Free CFA Institute CFA-Level-II Exam Questions

Cummings Enterprises, Inc. (CEI), is a U .S . conglomerate that operates in a variety of markets. One of CEI's divisions manufactures small fiberglass products, such as bird baths and outdoor storage lockers. CEI is currently considering the expansion of its fiberglass product line to include booms and buckets for aerial lift trucks (often called cherry pickers) which are used for applications such as high voltage power line maintenance. The addition of this new product line is expected to increase CEI's sales by $750,000 per year.Cal Holbrook, CEI's manager of fiberglass operations, is deciding whether to purchase a robotic system to produce cherry picker booms and buckets. The price of the robotic system will be $700,000, plus an additional $ 100,000 for shipping, site preparation and installation. The new equipment will require a $50,000 increase in inventory and a $20,000 increase in accounts payable. The company uses MACRS to calculate depreciation for tax purposes and the straight-line method for financial reporting. The project has an expected life of four years, at which time the robot is expected to be sold for $75,000. The project will be funded with the debt/equity mix reflected by the company's current capital structure. CEI's pretax cost of new debt is 7%. Assume a WACC of' 8%. Some of the relevant end-of-year cash flows for the robotic project are presented in Exhibit 1.Holbrook calculates the NPV of the robotic project and presents his findings to his supervisor, Geoffrey Mans. After reviewing the report, Mans makes the following recommendations:1 'You forgot to include the $ 100,000 we have spent so far on consultants and project engineers and who knows what else to evaluate the project's feasibility. Rerun the numbers including that amount and get the revised calculations to me this afternoon.'2. 'Rerun the analysis assuming straight-line depreciation for tax purposes. The NPV will be higher, and we'll be more likely to get the project funded.'Cummings has two other projects under consideration that would affect the production of storage lockers. Project 1 relates to changing the production process, and Project 2 relates to expanding the distribution facility. Holbrook estimates the NPV of the expected cash flows for Project 1 at negative $7 million. An additional investment of $3 million would allow management to more rapidly adjust to the demand for a certain type of locker. The value of this flexibility is estimated at $9 million. He estimates that the NPV of the expected cash flows for Project 2 at $3 million. An expansion option would require an additional investment of $2 million. At this time, Cummings does not have any capital rationing restrictions.Holbrook emails the lead analyst for the budgeting group and indicates that he cannot make a decision on Project 2 without knowing the value the expansion option will provide.Holbrook calls a capital budgeting meeting with CEI's production manager and quality control manager. Holbrook opens the meeting by stating: 'I think we should accept this project based solely on the fact that it provides great operating margins. Nevertheless, I think we should conduct net present value (NPV) analysis to confirm my opinion.' Holbrook then receives the following comments:Comment 1:It is important that interest is included in the discounted cash flows used with NPV analysis because interest is a real and very significant expense.Comment 2:If applied correctly, the NPV of this project will be higher if we discount economic profits instead of net after-tax operating cash flows in our analysis. I suggest we calculate economic profit as net operating profit after tax minus the dollar cost of capital.The economic income for year 3 for the robotics project from Exhibit 1 is closest to:

Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1.The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides detail about the Alpha Fund with a vintage year of 2006 and committed capital of SI95 million.The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's new drug pipeline, a company value of $300 million is reasonable in five years. Management at Alpha Fund views Targus Company as a risky investment and is using a discount rate of 40%. After a thorough analysis of Targus's future prospects, Alpha Fund's management believes that there is a possible 15% risk of failure for the company.Using Exhibit 2 and assuming a 20?rried interest, the Alpha Fund's 2008 dollar amount of carried interest is closest to:

