Mock 3

Question 1

A professional organization most appropriately enforces upon its members:

A)
legal standards only.
B)
ethical standards only.
C)
both legal and ethical standards.

Answer 1

B)
ethical standards only.

Professional organizations adopt codes of ethics that govern their members’ behavior. Legal standards are enforced by governments or regulatory agencies. (

Question 2

Moe Girard, CFA, works in a large group that decides on recommendations by consensus. Girard does not always agree with the group consensus, but he is confident in the group’s analytical ability. To comply with the Code and Standards when the group issues a recommendation with which he disagrees, Girard:

A)
does not need to take any action.
B)
must request that his name be removed from the group’s report.
C)
should include his independent opinion as an appendix to the group’s report.

Answer 2

A)
does not need to take any action.

Standard V(A) Diligence and Reasonable Basis does not require a Member to dissociate from a group recommendation, as long as the opinion has a reasonable and adequate basis.

Question 3

Carlos Mendez, CFA, is beginning an investment advisory relationship with a new client and plans to formulate an investment policy statement (IPS) for the client. According to the Standard concerning suitability, Mendez is least likely to consider the client’s:

A)
regulatory and legal circumstances.
B)
conflicts of interest.
C)
performance measurement benchmarks.

Answer 3

B)
conflicts of interest.

Under Standard III(C) Suitability, the investment advisor should consider the following in writing an investment policy statement (IPS) for each client: (1) client identification (type and nature of clients, existence of separate beneficiaries, and approximate portion of total client assets); (2) investment objectives (return objectives and risk tolerance); (3) investor constraints (liquidity needs, time horizon, tax considerations, legal and regulatory circumstances, unique needs and preferences); and (4) performance measurement benchmarks. Standard VI(A) Disclosure of Conflicts requires that members and candidates disclose all potential areas of conflict to clients, but this disclosure is not part of a client’s IPS

Question 4

Telling potential investors that a short-term U.S. Treasury fund contains “guaranteed” securities:

A)
does not violate any Standard.
B)
violates the Standards by misrepresenting the securities in the fund.
C)
violates the Standards by failing to consider the suitability of the fund for potential investors

Answer 4

A)
does not violate any Standard.

Standard I(C) Misrepresentation does not prohibit members and candidates from making truthful statements that some investments, such as U.S. Treasury securities, are guaranteed in one way or another. Suitability does not become a concern until the potential clients take investment action

Question 5

Riley and Smith, a broker-dealer, is bringing to market a secondary offering for All Pro Company. One of the reasons All Pro selected the firm to lead the offering is because Riley and Smith has been a market maker for All Pro’s stock for the past five years. The firm is in possession of material nonpublic information relevant to All Pro’s offering. To be in compliance with the Code and Standards, Riley and Smith:

A)
may not serve as underwriter for the same stock in which it acts as a market maker.
B)
should continue to serve as market maker but take only the contra side of unsolicited customer trades.
C)
should abstain from making a market in All Pro stock during the offering period but may resume market making activities after the offering.

Answer 5

B)
should continue to serve as market maker but take only the contra side of unsolicited customer trades.

The firm should continue making a market but should only carry out unsolicited transactions for clients. A complete withdrawal from market-making activities could be a signal to outsiders that a significant transaction is underway

Question 6

Riley and Smith, a broker-dealer, is bringing to market a secondary offering for All Pro Company. One of the reasons All Pro selected the firm to lead the offering is because Riley and Smith has been a market maker for All Pro’s stock for the past five years. The firm is in possession of material nonpublic information relevant to All Pro’s offering. To be in compliance with the Code and Standards, Riley and Smith:

A)
may not serve as underwriter for the same stock in which it acts as a market maker.
B)
should continue to serve as market maker but take only the contra side of unsolicited customer trades.
C)
should abstain from making a market in All Pro stock during the offering period but may resume market making activities after the offering.

Answer 6

B)
should continue to serve as market maker but take only the contra side of unsolicited customer trades.

The firm should continue making a market but should only carry out unsolicited transactions for clients. A complete withdrawal from market-making activities could be a signal to outsiders that a significant transaction is underway

Question 7

Matt O’Neill, CFA, is an advisor for Century Investments, a retail financial services firm. Century has a firmwide policy that its advisors recommend the firm’s own investment products to clients unless Century does not offer a product suitable for the client’s needs. Can O’Neill follow his firm’s policy without violating the Code and Standards?

A)
Yes, if O’Neill discloses this policy to his clients.
B)
Yes, if his firm’s offerings are competitive with other available products.
C)
No, because the policy conflicts with the Standard on loyalty, prudence, and care.

Answer 7

A)
Yes, if O’Neill discloses this policy to his clients.

Standard III(A) Loyalty, Prudence, and Care states that members and candidates must inform clients of any limitations that affect their advisory relationships. A policy to favor recommending a firm’s own products is an example of such a limitation.

Question 8

Ron Brenner, CFA, manages portfolios for individuals. One of his clients, John Perlman, offers Brenner several inducements above those provided by his employer to motivate superior future performance in managing his portfolio. Brenner notifies his manager via e-mail about the terms of this offer, and his employer grants permission. According to the Standard on additional compensation arrangements, Brenner:

A)
must notify “all parties involved,” which includes his other clients.
B)
has taken all the actions required to accept the arrangement.
C)
should decline this arrangement because it could cause partiality in the handling of other client accounts.

Answer 8

B)
has taken all the actions required to accept the arrangement

Brenner’s actions comply with the conditions specified in Standard IV(B) Additional Compensation Arrangements. He notified his employer in writing (e-mail is acceptable) of the terms and conditions of additional compensation arrangement and received permission from his employer. Loyalties to other clients may be affected, but it is the employer’s duty to determine this. Nothing in the Standard specifies that “all parties involved” includes other clients.

Question 9

Ray Brown, CFA, gives prospects his firm’s marketing materials, not prepared by him, that indicate he has a graduate degree from State University, when in fact he did graduate work there but did not receive a degree. Brown informed the marketing department of this error when he first saw it. Brown has:

A)
violated the Standards by misrepresenting his qualifications.
B)
not violated the Standards because he has informed his firm of the mistake.
C)
not violated the Standards because he did not prepare the marketing materials or misrepresent his credentials to his firm.

Answer 9

A)
violated the Standards by misrepresenting his qualifications.

Brown has violated Standard I(C) Misrepresentation by giving prospects firm marketing materials that he knows are incorrect.

Question 10

Jenny Pickler, a Level II CFA Candidate, writes an economic forecast containing several interest rate projections. Her firm’s investment committee reviews Pickler’s report and changes several of the interest rates Pickler had forecast. To comply with CFA Institute Standards, Pickler:

A)
does not need to take any further action.
B)
should ask that her name be removed from the report.
C)
is required to independently review the data supporting the investment committee’s changes.

Answer 10

A)
does not need to take any further action.

According to Standard V(A) Diligence and Reasonable Basis, group consensus is not required in the course of preparation of analytical reports. Pickler would only need to have her name removed from the report if she had reason to believe the investment committee did not have a reasonable and adequate basis for their changes.

Question 11

A member provides a client with an investment performance presentation that does not include detailed information, but reflects the member’s reasonable efforts to present results that are fair, accurate, and complete. Has the member complied with the Standard related to performance presentation?

A)
Yes, the member has met the requirements of the Standard.
B)
No, because the performance presentation must comply with Global Investment Performance Standards.
C)
No, because “reasonable efforts” do not ensure that the presentation is fair, accurate, and complete.

Answer 11

A)
Yes, the member has met the requirements of the Standard.

Brief presentations are acceptable if they include a statement that detailed information is available upon request. Standard III(D) Performance Presentation requires members and candidates to make reasonable efforts to ensure fair, accurate and complete presentation of results. While compliance with GIPS is recommended to meet Standard III(D) obligations, use of GIPS is not required.

Question 12

With respect to the responsibilities of supervisors, the Code and Standards state that those with supervisory responsibility:

A)
may not delegate supervisory responsibility.
B)
are in violation if an employee under their supervision commits securities fraud.
C)
must institute procedures to prevent and detect violations of rules and regulations by those subject to their supervision.

Answer 12

C)
must institute procedures to prevent and detect violations of rules and regulations by those subject to their supervision.

Standard IV(C) Responsibilities of Supervisors requires members and candidates with supervisory responsibility to make reasonable efforts to detect and prevent violations of rules and regulations (as well as of the Code and Standards) by those under their supervision. The fact that violations occur is not necessarily evidence that reasonable efforts were not made. In large organizations, delegating supervisory responsibility may be necessary, but this does not relieve the person with overall authority of supervisory responsibility.

Question 13

George Reilly manages the Ivy Foundation portfolio. The Ivy Foundation has a minimum acceptable return of 7%. The current risk-free rate is 6%. Reilly assumes that returns are normally distributed and wants to choose the optimal portfolio for the foundation. The best approach Reilly should take is to choose the portfolio that:

A)
maximizes the Sharpe ratio.
B)
maximizes the safety-first ratio.
C)
minimizes the standard deviation of returns.

Answer 13

B)
maximizes the safety-first ratio.

Because the Ivy Foundation has a minimum acceptable return that is greater than the risk-free rate, the safety-first ratio is a more suitable criterion than the Sharpe ratio for choosing the optimal portfolio. Given a set of available portfolios, the one that maximizes the safety-first ratio will minimize the probability that the return will be less than the minimum acceptable return if we assume returns are normally distributed. This is the optimal portfolio. Minimizing standard deviation of returns could lead to choosing a portfolio with an expected return below Ivy Foundation’s minimum acceptable return

Question 14

Items that appear in other comprehensive income, but are excluded from the income statement, include:

A)
losses due to expropriation of assets.
B)
gains and losses due to foreign currency translation.
C)
unrealized gains and losses on trading securities.

Answer 14

B)
gains and losses due to foreign currency translation.

Other comprehensive income includes unrealized gains and losses on available-for-sale securities, foreign currency translation gains and losses, minimum pension liability adjustments, and unrealized gains and losses on derivatives used for cash flow hedging.

Unrealized gains and losses on held-for-trading securities are included in net income on the income statement. Losses due to expropriation of assets would be included in net income, most likely as an unusual or infrequent item

Question 15

Other things equal, which of the following conditions would place a company highest on a spectrum of financial reporting quality?

A)
Reported earnings that are not sustainable.
B)
Efforts by management to keep net income steady over time.
C)
Financial statements that reflect the company’s economic activities accurately but are not in compliance with accounting principles.

Answer 15

A)
Reported earnings that are not sustainable.

Earnings quality may be low in a period because of one-time gains that do not otherwise call a company’s financial reporting quality into question. Earnings smoothing or reporting that does not comply with generally accepted accounting principles represents a lower quality of financial reporting.

Question 16

Based on the aggregate demand/aggregate supply model:

A)
an inflationary or recessionary gap may exist in the long run.
B)
actual real GDP is equal to potential real GDP in the long run
C)
no upward or downward pressure on the price level is present at short-run equilibrium.

Answer 16

B)
actual real GDP is equal to potential real GDP in the long run.

In the short run, real GDP can be less than its full-employment level (a recessionary gap that causes downward pressure on prices) or more than its full-employment level (an inflationary gap that causes upward pressure on prices). In long-run macroeconomic equilibrium, actual real GDP is equal to potential real GDP and there is no upward or downward pressure on the price level

Question 17

A continuous uniform distribution is bounded by zero and 20. The probability of an outcome equal to 12 is closest to:

A)
0.00.
B)
0.05.
C)
0.60.

Answer 17

A)
0.00.

Because the distribution is continuous, the probability of any specific outcome is zero

Question 18

XYZ Company has decided to issue $10 million of unsecured bonds. If issued today, the 4% semi-annual coupon bonds would require a market interest rate of 12%. Under U.S. GAAP, how will these bonds affect XYZ’s statement of cash flows?

A)
The coupon payments will decrease operating cash flow each year and the discount will decrease financing cash flow at maturity.
B)
The periodic interest expense will decrease operating cash flow and the discount will decrease financing cash flow at maturity.
C)
The coupon payments and the discount amortization will decrease financing cash flow each year.

Answer 18

A)
The coupon payments will decrease operating cash flow each year and the discount will decrease financing cash flow at maturity.

It is the coupon payment, not the interest expense, that results in an outflow of cash. The difference between the coupon payment and interest expense is the discount amortization. The amortization does not result in a cash outflow. Under U.S. GAAP, the coupon payment is reported as an operating cash flow. The discount, when paid at maturity, is reported as a financing cash flow

Question 19

Placing a tariff on imports of a good is most likely to decrease:

A)
producer surplus for domestic producers of the good.
B)
quantity of the good supplied by domestic producers.
C)
quantity of the good demanded in the domestic market.

Answer 19

C)
quantity of the good demanded in the domestic market.

Placing a tariff on an imported good increases the good’s domestic price, which reduces the quantity demanded. However, the quantity supplied by domestic firms increases with the domestic equilibrium price, as does producer surplus for domestic firms.

Question 20

Consider two currencies, the VKN and the PKR. The PKR is trading at an annual premium of 2.3% relative to the VKN in the forward market. The 1-year risk-free PKR rate is 3.0%. If no arbitrage opportunities are available, the current 1-year risk-free VKN interest rate is closest to:

A)
0.7%.
B)
2.3%.
C)
5.3%.

Answer 20

C)
5.3%.

Because the PKR is trading at a forward premium (the forward VKN/PKR exchange rate is greater than the spot VKN/PKR exchange rate), the VKN interest rate must be greater than the PKR interest rate. VKN should have an interest rate higher than that for PKR by the amount of the forward premium, or approximately 3.0% + 2.3% = 5.3%.

Question 21

Jansen Co., a manufacturer of high-end sports equipment, earned $45 million in net income for the year. The company paid out $1.30 per share in dividends. Jansen issued 500,000 shares at the beginning of the year at $20 (1 million shares were outstanding before the issuance). The market value of Jansen’s trading securities decreased by $2.4 million. The increase in Jansen’s stockholders’ equity is closest to:

A)
$43 million.
B)
$51 million.
C)
$53 million.

Answer 21

C)
$53 million.

The unrealized loss on trading securities is reflected in net income. The total change in stockholder’s equity is:

$45,000,000 − [(1,000,000 + 500,000 shares) × $1.3/share] + (500,000 × $20/share) = $53,050,000

Question 22

Mullins Company’s financial statements include an auditor’s report with a qualified opinion. This most likely implies that the:

A)
auditor is reasonably assured that the financial statements are free of material errors.
B)
financial statements include exceptions to the applicable accounting standards but are presented fairly.
C)
financial statements are materially out of compliance with the applicable accounting standards and are not presented fairly.

Answer 22

B)
financial statements include exceptions to the applicable accounting standards but are presented fairly.

An auditor will issue a qualified opinion if the financial statements include exceptions to applicable accounting standards and will explain the nature and effect of these exceptions. An auditor will issue an adverse opinion if the financial statements are not presented fairly

Question 23

Wilmer Jones owns several restaurants in different cities. His restaurants compete on quality of food and service, price, and marketing. Competitors can enter and exit his markets, and there are usually several competitors in each market. His market structure can best be characterized as:

A)
perfect competition.
B)
monopolistic competition.
C)
oligopoly.

Answer 23

B)
monopolistic competition.

This is an example of monopolistic competition because this market has low barriers to entry and exit, and features product differentiation.

Question 24

When estimating a population mean or constructing a confidence interval based on the central limit theorem:

A)
the midpoint of a confidence interval is a point estimate of the population parameter.
B)
the degree of significance is the probability that the actual value of the parameter lies within the confidence interval.
C)
a point estimate with a 95% degree of confidence is more accurate than a point estimate with a 90% degree of confidence.

Answer 24

A)
the midpoint of a confidence interval is a point estimate of the population parameter.

Confidence intervals for a population mean based on a sample are constructed by multiplying the standard error of a point estimate by a reliability factor, and adding this value to, and subtracting it from, the point estimate. Thus, the point estimate is the midpoint of the confidence interval. The probability that the actual value of the parameter is within a confidence interval is the degree of confidence, which equals one minus the degree of significance. Degrees of confidence or significance apply to confidence intervals but not to point estimates.

Question 25

A firm has undertaken a contract with an estimated total cost of $500 million at a price of $800 million. At the end of the first reporting period, the firm has devoted resources of $180 million to the project. The customer has been billed for $250 million and made payments of $160 million. The amount of revenue the firm should record for the period is closest to:

A)
$180 million.
B)
$250 million.
C)
$290 million.

Answer 25

C)
$290 million.

Using the percentage of total costs incurred to date as an estimate of the portion of the performance obligations completed, revenue should be (180 / 500) × $800 million = $288 million.

Question 26

Inventory cost is most likely to include:

A)
storage costs for finished goods until they are actually sold.
B)
shipping cost for delivery to the customer.
C)
an allocation of fixed production overhead.

Answer 26

C)
an allocation of fixed production overhead.

An allocation of fixed production overhead based on normal production capacity is included in inventory cost. Neither storage costs that are not required as part of the production process nor shipping costs for delivery to the customer are included in inventory cost

Question 27

Which of the following statements most accurately describes the general features of financial statements under IFRS?

A)
All of the required financial statements are prepared using accrual accounting.
B)
Assets may not be offset against liabilities unless specifically permitted or required by a standard.
C)
Prior-period information may only be presented when specifically permitted or required by a standard.

Answer 27

B)
Assets may not be offset against liabilities unless specifically permitted or required by a standard.

One of the general requirements stated in IAS No. 1 is that firms not offset assets against liabilities unless a specific standard permits or requires it. The statement of cash flows is not prepared using accrual accounting. IAS No. 1 states that firms should present comparative information for prior periods unless a specific standard states otherwise.

Question 28

ony Borden is analyzing the earnings of two companies. For each company, Borden estimates a probability that its earnings will exceed the consensus estimate. To estimate the probability that at least one of the companies will exceed its earnings estimate, Borden should use the:

A)
total probability rule.
B)
addition rule of probability.
C)
multiplication rule of probability.

Answer 28

B)
addition rule of probability.

The addition rule of probability is used to calculate the probability that at least one of two events will occur: P(A or B) = P(A) + P(B) − P(AB). The total probability rule is used to calculate the unconditional probability of an event given conditional probabilities related to the event: P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) + … + P(A|BN)P(BN). The multiplication rule of probability is used to calculate the joint probability that two events will occur together: P(AB) = P(A|B) × P(B).

Question 29

A central bank’s policy rate is considered expansionary if it is less than:

A)
the central bank’s target inflation rate.
B)
the long-term growth rate of real economic output.
C)
the sum of the long-term growth rate of real economic output and the target inflation rate.

Answer 29

C)
the sum of the long-term growth rate of real economic output and the target inflation rate.

Monetary policy is said to be expansionary if the central bank’s policy rate is less than the neutral interest rate, which is the sum of the long-term trend rate of real economic growth and the central bank’s target inflation rate.

Question 30

Dot Corporation uses accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. The company has a large cash position which is invested in tax-free municipal bonds. With regard to Dot’s financial statements and tax reporting:

A)
both the interest income and the depreciation method will necessitate the use of a valuation allowance account.
B)
the interest income will result in a deferred tax asset and the depreciation method will result in a deferred tax liability.
C)
the depreciation expense causes a temporary difference between income tax expense and taxes payable, and the interest income creates a permanent difference.

Answer 30

C)
the depreciation expense causes a temporary difference between income tax expense and taxes payable, and the interest income creates a permanent difference.

The interest income from municipal bonds is a permanent difference; thus, no deferred taxes are created and the difference is reflected in the company’s effective tax rate. The different depreciation methods result in temporary differences that are expected to reverse. In the case of depreciation, a deferred tax liability is created. Valuation allowance accounts only apply to deferred tax assets and are created when it becomes probable that the company will not have enough future income to realize the full value of the deferred tax assets.

Question 31

An analyst who expects the economy to experience stagflation should most appropriately recommend investing in:

A)
bonds.
B)
equities.
C)
commodities.

Answer 31

C)
commodities.

Stagflation is a period of economic contraction with increasing inflation, typically brought on by a sharp decrease in aggregate supply. Investments in equities tend to perform poorly in an economic contraction due to decreasing profitability of companies. Fixed income investments decrease in price when nominal interest rates increase due to increases in inflation. Commodity prices tend to increase with inflation

Question 32

Bivac Corp. has been experiencing a declining return on equity over the past few years. Selected financial statement ratios for Bivac appear below:

Prior Year Current Year
Tax Burden 0.60 0.62
Interest Burden 0.80 0.81
EBIT Margin 0.26 0.26
Asset Turnover 1.06 1.06
ROE 0.15 0.14
What is the most likely reason for the decline in Bivac’s ROE?

A)
Leverage has declined.
B)
The tax rate has increased.
C)
Net profit margin has declined.

Answer 32

A)
Leverage has declined.

ROE can be broken out as:

ROE = Tax burden × Interest burden × EBIT Margin × Asset Turnover × Leverage

Prior Year: 0.15 = 0.60 × 0.80 × 0.26 × 1.06 × Leverage

Current Year: 0.14 = 0.62 × 0.81 × 0.26 × 1.06 × Leverage

Solving the equation for leverage reveals that the measure has decreased from 1.13 in the prior year to 1.01 in the current year. This indicates Bivac is using less debt in its capital structure and is the most likely reason the company’s ROE has declined.

The company’s net profit margin has increased:

Net profit margin (Prior Year): 0.60 × 0.80 × 0.26 = 0.12

Net profit margin (Current Year): 0.62 × 0.81 × 0.26 = 0.13

The company’s tax rate has decreased from 0.40 = (1 − 0.60) to 0.38 = (1 − 0.62

Question 33

Sydney Burns is considering the purchase of a bond issued by SubPrime Providers. The bond is highly liquid and has a maturity equal to that of a long-term Treasury bond. The SubPrime Providers bond carries a default risk premium of 5%. Burns notices that the difference in interest rates offered on long-term Treasury bonds and short-term Treasury bills currently equals 4%. The real risk-free rate equals 1% and the expected inflation rate equals 2%. Burns should expect the interest rate on the SubPrime Providers bond to:

A)
be greater than or equal to 4%, and less than or equal to 8%.
B)
be greater than or equal to 5%, and less than or equal to 9%.
C)
be greater than or equal to 7%, and less than or equal to 12%.

Answer 33

C)
be greater than or equal to 7%, and less than or equal to 12%.

The interest rate equals the sum of the real rate, the expected inflation rate, the total risk premium (which equals the sum of the maturity risk premium, the liquidity risk premium, and the default risk premium). The real rate equals 1%, the expected inflation rate equals 2%, the maturity risk premium equals 4%. Treasury bonds have no liquidity or default risk, so the interest rate on a long-term Treasury bond would be expected to equal 7%. Since the SubPrime Providers (long-term) bond incurs default risk, its interest rate must exceed that of the long-term Treasury bond (i.e., 7%). The SubPrime Providers bond is highly liquid, so it has no liquidity premium. The default risk premium for SubPrime Providers bond equals 5%. Taken together, this implies that the SubPrime Provider bond interest rate should exceed the Treasury bond interest by 5 percentage points (12%).

Question 34

An analyst has calculated the arithmetic, harmonic, and geometric mean using the last 10 years of returns on a stock. Which of these means should the analyst most appropriately use to forecast next year’s return on the stock?

A)
Harmonic mean.
B)
Geometric mean.
C)
Arithmetic mean.

Answer 34

C)
Arithmetic mean

The arithmetic mean is statistically the best estimate (expected value) of the next year’s return. The harmonic mean is not typically used to compute the historical performance or forecast the expected performance of an investment; rather it is used to compute the average cost of shares purchased over time. The geometric mean is used to calculate average annual compound returns. It is the best estimate of future multi-year annual compound returns, but the arithmetic mean is the best estimate of a single year’s return

Question 35

A spot exchange rate is 8.6145 and the 1-year forward quotation is +0.25%. The 1-year forward quotation on a points basis is closest to:

A)
2.
B)
25.
C)
215.

Answer 35

C)
215.

Convert the percentage quote to a points quote as 0.0025 × 8.6145 = 0.0215, which is 215 points (each point is 0.0001)

Question 36

Which of the following most likely describes a loss that consumers suffer under an unregulated monopoly compared to a competitive market?

A)
Monopolies produce less goods than a competitive market would.
B)
Costs of production are higher with monopolies.
C)
Monopolists charge the maximum price.

Answer 36

A)
Monopolies produce less goods than a competitive market would.

A reduction in output and increase in price under monopoly decrease consumer surplus and welfare compared to perfect competition. A natural monopoly may have lower costs than several competitive suppliers. Monopolists charge the profit maximizing price, not the “maximum price.”

Question 37

During 20X1, Tusa Company sold machinery with an original cost of $100,000, and recognized a $15,000 gain from the sale. At the time of the sale, the accumulated depreciation of the machinery was $80,000. Ignoring taxes, the machinery sale will produce a:

A)
$15,000 inflow from investing activities.
B)
$20,000 inflow from operating activities.
C)
$35,000 inflow from investing activities.

Answer 37

C)
$35,000 inflow from investing activities.

Ignoring taxes, the cash flow for 20X1 consists of the sale proceeds. The sale proceeds equal $35,000, or the $20,000 book value ($100,000 cost – $80,000 accumulated depreciation) plus the $15,000 gain. The proceeds are reported as an inflow from investing activities.

Question 38

Under the production function approach to modeling economic growth, will growing an economy’s amount of physical capital at a constant rate support long-term economic growth at that rate?

A)
No, because physical capital depreciates over time.
B)
Yes, because output is a positive function of both labor and capital.
C)
No, because physical capital exhibits diminishing marginal productivity.

Answer 38

C)
No, because physical capital exhibits diminishing marginal productivity.

A constant growth rate of physical capital will increase output over time, but because capital exhibits diminishing marginal productivity, the economy will grow at a rate that decreases over time.

Question 39

For a test with sample size n of whether two variables are correlated, the critical values are based on:

A)
n degrees of freedom.
B)
n – 1 degrees of freedom.
C)
n – 2 degrees of freedom.

Answer 39

C)
n – 2 degrees of freedom.

The test statistic for the hypothesis that correlation = 0 follows a t-distribution with n – 2 degrees of freedom

Question 40

Magnus Aerospace produces and sells aircraft and has approximately a 2-year operating cycle. Magnus’s liabilities include commercial paper due in 270 days, a bank note due in one year, and bonds that will mature in 18 months. Magnus should most appropriately classify as current liabilities:

A)
all of these liabilities.
B)
only the commercial paper.
C)
the commercial paper and the bank note.

Answer 40

A)
all of these liabilities.

Current liabilities are obligations due within one year or the company’s operating cycle, whichever is longer. With an operating cycle of two years, Magnus should classify as current any liabilities that must be settled in less than two years.

Question 41

Which model of pricing strategy under imperfect competition requires that firms be able to identify groups of customers that have different elasticities of demand?

A)
Nash equilibrium.
B)
Price discrimination.
C)
Kinked demand curve.

Answer 41

B)
Price discrimination.

For a price discrimination strategy to increase a firm’s profits, the firm must face a downward-sloping demand curve, have at least two identifiable groups of customers that have different price elasticities of demand, and be able to prevent these customers from reselling the product to each other

Question 42

An analyst gathers the following selected financial information on Quip Corp.

Partial financials for 20X8 Quip Corp
Sales $350,000
Cost of goods sold 270,000
Net income 35,000
Current assets 165,000
Current liabilities 130,000
20X8 LIFO reserve 30,000
20X7 LIFO reserve 20,000
To compare Quip and its competitors, an analyst makes the necessary adjustments to restate Quip’s financial statements to reflect the FIFO inventory accounting method. Quip’s adjusted gross profit margin is closest to:

A)
20%.
B)
23%.
C)
26%.

Answer 42

C)
26%.

adjusted cost of goods sold Quip = 270,000 − (30,000 − 20,000) = 260,000

adjusted gross profit margin Quip = (350,000 − 260,000) / 350,000 = 0.257 ≈ 26%

Question 43

Martin Zwingle is making a capital allocation decision with regard to a new project. The initial expense of the project would cause the company’s earnings per share for the current year to come in below analysts’ expectations. If Zwingle decides against the project, his firm will allocate his division a smaller capital budget next year. Which of these factors are appropriate for Zwingle to include in the capital allocation decision?

A)
Both of these factors are appropriate.
B)
Neither of these factors is appropriate.
C)
Only one of these factors is appropriate.

Answer 43

B)
Neither of these factors is appropriate.

Two common capital allocation pitfalls are basing investment decisions on the change in earnings per share in the short term and considering the effects of not spending the entire capital budget available for the current period.

Question 44

Mentemeyer Corporation is a small firm that needs to increase short-term liquidity but has weak credit. The source of short-term financing that would most likely be available to Mentemeyer is:

A)
commercial paper.
B)
nonbank finance companies.
C)
a revolving credit agreement.

Answer 44

B)
nonbank finance companies.

Nonbank finance companies are a source of short-term financing for smaller firms and firms with lower credit ratings. Commercial paper issuance and revolving credit agreements are typically only available to larger corporations with high credit ratings

Question 45

While analyzing HMS Inc., Fred Browne notes that the company’s liquidity as measured by its quick ratio has decreased over time while its current liabilities have remained constant. This could be explained by:

A)
a decrease in inventory.
B)
an increase in marketable securities.
C)
a decrease in accounts receivable.

Answer 45

C)
a decrease in accounts receivable.

The quick ratio is defined as: (cash + marketable securities + accounts receivable) / current liabilities. If current liabilities have remained constant, cash, marketable securities, or accounts receivable must have decreased. Inventory is not included in the quick ratio.

Question 46

Compared to a normal distribution, historical returns on major asset classes in developed markets have exhibited:

A)
less frequent large positive deviations.
B)
more frequent large negative deviations.
C)
the expected frequency of large deviations.

Answer 46

B)
more frequent large negative deviations.

Historical data from global asset markets show that returns distributions exhibit negative skewness and positive excess kurtosis. Large negative deviations, and large deviations in general, have been more frequent than would be expected if returns were normally distributed

Question 47

Which of the following pooled investments is likely to require the smallest minimum investment amount?

A)
Wrap fee account.
B)
Market neutral fund.
C)
Closed-end mutual fund.

Answer 47

C)
Closed-end mutual fund.

Closed-end mutual fund shares can be purchased for market-determined prices. Hedge funds (which include market neutral funds) and wrap fee (separately managed) accounts typically require substantial minimum investment amounts.

Question 48

An owner of a business is most likely to have limited liability if he is a:

A)
shareholder.
B)
sole proprietor.
C)
general partner.

Answer 48

A)
shareholder.

Shareholders are the owners of a corporation and have limited liability. Sole proprietors and general partners have unlimited liability.

Question 49

The sensitivity of a derivative’s value to the price of the underlying asset is measured by the derivative’s:

A)
beta.
B)
delta.
C)
gamma.

Answer 49

B)
delta.

Delta measures the sensitivity of a derivative’s value to the price of its underlying asset. Gamma measures the sensitivity of delta to the price of the underlying asset. Beta measures the market risk of a security

Question 50

Other things equal, a company’s operating breakeven level of sales is most likely to increase when:

A)
the tax rate is increased.
Incorrect Answer
B)
its scale of operations is increased.
C)
fixed interest charges are increased.

Answer 50

B)
its scale of operations is increased.

Question 51

To choose the weights for a firm’s weighted average cost of capital (WACC), an analyst would most prefer to use the

A)
firm’s current debt and equity weights based on market value.
B)
firm’s stated target capital structure even if recent fund raising has diverged slightly from the target weights.
C)
average debt and equity weights based on market value of the firm’s competitors.

Answer 51

B)
firm’s stated target capital structure even if recent fund raising has diverged slightly from the target weights.

The analyst should use the target capital structure weighting if possible (i.e., if the firm has stated its target weights). If the targets are unstated, the analyst must estimate the weights.

Question 52

An appropriate way to address the effectiveness of a company’s management in creating value for shareholders is to compare the company’s:

A)
net profit margin to its cost of equity.
B)
weighted average cost of capital to its return on invested capital.
C)
total cost of debt and equity financing to its earnings before interest and taxes.

Answer 52

B)
weighted average cost of capital to its return on invested capital.

When the return on invested capital exceeds the weighted average cost of capital, firm management is creating value for shareholders

Question 53

A stakeholder who would most likely oppose a significant debt-funded corporate expansion into a new product area is:

A)
an auditor employed by the company.
B)
an employee with company-specific skills.
C)
a holder of the company’s convertible preferred stock.

Answer 53

B)
an employee with company-specific skills.

A significant debt-funded expansion will very likely increase a company’s financial risk. An employee with company-specific skills stands to lose more in the event the company has significant financial distress or enters bankruptcy than an employee with skills that are easily transferred to other employment, such as an accountant. Holders of convertible preferred stock participate in the upside gains of the company, so they would not necessarily be opposed to corporate expansion supported by debt.

Question 54

The problem of investment managers taking offsetting active positions is most likely addressed by employing:

A)
risk budgeting.
B)
tactical asset allocation
C)
a core-satellite approach.

Answer 54

C)
a core-satellite approach.

With a core-satellite approach, a majority of the assets are invested passively (in the “core” portfolio) with a smaller proportion in actively managed “satellite” portfolios. This reduces the likelihood of excessive trading and offsetting active positions

Question 55

Bearing unsystematic risk should provide no additional expected return:

A)
under any circumstances.
B)
if diversification is cost-free.
C)
in a strong-form efficient market.

Answer 55

B)
if diversification is cost-free.

The theory that bearing unsystematic risk will provide no additional expected return assumes that unsystematic risk can be diversified away at no cost

Question 56

An investor buys a non-dividend paying stock for $100 at the beginning of the year with 50% initial margin. At the end of the year, the stock price is $95. Deflation of 2% occurred during the year. Which of the following return measures for this investment will be greatest?

A)
Real return.
B)
Nominal return.
C)
Leveraged return

Answer 56

A)
Real return.

No calculations are needed. The real return is greater than the nominal return because the inflation rate is negative. The leveraged return is more negative than the nominal return because the investment lost value and leverage magnifies the loss.

Question 57

A bond pays a quarterly coupon of 8% minus one-half of an annual 90-day market reference rate. This bond is most accurately classified as a:

A)
leveraged instrument.
B)
participation instrument.
C)
yield enhancement instrument.

Answer 57

A)
leveraged instrument.

An inverse floater is classified as a leveraged instrument. The example given here is a deleveraged inverse floater because the multiplier for the reference rate is less than one

Question 58

A leveraged buyout fund is evaluating Siena Company relative to its peer companies. Siena is most likely a good candidate for a management buy-in if it has:

A)
higher cash flow and less capable managers than its peers.
B)
lower cash flow and more capable managers than its peers.
C)
higher cash flow and more capable managers than its peers

Answer 58

A)
higher cash flow and less capable managers than its peers.

In a management buy-in, a leveraged buyout (LBO) fund replaces the existing managers of a portfolio company with a new team it believes can increase the value of the company. Companies with high cash flow are attractive candidates for LBOs because their cash flow can help service the debt issued to finance the LBO. A company with high cash flow and capable managers is a potential candidate for a management buyout (MBO), a transaction in which the managers participate and stay on after the company goes private

Question 59

An investor in a sponsored depository receipt (DR):

A)
holds the voting rights for the DR shares.
B)
must obtain the foreign currency in which the DR is traded.
C)
should be familiar with market procedures and regulations in the DR issuer’s country.

Answer 59

A)
holds the voting rights for the DR shares.

In a sponsored DR, voting rights of the shares are held by the investor. In an unsponsored DR, voting rights are retained by the depository bank. An advantage of DR shares over direct investments in foreign companies is that DR shares trade in the investor’s domestic market and currency

Question 60

Which of the following mortgage-backed securities is most likely to feature credit tranching?

A)
Collateralized mortgage obligations.
B)
Commercial mortgage-backed securities.
C)
Agency residential mortgage-backed securities.

Answer 60

B)
Commercial mortgage-backed securities.

Commercial mortgage-backed securities often feature credit tranching in which subordinated tranches are the first to absorb credit losses. Sequential-pay CMOs employ time tranching in which all principal payments flow to Tranche 1 up to its principal amount, then to Tranche 2 up to its principal amount, and so on. Agency RMBS are pass-through securities and do not feature credit tranching or time tranching

Question 61

Ian Goode is analyzing the price of the preferred stock of MegaGym. Goode estimates that MegaGym’s earnings growth rate over the next five years will be 20%, and that MegaGym’s earnings will then grow at a sustainable rate of 5%. The most appropriate method for Goode to value MegaGym’s preferred stock is to:

A)
use a justified price-to-earnings multiple.
B)
use a multistage dividend discount model with 20% growth for five years and 5% thereafter.
C)
divide the preferred dividend by the required rate of return on MegaGym’s preferred stock.

Answer 61

C)
divide the preferred dividend by the required rate of return on MegaGym’s preferred stock.

The value of preferred stock is the preferred dividend divided by the required rate of return on the preferred. Earnings growth rates do not factor into the valuation of preferred stock since the dividend is typically fixed. Therefore, neither a historical price-to-earnings model nor a multistage dividend discount model is appropriate.

Question 62

Roland Carlson owns a portfolio of large capitalization stocks. Carlson has a positive long-term outlook for the stock market, but would like to protect his portfolio from any sudden declines in the stock market, without selling his holdings. The most likely way for Carlson to achieve his objective of limiting the downside risk of his portfolio is to:

A)
sell put options on the S&P 500.
B)
sell an S&P 500 futures contract.
C)
buy an S&P 500 forward contract.

Answer 62

B)
sell an S&P 500 futures contract.

Losses on Carlson’s portfolio of large cap stocks can be offset by gains on a short position in a futures contract. (Gains on the portfolio would be offset by futures losses.) He could also buy put options on the S&P 500. A long position in an S&P 500 forward contract would not offer any downside protection.

Question 63

Which of the following forward rates can be used to construct a forward yield curve?

A)
1-year and 2-year forward rates one year from now.
B)
1-year forward rates one year and two years from now.
C)
1-year forward rate one year from now and 2-year forward rate two years from now.

Answer 63

B)
1-year forward rates one year and two years from now.

A forward yield curve is composed of forward rates of the same tenor at different future periods.

Question 64

Industry rotation is best described as:

A)
adjusting the industry weights in a portfolio based on the current stage of the business cycle.
B)
a recommended practice of periodically changing the industries that investment analysts are assigned to cover.
C)
the long-term trend of talented managers and employees exiting mature and declining industries and entering embryonic and growth industries.

Answer 64

A)
adjusting the industry weights in a portfolio based on the current stage of the business cycle.

Industry rotation is an active management strategy of overweighting or underweighting industries, compared to their strategic allocation weights, based on the stage of the business cycle.

Question 65

An alternative investment partnership with a 2-and-20 fee structure has increased in value each period and earned a return of 8% net of management fees in 20x7. Under which of the following provisions would incentive fees for 20x7 be the highest?

A)
5% hard hurdle rate and a high water mark provision.
B)
6% soft hurdle rate and a high water mark provision.
C)
7% hard hurdle rate and no high water mark provision.

Answer 65

B)
6% soft hurdle rate and a high water mark provision.

With a soft hurdle rate, the incentive fee is a percentage of the entire return once the hurdle rate is met. With a hard hurdle rate, the incentive fee is a percentage of return in excess of the hurdle rate. A high water mark does not affect the incentive fee for an account that has increased in value each period. A soft hurdle rate would result in incentive fees of 20% × 8% = 1.6% of assets; a 5% hard hurdle rate would result in incentive fees of 20% × (8% − 5%) = 0.6% of assets; and a 7% hard hurdle rate would result in incentive fees of 20% × (8% − 7%) = 0.2% of assets.

Question 66

Contingent convertible bonds are described most accurately as those which, if a specified event occurs:

A)
become convertible to equity.
B)
convert automatically to equity.
C)
increase the equity conversion ratio.

Answer 66

B)
convert automatically to equity.

Contingent convertible bonds are converted automatically to common stock if a specified event occurs.

Question 67

Which of the following types of index is least likely to require frequent reconstitution of constituent securities?

A)
Equity index.
B)
Commodity index.
C)
Fixed income index.

Answer 67

A)
Equity index.

Equity indexes typically require reconstitution only in response to corporate events, such as mergers or bankruptcies. Commodity indexes, which use futures contracts as their constituent securities, and fixed income indexes require frequent reconstitution as futures contracts expire and bonds mature.

Question 68

A synthetic collateralized debt obligation is backed by a portfolio of:

A)
credit default swap
B)
structured securities.
C)
bonds and other CDOs.

Answer 68

A)
credit default swaps.

Synthetic CDOs have portfolios of credit default swaps as the underlying collateral

Question 69

An investor places a market order to buy a stock on the holder-of-record date for the stock’s next dividend. Is the investor entitled to receive this dividend?

A)
No, because the order is placed after the declaration date.
B)
No, because the order is settled after the holder-of-record date.
C)
Yes, because the order is executed on the holder-of-record date.

Answer 69

B)
No, because the order is settled after the holder-of-record date.

To receive the next dividend, an investor must buy a stock before its ex-dividend date, which is one or two business days before the holder-of-record date. This one- or two-day period allows orders executed before the ex-dividend date to be settled by the holder-of-record date. The buyer would be entitled to the dividend if the order was executed after the declaration date but before the ex-dividend date

Question 70

Ann Lloyd observes that a 3-year senior unsecured bond of Hawk, Inc. has a rating of Baa3/BBB– and a 3-year senior unsecured bond of Osprey, Inc. has a rating of Ba1/BB+. Based only on this information, Lloyd can most appropriately conclude that:

A)
credit risk is greater for the Osprey bond than for the Hawk bond.
B)
loss severity is greater for the Osprey bond than for the Hawk bond.
C)
the Hawk bond is investment grade and the Osprey bond is non-investment grade.

Answer 70

C)
the Hawk bond is investment grade and the Osprey bond is non-investment grade.

The classifications “investment grade” and “non-investment grade” are based on ratings from recognized credit rating agencies. Bonds rated Baa3/BBB– or higher are classified as investment grade, while bonds rated Ba1/BB+ or lower are classified as non-investment grade. However, an analyst should not rely exclusively on credit ratings to draw conclusions about the credit risk or loss severity of bond investments.

Question 71

An analyst develops the following information to value a common stock.

Last year’s earnings per share = $4.00
Real risk-free rate = 4%
Inflation premium = 5%
Return on equity (ROE), expected to remain constant in the future = 10%
Dividend payout, expected to remain stable in the future = 30%
Stock’s beta = 1.4
Expected market return = 14%
The value per share is closest to:

A)
$14.39.
B)
$21.28.
C)
$31.39.

Answer 71

A)
$14.39.

RFRnominal = (1 + RFRreal)(1 + IP) − 1 = (1.04)(1.05) − 1 = 1.0920 − 1 = 0.0920 = 9.20%

Using the CAPM, the required rate of return (ke) = RFRnominal + β(Rmkt − RFRnominal) = 9.20% + 1.4(14.0% − 9.2%) = 9.20% + 6.72% = 15.92%

The retention rate (RR) = 1 − dividend payout ratio = 1 − 0.30 = 0.70

The growth rate (gc) = (RR)(ROE) = (0.70)(10%) = 7.00%

D0 = E0(dividend payout) = $4.00(0.30) = $1.20

Next year’s dividend (D1) = D0(1 + gc) = $1.20(1 + 0.07) = 1.284

P0 = D1 / (ke − g) = 1.284 / (0.1592 − 0.07) = 14.39

Question 72

Kate Johnson owns shares of a stock that currently trades at $15. If Johnson wants to buy more shares if the price increases to $17, she should enter a:

A)
stop buy order at $17.
B)
limit order to buy at $17.
C)
market order to buy at $17.

Answer 72

A)
stop buy order at $17.

An order to buy if a price increases to a specified level is a stop buy order. A limit order at $17 will execute immediately if the market price is $15. A market order does not specify a price, but is executed at the prevailing market price.

Question 73

A put option with an exercise price of $75 sells for a premium of $10. At expiration, the put buyer may experience a loss:

A)
of as much as $10.
B)
of as much as $65.
C)
that is theoretically unlimited.

Answer 73

A)
of as much as $10.

The greatest loss a put buyer can experience is the premium paid. If the price of the underlying asset decreased to zero, the put writer would experience a loss of ($0 – $75) + $10 = –$65.

Question 74

Chris Renburg owns the following portfolio of option-free bonds:

Par value Full price Duration
$3,000,000 $2,400,000 4.625
$3,500,000 $3,600,000 7.322
$1,500,000 $1,200,000 9.300
$8,000,000 $7,200,000
The duration of Renburg’s bond portfolio is closest to:

A)
6.6.
B)
6.8.
C)
7.0.

Answer 74

B)
6.8.

Portfolio duration is the weighted average of component securities, using full prices:

(2,400,000 / 7,200,000) × 4.625 + (3,600,000 / 7,200,000) × 7.322 + (1,200,000 / 7,200,000) × 9.3 = 6.753

Question 75

The convenience yield associated with holding the underlying asset of a derivative is most accurately described as:

A)
the nonmonetary benefits of holding the asset.
B)
the monetary and nonmonetary benefits of holding the asset.
C)
the monetary and nonmonetary benefits of holding the asset, net of its holding costs.

Answer 75

A)
the nonmonetary benefits of holding the asset.

Convenience yield refers to the nonmonetary benefits of holding an asset. An example is being in a position to sell an overvalued asset that is difficult to sell short. Convenience yield does not include monetary benefits such as interest and dividend income. The costs of holding the asset, net of the monetary and nonmonetary benefits of holding it, is referred to as the net cost of carry.

Question 76

Enterprise value is most accurately interpreted as the:

A)
cost to take over a firm.
B)
fair market value of a firm’s equity.
C)
market value of a firm’s equity plus the market value of its debt.

Answer 76

A)
cost to take over a firm.

Enterprise value equals the market value of a firm’s common stock and debt minus its cash and short-term securities. Enterprise value is interpreted as the amount that would be needed to take over a firm.

Question 77

The period of time during which a private capital fund will select investments and direct committed capital to them is best described as a:

A)
notice period.
B)
lockup period.
C)
drawdown period.

Answer 77

C)
drawdown period.

The drawdown period for a private equity fund is the span of time over which the fund will draw down its committed capital and use it to invest in portfolio companies. Lockup periods and notice periods are related to hedge fund redemptions

Question 78

An investor writes a put option that will expire in six months with an exercise price of 23 when the underlying price is 20. The investor will collect a premium that is:

A)
equal to 3.
B)
less than 3.
C)
greater than 3.

Answer 78

C)
greater than 3.

The option premium at initiation will equal the option’s exercise value of 23 – 20 = 3 plus some positive time value.

Question 79

For an underlying asset with no holding costs or benefits, the no-arbitrage forward price equals:

A)
the spot price.
B)
the future value of the spot price.
C)
zero at initiation of a forward contract.

Answer 79

B)
the future value of the spot price.

With no costs or benefits to holding the underlying asset, the no-arbitrage forward price is the future value of the spot price, compounded at the risk-free rate over the term of a forward contract.

Question 80

A bond indenture states that the source of funds for repayment will be tolls paid by drivers using a highway constructed with the bond proceeds. This bond is most likely a:

A)
secured bond.
B)
revenue bond.
C)
quasi-government bond.

Answer 80

B)
revenue bond.

Revenue bonds are municipal bonds that will be repaid from revenues generated by a specific project such as a toll road. Secured bonds have specific assets pledged as collateral. Quasi-government entities are agencies created by sovereign governments

Question 81

A collateralized mortgage obligation with agency RMBS as the collateral is least likely to be created to offer securities with less:

A)
default risk than the underlying RMBS.
B)
extension risk than the underlying RMBS.
C)
prepayment risk than the underlying RMBS.

Answer 81

A)
default risk than the underlying RMBS.

Agency CMOs are created to reapportion prepayment risk, which includes extension and contraction risk. Agency CMOs have little or no default risk because they are backed by the government or by GSEs.

Question 82

Jim Boo is analyzing Justin Corp., a maker of home appliances. Boo’s research provides the following facts:

Justin’s stock price is $60 per share.
Expected growth rate of dividends is 5%.
Expected retention rate is 60%.
Required rate of return is 10%.
Justin’s expected price to earnings ratio (P0/E1) is closest to:

A)
8.0x.
B)
10.0x.
C)
12.0x.

Answer 82

A)
8.0x.

D1/E1 / K-g

(1-0.6)/0.1-0.05 = 8

Question 83

Bond X carries a rating of BBB-/Baa3. Bond Y has a rating of B/B2. Both bonds mature in 10 years. Which bond’s value would be most affected by a ratings downgrade, and which bond has the higher default risk?

A)
Bond X would be more affected by a ratings downgrade, but Bond Y has higher default risk.
B)
Bond Y would be more affected by a ratings downgrade, but Bond X has higher default risk.
C)
Bond X has higher default risk, but both bonds would experience similar effects of a ratings downgrade.

Answer 83

A)
Bond X would be more affected by a ratings downgrade, but Bond Y has higher default risk.

Bond X carries the lowest investment grade rating. If it is downgraded, it will fall to a speculative rating, and many investors will be restricted from owning it. A downgrade would therefore have a more significant impact on Bond X. Bond Y carries a speculative rating that implies more risk of default than the higher rated Bond X.

Question 84

An investor purchased a stock for $60 a share using margin from his broker. If the initial margin requirement is 40%, and the maintenance margin requirement is 20%, a margin call will initially be triggered below a share price of:

A)
$30.
B)
$45
C)
$48.

Answer 84

B)
$45.

(1-0.4)/(1-0.2) = 0.75
0.75 x 60 = 45

Question 85

Arkex Funds is a hedge fund with a value of $100 million at the beginning of the year. Arkex Funds charges a 2.0% management fee based on assets under management at the beginning of the year and a 20.0% incentive fee with a 5.0% hard hurdle rate. Incentive fees are calculated net of management fees. The value of the fund at the end of the year before fees is $110 million. The net return to investors is closest to:

A)
6.8%.
B)
7.4%.
C)
8.0%.

Answer 85

B)
7.4%.

Management fee = $100 million × 2.0% = $2.0 million

Incentive fee = [$110 million − $100 million − $2 million − ($100 million × 5.0%)] × 20% = $0.6 million

Total fee = $2.0 million + $0.6 million = $2.6 million

End-of-year value after fees = $110.0 − $2.60 = $107.4 million

Net return = ($107.4 million / $100.0 million) − 1 = 7.4%.

Question 86

An investor buys an annual pay, 4% coupon bond for 102. The trade will settle immediately after the annual coupon payment and the bond has five years left to maturity. The investor sells the bond two years later for 101.5. The investor’s holding period return on the bond includes:

A)
a capital loss.
B)
a capital gain.
C)
neither a capital loss nor gain.

Answer 86

B)
a capital gain.

The yield to maturity at the time of purchase is:

N = 5; PV = –102; PMT = 4; FV = 100; CPT I/Y = 3.5563%.

The bond’s constant-yield price two years later is:

N = 3; I/Y = 3.5563; PMT = 4; FV = 100; CPT PV = –101.24.

Because the price is greater than the constant-yield price, the investor has a capital gain on the sale.

Question 87

Gerald Snow is a bond manager for Long Vision Investments. Snow is evaluating potential arbitrage opportunities. He has the following list of bonds:

Bond X is a 1-year zero coupon bond selling at 950.
Bond Y is a 2-year zero coupon bond selling at 850.
Bond Z is a 2-year bond with an annual coupon of 8%.
All three bonds have a par value of $1,000. If no arbitrage opportunity exists, the price of Bond Z is closest to:

A)
$975.
B)
$995.
C)
$1,015.

Answer 87

B)
$995.

Bond X = 1000 / 950 = 1.0526; Bond Y = 1000 / 850 = 1.1765

80 / (1.0526) = 76; 1080 / (1.1765) = 917.98

Bond Z = 76 + 917.98 = 993.98 ≈ 995

The arbitrage-free valuation approach applies time-appropriate spot interest rates to each cash flow of the bond

Question 88

Larry Rile is evaluating the investment merits of Bing Corp., a successful motorcycle manufacturer. Rile is forecasting a dividend in year 1 of $1.50 per share, a dividend in year 2 of $3.00 per share, and a dividend in year 3 of $4.50 per share. After year 3, Rile expects dividends to grow at the rate of 6% per year. Rile calculates a beta of 1.3 for Bing. Rile expects the S&P 500 index to return 8%. The U.S. Treasury bill is yielding 2%. Using the multistage dividend discount model, Bing’s intrinsic value is closest to:

A)
$92 per share.
B)
$102 per share.
C)
$112 per share.

Answer 88

B)
$102 per share.

D1 = 1.50
D2 = 3.00
D3 = 4.50
g = 0.06

required return = RFR + β(Rm − RFR)
required return = 0.02 + 1.3(0.08 − 0.02) = 0.098

p3 = 4.50 x 1.06/(0.098-0.06) = 125.53

v= 1.50/1.098 + 3/1.098’2 + (4.50 + 125.53)/1.098’3 = 102.08