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Kostecka

Jacob Kostecka, CFA, is a portfolio manager at Forkson Investment Management, an asset


management and research focused organization. After obtaining his CFA charter last month,
Kostecka was transferred to the private wealth management division at Forkson.

Dharshi Bope, a private wealth client, was involved in a major motorcycle accident and is in
critical condition, fighting for his life. Bope is a single parent with a daughter, Paveen Nathoo, in
her mid-twenties. Since the accident, Nathoo has managed her father’s affairs, paying all
expenses, including investment advisory fees. In several conversations with Nathoo, Kostecka
highlighted Bope’s low risk tolerance and investment goal of capital preservation. Nathoo has
indicated her interest in managing the account more aggressively and possibly moving to
another management firm. Nathoo recently petitioned the court to appoint her full power of
attorney to legally manage Bope’s affairs. Prior to the court decision, Nathoo asks Kostecka to
invest her father’s account in the initial public offering (IPO) of Chatterbox, a highly sought after
social media company that has yet to generate a profit.

The following week, the court approves Nathoo’s request to act on behalf of her father. Going
through records in her father’s home, Nathoo discovers documents showing Bope embezzled
several million dollars from his employer, a real estate development company. Most of these
funds were placed directly into Bope’s personal account, for which Nathoo is now responsible.
Nathoo informs Kostecka about her discovery; however, Kostecka does not act on this
information, however, because it is a large account for Forkson.

Nathoo establishes a non-discretionary investment account at Forkson tied to her newly


established business. Shortly thereafter, Kostecka joins the board of Jabbertalk.com, a smaller
social media competitor to Chatterbox. Based on his knowledge of Chatterbox, Kostecka
believes the stock of Jabbertalk is a good investment, even though it is not yet profitable.
Buoyed by his faith in social media, Kostecka ultimately purchases shares of Jabbertalk’s IPO for
Nathoo’s account, as well as for all clients he currently manages. When Kostecka informs
Nathoo of the purchase, she expresses concern about her legal responsibilities and lack of
accounting knowledge in overseeing the account. Kostecka provides Nathoo a list of
recommended professionals he has worked with in the past, including attorneys and
accountants. When he was in college 10 years earlier, Kostecka was engaged to one of the
attorneys but broke off the relationship prior to their wedding, and one of the accountants was
Kostecka’s college roommate. Since then, Kostecka has not had any contact with the lawyer and
accountant.

The Jabbertalk investment is profitable on the first day of trading, doubling from its opening
price. Kostecka tells his clients the multifactor valuation model used by Forkson shows
Jabbertalk stock is still undervalued. Forkson’s research report, due out the next day, will
recommend investors hold their Jabbertalk shares. However, Kostecka tells all his clients
simultaneously they should sell their shares because he believes Jabbertalk is overvalued and
the stock price will fall soon. Kostecka notes he has followed through on this belief by selling his
personal holdings of Jabbertalk shares. Nathoo ignores Kostecka’s recommendation to sell
Jabbertalk. Over the next week, the stock declines 75%.
Watching Jabbertalk’s severe share price decline, Nathoo becomes furious with Kostecka
because he did not sell shares of Jabbertalk in her account. She files a complaint with Kostecka’s
supervisor, Sally Fang, CFA, claiming she was misled on the value of the IPO in the days
immediately after the stock started trading. Kostecka responds to the complaint by telling Fang,
“the analyst who wrote the hold recommendation on Jabbertalk has only passed his CFA Level II
examination. As a charterholder, I have earned the right to use the CFA designation, so I am
more qualified to manage clients’ investments.”

In order to build his client base, Kostecka prepares performance information to show
prospective clients. He includes the firm’s composite performance based on similar
discretionary client portfolios that are in compliance with the GIPS Standards. In addition,
Kostecka prepares his own composite performance, including all accounts he manages. This
presentation includes Nathoo’s account assuming she had sold her shares of Jabbertalk. Along
with his performance record, Kostecka provides a footnote disclosing the following language: “If
your account is managed on a discretionary basis, you might expect results similar to those
shown above.”

1.) With regard to the investment request made by Nathoo to invest in Chatterbox,
Kostecka should most likely:

A. seek advice from the court.


B. comply with her request.
C. follow Bope’s investment goals.

2.) By not acting on the information reported by Nathoo, which CFA Institute Standard of
Professional Conduct has Kostecka least likely violated?

A. Loyalty, Prudence, and Care


B. Duties to Employers
C. Knowledge of the Law

3.) With regard to investing in Jabbertalk and recommending experts, Kostecka most likely
needs to disclose conflicts related to his:

A. attorney relationship.
B. board membership.
C. accountant relationship.

4.) In relation to Kostecka’s handling of the Jabbertalk stock recommendation, which of the
following CFA Institute Standards of Professional Conduct did he least likely violate?

A. Fair Dealing
B. Communication with Clients
C. Priority of Transactions

5.) When Kostecka defends himself against Nathoo’s complaint, he most likely violated the
CFA Institute Code of Ethics and Standards of Professional Conduct concerning the:
A. misrepresentation of the meaning of the designation.
B. right to use the CFA designation.
C. reference to candidacy in the CFA Program.

6.) Kostecka’s performance presentation most likely conforms to the CFA Institute Standard
III (D) Performance Presentation with regard to:

A. composites representing similar discretionary investment portfolios.


B. fair and accurate representation of performance.
C. disclosure in the footnote.
KingFisher

The government of a developing country published a request for proposal (RFP) for the
development of policies to improve the business conduct of its capital markets licensees, with
the hope of improving confidence levels among investors.

Kingfisher Financial Development Partners responded with a detailed proposal including the
following justifications for why the firm should win the tender:

Justification 1: With a team of three CFA charterholders, Kingfisher is more qualified than our
competitors to design policies to uphold and enhance capital market integrity.
Justification 2: Each team member must annually renew his or her commitment to abide by
the CFA Institute Code of Ethics and Standards of Professional Conduct (Code
and Standards).
Justification 3: In addition, every team member passed each level of the CFA exam on the
first attempt.

Kingfisher is later notified that it had won the tender. The Kingfisher team consists of team
leader Khalid Juma, CFA, and his two associates, Vimal Bachu, CFA, and Anila Patel, CFA.
Kingfisher and the government agree that the first step toward improving market integrity is to
create an industry-wide code of conduct based on the Code and Standards. Although the Code
and Standards are not intended to be adopted in full by the government, the decision is made to
concentrate on four main areas: professionalism, capital market integrity, duties to clients, and
investment recommendations.