James Kelley is the CFO of X-Sport Inc., a manufacturer of high-end outdoor sporting equipment. Using both debt and equity, X-Sport has been acquiring small competitor companies rather rapidly over the past few years, leading Kelley to believe that the firm's capital structure may have drifted from its optimal mix. Kelley has been asked by the board of directors to evaluate the situation and provide a presentation that includes details of the firm's capita! structure as well as a risk assessment. In order to assist with his analysis, Kelley has collected information on the current financial situation of X-Sport. He has also projected the financial information for alternative financing plans. This information is presented in Exhibit 1.After carefully analyzing the data, Kelley writes his analysis and proposal and submits the report to Richard Haywood, the chairman and CEO of X-Sport Inc. Excerpts from the analysis and proposal follow:* In selecting a re-financing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current Baa rating, causing our cost of debt to rise dramatically. This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest tax shield will be more than The marginal increase in the costs of financial distress. However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of X-Sport management with its shareholders.* In the event that X-Sport decides to proceed with a recapitalization plan, I recommend Plan D since it is the most consistent with the shareholders' interests.Haywood reviews the report and calls Kelley into his office to discuss the proposal. Haywood suggests that Flan B would be the most appropriate choice for adjusting X-Sport's capital structure. Before Kelley can argue, however, the two are interrupted by a previously scheduled meeting with a supplier.Haywood takes Kelley's data and proposes to the board of directors that X-Sport pursue one of three alternatives to restructure the company. The first alternative is Plan B from Kelley's analysis. The second alternative involves separating GearTech, one of the companies acquired over the last few years, from the rest of the company by issuing new GearTech shares to X-Sport common shareholders. The third alternative involves creating a new company, Euro-Sport, out of the firm's European operations and selling 35% of the new Euro-Sport shares to the public while retaining 65% of the shares within X-Sport. After some persuading, Haywood convinces the seven-member board (two of whom were former executives at GearTech) to accept the second alternative, which he had favored from the beginning. The board puts together an announcement to its shareholders as well as the general public, detailing the terms and goals of the plan.A group of shareholders, upset about the board's plan, submit a formal objection to X-Sport's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of the company and its shareholders. The objection also states that:* The value of X-Sport's common stock has been impaired as a result of the poor corporate governance system.* The liability risk of X-Sport has increased due to the increased possibility of future transactions that benefit X-Sport's directors, without regard to the long-term interests of shareholders.* The asset risk of X-Sport has increased due to the inability of investors to trust the GearTech financial disclosures necessary to value the division.Which of the following best explains the difference between X-Sport's current cost of debt and the cost of debt associated with Plan A?

Mary Pierce, CFA, has just joined The James Group as a fixed income security analyst. Pierce has taken over for Katy Williams, who left The James Group to start her own investment firm. Pierce has been reviewing Williams's files, which include data on a number of securities that Williams had been reviewing.The first file had information on several different asset-backed securities. A summary schedule that Williams had prepared is shown in Exhibit 1.Exhibit 1: Summary ScheduleThe second file included the following schedule of information relating to a specific CMO thai Williams had been considering. Exhibit 2 reflects the results of a Monte Carlo simulation based on 15% volatility of interest rates. This security is stil! available, and Pierce needs to evaluate the investment merit of any or all of the listed tranches.A third file contained notes Williams had laken at a seminar a couple of months ago on valuing various types of asset-backed and mortgage-backed securities. These notes included the following comments that Pierce found interesting:'Cash flow yield (CFY) is one method of valuing mortgage-backed securities. An advantage of the CFY is that it does not rely on any specific prepayment assumptions. An important weakness of CFY is the assumption that interim cash flows will be reinvested at the CFY. This is rarely true for mortgage-backed securities.''Cash flow duration is similar to effective duration, but its weakness is that it fails to fully account for changes in prepayment rates as cash flow yields change. Empirical duration suffers two disadvantages as a measure of interest rate exposure: reliance on theoretical formulas and reliance on historical pricing data that may not exist for many mortgage-backed securities.''The recent increase in the default rate for subprime adjustable rate mortgages can be traced to the structure of these loans. The negative amortization feature of these loans basically gave the borrower an at-the-money call option on their property. Once the property decreased in value, this call option was worthless, and the borrower had no incentive to make any additional payments.'Pierce realizes that she will need to do a more in-depth analysis, but based only on the information in Williams's CMO table, she can conclude that:

Amie Lear, CFA, is a quantitative analyst employed by a brokerage firm. She has been assigned by her supervisor to cover a number of different equity and debt investments. One of the investments is Taylor, Inc. (Taylor), a manufacturer of a wide range of children's toys. Based on her extensive analysis, she determines that her expected return on the stock, given Taylor's risks, is 10%. In applying the capital asset pricing model (CAPM), the result is a 12% rate of return.For her analysis of the returns of Devon, Inc. (Devon), a manufacturer of high-end sports apparel, Lear intends to use the Fama-French model (FFM). Devon is a small-cap growth stock that has traded at a low market-to-book value in recent years. Lear's analysis has provided a wealth of quantitative information to consider. The return on a value-weighted market index minus the risk-free rate is 5.5%, the small-cap return premium is 3.1%, the value return premium is 2.2%, and the liquidity premium is 3.3%. The risk-free rate is 3.4%. The market, size, relative value, and liquidity betas for Devon are 0.7, -0.3, 1.4, and 1.2, respectively. In estimating the appropriate equity risk premium, Lear has chosen to use the Gordon growth model.Lear's assistant, Doug Saunders, presents her with a report on macroeconomic multifactor models that includes the following two statements:Statement 1: Business cycle risk represents the unexpected change in the difference between the return of risky corporate bonds and government bonds.Statement 2: Confidence risk represents the unexpected change in the level of real business activity.Lear is also attempting to determine the most appropriate method for determining the required return for Densmore, Inc. (Densmore), a closely held company that is considering a debt issue within the next year. The company has not previously issued debt securities to the public, relying instead on bank financing. She realizes that there are a number of models to consider, including the CAPM, multifactor models, and build-up models.Based on Lear's analysis, Taylor's stock is most likely to be: