operating activities (CFO) 1,533 Additions to property, plant, and equipment Disposition of property and equipment Cash flow from investing activities (CFI) Cash dividends Cash flow from financing activities (CFF) Net increase (decrease) in cash and cash equivalents

2006/7 1,010 252 (123) 1,139

(1,317) 65 (1,252)

(1,372) 50 (1,322)

(241) (241) 40

(183)

19. Sweet Home’s 2007/8 free cash flow to the firm (in SEK millions) is closest to: A. 368.5. B. 404.5. C. 506.0.

20. After completing the analysis Gustafson had started in Exhibit 1, the most appropriate conclusion that Nyberg can make about earnings quality is that it has: A. improved because it is lower than 0.18. B. improved because it is higher than 0.18. C. deteriorated because it is higher than 0.18.

21. Which factor stated in the first quote of the MD&A will Nyberg least likely use to adjust Sweet Home’s reported debt? A. Guarantees. B. Sale of receivables. C. Advances from customers.

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22. Compared to its reported 2007/8 financials, after Nyberg adjusts Sweet Home’s working capital given the second and third quote of the MD&A, the most likely effect will be that: A. both accounts receivable and inventories will be lower. B. accounts receivable will be lower and inventories will be higher. C. accounts receivable will be higher and inventories will be lower.

23. Compared to its reported 2007/8 financials, if Nyberg adjusts Sweet Home’s financial statements given the second quote of the MD&A, the effect (in SEK millions) on total assets and net income will most likely be a: A. 150 decrease in both total assets and net income. B. 97.5 decrease in total assets and no effect on net income. C. 150 decrease in total assets and a 97.5 decrease in net income.

24. Which of the following activities of Sweet Home A/B would least likely indicate a lower quality of earnings for the company to Nyberg? The company’s: A. sale of receivables with partial recourse. B. choice of depreciation methods for fixed assets. C. guarantee of bank loans for non-consolidated subsidiaries.

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Questions 25 through 30 relate to Corporate Finance

Felipe da Rocha Case Scenario Felipe da Rocha, CFA, heads the capital budgeting committee for Brasilia Distribuidora, SA (BD), a privately held Brazilian electronic components wholesaler. The committee has two mutually exclusive proposals to evaluate. One proposal is from BD’s Northern Division, which requests BRL 30 million (Brazilian real) to construct a new distribution center. Specific details of this proposal are presented in Exhibit 1. The second proposal is from BD’s Southern Division, which requests BRL 25 million to form a joint venture with a producer of electrical components. Details of this proposal are presented in Exhibit 2. Exhibit 1 Selected Data for Distribution Center Proposal (currency amounts in BRL thousands) Initial fixed capital outlay (5,000 allocated to land) 30,000 Increase in net working capital 20,000 Annual sales revenues (cash) 50,000 Annual operating costs (cash) 30,000 Annual depreciation 1,000 Investment horizon Six years Salvage value (book) at end of investment horizon 24,000 Salvage value (market) at end of investment horizon 22,000 Marginal tax rate 40% increase in net working capital accounts will be recovered at end of investment horizon. 4 percent straight-line depreciation on buildings of BRL 25 million.

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Exhibit 2 Selected Data for Joint Venture Proposal (currency amounts in BRL thousands) Initial fixed capital outlay 25,000 Increase in net working capital 15,000 Annual sales revenues (cash) 65,000 Annual operating costs (cash) 40,000 Annual depreciation 2,000 Investment horizon Three years Salvage value (book) at end of investment horizon 19,000 Salvage value (market) at end of investment horizon 26,000 in net working capital accounts will be recovered at end of investment horizon. straight-line depreciation of initial fixed capital outlay.

In the case of the distribution center, the entire project will be sold in six years when a new highway opens between BD’s primary customers in the north. The initial term of the joint venture is three years. BD can extend the joint venture for three more years by replicating the project as shown in Exhibit 2 (e.g., identical capital outlay as well as cash inflows, outflows, and salvage value). At the end of the joint venture, BD will transfer its interests to the joint venture partner. At least initially, both projects will be analyzed using a 10 percent discount rate. Selected data for Brasilia Distribuidora are shown in Exhibit 3. Exhibit 3 Selected Data for Brasilia Distribuidora, SA (currency amounts in BRL thousands) 1,400,000 Book value of long-term debt Market value of long-term debt 1,370,000 Book value of equity 800,000 Market value of equity 1,710,000 Coupon rate on long-term debt 8.00% Yield-to-maturity on long-term debt 8.50% Asset 1.0 Estimated debt beta 0.0 Expected return on market 9.50% Expected market risk 5.00% Marginal tax rate 40% pure-play (unlevered) beta derived from a publicly traded firm. Index, São Paolo. for Bovespa Index, São Paolo.

Prior to selecting between the two proposals, the capital budgeting committee asks da Rocha to address the following questions: By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

1. Assuming that the net present value (NPV) of the distribution center is approximately BRL 30 million and using a discount rate of 10 percent, can the joint venture proposal be analyzed using the equivalent annual annuity method? 2. Because a contract for electrical components remains under negotiation, the joint venture partner wants to evaluate the project with annual operating costs that are 20 percent higher than originally forecast. How will this impact the project’s NPV, assuming a discount rate of 10 percent and a term of three years, while holding all else constant? 3. If the joint venture project’s levered beta were 1.2, instead of equal to that of BD’s typical project, what would be the appropriate required rate of return on equity? 4. What may we conclude about the use of NPV or internal rate of return (IRR) methods as a selection criterion for mutually exclusive projects?

25. The total after-tax cash flow (in BRL thousands) to be derived from the proposed distribution center in its terminal year is closest to: A. 35,200. B. 53,600. C. 55,200.

26. Using the assumptions from question 1 asked of da Rocha, the equivalent annual annuity (in BRL millions) for the distribution center project would be closest to: A. 3.89. B. 5.00. C. 6.89.

27. da Rocha’s most accurate response to question 2 is that NPV (in BRL thousands) will most likely be reduced by: A. 7,958. B. 11,937. C. 19,895.

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28. da Rocha’s most accurate response to question 3 is that the required rate of return on equity for the joint venture project would be closest to: A. 9.50%. B. 10.50%. C. 15.90%

29. da Rocha’s most accurate response to question 4 is that: A. projects with longer lives will offer higher IRRs. B. IRR and NPV methods can differ in their selection of such projects. C. for projects with non-conventional cash flows, IRR is more economically meaningful than NPV.

30. If the proposed distribution center were financed 40 percent by debt, the accounting income (in BRL thousands) for the first year would be closest to: A. 10,125. B. 10,635. C. 10,680.

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Questions 31 through 36 relate to Equity Investments

Skate-O-Rama Case Scenario Charville Securities Roxanne Bouvier, CFA

Skate-O-Rama, Inc. (SKATE) Price: $36.00 CAD Skating on Thin Ice?

International/Canada Recreation 6 March 2009

12-Month Price Objective:

$45.00 CAD BUY

Company Description Skate-O-Rama is Canada’s largest owner and operator of recreational ice facilities and the only one that is publicly traded. In addition to ice rinks, their facilities all contain sports bars and restaurants that overlook the ice, and retail stores that sell equipment and clothing. The company generates revenue from three sources: in-house skating programs (71 percent of revenues), food and beverage operations (20 percent), and retail stores (9 percent). The company’s in-house programs focus on skating lessons, youth and adult hockey leagues, multi-sport day camps, and sports tournaments. Visit with Skate-O-Rama management reinforces our Buy rating After participating in a publicly held conference call, we are reiterating our Buy recommendation and consider SKATE our top equity selection for 2009. The company’s pursuit of both cost leadership and differentiation strategies has enabled it to charge premium prices for its in-house skating programs, while at the same time lowering operating costs through economies of scale. Based on our analysis of industry structure, the competitive forces influencing the industry are: low barriers to entry, intense rivalry among competitors, weak bargaining power of buyers (customers), and strong bargaining power of suppliers. However, a key factor contributing to SKATE’s profitability is management’s continued ability to capture the value that they create for customers. Therefore, we have a high degree of confidence in both our revenue projections and our above-consensus EPS estimates for 2010 and 2011 (Exhibits 1 and 2).

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Three important conclusions after the conference call: • In 2009 enrollments in in-house hockey programs and figure and speed skating classes are increasing. • Management’s development and delivery of high quality programming has had a beneficial impact on food and beverage revenues and retail sales. • Management plans to continue to expand geographically, by acquiring individually owned ice rinks and converting them into recreational ice sports arenas by redesigning the facilities (adding restaurants, bars, and retail stores) and developing skating programs. We view SKATE as undervalued with strong future growth potential We believe our estimate of a three year cumulative annual growth rate (CAGR) in EPS provided in Exhibit 1 is conservative due to our expectations of: a) 10 percent growth in program enrollment; b) 12 percent growth in food and beverage revenues; c) an 8-10 percent increase in retail sales per square foot; and d) 40-60 basis points of annual operating margin improvement that reflects economies of scale and improved product pricing. We believe that SKATE will continue to generate a positive franchise value that will accrue to the existing stockholders. Using a franchise value approach and computing an intrinsic priceearnings ratio, we believe that SKATE’s current stock price does not fully reflect the present value of the company’s future investment opportunities and the return levels associated with these opportunities. Therefore, we expect SKATE’s price-earnings multiple to expand further as the market revalues the company in the context of its greater size, earnings power, and ability to create shareholder value. Price Objective & Risk We are reiterating our Buy recommendation on SKATE with a 12-month price objective of $45. This assumes that SKATE trades at 16.0X our 2010 estimated EPS of $2.25 and 17.3X our 2011 estimated EPS of $2.60. Risks to our price objective include: a slowdown in consumer spending and a decline in disposable income. If the above two risk factors become severe, the company may experience no real growth in earnings. In that event, as SKATE can pass along only 60 percent of inflation effects to its customers, our P/E estimates and 12-month price objective for the stock might not be realized.

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Exhibit 1 Estimates and Assumptions Skate-O-Rama Estimated 2010 ROE Estimated 2011 P/E Expected EPS Growth Rate Dividend Payout Ratio Nominal Required Rate of Return Expected Inflation

18.0% 16.0X 15.0% 20.0% 15.0% 5.0%

Recreation Industry Average 20.0% 14.0X 12.0% 15.0% --5.0%

Exhibit 2 Selected Financial Data For the Year Ending 31 December 2008 (In CAD$ millions) Recreation Skate-O-Rama Industry Average Revenue 46.00 54.00 Earnings before interest and taxes 6.00 9.00 Earnings before taxes 4.75 5.75 Net Income 2.88 3.00 Total assets (average) 123.00 145.00 Total equity (average) 16.00 15.00

31. Based on Bouvier’s analysis of the industry structure, SKATE’s ability to capture value is most likely due to: A. barriers to entry. B. bargaining power of buyers. C. bargaining power of suppliers.

32. Based on Exhibit 2 and the DuPont Model, Skate-O-Rama’s lower 2008 return on equity compared to the recreation industry is best explained by: A. net profit margin. B. financial leverage. C. operating leverage.

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33. Based on Exhibit 2 and the DuPont Model, Skate-O-Rama’s higher 2008 net profit margin compared to the recreation industry is best explained by: A. pretax margin. B. interest burden. C. operating margin.

34. Using Bouvier’s assumptions in Exhibit 1, Skate-O-Rama’s franchise P/E as of 31 December 2008 is closest to: A. 16.67. B. 17.79. C. 26.67.

35. Using Bouvier’s assumptions in Exhibit 1 and the franchise value approach, Skate-ORama’s intrinsic P/E as of 31 December 2008 is closest to: A. 20.0. B. 33.3. C. 42.7.

36. Considering the two risk factors and the inflation related effects, the most accurate estimate of SKATE’s intrinsic P/E ratio using prospective earnings is: A. 7.69. B. 8.33. C. 12.50.

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Questions 37 through 42 relate to Equity Investments

Carl Heuser Case Scenario Carl Heuser is senior equity analyst with Kaleidoscope AG, a specialized Austrian research company. Heuser has recently assumed responsibility for the global food and beverage industry and is preparing an industry study. A colleague, Joseph Mayer, who is working on parts of the report, asks why Heuser places so much emphasis on valuation, given that in efficient markets prices correctly reflect fair market values. Heuser states that valuation models help: • • • •

determine objective prices. estimate intrinsic stock values. assess the impact of corporate events. infer market expectations reflected in prices.

Mayer also questions the use of relative valuation models. He argues that absolute valuation models help determine an asset’s intrinsic value, whereas relative valuation models specify an asset’s value relative to another asset or a benchmark value. Heuser is focusing his analysis on chilled foods, because he classifies this sub-industry to be in the growth phase of its life cycle. He investigates French Belle Cuisine S.A. and American Fast Foods, Inc. Belle Cuisine makes branded products served in private hospitals. In this niche market, Belle Cuisine strives to remain the quality leader at reasonable production costs. In contrast, American Fast Foods is a mass-market producer. Its success is based on reasonable quality with highly cost-efficient production. Heuser gathers financial information, shown in Exhibit 1, about both companies. Exhibit 1 Belle Cuisine S.A. and American Fast Foods, Inc. Selected Financial Information, Year End (in millions, Euros) Belle Cuisine, American S.A. Fast Foods, Inc. Sales 120.0 200.0 Earnings before interest and taxes 17.0 30.0 Earnings before taxes 9.0 14.0 Net income 6.0 9.3 Assets 200.0 225.0 Equity 40.0 50.0 Dividend payout ratio 40.0% 40.0% Required rate of return on the stock 16.0% 16.0% Analyzing the competitive forces within the chilled foods sub-industry, Heuser finds that Belle Cuisine, American Fast Foods, and their various competitors buy ingredients from a large By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

number of suppliers. Although both companies currently experience above industry average operating returns, Heuser notes that Belle Cuisine depends on five private hospital groups for more than 75 percent of its sales. American Fast Foods, on the other hand, sells to a broad range of customers throughout the country. In his study Heuser rates the chilled foods sub-industry to be attractive for investors because, considering the industry structure, companies can capture a high proportion of the product value created. He states that the: • • •

industry growth is an element in determining rivalry. absence of supplier concentration keeps input factor costs low. buyer propensity to substitute reduces intensity of rivalry.

Finally, Heuser makes the following two concluding statements: (1) The sustainable growth rate of both Belle Cuisine and American Fast Foods is the same and from that perspective both firms are equally attractive. (2) On the basis of intrinsic price-to-earnings (P/E) ratio, however, American Fast Foods is more attractively priced than Belle Cuisine. Mayer, however, expresses his concern regarding the attractiveness of the chilled foods subindustry. He considers it is in the pioneering stage of the industry life cycle because: • • •

it is still at risk for many business failures. product acceptance is established. shifting consumer tastes drive the sub-industry.

37. Mayer’s arguments concerning absolute and relative valuation models are most accurate with respect to: A. both types of models. B. relative valuation models only. C. absolute valuation models only.

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38. Based on DuPont analysis, American Fast Foods’ higher return on equity, compared to that of Belle Cuisine, is due most likely to American’s: A. lower tax burden. B. higher asset turnover. C. higher net profit margin.

39. Which of the following best describes Belle Cuisine’s bargaining power of buyers and suppliers? The bargaining power of: A. both buyers and suppliers is low. B. buyers is high but that of its suppliers is low. C. suppliers is high but that of its buyers is low.

40. With regard to capturing product value created as a result of industry structure, Heuser’s least accurate statement relates to: A. industry growth. B. supplier concentration. C. buyer propensity to substitute.

41. In regard to Heuser’s two concluding statements, it is most accurate to say that he is: A. correct with respect to both statements. B. incorrect with respect to both statements. C. correct with respect to statement (2) but not statement (1).

42. In the context of the industry life cycle, Mayer’s classification of the chilled food subindustry is best supported by his argument relating to: A. business failures. B. product acceptance. C. shifting tastes driving the sub-industry.

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Questions 43 through 48 relate to Fixed Income Investments.