The Kingfisher team subsequently drafts the following policy statements:

Levels of Professionalism
Financial services professionals must act in a professional manner at all times to help protect the
integrity of the country’s capital markets. As such, financial services professionals must ensure
that they meet at a minimum three major requirements. Professionals must (1) disclose all
conflicts of interest, (2) selectively differentiate services to clients, and (3) outline all manager
compensation arrangements for clients.

Capital Market Integrity


Financial services professionals must protect the integrity of the capital markets by ensuring
that any insider information obtained is managed in such a way as to prevent the investing
public from being disadvantaged. In addition, no financial services professional can knowingly
participate in any activity devised to mislead investors or distort any price-setting mechanism.

Duties to Clients
Clients’ interests must come before those of the financial services firm and/or its staff. To
ensure that clients’ interests are protected, all portfolios must be invested according to each
client’s investment plan and must be well diversified across all asset classes available.
Furthermore, fund managers must annually review client needs and objectives and rebalance
portfolios if required.

Investment Recommendations
All investment recommendations should be made after extensive research undertaken by or on
behalf of the firm. In addition, each research report must

Requirement 1: be reviewed by peers as soon as practical to ensure adequate basis and due
diligence policies were followed,
Requirement 2: be assessed to determine the quality of the recommendation over time, and
Requirement 3: only include names of team members who took part in the research and
agreed with the recommendation.

The Kingfisher team and the government committee meet to agree on the draft code of
conduct. Members of the government committee suggest the following additional policy: “Each
financial services firm must have a compliance supervisor to ensure that

Task 1: systems are in place to detect violations of laws, rules, regulations, firm policies, and the
industry-wide code of conduct and to enforce investment-related compliance policies;
Task 2: the firm has adequate documented compliance policies and procedures and it trains all
personnel on the same and makes sure the policies and procedures are followed; and
Task 3: inadequate procedures are identified and recommendations to correct inadequate
procedures are submitted to senior management for approval and implementation.”

1.) Which of Kingfisher's statements in the RFP regarding its qualifications most likely
violates the CFA Institute Standards of Professional Conduct?

A. Justification 2.
B. Justification 3.
C. Justification 1.

2.) With regard to the proposed policy statement relating to Levels of Professionalism,
which draft requirement least likely reflects any of the CFA Institute Standards of
Professional Conduct?

A. Differentiation of services
B. Conflicts of interest
C. Compensation arrangements

3.) Do Kingfisher's proposed policy statements related to Capital Market Integrity most
likely violate any CFA Institute Standards of Professional Conduct?

A. Yes, with regard to material nonpublic information


B. No
C. Yes, with regard to market manipulation

4.) Which of Kingfisher's proposed requirements to ensure Duties to Clients is least


appropriate to prevent violations of CFA Institute Standards of Professional Conduct?
The requirement calling for a(n):

A. investment plan.
B. diversified portfolio.
C. periodic review.

5.) Which of Kingfisher's proposed requirements regarding investment recommendations is


most appropriate to prevent violations of Standard V(A): Diligence and Reasonable
Basis?

A. Requirement 2
B. Requirement 1
C. Requirement 3

6.) Which of the following tasks suggested by the government committee would least likely
conform to Standard IV(C): Responsibilities of Supervisors?

A. Task 1
B. Task 3
C. Task 2
National Plastics

National Plastics Corp. is a leading manufacturer of high-quality injection-molded plastic


packaging materials used by various industries, primarily food and beverage processing and
packaging firms. In late November 2012, the company received approval for two important
patent applications—one providing for improved tamper protection for plastic containers and
another for an improved biodegradable plastic film that allows for better food preservation.

On 4 January 2013, Haines Foods and Snacks, Inc., launched a hostile takeover bid for all of the
shares of National at $30 per share (a $5 premium in excess of the pre-bid price). Haines Foods
is a national distributor of deli and dairy products. If its bid is successful, it plans to continue to
operate National as a wholly owned subsidiary.

Zenith ThermoPlastics Inc. produces plastic containers and bags that are used by the food and
beverage industry. Keith Whelan, who is both chief executive officer and chief financial officer of
Zenith, had been in discussions with National to either purchase or license their newly patented
technologies. As a possible alternative, in view of the Haines bid, Whelan began to consider
having Zenith make its own takeover bid for National.

Whelan provided National’s most recent financial statements, shown in Exhibits 1, 2, and 3, to
one of his assistants, Mike Noth, with directions to calculate National’s free cash flow using the
discounted cash flow approach as a first step in determining the maximum value that Zenith
should be willing to pay for National’s shares.

Exhibit 1: National Plastics Corp. Selected Financial Data, for Year


Ending 31 December
($ millions) 2012
Revenues 1,614
Cost of goods sold 841
Selling, general, and administrative expense 436
Earnings before interest, taxes, depreciation, and
337
amortization (EBITDA)
Depreciation expense 61
Operating income 276
Interest expense 47
Pretax income 229
Income tax (32%) 73
Net income 156
Share Information
Number of outstanding shares (millions) 60
2012 Earnings per share $2.60
2012 Dividends paid (millions) $37
2012 Dividends per share $0.62
Exhibit 2: National Plastics Corp. Consolidated Balance Sheets
as of 31 December
($ millions) 2012 2011
Cash and cash equivalents 8 5
Other current assets 315 295
Total current assets 323 300
Long-term assets, net 1,203 1,130
Total assets 1,526 1,430

Current liabilities 696 670


Long-term debt 562 611
Common stockholders’ equity 268 149
Total liabilities and stockholders’ equity 1,526 1,430

Exhibit 3: Other Financial Information


for National Plastics Corp. as of 31
December 2012
Effective tax rate 32.00%
Cost of equity 12.00%
Weighted average cost of
9.00%
capital

Noth soon returns and points out that the free cash flows from National will differ in future
years as a result of its new patents—he suggests that, just as Zenith wanted to license the
technology, other plastic firms would also be interested. Noth also suggests that because
National has a lower debt-to-equity ratio than the rest of the industry, it could support more
debt, so he has adjusted the weighted average cost of capital (WACC) accordingly. Noth’s
projected cash flows and other estimates are provided in Exhibit 4.

Exhibit 4: Estimates and Assumptions of Mike Noth Used in Valuing National


Plastics as of January 2013
($ millions except WACC)
2013 2014 2015 2016 Thereafter

End-of-year
free cash 170 165 180 195 Growth at 5% a year
flow to firm

WACC 10.50%
Total debt immediately following acquisition 650
After a discussion about the appropriate cash flow estimates and discount rates to use in
determining the value of National to Zenith, Whelan decides that Zenith should make a mixed
offer for all of National’s shares at $35 per share, consisting of $23 in cash and Zenith common
stock with an exchange ratio of 0.24. The details of the offer are in Exhibit 5.

Exhibit 5: Details of Zenith’s Planned Tender Offer for All of National


Plastics’ Common Shares
National Plastics Zenith ThermoPlastics
Pre-merger price $25/share $50/share
Shares outstanding 60 million 100 million

Zenith will pay $35 per share for National,


Tender Offer consisting of $23 in cash and Zenith common
shares with an exchange ratio of 0.24.

Following the merger, Zenith’s shares are


Post-merger
expected to be priced at $53/share.

Zenith believes that most of the synergies arising


Synergies from the
from the merger will result from National’s new
merger
patents.

Because National and Zenith are based in the United States, Whelan also decides to have Noth
calculate the pre- and post-acquisition Herfindahl-Hirschman Index (HHI) for the industry. Noth’s
HHI calculations are 1,910 pre-acquisition and 2,000 post-acquisition. Based on the HHI values,
Whelan concludes that (1) the industry is currently highly concentrated but (2) under applicable
US law, an increase in the HHI of less than 100 should not generate any governmental
challenges to block the acquisition of National.

When Whelan presents Zenith’s proposed takeover to the board of directors the following day,
one of the directors made the following statements:

1. Although I am certainly in favor of this takeover, I think we would achieve the greatest
value from the acquisition if we offered more stock and less cash.
2. If Zenith does not realize the potential synergies of this acquisition in the next five years,
I suggest a “spin-off” as a means to recover some of the money lost in this venture.
3. A positive initial market reaction will confirm that we did not overpay for Zenith.

1.) If Haines Foods is successful in its attempt to acquire National Plastics, the business
combination is best classified as which type of merger?

A. Horizontal, conglomerate
B. Vertical, backward
C. Vertical, forward

2.) National's free cash flow to the firm (FCFF) for 2012 is closest to (in millions):

A. $104.
B. $121.
C. $182.

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

NI Net income 156


+ Int(1 –
+ Net interest
Tax 47 × (1 – 0.32) 32
after tax
rate)
+ Non-cash
+ NCC Depreciation expense 61
charges
– Capital
– FCInv (1,203 − 1,130) + 61 – 134
expenditures
– – Changes in net (315ª – 696) – (295ª –
– (6)
WCInvª working capitalª 670) = –6

Free cash flow


FCFF =121
to firm
ªChange in net working capital excludes changes in cash and cash
equivalents.
3.) Based on Noth's assumptions in Exhibit 4, the most that Zenith should be willing to
pay per share of National is closest to:

A. $60.
B. $51.
C. $40.

4.) Based on Zenith's proposed tender offer and information in Exhibit 5, the synergy
arising from this merger is closest to (in millions):

A. $943.
B. $1,063.
C. $643.

5.) The most accurate interpretation of Whelan's conclusions concerning the pre- and
post-acquisition HHI is that they are:

A. both correct.
B. incorrect in regard to the increase in HHI necessary to trigger a governmental
challenge to the acquisition.
C. incorrect in regard to the industry being highly concentrated.

6.) Which of the statements made by the member of the Board of Directors is most
accurate?

A. Statement 3
B. Statement 1
C. Statement 2
Sagara

Sagara, a resource-abundant West African country, has a developing economy with low
capital per worker available. Although the majority of its population is impoverished, Sagara
has a long history of advanced education and is committed to technological progress.
President Benjamin Banantoumou recently appointed Fatima N'Diarra, PhD, as Economic
Development Secretary, and asks her to help him develop economic policies to promote
growth.
Last year, Banantoumou attended a summit of international leaders, where he learned that
developing countries typically face several factors that affect their growth prospects, such as

1 enforcement of substantive laws,


2 restrictions on imports, and
3 low rates of saving.

N'Diarra, who has studied the Cobb–Douglas production function, believes that Sagara's
primary goal should be to raise the growth rate of per capita GDP. Her two
recommendations, therefore, are to

1 increase capital, and


2 invest in technology to raise total factor productivity (TFP).

N'Diarra adds this conclusion:


"Because the Cobb–Douglas function exhibits constant returns to scale, as we approach the
steady state rate of growth, we should place greater emphasis on continuing to grow TFP in
order to avoid diminishing marginal returns on capital."

Banantoumou believes that the Sagara economy relies too heavily on the export of natural
rubber. He is convinced that significant industrial capital investment will persuade foreign
direct investors that he is serious about economic development. He announces that the
Sagara government will construct a large tire factory to take advantage of the country's
rubber resources. Banantoumou expects that as a result of this investment, per capita
productivity will rise rapidly driving rapid growth in GDP.

N'Diarra is not as optimistic. She warns Banantoumou that Sagara could fall prey to a
resource curse known as the Dutch disease. As demand from the tire factory drives up the
price of rubber, capital flows out of the country and the local currency could depreciate
rapidly. This situation can be prevented if foreign investors are allowed to own rubber
plantations directly rather than just having access through international markets.

N'Diarra believes that according to the classical growth theory, gains in per capita GDP are
temporary because the resulting population explosion will lower per capita GDP to
subsistence real wage levels. She considers endogenous growth theory to be more realistic,
believing that (1) investments, such as the new tire factory, will increase the rate of per
capita output growth until the steady state rate of growth is achieved; and (2) investment in
research and development will boost growth even further, thus extending the abnormal
growth period before diminishing marginal returns eventually set in.
In the years after the tire factory begins production, Sagara's GDP is expected to grow at a
rate exceeding 10% annually, the per capita GDP will increase commensurately, and the
country's literacy rate will double. Manufacturing is likely to grow by 15% annually. But this
rapid growth will also bring concerns regarding regulation of the manufacturing sector. The
government has at times struggled to advance the regulatory structure to address problems
associated with the impact of rapid growth on such problems as pollution, power outages,
and water shortages. Banantoumou is worried that companies have learned to preemptively
cooperate with their regulators with the expectation that the regulators will favor their
point of view over a competitor's.

As the local financial markets evolve, N'Diarra recommends that she and Banantoumou
study and discuss the legal and regulatory structure of the United States to generate ideas
that they can implement in Sagara. During their discussion, N'Diarra remarks, "In the United
States, self-regulated organizations can become independent regulators empowered by a
government agency to enforce laws. The US government usually provides this type of
regulator with funding."
1.) Of the factors cited by Banantoumou after the international leaders summit, which
is least likely to limit sustainable growth?

A. Factor 1
B. Factor 3
C. Factor 2

2.) In reference to the Cobb–Douglas function, N'Diarra's conclusion is best described


as:

A. incorrect because the Cobb–Douglas function does not exhibit constant returns
to scale.
B. incorrect because increased TFP is not subject to the law of diminishing returns.
C. correct.

3.) N'Diarra's warning regarding the resource curse and its prevention is most likely
incorrect with respect to:

A. her comments about both currency depreciation and direct ownership of rubber
plantations.
B. her comment about currency depreciation.
C. her comment about owning rubber plantations directly.

4.) N'Diarra's understanding of the two growth theories is most accurate with regard
to:

A. endogenous growth theory.


B. both classical growth theory and endogenous growth theory.
C. classical growth theory.
5.) Banantoumou's concern regarding the regulatory structure is most likely an example
of regulatory:

A. arbitrage.
B. capture.
C. competition.

6.) N'Diarra's remark about self-regulated organizations (SROs) is best described as:

A. correct.
B. incorrect because SROs do not enforce laws.
C. incorrect because the US government does not fund independent regulators.
Treadway

Hannah Treadway is an analyst at Knight Investment Management. Knight holds Cooper


Creek Cable Limited (CCCL) as part of its Australian and Far East investment portfolio. CCCL
is a diversified cable and communications company operating in Western Australia. The
company consists of three divisions:

 Cable: Provides subscription television services and high speed internet to


residential customers.
 Media: Owns and operates a group of radio stations and publishes several
magazines.
 Wireless: Offers wireless voice and data communications services.

Treadway is just starting her annual review of the company based on its most recent
financial statements, excerpts of which are shown in Exhibits 1 and 2. The financial
statements for CCCL are prepared in accordance with Australian Accounting Standards
(AASB) which comply with International Financial Reporting Standards (IFRS). All figures are
in Australian dollars.

Exhibit 1: Cooper Creek Cable Limited Statement of Earnings, For Years Ending 31 December
(A$ thousands) 2013 2012
Revenue 711,200 674,600
Programming and communication expenses 312,900 317,000
Gross margin 398,300 357,600
Depreciation expense 98,750 78,650
Amortization of intangibles 7,250 8,150
Reversal of impairment loss -12,500 0
Gain (loss) on sale of assets held for sale -14,400 0
Operating costs 185,900 173,000
Interest expense 64,100 65,900
Income from investments in associates 1,200 850
Profit before tax 70,400 32,750
Tax benefit (expense) 17,600 -8,187
Net profit for the year 88,000 24,563

Exhibit 2: Cooper Creek Cable Limited Balance Sheet, As of 31 December


(A$ thousands) 2013 2012
Cash 95,600 74,400
Accounts receivable, net 35,700 33,500
Assets held for sale ______0 23,500
Total current assets 131,300 131,400
Investments in associates 42,700 42,300
Capital assets, net 221,800 241,200
Intangible assets, net 43,250 24,500
Goodwill 11,000 6,500
Deferred tax assets 185,500 169,900
Total assets 635,550 615,800

Trade payables 92,100 104,200


Interest bearing loans 49,700 0
Short-term unearned revenue 12,500 21,250
Other liabilities 23,800 23,000
Total current liabilities 178,100 148,450
Interest bearing debt 703,800 814,300
Long-term unearned revenue 6,500 13,500
Total liabilities 888,400 976,250

Issued capital 556,400 536,800


Accumulated losses -809,250 -897,250
Total equity -252,850 -360,450
Total liabilities and equity 635,550 615,800

CCCL sustained substantial losses in its start-up period (1998–2002), from which it is still
benefiting for tax purposes, but it has been profitable since 2002 and reported a record
profit after tax in 2013. But Treadway is wondering if CCCL’s revenues in general are
supported by cash flows and if the company might be trying to increase the appearance of
profitability in order to increase the share price, which remains low.

The wireless division was acquired by CCCL in a share purchase in late 2012. Treadway
wants to review the accounting policies CCCL has adopted for both revenue and expenses
incurred on long-term wireless contracts. Excerpts of the accounting policies are shown in
Exhibit 3.

Exhibit 3: Excerpts of Accounting Policy Notes


(all figures A$ thousands)
Note 1 d) Long-Term Wireless Contracts
Customers who enter into long-term service contracts for wireless services can obtain their
handsets for a nominal amount. Commencing in 2013 the discount offered on the handsets,
relative to the regular price, is capitalized as a customer acquisition cost and straight-line
amortized over the life of the contract, or a minimum of three years.

Note 1 g) Unearned Revenue


Unearned revenue for subscriptions, or for services paid in advance, was historically
recognized on a straight-line basis over the term of the contract or subscription. After
reviewing the historical pattern of usage and cancellations for service contracts in 2013, the
pattern of recognition was changed to recognize the majority of the revenues in the first 12
months after the service contract is signed and the remainder in the year following.

Note 12) Broadcast Licenses


During 2013, the company successfully disposed of broadcast licenses that were held for
sale for $37,900 (net book value of $23,500). Based on the successful completion of that
sale, the impairment losses taken in 2011 on other licenses have been reversed, restoring
those intangible assets to their amortized historical cost.

After reading the note about the rapid reversal of the impairment loss related to the
broadcast licenses (Exhibit 3, Note 12), Treadway strongly believes that it arose as an
attempt by management to manage earnings. She realizes that both her 2011 and 2012
analyses were affected by these actions and now need to be reconsidered.

Finally, Treadway noted that during 2013, CCCL acquired 100% of MusicMusic (MM), a
specialty cable music channel. At the time of the acquisition the company disclosed the
following information:

The company has assigned the following values to the two intangibles (the MusicMusic brand
name and its associated broadcast licenses) that arise from this acquisition:
MusicMusic brand name A$2,000 (A$ thousands)
Broadcast licenses A$5,500 (A$ thousands)

1.) The cash collected from customers in 2013 is closest to (A$ thousands):

A. $700,250.
B. $709,000.
C. $693,250.

2.) The cash received from CCCL's investments in associates in 2013 is closest to (A$
thousands):

A. $800.
B. $1,200.
C. $400.

3.) The change in which of the following items is most likely an indication that CCCL
might be recognizing revenue early?

A. Deferred tax assets


B. Days sales in receivables
C. Unearned revenue

4.) The new accounting policy adopted in 2013 for the customer acquisition cost (Note
1d) most likely increases CCCL's:
A. cash from operations.
B. debt-to-asset ratio.
C. quality of earnings.

5.) If Treadway's belief about management's motivation behind the 2011 treatment of
the broadcast licenses is correct, compared with the economic reality in 2012, her
original 2012 analysis would most likely have:

A. overstated net profit margin.


B. understated return on assets.
C. understated fixed asset turnover.

6.) The amount of customer acquisition costs, Exhibit 3, Note 1d, capitalized during
2013 is closest to (A$ thousands):

A. $18,500.
B. $6,000.
C. $13,500.
Ready Power

Ready Power Inc. is a manufacturer of high-quality industrial electric generators. Although


many companies have been negatively affected by the continued global economic
weakness, Ready Power has experienced strong demand for its products, largely as a result
of several recent natural disasters and many occurrences of rolling brownouts and blackouts
arising from excessive strains on power grids. Although this strong demand has resulted in
higher inventory costs in recent years, the company has been able to pass the cost on to
customers through higher prices. The company’s generators have expected useful lives of
about 25 years. The company also normally depreciates its assets on a straight-line basis.

Margo Lenz, CFA, an equity analyst at Livermore Investment Council, is reviewing Ready
Power’s recent financial statements, which are prepared according to US GAAP.

Exhibits 1 and 2 contain selected portions of the company’s statement of operations and
statement of financial position, and Exhibit 3 contains selected notes from the company’s
2013 financial statements.

Exhibit 1: Ready Power Consolidated Results of Operations


($ millions)
For the Year Ending 31 December 2013 2012
Sales 24,910 21,803
Cost of goods sold 17,729 15,935
Gross profit 7,181 5,868

Net profit 2,122 1,712

Exhibit 2: Ready Power Consolidated Financial Position


($ millions)
As of 31 December 2013 2012
Cash 318 665
Receivables 8,983 8,381
Inventories 3,811 3,134
Other current assets 744 1,441
Current assets 13,856 13,621
Net property, plant, and equipment 5,311 4,794
Other assets 11,360 9,826
Total assets 30,527 28,241
Exhibit 3: Ready Power Selected Notes to Consolidated Financial Statements

Note 1. Operations and Summary of Significant Accounting Policies

D. Inventories

Inventories are stated at the lower of cost or market, with cost determined using
the last in, first out (LIFO) method.

($ millions) 2013 2012


LIFO reserve 1,442 1,407

No LIFO liquidation occurred during 2012 and 2013.

F. Depreciation and amortization


Depreciation of plant and equipment is computed using the straight-line
depreciation method.
($ millions) 2013 2012

Consolidated
332 235
depreciation expense

J. Income taxes: The company’s effective tax rate has always been 29%.

Note 10. Property, plant, and equipment (PP&E)


31-Dec
($ millions) 2013 2012
Land 110 92
Plant and equipment 10,257 9,426

Total plant and


10,367 9,518
equipment

Less accumulated
–5,056 –4,724
depreciation

Net PP&E 5,311 4,794


Harold Mays, one of Lenz’s assistants, made the following comments about Ready Power’s
inventory policy:

1. One of the advantages of using LIFO is that it simplifies the accounting process
for inventory because it gives the same results for inventory and cost of goods sold
whether the company uses a periodic or perpetual inventory system.
2. Another advantage of using LIFO is that it appears to improve the company’s
cash conversion cycle.
3. One disadvantage with LIFO, however, is that it is more likely that the company
will incur inventory write-downs than under the first in, first out (FIFO) method

Lenz mentioned to Mays that earlier that day, she had seen Bill Jacobs, the CEO of Ready
Power, in an exclusive interview on a cable news network specializing in financial news and
information. Lenz was particularly interested in the portion of the interview dealing with the
company’s new program to lease electrical generators. An excerpt from a transcript of the
interview is shown in Exhibit 4.

Exhibit 4: Excerpt from an Interview of Bill Jacobs on Cable TV, 4 March 2014
Jacobs: The firm is meeting the growing demand for our electrical generators and will be
introducing a leasing program to further consolidate our lead in this area. We anticipate that
about 80% of the leases we grant will have a term of 20 years or more, with the remainder
having shorter terms of around 5 years.

After reading the excerpt from the interview, Mays wondered what impact the company’s
new position as a lessor and its classification of leases would have on the company’s future
financial statements. Finally, he comments:

1. For a given leased asset, in the initial year of the lease, Ready Power’s profits
should be higher if the company classifies the lease as an operating lease.
2. Regardless of how the company classifies a lease, its total cash flow and
operating cash flow over the lease term will be the same.
3. The leasing program will decrease Ready Power’s liquidity position.

1.) If Ready Power had used the FIFO method to account for its inventory, its cost of
goods sold (COGS) in 2013 would have been closest to (in millions):

A. $17,694.
B. $16,287.
C. $17,764.
D.
2.) If Ready Power had been using FIFO accounting since incorporation, its retained
earnings at the end of 2013 would most likely be higher by (in millions):

A. $1,024.
B. $2,927.
C. $1,442.
3.) The statement in Note 1.D of Exhibit 3 concerning LIFO liquidations most likely
means that for the stated period:

A. there were no inventory write-downs in either of the two years.


B. units manufactured (or purchased) equaled or exceeded unit sales for each
year.
C. costs and prices must have been rising throughout.

4.) With regard to Mays' comments about the LIFO method, which of his statements is
most accurate?

A. Statement 3
B. Statement 1
C. Statement 2
D.
5.) In 2013, the estimated remaining life (in years) of the company's asset base is
closest to:

A. 15.7.
B. 16.0.
C. 15.2.

6.) Which of May's statements about the new leasing program is most accurate?

A. Statement 1
B. Statement 2
C. Statement 3
Moyle

Bridget Moyle is a senior associate in the risk management division of ANM Financial
Advisers (ANMFA). Moyle specializes in the use of derivatives to help ANMFA manage its
various risk exposures. Moyle is meeting with two recently hired analysts, Jordan Petsas and
Katy Iacocca. Petsas and Iacocca have been asked to prepare for a discussion on the
fundamentals of futures, options, and swaps.

Moyle asks, “Is it true that the futures price on an asset must equal the spot price of the
asset on the expiration date of the futures contract? Explain why or why not.”

Petsas responds,
At expiration, futures prices and spot prices must converge. If the spot price exceeds
the futures price, then an investor could purchase the futures contract and execute
the contract to purchase the underlying at the lower futures price, sell it at the
higher spot price, and make an arbitrage profit. If the spot price is less than the
futures price at expiration, then an investor could purchase the asset at the spot
price and enter into a short futures contract to sell it at the higher price, thus
locking in a profit.

Moyle provides Petsas and Iacocca with the following information for a Treasury bond and
asks them to calculate the price of a futures contract on this bond. The bond has a face
value of $100,000, pays a 7% semiannual coupon, and matures in 15 years. The bond is
priced at $156,000 and yields 2.5%. The futures contract expires in eight months, and the
annualized risk-free rate is 1.5%. There are multiple deliverable bonds, and the conversion
factor for this bond is 1.098.

The next item on the agenda is a discussion of option valuation models. Moyle states, “We
are currently considering the purchase of put options on shares of the Rousseff Corporation.
Selected information is provided in Exhibit 1.
Exhibit 1: Selected Stock and Options Data for Rousseff Corporation and the Risk-Free
Interest Rate
Exercise price $590
Days to expiration (two 30-day periods) 60
Current stock price $609.90
Up move on stock (per 30-day period) 12%
Down move on stock (per 30-day period) 4%
30-day risk-free interest rate 0.25%

Iacocca responds, “In general, we could value the option using either the Black–Scholes–
Merton model or the binomial option pricing model. But there is not enough information
presented to use the Black–Scholes–Merton model.”
“That is correct,” states Moyle, and continues, “With respect to the Black–Scholes–Merton
model, can you explain how the risk-free rate, time to expiration, and volatility affect
European option prices?”

In answer to Moyle’s question, Iacocca states, “Higher risk-free rates result in lower call and
put option prices. Longer times to expiration result in higher call prices, but the impact on
put prices is unclear. Higher volatility results in higher call and put option prices.”

The group turns its attention to swaps. Moyle states, “As you all know, a plain vanilla
interest rate swap allows the buyer of the swap to make a fixed payment and receive a
variable payment. Can you explain how these interest rate swaps can be described as being
equivalent to a combination of other assets?”

Petsas responds, “An interest rate swap can be viewed as a series of forward rate
agreements (FRAs) priced at the swap fixed rate or as a combination of a purchase of an
interest rate call option and the purchase of an interest rate put option.”

Finally, Moyle presents the term structure of Libor spot rates in Exhibit 2 and asks Iacocca
and Petsas to use this information to calculate the annualized swap fixed rate on a one-year
interest rate swap with quarterly payments, for which the underlying is 90-day Libor.

Exhibit 2: Current Libor Term Structure of


Spot Rates
Days Rate (%)
90 3.13
180 3.41
270 3.73
360 4.12

1.) Is Petsas' response to Moyle regarding futures and spot prices most likely correct?

A. No, the explanation of when the spot price exceeds the futures price is incorrect
B. Yes
C. No, the explanation of when the spot price is less than the futures price is
incorrect

2.) Based on the information provided by Moyle, the futures price on the Treasury
bond is closest to:

A. $140,298.
B. $154,047.
C. $143,494.
3.) Based on the information in Exhibit 1, the price of the put option using the two-
period binomial option pricing model is closest to:

A. $9.31.
B. $14.98.
C. $1.96.

4.) With respect to Moyle's question about the impact of selected inputs on the price of
options, Iacocca is least likely correct about:

A. volatility.
B. time to expiration.
C. the risk-free rate.

5.) Is Petsas' response to Moyle regarding an interest rate swap most likely correct?

A. No, he is incorrect about the combination of calls and puts


B. No, he is incorrect about the pricing of FRAs
C. Yes

6.) Based on the information in Exhibit 2, the annualized fixed rate on the swap is
closest to:

A. 3.60%.
B. 4.04%.
C. 4.12%.

Metev

Rila Rakia & Beer Ltd. (RRBL), a small privately owned company, produces high quality rakia
(a high-potency hard liquor), vino (wine), and bira (beer) in Bulgaria. After Bulgaria joined
the European Union in 2007, international demand for the country’s liquor, wine, and beer
increased substantially. Most firms in the industry, including RRBL, have been reporting
double-digit sales growth on a year-over-year basis.

Metiu Metev, a portfolio strategist at a major German investment consulting firm, inherited
RRBL from his grandparents. Frankfurter Destillerie & LiqueurFabrik (FDLF), a German
distillery interested in entering the Bulgarian market, has made a cash offer of BGN900
million for the company’s equity (BGN = Bulgarian Lev; EUR1 = BGN1.95586, pegged rate).
FDLF will assume RRBL’s entire outstanding debt, including both current liabilities and long-
term debt. If Metev does not want to sell a controlling interest, FDLF’s minimum equity
stake will be 40%, with an appropriate discount for lack of control.

Metev starts by evaluating the company himself using the capitalized cash flow method
(CCM) and taking the following steps:
· Using the build-up method to estimate the required rate of return on equity
· Computing the firm’s weighted average cost of capital (WACC) using the book values
of debt and considering the current weight of total debt in capital structure to be optimal

Exhibits 1A, 1B, 2, and 3 contain RRBL’s financial data and other inputs that Metev uses.

Before responding to FDLF’s offer, however, Metev meets with Vasil Nenkov, his colleague
and a senior equity analyst covering the wine and beer industry in the Balkan region. After
reviewing the data and Metev’s valuation analysis, Nenkov suggests that 11% would be a
more reasonable estimate of RRBL’s WACC based on an analysis of industry peers. Metev
decides to use this rate to calculate the value of RRBL’s equity.

Nenkov also makes the following comments:

1. CCM is most often used for the valuation of large public companies, and it is less
valid for valuing private companies, such as RRBL.
2. The excess earnings method is preferable because it provides an estimate of the
value of intangible assets by capitalizing future earnings in excess of the estimated
return requirements associated with working capital and fixed assets.

Nenkov also suggests that the enterprise value (EV) multiple approach should work well for
valuing RRBL. After searching his database, Nenkov finds that Rhodopi Wineries PLC, a
publicly traded company and a close competitor of RRBL, is currently valued at an
EV/EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple of 7.2.
Nenkov further suggests two adjustments:

 RRBL should command an upward adjustment of 25% in the EV/EBITDA


multiple reflecting its lower risk and higher growth relative to Rhodopi
Wineries.
 Forward-looking EBITDA should be used to determine RRBL’s value.

On a cautionary note, Nenkov makes two statements regarding the use of EV/EBITDA
approach to valuation.
1. It is more appropriate than the P/E for comparing companies with different
financial leverage.
2. EBITDA underestimates cash flow from operations if working capital is growing.

Finally, Metev recalls FDLF’s willingness to purchase a non-controlling ownership interest at


a discount for lack of control. Nenkov responds by saying that a control premium of 30% is
typically applied for purchase transactions of small privately owned firms similar to RRBL
and proper adjustment for lack of control should be made if the transaction involves a non-
controlling interest. Metev thanks Nenkov for his help and goes back to his desk to revise his
valuations.

Exhibit 1A: RRBL EBITDA and Other Data


FY2012 FY2013
(BGN millions)
(Actual) (Pro Forma)
Revenues 248.5 300.6
Cost of goods sold –132.3 –172.5
Gross profit 116.2 128.1
Selling, general, and
–19.2 –23.0
administrative expenses
EBITDA 97 105.1
Other Data
Capital expenditures 2.5 4
Interest expense 2.7 3.6
Depreciation and
5 6.4
amortization
Increase in working
0.8 1
capital

Exhibit 1B: Additional Information for RRBL


Pre-tax cost of debt 10.00%
Weight of total debt in capital
30%
structure
Tax rate 25%

Exhibit 2: RRBL Balance Sheet for FY2012


(BGN millions)
Assets Liabilities and Equity

Cash and short-term


50 Accounts payable 10
investments

Receivables and
40 Notes payable 8
inventory
Net fixed assets 50 Long-term debt 30
Patents and
20 Common equity 112
trademarks
Total liabilities and
Total assets 160 160
equity
Exhibit 3: Other Data and Inputs

Bulgarian government’s 10-year bond yield 3.90%


Beta of publicly traded firms in the
0.75
industry
Equity risk premium 6.00%
Small stock risk premium 2.50%
Industry risk premium –1.0%
RRBL’s company-specific risk premium 1.50%

Long-term growth rate beyond FY2013 5.00%

1.) According to the method used by Metev for computing the cost of equity and data
in Exhibits 1B and 3, RRBL's WACC is closest to:

A. 10.9%.
B. 11.3%.
C. 9.2%.

2.) According to the revised method used by Metev, the WACC suggested by Nenkov,
and the data provided in Exhibit 3, RRBL's capitalization rate is closest to:

A. 11.0%.
B. 6.0%.
C. 8.5%.

3.) Regarding the two comments that Nenkov made after reviewing Metev's valuation
analysis, he is most accurate with respect to:

A. Comment 1 only.
B. both Comments 1 and 2.
C. Comment 2 only.

4.) Using Nenkov's findings from his search of the database, his suggestions regarding
appropriate adjustments, the information in Exhibit 1A and Exhibit 2, and the
EV/EBITDA multiples approach, RRBL's value of equity is closest to:

A. BGN946 million.
B. BGN916 million.
C. BGN966 million.

5.) Regarding Nenkov's two cautionary statements concerning the use of the enterprise
value method of valuation, he is most likely correct with respect to:
A. both Statements 1 and 2.
B. Statement 1 only.
C. Statement 2 only.

6.) The discount for lack of control, given the typical control premium indicated by
Nenkov, is closest to:

A. 12%.
B. 30%.
C. 23%.
Richter

Katharina Richter, CFA, is a fixed-income analyst at Paar Advisers, an investment advisory


firm. She is evaluating a set of mortgage-backed securities (MBS) so that she can make
recommendations about those securities for the firm's clients.

The securities, which are not yet issued, will be backed by a pool that currently contains
$117.54 million of US 30-year residential mortgages. The pool has a weighted average
coupon (WAC) of 4.80% and a weighted average maturity (WAM) of 243 months, which
implies 17 months of seasoning. Richter reviews current prepayment estimates for this pool
from three different providers. The first estimates a conditional prepayment rate (CPR) of
8.50%; the second, a prepayment speed of 220 PSA (Public Securities Association
prepayment benchmark); and the third, a single monthly mortality rate (SMM) of 0.70%. As
Richter reads about one provider's prepayment expectations, she finds the following
statement: "Although US mortgage interest rates are very low relative to the historical
average, rates have been this low or lower for a number of years. Furthermore, the general
state of the economy is very poor. These factors cause us to expect low prepayment rates
for the coming months." After some analysis, Richter realizes market conditions are such
that these securities will not to be issued for another two months. At issue, the pool will not
be replenished with new mortgage loans. She adjusts her analysis of the pool, using the
SMM estimate of 0.70%, to reflect this delay.

One of Paar's clients, Konrad Hartmann, is concerned that mortgage interest rates might rise
by about 1% in the near future and remain at that higher level for some time. He asks
Richter which of the many types of collateralized mortgage obligation (CMO) tranches and
stripped MBS would perform best if his concerns are realized. Hartmann is also interested in
the characteristics of MBS. He tells Richter that he understands that MBS are considered
path-dependent securities for three reasons:

Reason 1 The influence of earlier prepayments on current cash flows.


Reason 2 The tendency of few mortgage borrowers to prepay early in the life of
their mortgages.
Reason 3 The way the current prepayment rate reflects whether borrowers have
already had an opportunity to refinance at the current mortgage rate.

Hartmann shows Richter some spread information he has received regarding three CMO
tranches. This information is shown in Exhibit 1. He tells Richter that he would be happy to
invest in any of these securities based on their other characteristics and asks which he
should choose, based solely on this information.
Exhibit 1: Spread Comparison
Zero Option-
Nominal Volatility Adjusted
Spread Spread Spread
Security X 2.12% 1.67% 0.00%
Security Y 3.18% 1.30% –0.27%
Security Z 1.84% 1.46% 0.67%

1.) Of the three prepayment estimates Richter reviews, the highest is most likely the
one presented in terms of:

A. PSA.
B. CPR.
C. SMM.

2.) The statement Richter reads about prepayment expectations is most likely:

A. correct.
B. incorrect with regard to the impact of current mortgage rates.
C. incorrect with regard to the impact of current economic conditions.

3.) The expected balance of the mortgage pool Richter is analyzing on the revised date
of issue is closest to:

A. $115,329,054.
B. $115,894,440.
C. $115,333,047.

4.) Which of these security types is Richter most likely to suggest for Hartmann?

A. A principal-only strip
B. A planned amortization class (PAC) tranche
C. A support tranche

5.) Which of Hartmann's reasons as to why MBS are path-dependent securities is least
likely correct?

A. Reason 2
B. Reason 1
C. Reason 3

6.) Based on the information in Exhibit 1, Hartmann should most likely invest in:

A. Security Z.
B. Security Y.
C. Security X.
Shah

Vikram Shah works as a portfolio manager for Heddon Investment Advisers. Shah is meeting
with the investment committee of a corporate pension fund to discuss portfolio
performance as well as strategies and techniques used in the management of the pension
fund. For the meeting, Shah has collected the information shown in Exhibit 1.

Exhibit 1: Selected Financial Information

Emerging
Large- Investment-Grade
Market
Cap US US Corporate Bonds
Stocks
Stocks
Expected Annual Return
11 8 16
(%)
Expected standard
deviation of annual 14 6 22
returns (%)
Return Correlations
Large-cap US stocks 1 0.3 0.4
Investment-grade US
--- 1 –0.1
corporate bonds
Emerging market stocks --- --- 1

Shah explains that his firm uses mean–variance portfolio analysis to guide asset allocation.
He states:
We use mathematical techniques to identify a set of efficient portfolios. From this set, we
select a portfolio that best matches our risk preferences. The pension fund’s assets are
currently invested in the following proportions: 60% US large-cap stocks, 35% US
investment-grade corporate bonds, and 5% emerging market stocks. Our analysis suggests
that we should modify our current allocations so that the new allocations are 55% US large-
cap stocks, 30% US investment-grade corporate bonds, and 15% emerging market stocks.
This reallocation will result in a mean–variance efficient portfolio that is better aligned with
our risk preferences.

Jerry Cramer, a member of the investment committee, wants to know how correlations
between securities and the number of securities in the portfolio affect the pension
portfolio’s diversification benefits.

Shah responds, “As the average correlation between securities in a portfolio increases, the
risk reduction benefits of diversification decrease. Furthermore, as the average correlation
between securities in a portfolio rises, the number of securities in the portfolio must be
increased in order to achieve the same percentage of portfolio risk reduction when the
average correlation between securities is lower.”

Another board member, Kala Amato, notes that no part of the pension portfolio is invested
in a risk-free asset. She wants to know the impact of combining the current portfolio with an
investment in a risk-free asset.

In response, Shah states: “If we combine our portfolio with an investment in a risk-free
asset, the result will be a new linear efficient frontier that is referred to as the capital
allocation line (CAL), or the capital market line (CML). The risk and return of the resulting
new portfolio will be linear combinations of the risk and return of the risk-free investment
and our portfolio.”

Cramer asks Shah, “Can you explain the model that you use to select stocks for inclusion in
the equity portion of the pension portfolio?”

Shah responds, “At Heddon, the primary model we use is a multifactor model in which the
factors are price-to-earnings ratio (P/E), financial leverage, and market capitalization.”

Shah moves on to a discussion about how Heddon assesses portfolio risk. He states, “We
use a risk model to decompose active risk into the following two components:

Component 1
This component is referred to as ‘active factor risk,’ which is systematic risk attributable to
differences in factor exposures between the portfolio and the benchmark. Note that the
factors in our model are P/E, financial leverage, and market capitalization.

Component 2
The second component is a function of the individual asset’s active weight in the portfolio
and the variance of returns unexplained by the three factors. This component is the active
specific risk or asset selection risk.”

Shah continues, “We prefer to structure our portfolio so that in addition to being on the
efficient frontier, it tilts, relative to the benchmark, toward stocks of large-capitalization
companies with lower P/Es and lower levels of leverage. Exhibit 2 shows the factor
sensitivities for the recommended portfolio and the benchmark.”

Exhibit 2: Factor Sensitivity


Factor Portfolio Benchmark
P/E –0.25 –0.35
Financial leverage –0.60 –0.40
Market capitalization 0.5 0.35

1.) Based on the information presented in Exhibit 1, the standard deviation of Shah's
new portfolio is closest to:
A. 10.04%.
B. 6.34%.
C. 12.80%.

2.) Is Shah's response to Cramer's question about the impact of correlation on portfolio
risk diversification benefits and the number of securities required to achieve a
certain level of risk diversification most likely correct?

A. No, he is incorrect about average correlation and the number of securities


required to achieve a certain level of portfolio risk diversification
B. No, he is incorrect about the impact of average correlation on risk diversification
C. Yes

3.) In his response to Amato, Shah is most likely correct with respect to the:

A. risk and return of the new portfolio.


B. CAL and the CML.
C. new efficient frontier.

4.) Shah's response to Cramer's question regarding the model used by Heddon
Investment Advisers would imply that the multifactor model is most likely a:

A. fundamental factor model.


B. macroeconomic factor model.
C. statistical factor model.

5.) Is Shah correct about the components of active risk?

A. Yes
B. No, he is incorrect about Component 1
C. No, he is incorrect about Component 2

6.) With respect to the factor tilts of the portfolio in Exhibit 2, Shah is least likely correct
about the:

A. market capitalization.
B. financial leverage.
C. P/E.

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