Mike Sutherland Case Scenario Mike Sutherland is a mortgage-backed securities (MBS) analyst for a University endowment investment group and is evaluating the possible purchase of a MBS in the endowment’s fixed income portfolio. He is considering several U.S. government agency collateralized mortgage obligation (CMO) tranches. Because he is concerned interest rates will increase over the next 12 months, he wants to invest in a MBS-CMO rather than a pass-through MBS (MBS-PT). Sutherland’s additional investment objective is to purchase an MBS-CMO with principal repayments that approximate the principal repayment of a ‘bullet’ corporate bond. Selected characteristics for several MBS-CMO tranches are found in Exhibit 1. The current principal prepayment rate is 275 PSA. Exhibit 1 Selected Tranche Information for CMO FNR 2005-XX Effective PAC Expected Principal MBS-CMO Tranche Collar (PSA) Repayment Dates PAC1 (PAC Bond) 125-400 Feb. 2009 to March 2010 PAC2 (PAC Bond) 125-325 March 2010 to May 2011 PAC3 (PAC Bond) 135-285 May 2011 to June 2012 PAC4 (PAC Bond) 135-295 June 2012 to June 2014 SUP (Support Bond) n/a June 2007 to Dec. 2007 FLT* (Support Bond) n/a June 2007 to March 2035 * FLT is a floating-rate tranche with its coupon equal to 3 month LIBOR + 45 bps

One of Sutherland’s colleagues asks if he considered purchasing an interest only (IO) stripped MBS-PT because its value should increase as interest rates rise. Sutherland replies that although the IO’s value should increase as interest rates rise above the contract rate, it is not an option because he can only purchase securities with principal repayments. As Sutherland continues his analysis, he decides to evaluate the MBS-CMO PAC Bond tranches on an option adjusted spread (OAS) basis. Sutherland wants to examine how changing interest rate volatility might affect the OAS and price for each MBS-CMO tranche. He summarizes his analysis in Exhibit 2.

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MBS-CMO Tranches PAC1 PAC2 PAC3 PAC4

Exhibit 2 OAS Analysis Interest Rate Volatility of 10% and 30% Change in Price per $100 par New OAS (holding OAS constant) Current Current OAS Z-Spread 20% Vol 10% Vol 30% Vol 10% Vol 30% Vol 76 36 56 13 0.39 -0.76 92 54 79 5 1.12 -1.70 98 63 93 13 1.87 -1.36 113 67 89 (2) 1.60 -3.63

Sutherland assumes a binomial interest rate tree model was used to calculate the OAS for the MBS-CMO PAC Bonds shown in Exhibit 2 because prepayment risk is just another form of call option risk. Sutherland then turns his attention to measures of duration for MBS-CMOs. He knows that MBS-CMO duration can be calculated by using Monte Carlo simulation, but that cash flow duration is an alternative measure. He believes that the cash flow duration measure is more reliable than Monte Carlo simulation because the former uses static principal prepayment assumptions to determine the bond values used to calculate the effective duration.

43. Given Sutherland’s concern regarding interest rates, the risk he is most likely attempting to avoid is: A. liquidity risk. B. extension risk. C. contraction risk.

44. Based on Exhibit 1, the MBS-CMO tranche that will most likely satisfy Sutherland’s investment objectives is: A. SUP. B. PAC1. C. PAC3.

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45. Are Sutherland’ statements regarding an IO’s value and principal repayment, respectively, most likely correct? A. Yes. B. No, he is incorrect regarding an IO’s value. C. No, he is incorrect regarding principal repayment.

46. Based on Exhibit 2, the MBS-CMO tranche with the most attractive relative OAS and price sensitivity most likely is: A. PAC1. B. PAC3. C. PAC4.

47. Is Sutherland most likely correct in using a binomial interest rate model? A. Yes. B. No, because CMO OAS is a function only of the level of interest rates. C. No because CMO OAS is a function of the level of interest rates and the evolution of interest rates over time.

48. Is Sutherland’s belief about the reliability of the cash flow duration measure most likely correct? A. Yes. B. No, because cash flow duration can only be used when cash flows are not affected by changes in interest rates (i.e., non callable bonds). C. No, because cash flow duration is based on naïve assumptions of how prepayment rates change over the life of an MBS for given interest rate changes.

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Questions 49 through 54 relate to Derivative Investments.

Tarja Stahlberg Case Scenario Tarja Stahlberg, the company treasurer for the Finnish-based Borealis Group Oyj, is planning to repatriate ₤100 million from its British subsidiary. She intends to convert the British pounds to euros (the home currency for Borealis) in 90 days. Nicholas Howell is advising Stahlberg on these transactions. Stahlberg has told Howell that she wants to protect Borealis against the possibility that the British pound depreciates against the euro before the funds are repatriated. Howell suggests that Stahlberg consider the use of foreign currency options. In particular, a European call option on euros will allow Borealis to hedge its foreign currency risk. Howell makes the following statements: Statement 1: “The call option price will decrease as the time to expiration decreases or the exercise price decreases; and is very sensitive to the risk-free rate. Statement 2: You can use 90-day call options on the euro with a strike price of ₤0.6400. The current 90-day forward exchange rate is ₤0.6500. A synthetic European call option on the euro can be created by combining a long put position on the euro, a short position in a forward contract on the euro, and a short position in a zero-coupon bond.” Stahlberg mentions that Borealis will have ongoing U.S. dollar borrowing needs, and that she wants to use the Eurodollar market to meet these. She prefers to use floating rate debt, and is considering issuing a U.S. dollar denominated floating rate note (FRN). Stahlberg is concerned that an increase in U.S. yields before the FRN issuance date will increase her future borrowing costs (measured in U.S. dollars). Howell explains how swaps and swaptions can be used to address Stahlberg’s concerns, stating: Statement 3: “Similar to a forward contract, a plain vanilla interest rate swap can fix borrowing costs. For example, if you issued a US$100 million FRN today that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR, a plain vanilla interest rate swap could convert it to a fixed rate obligation. Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk, but has potential credit risk that will increase steadily over the life of the swap. Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is equivalent to a put option.

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Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. You would want a European swaption with a notional principal amount of US$100 million and a 90-day expiry at the time of FRN issuance. The data for this example is presented in Exhibit 1. Exhibit 1 U.S. dollar LIBOR and Fixed Rates LIBOR, Swap, and Swaption Today Rates are Annualized 90-day U.S. LIBOR 3.50% 180-day U.S. LIBOR 3.85% Fixed rate on swaption 3.90% Fixed rate on swap n/a 90-day discount factor 180-day discount factor

0.9913 0.9811

In 90 days 4.00% 4.35% n/a 4.32% 0.9901 0.9787

49. The information in Statement 1 is correct with respect to: A. exercise price. B. time to expiration. C. risk-free interest rate.

50. Statement 2 is incorrect with respect to which position? A. put option B. forward contract C. zero-coupon bond

51. Given the information in Statement 3 and Exhibit 1, the annualized fixed rate on the plain vanilla interest rate swap would be closest to: A. 1.76%. B. 3.84%. C. 4.32%.

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52. Statement 4 can be best characterized as: A. correct with respect to current credit risk only. B. correct with respect to potential credit risk only. C. correct with respect to both current credit risk and potential credit risk.

53. Statement 5 can be best characterized as: A. incorrect with respect to the pay floating position. B. incorrect with respect to the put option equivalency. C. correct with respect to both put option equivalency and pay floating position.

54. Based on Statement 6 and Exhibit 1, the market value of the swaption at expiration would be closest to: A. $206,725. B. $207,764. C. $208,961.

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Questions 55 through 60 relate to Portfolio Management.

Julia Valverde Case Scenario Julia Valverde, CFA, is a trust officer at Royal National Bank (RNB). She recently met Luis Sevilla, age 45, owner of agriculture and real estate partnerships. Valverde hopes that Sevilla will bring his personal investment business to RNB, as well as that of his partnerships and perhaps also his family’s philanthropic foundation. Although Sevilla is fairly knowledgeable, he wants Valverde to analyze two stocks (Bici and Velo) which have been recommended by his broker at Ekimov Investment Partners. Sevilla tells Valverde that he will consider only those investments which are expected to return 10 percent pre-tax. Sevilla provides Valverde with the information in Exhibit 1.

Company Bici Velo

Exhibit 1 Bici and Velo Stock Data Provided by Ekimov Investment Partners Closing Price ($) Expected Price ($) Beta vs. DJ 31 Dec 2008 31 Dec 2009 Wilshire 5000 Index 30.00 31.50 1.0 20.00 25.00 1.5

Dividend Yield (%) 3 0

Valverde begins her analysis by reviewing RNB’s 10-year expected annualized returns for various markets (shown in Exhibit 2). Exhibit 2 RNB’s Benchmark Return Estimates Asset Class

Asset Class Benchmark

U.S. Equity

Dow Jones Wilshire 5000 Index MSCI World Index Lehman Aggregate Index 90-day T-bills

Global Equity U.S. Fixed Income Cash Equivalents (risk-free rate)

RNB’s Annualized 10-Year Return Estimates (%) 10.0 12.0 5.0 2.0

As Valverde conducts an analysis of Bici and Velo stock returns, Sevilla asks whether the assumptions of the Capital Asset Pricing Model (CAPM) are accurate. Specifically, Sevilla asked Valvarde about the assumptions that all: 1. assets can be traded without taxes or transaction costs. 2. assets are marketable in any quantity without affecting price. By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

3. investors have different views about the risk and return of risky assets. Sevilla asks whether an Arbitrage Pricing Theory (APT) model can be used instead of a CAPM model. Valverde responds that the APT model offers a richer context for investors to make portfolio decisions and makes less restrictive assumptions than the CAPM. Specifically, the APT model assumes that: A. returns are described by a factor model, B. investors can construct portfolios that eliminate asset specific risk, C. it is possible for investors to arbitrage among well diversified portfolios Before she provides an answer regarding the two stocks, Valverde asks Sevilla to complete RNB’s required “know your customer” questionnaire. Using Sevilla’s responses, Valverde completes the listing of Sevilla’s total assets (Exhibit 3) and his investment profile (Exhibit 4). Based on Sevilla’s investment profile, Valverde also develops the Investment Policy Statement (IPS) shown in Exhibit 5.

Exhibit 3 Questionnaire Responses: Sevilla’s Total Assets Investment Portfolio Market Value ($) Annual Income (Type/Name of Asset) December 31, 2008 (in U.S. $) Quality Hi-Tek Stock Fund 500,000 5,000 Quality Value Stock Fund 500,000 25,000 Personal Real Estate 1,500,000 10,000 Agricultural and Real Estate 76,000,000 300,000 Business TOTAL ALL ASSETS 78,500,000 340,000 Exhibit 4 Investment Profile for Luis Sevilla Age 45 years Willingness to take risk Unafraid of loss Tax concerns Tax rate is usually in the range 30% to 35% Unique circumstances Plans to gift $100,000 / year to charity from the investment portfolio Time Horizon Wants to retire at age 55 years. In retirement, wants to live on savings

Exhibit 5 Sevilla’s IPS Developed by Valverde IPS Element Valverde’s Assessment Return objective Above average Risk tolerance Above average Liquidity needs Not significant By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currentlyregistered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.

Tax concerns Unique Circumstances Time Horizon

Significant Not significant Multi-stage

55. Given the U.S. data in Exhibit 1 and Exhibit 2, the expected return for Velo stock (E( )) using the security market line is closest to: A. 12.0%. B. 12.5%. C. 14.0%.

56. Which of Sevilla’s three statements regarding the assumptions underlying the Capital Asset Pricing model is least accurate? A. Statement 1. B. Statement 2. C. Statement 3.

57. Which of Valverde’s three statements about the assumptions of the APT model is least accurate? A. Statement A. B. Statement B. C. Statement C.

58. Is Valverde’s assessment of Sevilla’s liquidity and unique circumstances, from Exhibit 5, most likely correct? A. Yes B. No, the assessment of liquidity needs is incorrect. C. No, the assessment of unique circumstances is incorrect.

59. In Exhibit 5, is Valverde most likely correct regarding Sevilla’s taxes and time horizon? A. Yes B. No, he is incorrect about taxes. C. No, he is incorrect about time horizon.

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60. Based on the information presented in Exhibits 3 and 4, Sevilla’s ability to take risk is most likely: A. average. B. below average. C. above average.

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